Michael_A._Hitt,_R._Duane_Ireland,_Robert_E._Hosk

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Chapter 10: Corporate Governance 317

Enron and WorldCom, and the more recent actions by major financial institutions. Partly
in response to these behaviors, the U.S. Congress enacted the Sarbanes-Oxley Act (SOX)
in 2002 and passed the Dodd-Frank Wall Street Reform and Consumer Protection Act
(Dodd-Frank) in mid-2010.
Because of these two acts, corporate governance mechanisms should receive greater
scrutiny.^42 While the implementation of SOX has been controversial to some, most believe
that its use has led to generally positive outcomes in terms of protecting stakeholders
and certainly shareholders’ interests. For example, Section 404 of SOX, which prescribes
significant transparency improvement on internal controls associated with accounting
and auditing, has arguably improved the internal auditing scrutiny (and thereby trust)
in firms’ financial reporting. Moreover, research suggests that internal controls associ-
ated with Section 404 increase shareholder value.^43 Nonetheless, some argue that the Act,
especially Section 404, creates excessive costs for firms. In addition, a decrease in foreign
firms listing on U.S. stock exchanges occurred at the same time as listing on foreign
exchanges increased. In part, this shift may be because of the costs SOX generates for
firms seeking to list on U.S. exchanges.
Dodd-Frank is recognized as the most sweeping set of financial regulatory reforms in
the United States since the Great Depression. The Act is intended to align financial insti-
tutions’ actions with society’s interests. Dodd-Frank includes provisions related to the
categories of consumer protection, systemic risk oversight, executive compensation, and
capital requirements for banks. Some legal analysts offer the following description of the
Act’s provisions: “(Dodd-Frank) creates a Financial Stability Oversight Council headed
by the Treasury Secretary, establishes a new system for liquidation of certain financial
companies, provides for a new framework to regulate derivatives, establishes new cor-
porate governance requirements, and regulates credit rating agencies and securitizations.
The Act also establishes a new consumer protection bureau and provides for extensive
consumer protection in financial services.”^44
More intensive application of governance mechanisms as mandated by legislation
such as SOX and Dodd-Frank affects firms’ choice of strategies. For example, more
intense governance might find firms choosing to pursue fewer risky projects, possibly
decreasing shareholder wealth as a result. In considering how some provisions asso-
ciated with Dodd-Frank dealing with banks might be put into practice, a U.S. federal
regulator said, “To put it plainly, my view is that we are in danger of trying to squeeze
too much risk and complexity out of banking.”^45 As this comment suggests, deter-
mining governance practices that strike an appropriate balance between protecting
stakeholders’ interests and allowing firms to implement strategies with some degree
of risk is difficult.
Next, we explain the effects of the three internal governance mechanisms on manage-
rial decisions regarding the firm’s strategies.

10-2 Ownership Concentration


Ownership concentration is defined by the number of large-block shareholders and the
total percentage of the firm’s shares they own. Large-block shareholders typically own at
least 5 percent of a company’s issued shares. Ownership concentration as a governance
mechanism has received considerable interest because large-block shareholders are
increasingly active in their demands that firms adopt effective governance mechanisms
to control managerial decisions so that they will best represent owners’ interests.^46 In
recent years, the number of individuals who are large-block shareholders has declined.
Institutional owners have replaced individuals as large-block shareholders.

Ownership concentration
is defined by the number of
large-block shareholders and
the total percentage of the
firm’s shares they own.
Large-block shareholders
typically own at least
5 percent of a company’s
issued shares.
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