FREE online courses on Introduction to Strategic Management - Corporate Governance and Stakeholders - Corporate Governance and Stakeholders

 

Corporate governance is a relationship among stakeholders that is used to determine and control the direction and performance of companies.  It is determining how shareholders (owners) can ensure that managers develop and implement strategic decisions that are in the best interests of the shareholders (owners) and not primarily self-serving (in the best interests of managers only, to the detriment of shareholders).  In the absence of effective internal governance mechanisms, the market for corporate control--an external governance mechanism--may be activated.

 

Several governance mechanisms are used in the modern corporation. Some of them are as follows:

 

Ownership Concentration, representing the relative amounts of stock owned by individual shareholders and institutional investors

 

The Board of Directors, or the individuals responsible for representing the company's owners by monitoring the strategic decisions of top-level managers

 

Executive Compensation, or the use of salary, bonuses and long-term incentives to align the interests of managers with those of shareholders (owners)

 

The Market for Corporate Control, or the purchase of a company that is underperforming relative to its industry rivals in order to improve its strategic competitiveness

 

The primary purpose of governance mechanisms is to prevent severe problems that may occur because of the separation of ownership and control in large companies by positively influencing managerial behaviour. The ability of governance mechanisms to direct top-level mangers' actions toward preferred shareholder objectives are dependent on the correct combination of mechanisms being used.

 

In the case of large, publicly owned corporations, a diverse group of owners contracts with professional managers to oversee the company's strategic decision process and pays them compensation in return for their services. These managers specialise in decision-making and strategy development. Without professional mangers that specialise in decision-making, owners would not be able to specialise in risk bearing (and risk-reduction). The strategic competitiveness of companies would then be limited to the abilities of owners to manage.

 

This efficient separation of ownership and control, while it enables specialisation both by owners and managers results in some potential costs (and risks) for owners by creating an agency relationship. The potential for conflicts of interests between owners and managers is created by the delegation of the responsibilities of decision making and managing by owners to managers.  Therefore, managers may take actions that are not in the best interests of owners by selecting strategic alternatives that serve managerial interests rather than shareholder or owner interests.

 

 

Figure: The Agency Relationship

 

This relationship enables the possibility of managerial opportunism, the seeking of self-interest with guile [i.e., cunning or deceit]. However, it is not possible before observing the results of decisions which agents will behave opportunistically and which ones will not because a manager's reputation is an imperfect guide to future behaviour and opportunistic behaviour cannot be observed until after it has occurred.  As a result, principals establish governance and control mechanisms because the opportunity for opportunistic behaviour and conflicts of interest exists.

 

Product diversification can be beneficial to both shareholders and managers, but it also is a potential source of agency problems. Managers may pursue higher levels of product diversification than are desired by shareholders to capture the value of opportunities that are available to managers, but are not beneficial to the owners. Increased diversification generally drives the growth of the company and company growth is positively related to managerial compensation. Thus, by diversifying to a greater extent than may be desired by shareholders, managers may be able to enjoy the higher levels of compensation that accompanies managing larger companies.

 

Increased diversification also can reduce managerial employment risk (the risk of job loss, loss of compensation, or loss of managerial reputation). This is because of the fact that the company (and the manager) is less affected by a reduction in demand for (or failure of) a single product line when the company produces and sells multiple products.

 

Owners may benefit from managers' decisions to diversify the company's products, but only to the point where investment returns at the margin are no longer positive.  That is, diversification is valuable to (and preferred by) owners as long as it has a positive effect on company value. However, some companies may be over-diversified, despite the lack of profitability in their dominant business. Owners may also prefer that excess funds be returned to them in the form of dividends so that they can control reinvestment decisions.

 

For company diversification to approach the levels where shareholders benefits are optimum, managerial autonomy must be controlled by the company's board of directors or by other governance mechanisms that encourage managers to make strategic decisions that are in the best interests of shareholders.

 

It should be noted that establishing and using governance mechanisms is not costless; agency costs are incurred. Agency costs are the sum of incentive, monitoring, and enforcement costs as well as any residual losses incurred by principals because it is not possible for principals to guarantee 100% compliance through monitoring arrangements.