Agency problem and corporate governance

8 August 2016

The concept of corporate governance in legal and economic terms is equivalent to “the defense of shareholders”. Corporate governance is the response to typical agency problems between investors and managers of the firm, who frequently have divergent interest. What constrains management to return profit to the suppliers of finance? For the investors “what will guarantee that their money is best exploited? ” managers may use many techniques to pursue personal benefits at the expense of investors.

For example they may spend money on unnecessary luxury items, make business decision with the primary intention of increasing their power, or improperly manage risk in a manner that does not maximize shareholders utility. The corporate governance framework consists of explicit and implicit contracts between the company and the stakeholders for distribution of responsibilities, rights, and rewards, procedures for reconciling the sometimes conflicting interests of stakeholders in accordance with their duties, privileges, and roles, and procedures for proper supervision, control, and information-flows to serve as a system of checks-and-balances.

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i Corporate governance became a pressing issue following the 2002 introduction of the Sarbanes-Oxley Act in the U. S. , which was ushered in to restore public confidence in companies and markets after accounting fraud bankrupted high-profile companies such as Enron and WorldCom. Most companies strive to have a high level of corporate governance. These days, it is not enough for a company to merely be profitable; it also needs to demonstrate good corporate citizenship through environmental awareness, ethical behavior and sound corporate governance practices.ii II. Content F. Definitions of corporate governance Corporate governance refers generally to the legal and organizational framework within which, and the principles and processes by which, corporations are governed. It refers to the powers, accountability, and relationships of those who participate in the direction and control of a company. Chief among these participants are the board of directors, and management. There are aspects of the corporate governance regime that have an impact on the relationship between shareholders and the company.

According to principles of good corporate governance and best practice recommendation: “Corporate governance is the framework of rules, relationships, systems, and processes within and by which authority is exercised and controlled in corporations. It encompasses the mechanisms by which companies, and those in control, are held to account. Corporate governance influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimized.

Effective corporate governance structures encourage companies to create value, through entrepreneurialism, innovation, development and exploration, and provide accountability and control systems commensurate with the risk involved”iii. From The USA perspective, it can be defined as, “ the implementation and execution of processes to ensure that those managing a company properly utilize the time, talents, and available resources in thebest interests of absent owners. These processes include all aspects of a company’s performance including risk management, operational and marketing strategies, internal control, conformance with applicable laws and regulation, public relations, communication, and financial reporting. ” In the broad sense corporate governance can be defined as the governance “dealing with problems that result from the separation of ownership and control”.iv Accordingly, corporate governance is concerned with the internal structure and rules of the board of directors; the creation of independent audit committees; rules of disclosure of information to shareholders and creditors; and control of the management. Hence corporate governance focuses on the following : 1. Shareholders elect directors who represent them. 2. Directors vote on key matters and adopt the majority decision. 3. Decisions are made in a transparent manner so that shareholders and others can hold directors accountable. 4.

The company adopts accounting standards to generate the information necessary for directors , investors and other stakeholders to make decisions 5. The company’s policies and practices adhere to applicable national, state and legal lawsv From the narrow sense , corporate governance as defined by Milton friedman is “ to conduct the business in accordance with the owner’s or shareholders’ desires, which generally will be to make as much money as possible, while conforming to the basic rules of the society embodied in law and local customs”.

The OECD also offers a broader sense “ corporate governance refers to the private and public institutions, including laws, regulations and accepted business practices, which together govern the relationship in a market economy, between corporate managers and entrepreneurs ( corporate insiders) on one hand, and those who invest resources in corporations, on the other” Hence, corporate governance is the system of rules, practices and processes by which a company is directed and controlled.

Corporate governance essentially involves balancing the interests of the many stakeholders in a company – these include its shareholders, management, customers, suppliers, financiers, government and the community. Since corporate governance also provides the framework for attaining a company’s objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure. G.

Theories behind corporate governance : The theories that have affected the whole development of corporate governance should be viewed in conjunction with the legal system and capital market development. For example countries like UK and USA have a common law system that tends to give good protection to shareholders rights, while civil law countries, such as France, tend to have less effective legal protection for shareholders rights and more emphasis may be given to stake groups.

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