Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
Overview
Corporations are complex structures with stakeholders beyond owners, lenders, and managers. Corporate governance involves the creation and maintenance of a system of checks, balances, and incentives that addresses conflicting interests among these stakeholders. In this Learning Module, we first identify key aspects of the relationships between these parties and the potential conflicts that may arise. In the second lesson, we turn to the various mechanisms established to manage these conflicts, settle disputes, and mitigate risk. Finally, we highlight the benefits of strong corporate governance and stakeholder management policies as well as the risks of weak policies and their potential impact on corporate performance.
- A principal-agent relationship is created when one party (a principal) hires another party (an agent) to perform a task or service. The relationship can exist with or without a contract. The agent is expected to act in the principal’s best interest.
- In many cases, the agent possesses more information than the principal, and conflicts arise where the interests of the principal and the agent diverge. In a corporation, shareholders are a principal and elect directors (an agent), who appoint managers (another agent), who are charged with maximizing shareholder value.
- Given the complex ecosystem of stakeholders in a corporation, the rights, responsibilities, and powers of each stakeholder must be considered when establishing an appropriate governance structure by striking a balance among the interests of these groups while meeting corporate objectives.
- A sound governance structure consists of mechanisms to ensure adherence to rules and regulations imposed by external authorities as well as to meet the unique requirements of internal stakeholders. These mechanisms include financial reporting, general and extraordinary meetings, compensation, debt covenants, and more.
- Weak corporate governance, unmanaged conflicts of interest, or inadequate stakeholder management can place firms at a competitive disadvantage. Strong governance practices and a proper balance among stakeholders’ interests are often reflected in increased competitiveness and operational efficiency, better control processes, and improved performance.
Learning outcomes
The candidate should be able to:
- describe the principal-agent relationship and conflicts that may arise between stakeholder groups;
- describe corporate governance and mechanisms to manage stakeholder relationships and mitigate associated risks;
- describe potential risks of poor corporate governance and stakeholder management and benefits of effective corporate governance and stakeholder management.
1 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.