Corporate Governance and Ethics


Studying this chapter should provide you with the knowledge to:

  1. Discuss the purposes of a corporation, including the shareholder primacy model and the stakeholder model.
  2. Explain the role of the board of directors in governing the corporation and their duties to shareholders and other stakeholders.
  3. Identify major ethical challenges managers face at each stage of the value chain.

In 1852, Henry Wells and William Fargo sat together in New York City and formed a joint stock company to provide banking and delivery services to a rapidly growing territory as far away from New York as possible: California. The new bank gained a reputation for dependa- bility and trust in transporting shipments of gold and other financial projects over its stagecoach network. While technology has grown from coaches to split-second electronic exchanges, the stagecoach continued to represent the company’s pioneering spirit, commit- ment to customer service, and, above all, reliability and trust.
Jim Collins and Jerry Porras wrote about Wells Fargo as a built-to-last company because of the bank’s strategic discipline and

commitment to its mission and vision over a number of decades and business cycles. The company’s mission statement was a 37-page vision and values book that touted the company’s com- mitment to customers, ethics, and trust.1 During the financial cri- sis of 2007–2009, Wells Fargo survived the meltdown that killed or crippled some of its strongest competitors. By the end of 2015, Wells Fargo was the most-trusted bank in the world,2 and the bank’s reputation for strategic discipline led pundits to list Wells Fargo as a bank that would stand the test of time.3
Within a year, however, many of those same pundits wondered whether the bank would survive a fall from grace. On September 8, 2016, three government agencies announced that Wells Fargo had been fined $185 million for opening more than 2 million accounts for its retail customers without their knowledge.4 It seemed that a 37-page mission and vision statement, one that mentioned “trust” 24 times, was only so very many words on paper and did not guide the bank’s actions. Wells Fargo announced that it had terminated 5,300 employees for opening unauthorized accounts and apolo- gized to its customers, saying, “We regret and take responsibility for any instances where customers may have received a product that they did not request.”5
Over the next few weeks, the driver of the renegade behav- ior became clear; it was not a group of rogue employees seeking to enrich themselves. The cause lay in a 2011 corporate incentive program that set aggressive quotas for new account openings, and backed them up with a carrot (bonuses) and stick (demotion or termination) incentive program.6 Tellers and other employees would create new accounts for an existing customer—sometimes


forging that customer’s signature to open the account—and move a small amount of money from an existing account into the new one in order to get credit for a new account. The Los Angeles Times described one tactic:
Employees opened duplicate accounts, sometimes without customers’ knowledge. Workers also used
a bank database to identify customers who had been pre-approved for credit cards — then ordered the plastic without asking them, [Erik] Estrada, [former Wells Fargo Personal Banker] said. “They’d just tell the customers: ‘You’re getting a credit card.’”7
The focus soon turned from the incentive program to members of the executive team and the board of directors, with congressional investigators, federal regulators, and state attorneys general all wanting to know where the program originated, how the executive team could allow such an unethical and illegal prac- tice to continue, and who had enriched themselves at customers’ expense. Attention turned to Carrie Tolstedt, head of Wells’ com- munity banking division that housed the retail operations. Shortly before the scandal broke, Tolstedt, in her mid-50s, announced her retirement from the bank at the end of 2016. On September 27, the Board announced that Tolstedt had left the company and would forgo about $19 million in incentive compensation. The board

also announced that CEO John Stumpf would also forfeit his
$41 million bonus for the year. Stumpf found himself testify- ing before the Senate banking committee in late September. Sen. Elizabeth Warren, D-Massachusetts, called for Stumpf to resign and face criminal charges: “You should resign,” she said. “You should give back the money that you gained while this scam was going on, and you should be criminally investigated.” Sen. Jon Tester, D-Montana, noted that the scandal had worked a miracle in the partisan Senate; outrage about Wells’ actions had created a united front among senators.8 The board announced the immediate departure of Stumpf on October 12; longtime executive Tim Sloan would become CEO. He said his first priority would be to “restore trust in Wells Fargo.”9
The fallout from the scandal continued into the fall of 2016. New account openings for November 2016 were off 40% from the number a year earlier, as customers fled a bank they couldn’t seem to trust.10 The bank faced numerous lawsuits from employees and customers affected by the fraudulent accounts scandal, and fed- eral and state regulators all announced continuing investigations and potential criminal charges against the bank. The oddest thing about the scandal and incentive program? Other than costing the bank its good reputation, the structure of the quota and incentive system resulted in millions of accounts that contributed nothing to the bottom line.

Wells Fargo’s ethical lapse highlights the issues, challenges, and problems of corporate governance and the importance of ethical behavior by those who sit at the top of a company, specifically, its executive team and board of directors. You may be thinking, “Just what is governance? I thought that we elected governors but corporations hired managers?” In this chapter, we’ll use a metaphor that should help you visualize the importance of good corporate governance. The metaphor comes from the history of the word govern. The English word govern traces its root back to in the ancient Latin word gubernare, which meant to steer or pilot a ship.
This metaphor paints an accurate picture of governance; it’s about steering the corporation. The notion of steering raises three simple questions about governance that all corporations must answer: Where will we steer the corporation? Who will act as the pilot? How will we steer, or what principles will guide the journey? This chapter is organized around these three key questions.

corporate governance The processes and structures that provide the ultimate decision- making authority for the firm.
corporation A legal structure for organizing where the organization is a distinct and separate entity from its owners, also known as shareholders.
individual proprietorship A legal structure for organizing where
the same person owns and runs the business.
partnerships A legal structure for organizing where the owners of
a business share ownership. The partnership is not separate from its owners.

