Understanding and Managing Strategic Governance. Wei Shi

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How many corporate governance teams are equipped to face the strategic challenges spurred by the cross currents within the contemporary activist environment? Authentic strategic governance must go beyond simply making a set of decisions in response to a specific issue, and move toward a comprehensive approach for dealing with activist governance actors. Although activists are mostly found outside the firm, more are working from the inside upon the election of activist representative board members. As activist governance players proliferate and refine new techniques (as those described in the Strategic Governance Challenge Box 1.1), top executives and boards of directors must make critical strategic decisions, often under conflicting pressures. Top managers face the difficulty of needing to move the company forward while managing the challenges to their leadership from outside stakeholders, many of whom hold leverage over firm ownership voting rights, wield power to marshal governance advocates, and exert influence over the views of journalists and analysts.

The Harley-Davidson case that opens this chapter stands as a powerful example of how activist shareholders, the primary initiators of activist campaigns, often try to gain control of a company or replace management. But the activist may force major corporate change through other ways, such as by demanding divestitures and selloffs.¹ Announcements to sway the strategic decision-making of a board and CEO have significant influence on stock prices.² Activist announcements often impact stock market analysts' views, prompting changes in analysts' buy or sell recommendations, which may influence a firm to change its strategy.³

Generally, hedge funds and activist pension funds originate this kind of activism. But, as we will see in our book, other corporations also engage in external governance campaigns through hostile takeover attempts for corporate control or by buying noncontrolling block ownership. Even shareholder governance watchdogs, such as the Institutional Shareholder Services (ISS) and Glass Lewis, as well as government regulators such as the Securities and Exchange Commission, may take actions that demand a strategic response. To manage these types of external governance actors, a firm's internal governance team needs to understand how to best interact with these actors and how to make strategic decisions that will respond to or counteract their targeting, while at the same time capitalizing on the expertise and experiences that these external influencers provide. Boards and managers must also prepare to handle legal interventions, as activist shareholders increasingly turn to the courts in efforts to maintain shareholder rights and value. Responding to these actions is proving expensive; the price of director and officer (D&O) insurance, for example, rose by 104 percent in the United States in the first quarter of 2020 compared with the same period a year earlier. The price rose by 255 percent for the same timeframe in Australia.⁴

The board of directors serves as a firm's central internal governance mechanism. Directors monitor management, provide advice on major strategic decisions, and direct employment relationships especially by selecting top executives and establishing executive compensation structures. Meanwhile, owners, especially institutional owners, are the main external governance mechanism for publicly traded firms. Historically, top executives have largely held control over major strategic decisions as boards only symbolically monitor, providing merely a “rubber stamp” on the critical strategic decisions.⁵ Although this tendency continues, especially in countries with large family-controlled diversified business groups like in India and many Asian (South Korea, Japan, Taiwan) and Latin American countries,⁶ change is occurring quite drastically in Western countries, especially in the United States and United Kingdom. Activist investors, who exercise their voice about strategic decisions and executive compensation, drive the change. Their central approach consists of buying significant stakes of shares to seek control of firms or to use the proxy voting system to place activist investor representatives on boards of directors of targeted firms. Activists lobby corporations for corporate governance changes along with proxy intermediaries and governance watchdogs such as ISS and Glass Lewis. Government policy and associated agencies have also fostered more shareholder power and transparency through increased regulation as with the Sarbanes-Oxley (SOX) and Dodd-Frank Acts. These combined forces have increased the potency of shareholder activism, especially when other institutional investors (even index focused institutional investors) follow the lead of the activists.⁷

Although the activism noted above has caused turmoil among firms' board members and top management teams, the practice has created more intense governance and has given more voice to shareholders on strategy issues. For instance, activists have pursued more long-term compensation packages, which has created pressure for improved performance. Yet the greatly added pressure to perform has led some firm leaders to “cook the books,” contributing to more financial fraud.⁸ Another indirect effect of activism impacts areas such as supply chains and market power, such as when a firm targeted by activists causes pressure on suppliers, especially those heavily dependent on the target for a large portion of their sales, to reduce costs.⁹

These increasing and sometimes severe impacts of shareholder activism explain the burgeoning number of academic treatises on corporate governance, usually defined as a set of mechanisms used to manage stakeholder relationships, establish rules to determine and control enterprise strategic decision-making, and distribute the returns from investments.¹⁰ At its core, corporate governance seeks to help ensure effective strategic decisions, facilitate the firm's strategic goals, and foster stakeholders' cooperation to achieve those goals. However, though the goals may be straightforward, the practice can prove difficult because of the many potentially conflicting interests of the various stakeholders.

Although substantial research examines the impact of these influences on governance outcomes, such as executive compensation,¹¹ less focus occurs on the effects that governance actors have on the various areas of organizational development, including corporate strategy (such as acquisitions and divestitures), competitive strategy, global expansion, and stakeholder policies like more socially responsible and nonmarket investments. We aim to provide strategic governance recommendations and direction for executives as well as board members to understand antecedents that trigger interaction between firm executives and activist governance actors, what the consequences of responses might be, and possible strategic actions that firm executives and governance actors might take under specific strategic governance situations. Such guidance might become particularly important when conflicting influences arise among executives, board members, and outside governance stakeholders during key strategic decisions. We lay out the organization of our book in Figure 1.1. Our discussion of internal governance mechanisms in this chapter will proceed to an exploration of external governance mechanisms in Chapter 2, followed by an examination of the