Understanding conflicts, mechanisms, risks, and benefits
Corporate governance is the system of relationships, rules, and processes by which a corporation is directed and controlled. Its primary goal is to protect the interests of all stakeholders, including owners (shareholders), lenders (creditors), managers, and others.
A core challenge in corporate governance is managing the inherent conflicts of interest among different stakeholder groups.
This relationship is central to corporate structure. Principals (e.g., shareholders) hire Agents (e.g., managers) to act on their behalf. However, conflicts arise because the agent may have different interests than the principal, and the principal cannot perfectly monitor the agent's actions (a problem called information asymmetry).
These are the costs that arise from managing these conflicts. They include:
Managers might prioritize their own job security or compensation over maximizing shareholder value.
Controlling shareholders hold enough shares to control the company. Conflicts arise when they use this power to benefit themselves at the expense of minority shareholders (e.g., through related-party transactions). A dual-class share structure (where insiders hold shares with multiple votes) can institutionalize this control.
Their interests diverge primarily over risk:
Benefit from high-risk projects and prefer higher leverage (debt) and more dividend payments.
Prefer stable, low-risk projects to ensure repayment. They favor less debt and fewer dividends to keep cash in the company.
To manage conflicts and align interests, various mechanisms are put in place to give stakeholders a voice and protect their rights.
The Board of Directors is the primary internal governance mechanism. It establishes committees to oversee critical functions:
Oversees financial reporting, internal controls, and the relationship with external auditors. Ensures compliance with accounting standards.
Manages board nominations and elections. Develops and oversees the company's corporate governance policies.
Sets the compensation policies for directors and senior executives, aiming to align their incentives with shareholder interests.
Governments, regulators, and other external parties also play a crucial role through:
Covering contracts, property rights, consumer protection, etc.
Standards for publicly traded firms, often on a "comply or explain" basis.
Requirements for public disclosure, enabling stakeholder oversight.
The quality of a company's governance has a direct impact on its performance and value.
When evaluating a company's governance, analysts should focus on:
Dual-class shares, controlling shareholders, and their impact on decision-making.
The skills, experience, and independence of board members and their ability to oversee management.
Structure of management's compensation and its alignment with long-term performance.
The strength of shareholder rights and ability to influence corporate decisions.
The company's approach to long-term risk management and strategic planning.