The Purposes of the Corporation
If we ask where we want to steer anything, be it a boat, a car, or a business, we are also asking where we want to end up, or what the goal is that we are trying to achieve. In terms of corpo- rate governance, this question is often worded in one of two ways: What is the purpose of the corporation? Or, who is the corporation run for? A corporation is a legal structure for organizing a business that is considered a distinct and separate entity from its owners, also known as shareholders. For the last 80 years, those questions have had at least two answers. The corpora- tion should either be run for the shareholders or be run for the stakeholders. To understand the implications of these answers, it is important to understand a little about the history and evolu- tion of the corporation in the United States.
For the first 100 years of our nation’s history, corporations were very rare. Most economic activity was carried out by individual proprietorships, where the same person owned and ran the business. Many small businesses today still operate as proprietorships. Some businesses operated as partnerships, a business owned by two or more partners. Today, law firms, accounting firms, medical practices, and other professional service firms typically organize as partnerships. Corporations that issued stock, or shares of ownership, to investors were rare. If

you wanted to form a corporation, you had to go to the state legislature to obtain permission to begin and to sell stock. That right came in a document known as a charter. That charter autho- rized you to form a corporation for a very limited purpose, such as building a canal, a railroad, or a turnpike. There was no debate about the purpose of the corporation because its purpose was clearly outlined in its charter.11
As the twentieth century dawned, states relaxed their hold on the corporate form because people realized the limited liability and dispersed ownership that came through incorporation allowed these entities to industrialize and grow the larger economy. Eventually corpora- tions could be formed for whatever purposes the owners wanted to pursue. One way these general-purpose corporations grew was to offer investors a share of ownership in the company, or stock. Those investors contributed their money but relied on managers to run the corpora- tion. During the nineteenth century, the owner and operator of the businesses were most often the same person, while in the twentieth century, as large organizations emerged, ownership became increasingly separated from management control of the corporation’s resources.12
In the 1930s, two famous law professors, Adolf Berle and Merrick Dodd, held a very public argument about the purposes of the corporation. Professor Berle believed that the corporation should be run primarily for the benefit of the shareholders while Professor Dodd wrote that the corporation should be run for the benefit of the entire community.13 We know Berle’s position today as the shareholder primacy model, and Dodd’s as the stakeholder model.

The Shareholder Primacy Model
In earlier chapters of this book, we’ve explained how a business can be thought of as a bundle of resources and capabilities, physical assets such as buildings or equipment and skills, knowledge, and processes. Just as the business itself represents a bundle of these resources, the corporation, the legal entity that is the business, can be thought of as a bundle, or a nexus of contracts between participating parties.14 Suppliers contract with the firm to provide needed inputs, employees contract to provide labor, and even distributors and many custom- ers purchase goods from the corporation through a sales contract. Governments contract with the corporation through a business license and tax authorities. Lenders and bondholders have explicit contracts that outline specific payment schedules and terms.
Advocates of the shareholder primacy model believe that shareholders have a special type of contract with the corporation. Unlike other stakeholders, investors exchange money with the corporation without a clearly specified payment in return. Shareholders put their money “at risk” without a guaranteed return, but in exchange, they receive two property rights from the corporation. First, shareholders have claim to the residual earnings of the cor- poration, or the profits after all other stakeholders have been paid. Second, shareholders buy the right to monitor the management team to make sure that the team works in their best interests.15 The first right specifies their reward for investing their money, and the second right protects them from being taken advantage of by the management team by providing them with oversight rights.
Proponents of the shareholder primacy model usually cite three reasons for their support. First, the shareholders are the legal owners of the corporation’s assets.16 The executive team is hired by the board of directors, the shareholders’ oversight group, and should be legally and morally obligated to work for the owners of the corporation. Second, proponents of the share- holder model claim that financial capital is the most important input into making a business successful. Without funds it’s hard to hire employees, buy inventory or other needed inputs, and produce products for customers to buy. Finally, advocates of the shareholder model point to other societies and business arrangements in which business firms try to maximize the welfare of some other stakeholder group—such as employees or the local community. They observe that corporations run for these other stakeholder groups don’t really maximize wel- fare for those groups and often cause real damage to economies, communities, and the natural environment.17
Critics of the shareholder primacy school also point to three issues as evidence against the model. First, they note that shareholders don’t really own the corporation, since shareholders

shareholder primacy model The belief that a corporation should be run, primarily or exclusively, for the benefit of its shareholders.
stakeholder model The belief that a corporation should
be run for the benefit of its entire stakeholder set, with no group enjoying primacy in decision making.

nexus of contracts A model of the corporation suggesting that the firm is the sum total of its contracts with different stakeholders.

property rights The rights of owners to: (1) claim the residual earnings of the corporation, or the profits after all other stakeholders have been paid, and/or (2) monitor the management team to make sure that the team works in their best interests.

own stock that they can easily trade. Second, shareholders have different objectives for invest- ing in a firm. Some investors, such as Warren Buffett or pension funds such as CalPERS (the California Pension and Retirement System), put their money in a company’s stock as a long-term investment and want to see the corporation managed to earn the greatest long-term return. Other investors (e.g., hedge funds, arbitragers, or speculators) buy stocks and hold them for very short periods of time. They want quick returns. Managing the corporation for the benefit of shareholders requires that managers make difficult trade-offs to satisfy one shareholder group at the expense of others.18 Finally, opponents of the shareholder primacy model point to fail- ures such as Enron, Long-Term Capital Management, BP and the Deepwater Horizon oil spill, the collapse of Lehman Brothers, the behavior of firms during the financial crisis of 2008, and the recent activities of Wells Fargo as evidence that managing for shareholder value creates negative consequences for firms, investors, and society at large.19

stakeholder Any person or group that can affect or is affected by the activities of the corporation.

The Stakeholder Model
Merrick Dodd believed that because the community grants the corporation the right to exist, the managers should run the corporation for the benefit of the community as a whole. Dodd’s fundamental argument has been made by a number of different scholars, policy makers, and social critics over the decades. The modern version of Dodd’s argument is called the stake- holder model, or stakeholder theory.20 A stakeholder is anyone who can affect or is affected by the activities of the corporation.
Stakeholders have a stake, or claim, in the activities of a corporation. The primary stake- holder groups for most organizations are shareholders, customers, suppliers, employees, and local communities (including governments). Secondary stakeholders include competitors, national or global communities, and many special-interest groups, such as those working to protect the natural environment. We are all stakeholders of many organizations.
Those who advocate stakeholder models do so from two grounds. They point to what executives and managers actually do, which is spend most of their time interacting with and managing the demands and needs of different stakeholder groups. This includes working to better understand and meet customer needs, negotiating wages, dealing with working conditions for employees, responding to government regulations, and reacting to the demands of special interest and advocacy groups. Most leaders of companies engage in a lot of stakeholder management, so it makes sense to do it more systematically and proactively. Second, many people believe that stakeholder groups have the right to be considered in decisions that will have an impact on them. This is known as the intrinsic stakeholder model.21
The stakeholder model, especially the version we described as the intrinsic stakeholder model, has also been criticized by many scholars, practitioners, and even policy makers. These critics argue that managers need to focus on a single objective.22 Making shareholder value the final decision criteria gives managers a clear direction for the tough tradeoffs they must make in the course of formulating and implementing strategy. With no way to decide whose claims have priority, managers have no way to efficiently and effectively run their firms. Other critics note that stakeholder management has a dark side: stakeholders may make, and try to enforce, unreasonable and narrow-minded claims on the firm.23 General Motors, for example, continues to incur costs related to union contracts signed decades ago. Some argue that this stakeholder group sought unreasonable benefits that hurt other stakeholder groups and even- tually contributed to General Motors filing for bankruptcy.
How a company engages with its key stakeholders and manages those relationships affects the firm’s overall performance and competitive advantage. Many of the ways stake- holders interact with the firm are predictable and not difficult to understand. Other interac- tions, however, are less obvious and have longer-term consequences on a firm’s performance and competitive advantage, as well as on how stakeholders benefit from (or are harmed by) the business. Companies can, and should, audit their performance in relation to stakeholder groups on a regular basis.

Our Strategy in Practice feature helps you understand stakeholder relations. The first column describes how company actions affect stakeholders. The middle column of the table lists how stakeholders can affect the firm. The most important element of the table, however, is the far right column, where managers list the formal mechanisms in place for the firm to attend and listen to its different constituencies. After a firm has these elements in place, it can better design actions, policies, and strategies to create positive interactions with different stakeholder groups. You can understand how effectively a company manages its stakeholders by examining the different activities listed in the third column.

Strategy in Practice
Mapping Stakeholder Influence

Stakeholder Group Is Affected by the Business Through . . . Affects the Business by . . . Tools for Listening and Responding to Stakeholders
Customers • Products and services
• Warranties, after sales services
• Integrity/honesty during the sales process
• Branding and advertising • Purchases
• Word-of-mouth advertising
• Formal complaints
• Boycotts
• Influencing brand perception and value • Market research groups
• Warranty fulfillment
• Customer hotlines
• Code of ethics, mission statements
Employees • Wages
• Benefits
• Safe working conditions
• Flex time
• Training and development
• Career paths • Productivity
• Loyalty (turnover)
• Word of mouth and reputation
• Lawsuits
• Trade secrets
• Theft or sabotage • Employee councils
• Employee hotlines
• Safety programs
• Wages and benefits
• Flex time, telecommuting
• Training opportunities
• Code of ethics, mission statements
Suppliers • Timely payment
• Order consistency
• Protection of intellectual property
• Word of mouth and reputation • Quality products
• Timely delivery
• Price and payment terms
• Willingness to innovate
• Flexibility in responding to crises or unusual demands • Supplier councils
• Quality control policies
• Payment policies
• Joint ventures, alliances, or other mechanisms to promote cooperation
Investors • Earnings
• Integrity/honesty in accounting policies and reporting
• Information disclosure about strategies and other material events • Providing capital
• Short selling
• Inducing others to buy
• Analyst reports and recommendations • Investor conference calls and guidance
• Investor relations offices
• Board of directors
• Code of ethics, mission statements
Communities/ Governments • Environmental pollution, traffic
• Tax revenue and demand for public services
• Employees living in the community
• Philanthropy and volunteering
• Lobbying and other legal activity • Tax policy
• Regulations and enforcement
• Investments in community infrastructure
• Educational systems and quality
• Quality of life for employees • Government relations
• Lobbying efforts
• Philanthropy and donations
• Environmental policies
• Community impact studies
• Volunteering efforts
• Employee involvement in local/regional political groups, activities

The first question of effective governance—What is the purpose of the corporation?—is hotly debated. On the one hand, corporate scandals, environmental crises, job offshoring, and business failures from fraud, corruption, or other illegal behaviors torment shareholder advo- cates. On the other hand, most adults have the majority of their retirement funds, or a part of their personal wealth, invested in company stocks, so they all have an incentive for managers to work for the good of the shareholders. Most people are both stakeholders and shareholders. Regardless of where you stand on this issue, the second question of governance, the question as to who should pilot the corporation, is important as well, because those pilots determine what the corporation actually does.

Governance: Boards and Incentives

agency problem A consequence of the separation of ownership (shareholders/principals) and control (managers/agents) in the corporation. Agency problems occur when the goals of principals differ from those of agents.
principals The owners of a resource or piece of property. In the corporation, shareholders are considered principals.
agents Individuals or groups hired to administer the property or resources of principals. The managers of a corporation are considered to be agents of the shareholders.

Whether a corporation is managed for shareholders or stakeholders, both of those groups face the same problem in relation to the executive team that runs the corporation. We outlined that shareholders’ property rights are twofold; they have claim on the profits of the firm and they have the right to monitor the performance of the managers of the corporation. The law recog- nizes this right as a way to overcome the fundamental agency problem facing the modern public corporation. As we describe the agency problem, you’ll recognize that stakeholders face the same challenge as shareholders. Figure 13.1 illustrates the agency problem.
The agency problem arises as consequence of the separation of ownership (shareholders/ principals) and control (managers/agents) in the corporation.24 The shareholders of a corpora- tion, also called the principals, want to maximize the return on the dollars they’ve put into the firm; they want the corporation managed in a way that maximizes revenue and minimizes cost, leaving the most profit.
The managers who act as the agents of the principals in operating the firm want to maxi- mize their own utility. That may mean maximizing the profit of the corporation or it may mean engaging in behaviors that increase their income, leisure, power, status, or any other thing they may care about.
Put simply, principals and agents have different goals. It is clear that if stakeholders make specific investments in a firm, they face the same problem. For example, employees may learn skills that have little value in other firms, customers may design their operations around a firm’s

FIGURE 13.1 The Agency Problem

unique products such as a software system, or suppliers may invest in specialized equipment to produce particular products for the firm.25
When agency problems arise, shareholders can always just sell their holdings in a company. As performance declines, more investors sell, and eventually the firm’s share price falls enough to attract the interests of some investors referred to as corporate raiders or takeover artists. These are investor groups who believe they can manage the corporation’s assets better than the current management team. These investors then make a public offer, called a tender offer, to purchase shares of dissatisfied investors, usually at a 10 percent to 30 percent premium above the current stock price but below what they believe the company is really worth. If these takeover artists convince enough other investors to sell their shares, then they take control of the company and begin to implement their own strategy.
Takeover artists can also mount a proxy fight, or an attempt to get the current owners of the company to change their strategy by placing their own people on the board of directors. Even if the takeover artists or raiders don’t gain complete control of the board, they often gain enough to influence the strategic decisions of the company in ways they believe will create more value for shareholders. The possibility of losing their jobs in a takeover should keep the firm’s managers focused on creating wealth for shareholders and maintaining or increasing the company’s stock price.26
Agency problems destroy value in two particular situations: first, when the principal’s investments are sunk and difficult to recover, and second, when their ability to monitor and supervise the actions and decisions of the agents, the managers of the corporation, is limited. Most businesses today require many sunk-cost investments in equipment or knowledge, satis- fying the first condition. To protect themselves against the second condition, principals employ two tools to monitor their manager-agents: monitoring through the board of directors, and reducing the agency problem through compensation and incentives.

The Board of Directors
US corporate law, and that of most countries, requires that all publicly held corporations have a board of directors. The board of directors is a group of individuals who monitor the executive team of the corporation and ensure that those executives are acting in the best interests of the shareholders.27 Directors, as well as the executives themselves, have a legal fiduciary duty to act in the best interests of the corporation’s owners. That duty has two differ- ent elements.28 On the one hand, a fiduciary is obligated to work for the greatest advantage for the principal, such as maximizing profits for shareholders. On the other hand, a fiduciary must exercise care and caution in protecting the value of the principal’s investment. As you saw in the Wells Fargo case, these two duties can conflict, and Wells’ board chose to abandon its duty of care in favor of the duty to advance shareholder interests.
Shareholders elect the board of directors at regular intervals. The board of directors usu- ally includes executives of the corporation as well as people outside the company. Inside direc- tors, executives or managers, bring their skills and working knowledge of the firm’s operations and strategies to the board. Outside directors, people not employed by the corporation in any other role, should bring deep knowledge and a fresh perspective, both of which ensure that the firm’s strategy will serve the financial interests of the shareholders. Outside directors should also bring independence to the board as they don’t have to worry about losing their jobs or compensation if they offer opinions that the firm’s executives might not want to hear.29
The laws of the United States do not require that directors take the interests of stake- holders in mind, but the laws of many European countries protect stakeholder interests by requiring that certain stakeholders have formal representation on the board. For example, public companies in Germany must have a representative of employees on the board; Japanese companies have one of the firm’s lenders (e.g., a bank executive) on the board. One-half of the states in the United States have what are known as other constituency laws that allow the board to freely consider the needs of stakeholders other than shareholders when making critical strategic decisions for the firm.30 Shareholders and many stakeholders care about the quality of corporate boards, as illustrated in the next Strategy in Practice feature.

tender offer An offer by those hoping to control the corporation to purchase shares of dissatisfied investors.

proxy fight An attempt by dissatisfied investors or
stakeholders to gain seats on the board of directors, or to influence corporate policy.

board of directors A group of individuals who monitor the executive team of the corporation and ensure that those executives are acting in the best interests of the shareholders.
fiduciary duty The legal obligation of an agent, a fiduciary, to act in the best interests of the principal, or owner. Fiduciary duties include the duty of loyalty, to work for the optimal good of the owner, and the duty of care, to not take undue risk that would jeopardize the principal.
inside directors Executives or managers working inside the company who also hold seats on the board of directors.
outside directors Members of the board of directors not
employed by the corporation in any other role.
other constituency laws Laws that allow the board of directors to freely consider the needs
of stakeholders other than shareholders when making critical strategic decisions for the firm.

Strategy in Practice
America’s Best and Worst Boards
With their investments at risk in an increasingly turbulent and global business environment, shareholders have become concerned about the composition and quality of the board of directors at large pub- lic companies. Government regulators, from tax authorities to the Securities and Exchange Commission (SEC), employee groups, and a number of social activists, pay attention to annual ratings of board quality.
Chicago-based board advisory consultants James Drury Part- ners have been systematically ranking America’s boards since 2011.

