Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Corporate governance is the system of rules, practices and controls by which a company is directed, and it exists because the people who run a company are rarely the only people with a stake in it. This module identifies the main conflicts of interest, explains the mechanisms that shareholders, boards, creditors, employees and governments use to manage them, and shows what goes wrong when governance is weak and what analysts look for when they assess it.

Start this lesson free Practice questions

What you will learn

1. Describe principal-agent relationships and the conflicts that arise between shareholders and managers, controlling and minority shareholders, shareholders and creditors, and shareholders and other stakeholders.

Agency costs = monitoring costs + incentive and contracting costs + value lost to remaining misaligned behavior.
Manager conflicts: low effort, empire building, entrenchment, perquisites, short-termism, too little or too much risk.
Controlling shareholders can extract private benefits through related-party transactions and control-enhancing structures.
Dual-class shares separate voting control from economic ownership.
Shareholders can gain at creditors' expense through risk-shifting, extra debt and large payouts.

2. Describe the mechanisms shareholders use to protect their interests, including disclosure, general meetings and voting, activism, derivative lawsuits and the market for corporate control, and calculate the board seats a minority can secure under cumulative voting.

Disclosure, general meetings, proxy voting and say-on-pay give shareholders information and voice.
Straight voting lets a majority elect all directors; cumulative voting lets a minority secure board representation.
Shares needed to guarantee n of N seats: more than n x S / (N + 1).
Activists use engagement, proposals and proxy contests; derivative suits recover losses for the company.
Proxy contests, tender offers and hostile bids form the market for corporate control; takeover defenses can entrench managers.

3. Describe the role, structure and committees of the board of directors and the mechanisms that protect creditors, employees, customers, suppliers and the public.

Directors owe duties of care and loyalty and oversee strategy, management, risk and reporting.
One-tier boards combine executives and non-executives; two-tier boards separate a supervisory board from the management board.
Independent directors, a separate chair and annual director elections strengthen accountability; staggered boards weaken it.
Key committees: audit, nominations and governance, remuneration, risk.
Creditors use covenants and collateral; employees, customers and suppliers rely on contracts and law; governments set rules and codes.

4. Describe the risks of weak governance and poor stakeholder management, the benefits of effective governance, and the governance factors analysts evaluate.

Risks of weak governance: weak controls, poor decisions, legal and reputational damage, higher default risk.
Benefits of strong governance: efficiency, better control, stronger performance, lower default risk and cost of capital.
Analysts compare economic ownership with voting control and assess board independence and expertise.
Pay should reward long-term value, with appropriate measures, holding periods and clawbacks.
Large related-party transactions, weak audit committees and long auditor tenure are red flags.

Module at a glance

Agency conflicts arise because agents know more than principals and have their own interests.
Key conflicts: shareholders vs managers, controlling vs minority holders, shareholders vs creditors and other stakeholders.
Dual-class shares give voting power out of proportion to economic ownership.
Shareholder tools: disclosure, voting (straight or cumulative), activism, derivative suits and takeovers.
Cumulative voting: more than n x S / (N + 1) shares guarantees n seats.
Boards need independence and strong audit, nominations and remuneration committees; staggered boards entrench.
Weak governance raises control, decision, legal and default risk; strong governance lowers the cost of capital.

This free module has 4 lessons, 14 practice questions with full explanations.

Start the lesson