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Defining Corporate Governance

We define corporate governance as the collection of control mechanisms that an organization adopts to prevent or dissuade potentially self-interested managers from engaging in activities detrimental to the welfare of shareholders and stakeholders. At a minimum, the monitoring system consists of a board of directors to oversee management and an external auditor to express an opinion on the reliability of financial statements. In most cases, however, governance systems are influenced by a much broader group of constituents, including owners of the firm, creditors, labor unions, customers, suppliers, investment analysts, the media, and regulators (see Figure 1.4).

Figure 1.4

Figure 1.4 Selected determinants and participants in corporate governance systems.

Source: Chart prepared by David F. Larcker and Brian Tayan (2011).

For a governance system to be economically efficient, it should decrease agency costs more than the costs of implementation. However, because implementation costs are greater than zero, even the best corporate governance system will not make the cost of the agency problem disappear completely.

The structure of the governance system also depends on the fundamental orientation of the firm and the role that the firm plays in society. From a shareholder perspective (the viewpoint that the primary obligation of the organization is to maximize shareholder value), effective corporate governance should increase the value of equity holders by better aligning incentives between management and shareholders. From a stakeholder perspective (the viewpoint that the organization has a societal obligation beyond increasing shareholder value), effective governance should support policies that produce stable and safe employment, provide an acceptable standard of living to workers, mitigate risk for debt holders, and improve the community and environment.25 Obviously, the governance system that maximizes shareholder value might not be the same as the one that maximizes stakeholder value.

A broad set of external forces that vary across nations also influence the structure of the governance system. These include the efficiency of local capital markets, legal tradition, reliability of accounting standards, regulatory enforcement, and societal and cultural values. These forces serve as an external disciplining mechanism on managerial behavior. Their relative effectiveness determines the extent to which additional monitoring mechanisms are required.

Finally, any system of corporate governance involves third parties that are linked with the company but do not have a direct ownership stake. These include regulators (such as the SEC), politicians, the external auditor, security analysts, external legal counsel, employees and unions, proxy advisory firms, customers, suppliers, and other similar participants. Third parties might be subject to their own agency issues that compromise their ability to work solely in the interest of the company. For example, the external auditor is employed by an accounting firm that seeks to improve its own financial condition; when the accounting firm also provides non-audit services, the auditor might be confronted with conflicting objectives. Likewise, security analysts are employed by investment firms that serve both institutional and retail clients; when the analyst covers a company that is also a client of the investment firm, the analyst might face added pressure by his firm to publish positive comments about the company that are misleading to shareholders. These types of conflicts can contribute to a breakdown in oversight of management activity.

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