The company believes that “The true measure of a board’s govern- ance capacity is the perceived ability, and courage, of its directors to understand complex business issues and take action. When examining a board’s governance capacity, do its directors have the heft and seasoned experience to step up to the plate?” To meas- ure the ability, the advisors calculated a measure they refer to as “director weight,” which captures the ability of each director, and the board as a whole, to carry out their responsibilities as fiduciar- ies of shareholders.31

For 2018, the top ranked and bottom rated boards are:
Company Economic Sector Average Director Weight
The Leaders
Waste Management Industrials 8.88
IBM Technology Services 8.83
Micron Technology Technology 8.83
3M Company Basic Materials 8.82
Lowe’s Companies Consumer Services 8.80
Xylem Industrials 8.78
Walt Disney Entertainment 8.64
The Laggards
SEI Investments Financials 3.40
Scripps Networks Interactive Consumer Services 3.91
MasTec Industrials 4.29
Telephone and Data Systems Communications 4.40
TravelCenters of America Oil and Gas 4.50
First Republic Bank Financials 4.55
Robert Half International Professional Services 4.60

Compensation and Incentives
The agency problem arises in the first place because the fundamental interests of principals (shareholders or stakeholders) and their agents (the managers) differ. That is, they are some- times out of alignment. For example, an executive might get a lot of value out of having a corporate jet, but shareholders might think that using their money to purchase a jet doesn’t maximize the return on their investment. One way to align the agent’s and principal’s incentives is through compensation. When managers, or employees, get paid by salary, they don’t have a strong incentive to work harder or smarter to create additional value for the company.32 If, how- ever, they get paid more when the company generates greater profits, they’ll have a much stronger incentive to create that additional value. Now principals and agents both care about

the same thing; the company pays agents for the performance desired by principals. Principals employ two types of pay for performance, or variable compensation, to align their interests with the management team.
First, companies often pay out bonuses to executives, managers, and employees when they meet certain performance objectives. Bonuses can be discretionary and given for any reason the principal desires, or they can be nondiscretionary and tied to some particular performance measure. Many employees receive a small bonus at the end of the year or during the holidays as a token of the company’s appreciation for their work. Other employees receive bonuses when they, or their work groups, hit preset targets around productivity, customer ser- vice, on-time delivery, product quality, or their unit’s profitability. Bonuses can be a powerful tool in helping managers align their interests with those of various stakeholder groups if the bonus is linked to measures these stakeholders care about.
Second, companies also use stock-based compensation, either in the form of options or grants of stock, to align incentives. Stock-based compensation aligns the interests of execu- tives or employees with those of shareholders. Stock-based compensation turns managers into shareholders. A stock option gives managers the right to buy a certain number of the corpora- tion’s shares at a specified future date for a specified price. A CEO may receive an option to buy 1,000 shares of stock at a price of $20 on June 1, 2021. If the stock price is above $20, the execu- tive pockets the difference. If the price is below $20, the option is worthless, often termed as underwater. In other cases, a company will simply grant executives or others shares of stock. These stock grants usually come with restrictions that prohibit the sale of those shares for a specified period of time.
Since scholars first identified the agency problem in the mid-1970s, the nature of executive compensation has changed dramatically. Executives used to be paid primarily in salary, with some money coming in the form of bonuses. Today, the bulk of a CEO’s total compensation comes in the form of stock compensation. The case of Apple CEO Tim Cook is an example. In 2011, Mr. Cook received his $900,000 base salary and a one-time, special grant of Apple stock worth $376.2 million.33 Under his leadership, Apple’s share price climbed substantially and the company created value for its shareholders.
Many critics worry that such huge paychecks create a gap between the richest CEOs and average workers, and that the gap does not benefit society as a whole.34 In 1950, CEOs earned about 20 times the wage of the average employee. By 1980, that number had more than doubled to 42 times; by 2000 the gap had increased to 120 times. In 2013, the pay gap had increased to 354 times the average worker salary.35 By 2015, that gap had declined to 335 to 1.36
The answer to the question of who pilots the corporation is the same whether one believes the corporation should be managed for shareholder or stakeholder interests. The board of directors is the body designated to look after the interests of shareholders and/or stakeholders and monitor managers. Both shareholder and stakeholder groups can push for compensation policies that align their interests with those of managers and executives. We now turn our attention to the last question of corporate governance: What principles will guide the pilots of the journey?

Corporate Ethics
We begin this section with a disclaimer. What you read in this chapter is not a substitute for a full course on business ethics. We intend to show you that ethics matters for strategists. Remember the tale of Wells Fargo in the chapter opening case? The bank enjoyed a powerful competitive advantage in its markets because of its reputation for honesty and trust. Wells had grown from a small, regional bank to the world’s most valuable financial institution. It turned out that many of those competitive advantages relied on behaviors that violated time-honored ethical values of honesty and integrity. Ethical values are those values that define for an individual, group, or society things that are morally right or wrong. We value

pay for performance Variable or contingent compensation that focuses managers on key variables, designed to align their interests with the shareholders.
bonuses Additional compensation paid to executives, managers, and employees when they meet certain performance objectives.

stock-based compensation Payment to organizational members in the form of shares in the corporation.
stock option The right to buy a certain number of the
corporation’s shares at a specified future date for a specified price.
stock grants A gift, or grant, of stock given to organizational members, primarily executives.

ethical values Values that define for an individual, group, or society things that are morally right or wrong.

honesty, kindness, fair dealing, and integrity because they are good or virtuous in a moral sense; similarly, we don’t value dishonesty, violence, or breaking promises because they are recognized as morally bad or evil.
Philosophers have debated what constitutes ethical behavior for centuries. Debates about ethics are debates about what is right and wrong, but also which behaviors lead to the good or just society. Participants in these debates employ one of four arguments in making their case:

