Comfort Products Division
Corporate governance is a necessary part of the strategic management process. It is used to monitor and control managers’ strategic decisions to prevent managerial opportunism and other risks associated with mismanaged firms. Specifically, corporate governance relates to the shareholders and the relationship they have with the firm, and involves guiding strategic decisions so that the interests of the shareholders and those of the decision-making managers are aligned to better predict future stock performance and overall efficiency of the organization.
An efficient organization results not just from strong and ethical leadership, but also from minimizing conflicts of interest and general oversight in the “election of directors, the general supervision of CEO pay and more focused supervision of director pay… ” (Hitt, Ireland & Hoskisson, 2004). In today’s corporate landscape, often the owners are not the managers. The managers are the people who run the company on a day-to-day basis and are responsible for operations. However, due to the separation of ownership and decision-making responsibilities, the owners may be out of touch with the firms daily activities.
This is where corporate governance comes in because a well-functioning organization will encourage the free-flow of information across all stakeholders in order to minimize managerial misconduct and maximize effective strategic decisions. At Emerson Electric Company, a highly diversified, “Fortune 100 conglomerate with over 50 autonomous divisions,” the CEO, Charles Knight’s strategic mission is to achieve “the lowest cost consistent with the highest attainable quality and performance” (Davis & Paige, 1991).
He is ultimately responsible for the company’s successes and failures and initiates strategies to protect profitability. When Emerson Electric does not meet its annual goal of 15% growth, he implements a “cost-cutting” strategy to ensure Emerson maintains its “29 consecutive years of increased earnings” (Davis & Paige, 1991). Since Emerson Electric is a global entity, the governance mechanisms are more complex. Managers of multinational firms must understand that differences exist in corporate governance across the global economy in order to control costly strategic errors that may jeopardize the future of the company.
Furthermore, global changes in governance are occurring with companies developing a board of directors with more members that are independent, ethnically diverse, and from a wider range of professional backgrounds (Hitt, Ireland & Hoskisson, 2004). The three internal governance mechanisms commonly used in modern organizations include ownership concentration, board of directors, and executive compensation. Ownership concentration refers to the number of shareholders and the percentage of stock owned.
There are different types of shareholders and therefore divergent incentives to monitor management. Large-block shareholders are individuals or entities that own at least five percent of a corporation’s stock and usually instigate stringent governance mechanisms. Most large-block shareholders are no longer individual shareholders, but rather institutional owners with considerable power and position to “influence a firm’s choice of strategies and overall strategic decisions” (Hitt, Ireland & Hoskisson, 2004).
Emerson Electric’s positive history of increased earnings should be lucrative enough to attract sufficient large-block shareholders to balance the concentration of power between the board of directors and the CEO. Having several institutional owners is positively correlated with higher levels of monitoring which can encourage managers to avoid ineffective strategic decisions (Hitt, Ireland & Hoskisson, 2004). The board of directors is another governance mechanism because shareholders elect the board.
It is the responsibility of the board to oversee the management of the firm and ensure that the companies’ actions are in accordance with the maximization of shareholders’ wealth. Shareholders monitor the firm’s actions through the board, whose members are elected to support the interests of the owners “by formally monitoring and controlling” upper-level management (Hitt, Ireland & Hoskisson, 2004). However, diffuse ownership limits the amount of oversight actually performed by board members.
In addition, there are several types of board members: insiders, related outsiders, and outsiders. Insiders are upper-level managers, related outsiders are consultants and others who have a relationship with the company and outsiders are independent individuals who have no relationship with the firm. Research shows that “firms with more independent outside directors tend to make higher-quality strategic decisions” (Hitt, Ireland & Hoskisson, 2004). This is a good strategy that Emerson Electric can employ to ensure sound strategic decisions.
The board must be highly vocal and question managers’ actions regularly as the board is equally responsible for any faulty judgments of the CEO since they select the CEO. Lastly, since Emerson Electric is a global competitor they should have an ethnically diverse board including a board member from Lao Chiang to represent the ACP division, and professionals from outside the fan industry as well. Executive Compensation is a mechanism used to entice managers to act in the interests of shareholders through the payment of salaries, bonuses, and employee stock options.
The general consensus is that executives should be paid based on their performance. However, linking compensation to the firm’s financial performance over an extended period of time is difficult to assess as “strategic decisions are more likely to have long-term… effects on a company’s strategic outcomes” (Hitt, Ireland & Hoskisson, 2004). Executive compensation simply is an incentive for managers to make decisions that will maximize shareholder wealth, and “are imperfect in their ability to monitor and control managers” (Hitt, Ireland & Hoskisson, 2004).
While the rationale for paying managers with stock options is to entice them to make sound decisions that will maintain or increase the stock price, it must be used carefully as not to create a conflict of interest. An agency relationship exists when the owners are not the people who manage the firm. When the owner hire decision makers to manage the daily operations an agency relationship has been created. In addition, an agency relationship is created when someone is hired to perform a service to or for the firm, including consultants.
This relationship results in a separation between ownership and managerial control which if not properly controlled, can be problematic due to conflicting interests. Managerial opportunism is the term used to describe managers acting in their own best interest to the detriment of the shareholders. It must be checked through the establishment of corporate governance and control mechanisms. Emerson Electric has an agency relationship with their CEO, Charles Knight, subpack vendor, Lao Chiang, and even foreign operations intern, Ken Powers.
Knight is responsible for the day-to-day management of the firm, developing cost-effective and profitable strategies, and increasing shareholder wealth. Lao Chiang is a contracted vendor responsible for providing parts for the Air Comfort Products Division. And Ken Powers is a summer intern responsible for making recommendations regarding the sourcing of the ceiling fan subpacks. While the responsibilities of each party is completely different, the nature of the relationship is the same. Each party is responsible for providing goods or services. Each agent must make decisions and act in the best interest of Emerson Electric.
Sometimes executives, including those with stock options, will make decisions that reflect their own personal welfare and is detrimental to the firm, including overdiversification and making the type of decisions such as those taken by Enron management who falsely inflated earnings to not only increase the stock price, but also to lower their own employment risk. These types of not only unethical decisions, but illegal as well, can have serious ramifications and can destroy a company’s reputation and bankrupt a firm. This is why executive oversight is a necessity.
Even though the CEO is ultimately responsible for the strategic direction of the firm, having a team-based decision-making process is also a solid idea when using facts and data to back up decisions and taking few calculated risks. References Davis, E. W. & Paige, K. L. (1991). Emerson electric company ACP division: The fan subpack sourcing decision. Darden Business Publishing, University of Virginia. Pp. 1-21, Primis pp. 92-112. Hitt, M. , Ireland, R. , & Hoskisson, R. (2004) Strategic Management: Competitiveness and globalization (6th ed. ) Mason, OH: South-Western Cengage Learning.