CHAPTER TWO CORPORATE GOVERNANCE AND SOCIAL RESPONSIBILITY This chapter describes the basic governance mechanisms of the

corporation: the board of directors and top management. These are the people who are primarily tasked with the strategic management process if the corporation is to have long-term success in accomplishing its mission. The responsibilities of both are described and explained. The chapter also examines the relationship between business firms and society and presents issues in social responsibility and ethics. Ethics and ethical behavior are considered in light of the challenge from moral relativism. The chapter considers stakeholder concerns and presents various responsibilities of business firms as well. TOPICS COVERED Role of the board in strategic management. Composition of the board of directors. Trends in corporate governance. Responsibilities of top management in strategic management. Positions for and against social responsibility. Importance of corporate stakeholders. Ethical decision making versus moral relativism. Guidelines for ethical behavior.

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS 1. Does a corporation really need a board of directors?

Given that a number of people do not consider the board of directors to have much of a role in a corporation's strategic management, this is no idle question. A good case can be made that a closely-held corporation has no need of a board. Since the owners are likely to compose both top management and board membership, the board becomes superfluous at best and may even create more problems than it solves by getting in the way of management's quick response to opportunities and threats. Even in a publicly-held corporation, the board may be composed of nothing but a few insiders who occupy key executive positions and few "good old boy" outsiders who go along with the CEO on all major issues. Nevertheless, the rationale for the board of

directors seems to be changing from simply one of safeguarding stockholder investments to a broader role of buffering the corporation from its task environment and forcing management to manage strategically. If nothing else, the board can do the corporation a great service by simply offering to top management a different point of view. The board's connections to key stakeholders in the corporation's task environment can also provide invaluable information for strategic decision-making. 2. What recommendations would you make to improve the effectiveness of today's boards of directors?

Among the many suggestions often made are the following: Add more outsiders (people not affiliated with the corporation) to the board of directors. Keep the percentage of insiders (typically top management) to less than 50% of board membership. Separate the positions of CEO and Chairman so that top management cannot unduly influence the board's meetings and agenda. This should improve the board's ability to properly evaluate top management. If they can't separate Chair from CEO, select a Lead Director from the outside directors. Use a committee composed of outsiders to nominate potential new directors. This will help to ensure that potential members are not friends of top management who may owe more allegiance to the CEO than to the shareholders. Nominate people to the board who have knowledge valuable to the board and who have expertise of value to top management. These should be people who will have the respect of top management and who can both advise and criticize top management as needed. Require board members to own substantial amounts of stock in the corporation to ensure that they have a personal as well as professional stake in the welfare of the corporation. 3. What is the relationship between corporate governance and social responsibility?

This question is partially answered by the last trend in corporate governance presented on page 36 of the text. Quite simply, it states that society in the form of special interest groups increasingly expects boards of directors to balance the economic goal of profitability with the social needs of society. Issues dealing with workforce diversity and the environment are now reaching the board level. If business corporations are to avoid increased governmental restrictions on their activities, management will need to be even more aware of the various needs of their stakeholder groups. The board of directors is in a unique position to view the corporation as a whole and to evaluate management's performance in terms of stakeholder criteria. To the extent that boards only use shareholder value as their key criteria, they may not be acting responsibly from society's point of view. Increasingly, concerns over social responsibility may be directed through the board of directors. Agency theory defines the boards interests quite narrowly. Perhaps it is time for agency theory to be expanded to include

stakeholders other than just shareholders. This is likely to be a very controversial issue in the future.
4. What is your opinion of Reebok's production standards of human rights for its suppliers? What would Milton Friedman say? Contrast his view with that of Archie Carroll.

Does a company's responsibilities end at its boundary or does its responsibilities extend to its suppliers and distributors as well? This very thorny question has become a point of contention in the area of social responsibility. The question includes a basic question in organization theory: What is the boundary of an organization? Certainly, one could argue that a company is composed of its employees and all of its assets, such as land, buildings, and equipment. These can thus define a company's boundary. Given this view, everything else may be called a company's "environment" and therefore outside of a company's control or responsibility. One could thus argue that a company like Reebok cannot be held responsible for the actions of a separate and independent supplier company/contractor. The very popularity of outsourcing as a substitute for vertical integration means that more firms are contracting with other firms to fulfill functions a company no longer wishes to do on its own. If the contract is long term in nature or if the purchasing company owns a substantial amount of stock in the supplying company, then the hands-length nature of transactions is compromised and it becomes difficult to discern where one firm's boundary begins and another firm's leaves off. Such a relationship suggests that one company does have some influence over another company's actions by nature of the other company's dependency on the first company. One could thus argue that a company's social responsibilities extend beyond what is normally thought of as its boundary to the extent that it has some control and influence over the other company's actions. Clearly, Reebok's management was thinking this way when it drafted its production standards of human rights. Milton Friedman would probably be very much against Reebok's meddling with the rights of its suppliers to freely contract with their employees. Using Carroll's categories, Friedman would probably argue that the only responsibilities of a business firm are economic and legal. Friedman does say that business should play "within the rules of the game." This can be interpreted as meaning a supplier's legal responsibilities to follow the rules established within that country. If a purely economic justification is used, it may be difficult but still possible to justify ethical and discretionary responsibilities. Carroll points out that a refusal to consider ethical responsibilities is likely to lead to an increase in a firm's legal responsibilities - which considering the usual inefficiencies of government will lead to higher costs and lower long-run business efficiency. Either the U.S. Federal Government or the United Nations may force companies in developed countries to follow a code like Reebok's or else face sanctions. Friedman would say that this is foolishness, but Carroll would argue that this is a natural result of ignoring one's ethical responsibilities. 5. Does a corporation have to act selflessly to be considered socially responsible?

This is a tough question. At first, it seems to be more appropriate to a philosophy class than to a strategic management class. Should motivation and attitudes be considered when judging a company's actions? The legal system normally does this when differentiating between different degrees of guilt: Intentionally killing is called murder and is usually punished severely; unintentional killing is called homicide and may not be punished at all if it is considered to be an

accident. Using this approach, one could say that a company is not socially responsible unless its motives fit its actions. A counter argument could be made, however, by arguing that the essence of the free enterprise system is laissez-faire capitalism in which the selfish motivations of business people result in a better society in terms of material goods. In this system, it is acceptable for a successful business firm to selfishly work for its own good - given that its actions result in side effects that are functional for society as a whole. We do not demand that a firm be altruistic when fulfilling its economic and legal responsibilities. Why should we then require that a firm be altruistic when fulfilling its ethical and discretionary responsibilities? This is not the type of question that pragmatic undergraduate business students are used to. Grad students will enjoy playing with the concepts involved. This question could either result in some interesting class discussion or it could bomb. Hopefully, it will make the class think on a higher level than simply regurgitating the book. ADDITIONAL DISCUSSION QUESTIONS A1. What aspects of a corporation's environment should be represented on a board of directors?

This is a wide-open question with no simple answer. Some may argue that representatives from each stakeholder group in the corporation's task environment should be included so as to keep top management aware of key environmental considerations. Others may argue that only outsiders with no personal stake in the corporation (i.e., not a member of a local bank or a key supplier, etc.) would be best able to bring the amount of objectivity needed to help make strategic decisions. A good argument can be started by suggesting that a representative from labor be a director. If this makes some sense, who should it be an employee of the corporation or an employee of another corporation? If the firm is not unionized, what then? Further discussion can be generated by suggesting that the composition of the board reflect the key demographics of the corporation's workforce in terms of race, sex, and age. A2. How appropriate is the theory of laissez-faire in today's world?

As indicated on page 38 in the text, Milton Friedman contends that it is very appropriate. The quote from his classic article, "The Social Responsibility of Business Is to Increase its Profits" does suggest a certain modification, however, to pure laissez faire. He states that business should work to increase its profits "so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud." These "rules of the game" form the crux of the argument. What should these rules be and who should communicate and enforce them? This leads directly into Archie Carroll's contention on pages 39 and 40 that there are four responsibilities of business corporations: economic, legal, ethical, and discretionary. Pure laissez faire argues for economic responsibilities only. Friedman modifies laissez faire by presumably adding legal responsibilities. One could make the point that the "rules of the game" should include ethical responsibilities as well. The problem, of course, is what happens to the concept of laissez faire when one adds all these responsibilities to it and then expects business people at all levels to accept them without outside force? Does laissez faire as proposed by Adam Smith and argued by others include only economic responsibilities? If legal

