Understanding and Managing Strategic Governance. Wei Shi

management team members can give rise to problematic social comparison, since a smaller number of officers may get large pay packages, whereas others receive less.⁵¹ Large pay dispersions can generate less cooperative teamwork and less effective overall strategy implementation, ultimately leading to lower firm performance. For instance, a large pay gap between CEOs and non-CEO top executives provides strong incentives for the latter to resort to misconduct as a means of outperforming others.⁵² Relatedly, high pay dispersion among employees in R&D groups leads to less innovation,⁵³ which is especially detrimental to firms in the pharmaceutical industry or other industries that depend on innovation for continued profitability. Collective incentives focused on the top management team can also influence how much the whole firm will focus on corporate social responsibility issues.⁵⁴ Also, by setting the pay culture for the firm, not only for top managers but for employees overall, the compensation committee influences strategic implementation throughout the organization.

Audit committees may likewise influence strategy, albeit at times indirectly. As noted earlier, boards with a majority of outside directors depend on financial outcomes to judge firm performance, or what is labeled financial control.⁵⁵ Comparatively, a strategic control emphasis allows for the evaluation of strategic situations subjectively, based on the quality of board member strategic comprehension during decision-making. If no one on the audit committee can help inform outside board members to understand the strategic contingencies involved, their sole dependence on their accounting and financial orientation will likely affect the firm's strategy, since managers will take actions that involve less risk, such as more unrelated diversification.⁵⁶ That is, if managers feel that they are judged on financial outcomes alone rather than on the upfront agreement of the board (or committee) on the quality of their decisions using strategic controls, they are likely to seek to diversify the firm to reduce their employment risk (see Chapter 3).⁵⁷

Business-level strategy (strategic positioning within the same industry) is also affected by these control systems. In a classic strategy book titled Organizational Strategy, Structure, and Process,⁵⁸ two polar business-level strategies are defined: defenders and prospectors. Defender strategies target stable and defensible market domains, seeking to solve the engineering problem by focusing efforts on producing and distributing goods and services in the most efficient and cost-effective manner possible. Alternatively, prospectors pursue strategies that tend to compete by continually finding and exploiting new product and market opportunities, seeking to establish strong product reputation and market dominance through product innovation and market development. Prospectors take risks, which enable them to quickly respond to new opportunities and changing competitive landscapes. When a firm pursues a less aggressive, more predictable, and stable strategy (such as those generally pursued by defenders), the audit committee can rely more on financial control, judging executives based on their achievement of financial objectives⁵⁹ and an appropriate tax strategy.⁶⁰ However, a prospector firm audit committee may need to allow executives to take on more risk. Directors should therefore make sure that the audit committee is structured with the right members to fit the business-level strategic approach that the firm pursues to enable proper strategy execution (see Chapter 4).

The most beneficial background for audit committee members and the optimal committee practices may differ between industries and even with the board as a whole; firms in high-technology industries with rapid change will need to have more emphasis on strategic control than more stable industries.⁶¹ In addition to industry, the stage of the firm in its lifecycle or its strategic focus may also affect optimum governance characteristics and processes.⁶² A small, young, rapidly growing firm with high institutional ownership, for example, may benefit more from directors with industry expertise and from a greater focus on serving, as in an advisory source to management. Conversely, a large, established firm in a declining industry, with a widely dispersed shareholder base, may benefit more from directors with financial expertise and a board more focused on its monitoring role.

EMPLOYEES AS INTERNAL GOVERNANCE ACTORS

Employees constitute an important group of internal stakeholders for firms. Employees not only provide human capital critical to sustain a firm's daily operations, but also play an essential role in maintaining and expanding customer bases. The impact of employees on corporate governance varies significantly across the world. In the United States, the key channel for employees to participate in governance occurs through employee stock ownership plans (ESOPs).⁶³ ESOPs are investment vehicles through which employers make tax-deductible contributions of cash or stock into a trust, whose assets are allocated in a predetermined manner to employee plan participants.⁶⁴ By 2016, around 6,624 ESOPs and ESOP-like plans were active in the US, holding total assets of nearly $1.4 trillion, according to the National Center for Employee Ownership.⁶⁵

By making employees owners, such ownership can lead to a convergence of interests between employees and shareholders.⁶⁶ Ownership gives employees a voice in corporate governance through their voting power, which can prevent firms from maximizing the interests of shareholders at the expense of those of the workers.⁶⁷ Yet in the United States, although employees can influence corporate governance through their ownership, they typically do not have board representation,⁶⁸ leaving employees with little say in boardroom discussions. As a result, directors often compromise employee interests to satisfy the interests of shareholders in firm decision-making.⁶⁹ To address this issue, several pieces of federal legislation have been introduced to grant employees the right to sit on corporate boards. For example, the Reward Work Act introduced by US senator Tammy Baldwin would empower workers by requiring public companies to directly elect one-third of their company's board of directors and reduce open-market stock buybacks.⁷⁰

As shown in the Strategic Governance Highlight (Box 1.2), Germany and other Western European countries have a two-tier board consisting of a board of directors and a supervisory board. In this system, the law guarantees employee representation on corporate boards of directors as a recognized fundamental worker right. Employees can vote for representatives in supervisory boards under corporate law, which is often referred to as co-determination. Like many Western European countries, China requires publicly traded companies to have a supervisory committee. Such a committee must include employee representatives elected by personnel through an assembly of some or all employees, or by other means. Although employee representation on boards does not necessarily lead to higher profits and faster growth,