As capital providers (shareholders) and management of a firm are separated, there exists an agency problem. Corporate governance is the way in which capital providers make sure management do not misappropriate their funds by aligning incentives. Corporate governance can therefore be thought of as a mechanism used by capital providers to ensure a return on investment (Shleifer & Vishny, 1997).
This mechanism can take many forms such as the structure of a firm with large shareholders and/or creditors. Large shareholders provide oversight of management due to their large investment in the company, and can potentially replace management (through proxy fights) or take over the firm (Shleifer & Vishny, 1986b). Large creditors have power over management through debt agreements and have an incentive to monitor due to their investment in the company (Smith & Warner, 1979).
The legal environment provides a forum for capital providers to seek repatriation when management expropriate their funds. The legal environment also sets standards for the behaviour of management and directors e.g. Companies Act 1993.
The primary form of the corporate governance mechanism is the board of directors. The board is elected by shareholders to monitor management on their behalf. The board of directors is entrusted by shareholders to provide oversight of management and the firm and to align the interests of managers with shareholders. This reduces the chance of agency problems and the associated costs.
To provide oversight, a number of policies have evolved in corporate governance. The first is related to the effectiveness of the board itself. For example, policies on the number of outside directors ensure that ‘insiders’ of the company do not have significant influence over board decisions (director independence).
Use of specific committees on issues such as auditing of the firm, remuneration and nominations (as well as others) ensure monitoring of major areas where manager/shareholder conflicts of interest could emerge.
To align manager’s interests with the firm the board can use policies on manager remuneration tied to the performance of the firm.
Shleifer, A., & Vishny, R. (1986b). Large shareholders and corporate control. Journal of Political Economy, 94, 461-488.
Shleifer, A., & Vishny, W. (1997). A survey of corporate governance. The Journal of Finance, 52(2), 737-783.
Smith, C., & Warner, J. (1979). On financial contracting: An analysis of bond covenants. Journal of Financial Economics, 7, 117-161.