and ethical responsibilities are also expected by society of business corporations, is it still "free enterprise" laissez faire or some other kind of system? A3. Is there a conflict between Agency Theory and the concept of stakeholders developed in this chapter? Agency theory is concerned with problems that occur in relationships between principals (owners) and their agents (top management). Because agents are, in effect, "hired hands," their interests are not usually aligned with those of the owner (stockholders) of a corporation. Consequently, agency theory is primarily interested in ways to better align these two sets of interests, such as management owning significant shares of stock or having a strong financial stake in the long-term performance of the corporation via long-term incentive plans. This helps to ensure that management looks beyond selfish short-term benefits of a decision to the more strategic issues that concern stockholders. The concept of stakeholders, in contrast, looks at more than just owners and managers. It argues that groups other than stockholders and top management have a significant stake in the actions of the corporation and need to be considered in strategic decisions. What might benefit owners and management might hurt employees, the local community, or the environment. The concept of stakeholders thus proposes that the suggestions of agency theory are incomplete and insufficient to ensure that top management deals fairly not only with stockholders, but also with the needs of all concerned stakeholder groups. As it is currently defined, agency theory is more in agreement with Milton Friedman's narrow view of the responsibilities of a corporation than with the stakeholder view more common to concerns of social responsibility. This could change if society begins to consider top management not only as direct agents for stockholders, but also as indirect agents for other groups with a stake in the corporation's activities. Agency theory could thus be expanded to include the concerns of other interested groups and thus incorporate the stakeholder approach. A4. Using Carroll's list of four responsibilities, should a company be concerned about discretionary responsibilities? Why or why not?

Except for a few die-hard followers of Milton Friedman's philosophy, few people would agree that a business firm should fulfill only its economic and legal responsibilities and completely ignore ethical ones. The same is not true of discretionary responsibilities, however. Since discretionary responsibilities are defined by Carroll as purely voluntary, there is no pressure by anyone for a business firm to fulfill them. One can argue, nevertheless, that there are three good reasons to undertake these kinds of responsibilities. The first reason is the morality rationale - it may be the right thing to do, even though the company may not benefit and may even be hurt in the short run. The second reason is enlightened self-interest. If a firm undertakes a discretionary activity, it may gain short-run advantages in the market place (e.g., a company offering free day care to its employees may attract more potential workers at lower wages). It may also serve as a role model for government to legislate if and when that responsibility moves from discretionary to ethical and finally to legal (and thus the firm is able to do things its way instead of the government's way). The third reason is also one of enlightened self-interest. If a company develops a reputation for voluntarily doing socially useful activities even though it gains little economically in return, it may collect valuable public relations credit in people's minds. This may translate sometime into better sales or a willingness on the part of some government agency to overlook a questionable activity the company might unthinkingly engage in.

SUGGESTIONS FOR STRATEGIC PRACTICE EXERCISE How far should people in a business firm go in gathering competitive intelligence? Where do you draw the line? This is an interesting exercise to use not only to cover Chapter Two, but to also introduce some of the concepts found in Chapter Three, Environmental Scanning and Industry Analysis. For this reason, you might want to use this exercise during Chapter Three rather than at the end of Chapter Two. Approach 1: First, ask your students to complete this exercise. Second, list all the items on the blackboard in which a large percentage of the class rates each of them as 4 or 5. Third, list all the items in which a large percentage of the class rates each of them a 2 or 1. Fourth, list all the items in which a large majority rates them as a 3. Once these three sets of items are listed on the board, ask the class what differentiates one group from another. Try to identify the criteria the class used to rate the items. This provides the rationale the students in your class are using to make ethical decisions. You might also want to challenge the class as a whole by asking for minority opinions - those who rated a particular item significantly differently than did the class as a whole. Approach 2: Have the class complete the exercise and hand in their ratings anonymously on a separate sheet of paper. Have them keep one copy of their ratings. After class, calculate the means for each item, put them into one of the three categories mentioned above, and list them on a transparency. At the beginning of the class dealing with Chapter Two, show the class their average responses by group. Ask them what differentiates one group from another and probe for the criteria they used to rate the items. Ask them to look again at their personal ratings of the items and identify where they differ from the overall average class rating. Encourage individual students to challenge the average class ratings. Some interesting discussion is bound to result. You may want to provide the class with the average responses found in the Jones and Bryan study cited below. This exercise was developed from a questionnaire constructed by William Jones, Jr. and Norman Bryan, Jr. of Georgia State University for their article "Business Ethics and Business Intelligence: An Empirical Study of Information-Gathering Alternatives," in the June 1995 issue of the International Journal of Management (pages 204-208). A total of 108 undergraduates in a strategic management class completed the questionnaire during the early part of the term prior to a discussion of ethics. The resulting mean responses were as follows: The business firm should try to get useful information about competitors by: 4.55 Careful study of trade journals. 1.13 Wiretapping the telephones of competitors. 2.59 Posing as a potential customer to competitors.

1.57 Getting loyal customers to put out a phony "request for proposal soliciting competitors' bids. 4.21 Buying competitors' products and taking them apart. 3.54 Hiring management consultants who have worked for competitors. 1.44 Rewarding competitors' employees for useful "tips." 4.00 Questioning competitors' customers and/or suppliers. 1.97 Buying and analyzing competitors' garbage. 1.37 Advertising and interviewing for non-existent jobs. 4.09 Taking public tours of competitors' facilities. 1.58 Releasing false information about the company in order to confuse competitors. 3.70 Questioning competitors' technical people at trade shows and conferences. 3.29 Hiring key people away from competitors. 3.59 Analyzing competitors' labor union contracts. 1.46 Having employees date persons who work for competitors. 2.61 Studying aerial photographs of competitors' facilities.

Jones and Bryan indicated that appropriate actions received mean responses between 3.51 and 5.00. Those items with a mean between 2.5 and 3.5 reflected student uncertainty about whether the action was appropriate or not. Items with a mean response of less than 2.5 were judged inappropriate. Jones and Bryan were surprised to find no statistically significant differences between males and females or on the basis of age. They suggested that the strong emphasis in the business curriculum on strategic management may have tended to suppress any gender and age differences. ADDITIONAL TEACHING MODULE
CORPORATE GOVERNANCE STYLES

Just as boards of directors vary widely on a continuum of involvement in the strategic management process, so do top management teams. For example, a top management team with a low involvement in strategic management will tend to be functionally oriented and will focus its energies on day-to-day operational problems; this type of team is likely either to be disorganized or to have a dominant CEO who continues to identify with his or her old division. In contrast, a top management team with high involvement will be active in long-range planning. It will try to get division managers involved in planning so that top management will have more time to scan the environment for challenges and opportunities. Both the board of directors and top management can be placed on a matrix that reflects four basic styles of corporate governance. Styles of Corporate Governance
High

Degree of Involvement by Top Management Low Low

Entrepreneurship Management Chaos Management

Partnership Management Marionette Management High

Degree of Involvement by Board of Directors

Chaos Management When both the board of directors and top management have little involvement in the strategic management process, their style is referred to as chaos management. The board waits for top management to bring it proposals. Top management is operationally oriented and continues to carry out strategies, policies, and programs specified by the founding entrepreneur who died years ago. The basic strategic philosophy seems to be, "If it was good enough for old J.B., it's good enough for us." There is no strategic management being done here. Entrepreneurship Management A corporation with an uninvolved board of directors but a highly involved top management has entrepreneurship management. The board is willing to be used as a rubber stamp for top management's decisions. The CEO, operating alone or with a team, dominates the corporation and its strategic decisions. An example is Control Data Corporation under the leadership of its founder William C. Norris. For twenty-nine years, Norris dominated both the company's top management and its board of directors. Insisting that the company could profit by addressing "society's unmet needs," Norris directed corporate investments into the rejuvenation of ghettos and support of wind-powered generators and tundra farming, among other projects. Although these investments tended to result in losses, few people were willing to challenge his strategic decisions. Some employees even referred to him as "the Pope." A former Control Data executive noted, "More often than not, he's proven his critics wrong, so now his visions aren't challenged." Marionette Management Probably the rarest form of strategic management style, marionette management occurs when the board of directors is deeply involved in strategic decision making, but top management is primarily concerned with operations. Such a style evolves when a board is composed of key stockholders who refuse to delegate strategic decision making to the president. The president is forced into a COO role and can do only what the board allows him/her to do. This style also occurs when a board fires a CEO but is slow to find a replacement. The COO or executive vicepresident stays on as "acting" president or CEO until the selection process is complete. In the meantime, strategic management is firmly in the hands of the board of directors. Marionette Management occurred at Winnebago Industries when the company's Board of Directors, chaired by its founder, 72-year-old John K. Hanson, took away Ronald Haugen's title as chief executive officer, but left him as company president. No new CEO was named. Hanson, whose family owned 46% of Winnebago's stock, had given up the CEO title in 1983 to President Haugen, a long-time employee. Outside observers noted that although Chairman Hanson did not also hold the title of CEO, he appeared to have taken on the CEO's responsibilities once again. Partnership Management

Probably the most effective style of strategic management, partnership management is epitomized by a highly involved board and top management. The board and top management team work closely to establish the corporate mission, objectives, strategies, and policies. Board members are active in committee work and utilize strategic audits to provide feedback to top management on its implementations of agreed-upon strategies and policies. This appears to be the style emerging in a number of successful corporations such as Texas Instruments, Dayton Hudson Corporation, and General Electric Company.