This reading gives an overview of corporate governance, the stakeholders of a company, describes how companies manage various stakeholders, the role played by the board of directors, the risks in a corporate governance structure, what corporate governance issues are relevant for investment professionals, and environmental and social considerations for investors.
The curriculum defines corporate governance as “the system of internal controls and procedures by which individual companies are managed.” Corporate governance defines the rights, roles, and responsibilities of various groups within an organization and how they interact. One of the goals of a good corporate governance system is to minimize the conflict of interests between the stakeholders within a company and external shareholders.
Corporate governance practices differ from country to country, and even within a country several governance systems may be practiced. Most corporate governance systems are based on one of these two theories or a combination of both: stakeholder theory and shareholder theory.
Shareholder theory is based on the premise that the goal of a company is to maximize shareholder returns.
Stakeholder theory is based on the premise that a company’s focus is not restricted to shareholders, but extends to other stakeholders as well such as its customers, employees, suppliers, etc.
A corporate governance system considers the needs of several stakeholder groups, some of whom may have conflicting interests. This section covers the various stakeholder groups in a corporation and the possible conflicts across these groups.
The primary stakeholder groups of a corporation include shareholders, creditors, managers and employees, a board of directors, customers, suppliers, and governments/regulators. We look at each group in detail now.
Shareholders own shares in a corporation and are entitled to certain rights, such as the right to receive dividends and to vote on certain corporate issues.
There are two types of shareholders in a company:
Creditors are suppliers of debt financing to a company such as bondholders and banks. Some of the key characteristics and rights of creditors are listed below:
Managers and Employees
Senior managers and employees are compensated for their work at a company through salary and bonuses linked to individual and company performance, stock options, etc. Lower level employees seek fair salary, career development through training, good working conditions, promotion, etc. Managers and employees are directly affected by a company’s performance. They can expect to receive a good payout when the company does well and similarly face layoffs when the performance is poor. They have conflicting interests with other stakeholders in situations like a takeover.
A Board of Directors
A company’s board of directors is elected by the company’s shareholders to protect their interests, monitor the company’s operations and performance of the management, and participate in strategic discussions about the company. Directors are experienced individuals and often experts in their fields who enjoy a good reputation in the business community. They must keep a tab on the company’s operations to ensure shareholders’ interests are protected. There are two ways in which a board is often structured:
Customers expect to receive products and services of good quality for the price paid. They also expect after-sales service, support, and guarantee/warranty for the period promised. In return, companies strive to keep their customers happy as this has a direct effect on its revenues. Of all the stakeholders, customers are least concerned about a company’s performance.
A supplier’s interest in a company is limited to being paid for the products and services supplied to a company. Some suppliers are keen to maintain a good long-term relationship with companies as it is recurring business. Suppliers are primarily concerned that a company has a good operating performance and steady cash flow so as to pay their dues.
Government is a stakeholder as it collects taxes from companies. It is in the interest of governments and regulators to pass laws and regulations to ensure the interests of the investors are protected. The state of a country’s economy, output, import/export, employment, and capital flows are all affected by how well companies function in a country.
A principal-agent relationship arises when a principal hires an agent to carry out a task or a service. An agent is obliged to act in the best interests of the principal and should not have a conflict of interest in performing a task. However, in reality, there are several conflicts of interest that arise in a principal-agent relationship and we look at a few of them in this section.
In this relationship, shareholders are the principals and managers/directors are the agents. Shareholders elect the board of directors and assign them the responsibility to act in their best interests by maximizing equity value. Examples of situations that may lead to a conflict of interest between shareholders and managers/directors are as follows:
Controlling shareholders are shareholders with a controlling stake and significant authority to influence decision-making in a company. Minority shareholders, on the other hand, have limited or no control over the management. Situations where the two ownership structures lead to a conflict of interest are as follows:
The management of the company is primarily responsible for the operations of a company and has access to all information about the company. Since the board relies on the management for information, its powers and monitoring ability is limited if information is withheld by the management or only selective information is provided.
There is a conflict of interest between the two suppliers of capital to a company under the following circumstances:
Examples of other conflict of interests among other stakeholders are as follows: