Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

A principal-agent relationship is formed when one party (the principal) hires another (the agent) to perform a task, with the agent expected to act in the principal's best interest. Conflicts arise when the agent's interests diverge from those of the principal, leading to agency costs.

Shareholders (principals) elect directors (agents) who hire managers (agents) to run the company. Information asymmetry and differing risk appetites can lead to conflicts, such as insufficient effort, inappropriate risk appetite, empire building, entrenchment, and self-dealing by managers.

Conflicts can arise between controlling shareholders who may have long-term interests or desire stability, and minority shareholders who may seek quick gains or have different risk appetites. Dual-class share structures can exacerbate these conflicts by allowing disproportionate control.

Shareholders and creditors have conflicting interests due to their different claims on the company's cash flows. Shareholders prefer actions that increase risk and potential returns, such as high leverage, while creditors prefer actions that ensure their fixed claims are met, favoring lower risk.

Corporate reporting and transparency are crucial for stakeholders to assess company performance and make informed decisions. This includes financial statements, governance structures, and risk factors, which are often regulated by legal and quasi-regulatory frameworks.

Shareholders use various mechanisms like AGMs, EGMs, proxy voting, and shareholder activism to influence company decisions and protect their investments. These mechanisms are supported by securities laws and corporate governance codes.

Creditors protect their interests through legal contracts such as bond indentures, which define the rights and obligations of the company and the bondholders. Creditor committees may also form during bankruptcy to represent bondholder interests.

The board of directors, central to corporate governance, often delegates specific responsibilities to various committees such as the Audit, Nominating/Governance, and Compensation/Remuneration Committees to handle detailed governance aspects requiring specialized knowledge.

Companies manage employee relations through compliance with labor laws, employment contracts, and potentially through mechanisms like ESOPs to align employee interests with those of the company.

Contracts between companies and their customers or suppliers specify terms of service or product delivery, pricing, and rights in case of breaches, ensuring clear mutual expectations.

Governments enforce regulations and laws that companies must adhere to, protecting broader societal interests and ensuring corporate actions align with legal standards.

Weak corporate governance can lead to poor control systems and decision-making, which may benefit one stakeholder group at the expense of others. Strong governance practices involve proper scrutiny and control at all corporate levels, enhancing operational efficiency and mitigating risks such as fraud.

Inadequate governance can expose a company to legal and regulatory risks, leading to investigations and lawsuits. Strong governance protects against these risks and supports a company's reputation, enhancing its ability to attract talent, secure capital, and maintain stakeholder trust.

Poor governance can impact a company's financial stability and increase its cost of debt due to higher perceived risks by creditors. Effective governance ensures transparency, better reporting, and alignment of interests between management and shareholders, leading to improved financial health and reduced cost of equity.