  1. A good society creates the greatest good for the greatest number of people. Goodness is measured as utility, or the presence of pleasure and the absence of pain.37 Utilitarianism, the name for this position, suggests that we can calculate what’s right by looking at the benefits created by the action and then subtracting out the costs. Utilitarian moral philos- ophy provides the foundation for economics. Milton Friedman, for example, wrote that the ethical responsibility of a business is to maximize profits for shareholders as the money they make creates the most utility.38
  2. The good society ensures a basic set of rights for its citizens. While utility is good, people have fundamental rights that cannot be violated or traded away and duties they cannot ignore.39 This ethical tradition views people as ends in themselves and argues that it is immoral to use people in any way as merely a means to an end. For example, people have a right, and companies have a moral obligation, to provide full and fair information about the potential risks of products.
  3. The good society creates the most freedom for people to act as they please. This moral philosophy is closely aligned with Libertarian political philosophies that advocate very limited government and efficient markets.40 Ethical behavior is that which promotes human freedom of expression and development. Free markets are morally good because they allow people the maximum amount of choice.41 This philosophy looks with approval on many technology products because they empower individuals to express themselves and develop their full potential.
  4. In a good society, individuals care for each other, exhibit empathy with others, and focus on meaningful relationships.42 Known as the ethic of care this position believes con- cerns for utility, rights, duties, and human freedom are all worthy aims, but in pursuit of these goals we need to be concerned about other people, empathetic to their plight, and mindful of the impact of exclusion. Strategies that marginalize certain groups or management techniques that threaten relationships are immoral for those who believe in the ethic of care.
    These four ethical orientations provide people with different perspectives on what con- stitutes ethical behavior; however, they are pretty abstract. It’s often difficult for people to see the link between their behavior and human rights, justice, or freedom. To bring these behaviors down to the level of everyday behavior, researchers have identified general ethical dimensions that lay the foundation for ethical behaviors in business.43 Although individuals, groups, and societies differ in the weight they put on different dimensions, these areas help us think about what it means to be ethical.

Caring for and Avoiding Harm to Individuals Many people include animals and the natural environment. Companies in the mining and oil extraction industries spend substan- tial resources making sure they avoid undue harm to the environment.

Concern About Fairness and the Condemnation of Cheating Fairness for some groups means equality, while for others it means equity or merit. Employees and managers of financial services companies work in an environment ripe for insider trading, a form of cheating. The best banks and investment houses have clear policies and procedures to steer clear of insider trading.

Strategy in Practice

Ethics and Your Career 2. How important are relationships to me? Although few of us are openly hostile toward others, we all feel differently about the
The link between ethical behavior and your career seems pretty importance of relationships in a successful life. For some of us, simple, right? Most companies emphasize ethical behavior; how- life is all about them, while others of us care about personal ever, they usually focus more on punishing violators than rewarding achievement, or making a big difference in the world. Building
conformance. That’s because so many ethical guidelines in organi- strong relationships depends on more than following the
zations have no rewards, they are written as “don’ts:” Don’t lie to “don’ts” outlined in most policies. Strong relationships come customers, don’t cheat on your expense report, don’t violate laws through the “do’s.” They grow when we do take an active and regulations, don’t harass or demean other employees. interest in the lives and success of others, when we do spend Having a successful career, and leading a flourishing and time with others in enjoyable, meaningful ways. It has been happy life, does not come from simply avoiding the “don’ts” in most said that few people say, at the end of their lives: “I wish I’d ethics policies. Flourishing depends on what you do more than spent more time at the office.” A flourishing life is one lived
what you don’t do. Here are three questions to help you think about with others.
some things you can do to flourish: 3. How important are development and growth to you? All jobs

  1. How much of what I do centers on money, promotion, and the you will have require you to learn new things and develop outward signs of success? While we all want to be successful yourself. After a while, however, we master our job roles and and well compensated, for some people flourishing means there is little apparent incentive to push ourselves to develop the accumulation of wealth and the things it can buy, and the and grow. We become stagnant, and our work becomes a titles and perks that define corporate success. The problem means to an end as we “live for the weekend.” Leading a with wealth, however, is when it becomes the only mea- flourishing life means continuing to grow and develop, both sure of success. It then leads us to treating others as means professionally and personally. It’s important to continue to our own ends and disregarding their needs and concerns. to push yourself, to read books or take classes to learn new Charles Dickens’ character Ebenezer Scrooge typifies this type professional skills, to find hobbies that will give you opportu- of individual; he broke no laws but had no friends or close nities for individual mastery in your personal life, or to volun- associates. teer and find ways to grow by helping and serving others.

Recognition of Things as Sacred or Degraded Many cultures revere sites as holy places or venerate people who exhibit particular virtuous behavior. Similarly, other groups view actions or elements as degraded, impure, or polluted. As companies enter markets where religious values and laws are strong, such as Islamic countries gov- erned by Sharia law, they must ensure that their products and services conform to those religious norms.

Praise of Liberty and Condemnation of Oppression Products, services, or policies that promote human development, flourishing, freedom, and growth are praise- worthy, while those that oppress people or cultures face condemnation. The next Strategy in Practice feature describes how Google wrestled with the ethics of censorship and the suppres- sion of human rights in China.
Our Strategy in Practice feature helps you think about some ethical choices that will help define your career success.

Corporate Culture and Ethics
How can company directors, executives, and managers ensure that their organizations act in ethical ways? The cultural values of honesty, reliability, and trust that Wells Fargo publicly stated could promote ethical behavior by everyone in the organization. The problem at Wells, however, was that these values were discussed and agreed on, but they had little impact in determining how bankers actually approached their jobs in the face of an incentive program that relentlessly focused them on opening new accounts. That incentive system provided a day- to-day and concrete operating context at Wells that was out of sync with its timeless and abstract mission and values. The real value for employees was to open as many accounts as possible.

Strategy in Practice
Facebook, Free Information, and Privacy Issues issues such as gun control, immigration, and LGBT rights.44 Trolls
also initiated streams that were “scathing or defamatory towards
The Internet and related technologies have changed all our lives for Hillary Clinton. Widely circulated fake stories include accounts of the better. It’s not just about shopping online or navigating a tricky Pope Francis endorsing the Republican candidate, Hillary Clinton new city with a smartphone map; it’s also about the vast amounts murdering an FBI agent and President Obama ‘admitting’ he was of information and knowledge available for people to consume and born in Kenya.” Facebook’s policy of filtering news feeds meant that acquire on a daily basis. Each new advance, from search engines these messages reached sympathetic viewers in the hope of influ- to social media, once seemed to usher in a new day of benefits for encing their votes.45
consumers and citizens. In March 2018, several publications reported that Facebook had The luster of technology dimmed substantially in late 2016 allowed data analytics firm Cambridge Analytica to “harvest” 87 mil-
as stories broke that social media giant Facebook had, perhaps lion Facebook user’s private data, which it then used to build “psych- unwittingly, become a tool for election manipulation. In the fall ographic” profiles to determine which types of political ads would of 2016, and following Donald Trump’s surprise election, evidence appeal most to different groups. It seemed that Cambridge Analytica appeared that Russian intelligence agencies had used Facebook’s had been one firm, but not the only one, to have access to protected tools and news feeds in an attempt to influence the election’s out- customer data. Facebook publicly apologized in a series of newspaper come. “Trolls,” Russian government agents and other actors posing ads, with CEO Mark Zuckerberg admitting a “breach of trust” and say- as American citizens, created false profiles on Facebook, dissemi- ing “I’m sorry we didn’t do more at the time. We’re now taking steps to nated stories, opinion posts, videos, and memes. These posts all ensure this doesn’t happen again.”46
hoped to incite division among the electorate around hot-button

culture A pattern of behaviors and beliefs that are considered appropriate and correct for organizational members.

mission statement A formal declaration of a company’s core values, business objectives, and ethical aspirations.

When we speak about culture, we speak about “the pattern of behavioral assumptions that a given group has invented, discovered, or developed . . . that have worked well enough to be considered valid, and, therefore, to be taught to new members as the correct way to perceive, think, and feel.”47 Put simply, culture is just how things are done in any orga- nization. Culture acts like a third governance mechanism because it pilots the organization by helping each individual employee or manager decide what to do. Culture proves to be very powerful because it informs action without the need for supervision or permission from managers, executives, or the board.48 An organization’s culture, by itself, is neither good nor bad; however, a culture will influence how people perceive and react to ethical challenges they face as they do their jobs. We’ll first look at how culture can promote unethical behavior, and then we’ll outline some steps companies can take to create an ethical culture.
Cultures influence how individuals will respond to ethical challenges in two ways.49 First, the culture tells us the “correct way to perceive” the world around us and, second, culture provides us with a set of reasons that justify our actions. Cultures that promote unethical behavior allow people to deny or not see the ethical dimension of their actions. If people do see the ethical challenge involved, the culture provides a set of justifications, or ways to rationalize their uneth- ical behavior. Remember that if you break apart the word rationalize you get “rational lies.”

Creating an Ethical Climate
Just as a culture can encourage people to act unethically, cultures can also help people see the ethical challenges they face and give them tools to make the correct choices. Wells Fargo’s val- ues all encouraged good behavior, but they were fundamentally out of alignment with the eve- ryday compensation system in place at the company. The 7 S model introduced in Chapter 12 identified shared values and style as the core of a company’s culture. These two elements can help a company create a climate where ethical behavior becomes the expected norm.

Shared Values A good place to start is to have a mission statement. We described mission statements in Chapter 12 and described how a mission outlines a company’s purpose and articulates its core values. A mission statement represents a powerful way to formalize the company’s core values and ethical aspirations for the entire world to see. A good mission statement clarifies who the company’s stakeholders are and how they should be treated. The

Strategy in Practice

The Johnson & Johnson Credo their family responsibilities. Employees must feel free to make suggestions and complaints. There must be equal
Robert Wood Johnson, a member of the founding Johnson family, opportunity for employment, development and advance-
served as CEO of Johnson & Johnson from 1932 to 1963. Just before ment for those qualified. We must provide competent the company went public, he took the time to write down the core management, and their actions must be just and ethical. values that drove the company, its strategy, and the executive team.
Those core values have been a reference for company managers We are responsible to the communities in which we live
and employees since then. He termed it the Credo:50 and work and to the world community as well. We must
be good citizens—support good works and charities and We believe our first responsibility is to the doctors, nurses bear our fair share of taxes. We must encourage civic
and patients, to mothers and fathers and all others who improvements and better health and education. We must use our products and services. In meeting their needs maintain in good order the property we are privileged to everything we do must be of high quality. We must con- use, protecting the environment and natural resources.
stantly strive to reduce our costs in order to maintain Our final responsibility is to our stockholders. Business reasonable prices. Customers’ orders must be serviced must make a sound profit. We must experiment with new promptly and accurately. Our suppliers and distributors ideas. Research must be carried on, innovative programs
must have an opportunity to make a fair profit. developed and mistakes paid for. New equipment must
We are responsible to our employees, the men and women be purchased, new facilities provided and new products who work with us throughout the world. Everyone must launched. Reserves must be created to provide for adverse be considered as an individual. We must respect their times. When we operate according to these principles, the dignity and recognize their merit. They must have a sense stockholders should realize a fair return.
of security in their jobs. Compensation must be fair and adequate, and working conditions clean, orderly and safe. We must be mindful of ways to help our employees fulfill

Strategy in Practice feature discusses the legendary mission statement at Johnson & Johnson, known as the Credo.
Having a mission on paper is a great place to start, but having a mission that actually guides people’s behavior is even better. Everyone from the board, to the executive team and every layer of management, to the employees on the shop floor must buy into the mission and figure out how it influences their daily behaviors. Companies should also make a formal code of ethics a part of their shared values.

Style Style comes next because it might be the most important way in which abstract shared values become real to members of the organization. The tone at the top matters, maybe more than any other factor. How individual executives behave provides the most important cue for employees to follow as they try to figure out how they should act at work. John Stumpf lost his job as CEO in large part because his behavior created and drove the reckless culture of sales that led to Wells’ downfall. Moral strategic managers and executives not only walk the talk and act ethically themselves, they provide ethical leadership for others to follow.
Aircraft maker Boeing experienced several ethical crises in the late 1990s and early 2000s, including allegations of bribing US Defense Department personnel to win contracts. To create a more ethical climate, the company emphasized leadership. Boeing51 now expects its leaders to deliver on six tasks:

  1. Chart the course for employees
  2. Set high expectations for performance
  3. Inspire others
  4. Find a way to get things done
  5. Live the Boeing values
  6. Deliver results

Delivering results mean earning profits and creating competitive advantage but in an eth- ical and responsible way. The company value of integrity states, “We will always take the high road by practicing the highest ethical standards.”52
Ethics provides the answer to the final question of corporate governance: What values will guide the journey? Successful corporate governance helps ensure that a company knows who its key stakeholders or primary beneficiaries are, and then works to create value for them. Good governance relies on having a strong board of directors to guide decision making and oversee the executive team as it formulates and implements strategy. Finally, having a culture that enables and encourages ethical behavior matters because, as experience has shown, culture may be the most powerful, yet subtle, form of corporate governance.

• The best way to think about governance comes from the word’s original meaning, to steer or pilot. People in the corporation need guidance and oversight to ensure that the corporation meets its strategic objectives.
• Some people believe that corporations exist to maximize the finan- cial value of the company’s shares. These advocates point to the many benefits that come from a clear focus on profitability and shareholder value. Others believe that corporations exist for a larger group of stakeholders, and the business should be run to serve their interests as well as shareholders. This debate has been going on since the Great Depression, and there is merit in both sides.
• Shareholders and stakeholders both face the agency problem: Their goals and interests may differ from those of the executives who run the company. Two mechanisms exist to overcome the agency

problems and provide good governance. The board of directors, a legal requirement for public companies, has ultimate control over corporate decision making and can ensure that the executive team works to create value for the primary stakeholders. Compensa- tion systems, such as bonuses and stock-based rewards, pay for performance and can align the interests of managers and impor- tant stakeholder groups.
• Ethics and ethical values play a significant role in good gover- nance. The culture of the firm can either encourage or discourage ethical behavior. The 7 S model provides a framework to describe concrete steps managers can take to create a culture that encour- ages employees and others to act in ethical ways. Perhaps the most important of these is the “tone at the top,” or the behavior and lead- ership of those at the top of the corporation.

Key Terms
agency problem 238 individual proprietorship 234 property rights 235
agents 238 inside directors 239 proxy fight 239
board of directors 239 mission statement 244 shareholder primacy model 235
bonuses 241 nexus of contracts 235 stakeholder 236
corporate governance 234 other constituency laws 239 stakeholder model 235
corporation 234 outside directors 239 stock-based compensation 241
culture 244 partnerships 234 stock grants 241
ethical values 241 pay for performance 241 stock option 241
fiduciary duty 239 principals 238 tender offer 239

Review Questions

  1. What is governance? Why is it important for strategic managers to understand the role that governance plays in the operation of the firm?
  2. Explain the role of the board of directors in running a public company. What is the board’s primary job? What distinguishes inside from outside directors?
  3. Define the agency problem in corporate governance and describe the mechanisms many companies use to align the incentives of man- agers and owners.
  4. How can a company’s culture encourage members to engage in unethical behaviors? Ethical ones?

Application Exercise
Exercise: Thinking critically about governance and ethics.

  1. Write a short position paper (one or two pages) that supports either the shareholder primacy or stakeholder answer to the question, “For whom should the corporation exist?” Your paper should include responses to the main arguments of the opposing side.
  2. Choose a company that you admire. Use the sources suggested in the Strategy in Practice feature about stakeholder relationships and

analyze its performance with two to three of its stakeholder groups. What does the company do well? What suggestions would you make for improvement?

  1. Identify and research a business ethics crisis or scandal. Describe the event and what you see as the causes of the crisis. Where do you see failures in corporate governance? What about failures in the eth- ical culture and climate of the company?

1O. Staley, “Wells Fargo Just Became the Poster Child for When External and Internal Values Don’t Match,” Quartz Media, September 8, 2016,
-values-dont-match/, accessed March 6, 2017.
2Staley, op cit.
3A. Dumortier, S. Williams, and D. Caplinger, “3 Banks that Will Stand the Test of Time,” The Motley Fool (October 12, 2015), https://www.fool
-of-time.aspx, accessed March 6, 2017.
4The agencies were the Consumer Finance Protection Bureau, the Los Angeles City Attorney, and the Office of the Comptroller of the Currency. Paul Blake, “Timeline of the Wells Fargo Accounts Scandal,” ABC News, November 3, 2016,
/Business/timeline-wells-fargo-accounts-scandal/story?id=42231128, accessed March 6, 2017.
5Blake, Timeline, op cit.
6Former employees Alexander Polonsky and Brian Zaghi sued the bank, claiming they had been wrongly treated for failing to hit “impos- sible” new account goals. See Blake, op cit.
7E. S. Reckard, “Wells Fargo’s Pressure-cooker Sales Culture Comes at a Cost,” Los Angeles Times, December 21, 2013, http://www.latimes
.com/business/la-fi-wells-fargo-sale-pressure-20131222-story.html, accessed March 6, 2017.
8P. Blake, “Wells Fargo CEO John Stumpf Told to Resign by Sen. Warren,” ABC News, September 20, 2016,
/wells-fargo-ceo-john-stumpf-facing-senate-panel/story?id=42217002, accessed March 6, 2017.
9Blake, Timeline, op cit.
10J. R. Koren, “Wells Fargo Overhauls Pay Plan for Branch Employees Following Fake–Accounts Scandal,” Los Angeles Times, January 10, 2017,
-story.html, accessed March 6, 2017.
11H. Hovenkamp, Enterprise and American Law, 1836–1937 (Cambridge: Harvard University Press, 1991).
12A. A. Berle and G. C. Means, The Modern Corporation and Private Property (Transaction Publishers, 1932).

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