CI 3 Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
A corporation is a legal entity surrounded by a large group of stakeholders, and the ties among them take three broad forms: contractual, principal-agent, and other relationships. A principal-agent relationship, also called an agency relationship, arises when one party, the principal, engages another party, the agent, to perform some task or service. No formal contract is required for the relationship to exist; it can be present either way, and it rests on trust plus an expectation that the agent will act loyally and diligently for the principal.
The difficulty is that the agent usually holds more information than the principal, so the principal cannot directly verify that the agent is truly serving the principal’s interest. This is information asymmetry. When the interests of the two parties diverge, conflicts arise and produce agency costs. Those costs can be direct, such as paying a board of directors to hire an external auditor, or indirect, such as the profits and opportunities that are quietly lost when an agent underperforms.
Inside a corporation the agency chain runs in stages: shareholders act as a principal and vote in directors, who are an agent, and those directors then appoint managers, yet another agent, whose mandate is to build shareholder value. Because greater information asymmetry raises the potential for conflict, shareholders and lenders demand higher returns and larger risk premiums when they face it, which lowers the share price or multiple and raises the yield on debt.
Shareholders, directors, and managers
Directors and managers see a company’s results, exposures, and investment prospects far more clearly than outside parties like lenders and shareholders. That asymmetry weakens the ability of owners to judge the people running the firm and, therefore, to identify and remove poor performers. It is more severe for companies that operate across many markets and geographies, sell complex products, or hold a smaller institutional ownership base and free float.
Compensation is the main lever used to pull manager and shareholder interests together. Even so, several recurring gaps remain between what managers do and what shareholders want.
| Conflict | What it looks like |
|---|---|
| Insufficient effort | Managers underinvest, fail to control costs, avoid hard decisions such as closing unprofitable lines, monitor employees too loosely, or spread themselves thin across outside activities. |
| Inappropriate risk appetite | Heavy use of options can push managers toward excessive risk, since option holders share only in the upside; too little equity can leave them unduly cautious and unable to attract talent. |
| Empire building | Because pay and status often track business size, managers chase growth for its own sake, including acquisitions that do not add shareholder value. |
| Entrenchment | Managers and directors protect their jobs by copying peers, avoiding risk, or pursuing complex deals they alone can manage; directors may stay silent when speaking out would serve owners. |
| Self-dealing | Managers use firm resources for personal gain, from excessive perquisites to outright misappropriation; a smaller ownership stake means they bear less of the cost. |
The risk-appetite point is worth underlining. Investors can hold diversified portfolios, so they may tolerate more risk than a manager whose reputation and time are concentrated in one company. That difference is exactly why a purely cash pay package can leave managers too cautious, while a package dominated by options can tip them into taking on too much.
A construction firm can invest in a high-risk, high-reward capital infrastructure project but decides not to pursue it.
Controlling and minority shareholders
Ownership is generally described as dispersed or concentrated. Dispersed ownership means many shareholders, none able to control the firm. Concentrated ownership means an individual or a group (the controlling shareholders, which may be a family, another company, or a government) can exercise control. Shareholders are often treated as one homogeneous group, but their interests frequently diverge. A founding family holding much of its wealth in the stock may want management to diversify for stability, while minority holders with diversified portfolios would rather management simply maximize value, since they can diversify cheaply on their own. A controlling owner may take a multi-decade view, whereas some minority holders chase quick gains from cost cutting, asset sales, or buybacks. Shareholders can also talk to one another and form voting blocs to press their case.
Ownership percentages alone do not settle whether control is dispersed or concentrated, because voting schemes and share classes with unequal rights change the picture. Under a dual-class structure, one class (say Class A) carries one vote per share and trades publicly, while another class (say Class B) carries multiple votes per share and stays in the hands of insiders or founders. That arrangement lets a small group control board elections, strategy, and every significant matter without owning most of the shares, and it protects them from voting dilution if new shares are issued. CFA Institute has long argued against dual-class structures, because they hand one group disproportionate power to override the majority for private benefit; where such structures are legal, it advises issuers to disclose them and their implications clearly.
Magna International Inc., a Canadian auto parts maker, began with two share classes: Class A carried one vote per share and Class B carried 500 votes per share. Founder Frank Stronach and his family held 75 percent of the voting rights while owning just 3 percent of the shares outstanding. Investors grew frustrated as the founder and his family drew millions in consulting fees, salaries, bonuses, and options despite a weak share price. Shareholders voted for a single-class structure at an extraordinary general meeting, agreeing that Stronach would leave after being paid CAD870 million over five years.
A controlling shareholder of Stillcreek Corporation owns 55 percent of the shares, and the remaining shares are spread across a large group of holders.
Shareholders versus creditors
Shareholders and creditors hold claims on the same cash flows, but the nature of those claims differs and can put them at odds. Debtholders have a fixed claim and tend to be risk averse; they prefer that the firm keep enough cash flow to service its debt, which is why they favor raising more equity and limiting distributions to shareholders. Shareholders lean the other way, preferring more leverage and larger distributions over dilutive equity issuance. The tension grows with long-term debt, because time exposes lenders to shifts in business conditions, strategy, and management behavior, so long-term creditors are the most likely to set contractual limits on leverage and payouts.
KLD Marine Ltd. builds welded metal boats, carries no debt, and sells into a competitive and cyclical market; it is also the main employer in a small and remote town. Its workforce of 50 splits roughly in half between specialized aluminum welders and staff in sales and management. Dealers that each stock three or four brands handle its sales, and its only supplier of aluminum is a large multinational serving many other clients. The firm has paid no dividends historically, funding its assets from sizable retained earnings, and it has just chosen to take on substantial borrowing so it can distribute a single large dividend to shareholders.
Given the range of stakeholders in a corporation, an appropriate governance structure has to weigh the rights, responsibilities, and powers of each while still meeting corporate objectives. A sound structure puts mechanisms in place that both satisfy rules imposed by outside authorities and serve the specific needs of internal stakeholders. The sections below run through those mechanisms by stakeholder group.
Corporate reporting and transparency
Reporting and transparency sit at the foundation of governance. Without them, outside stakeholders would not know how the company is performing or positioned and could not advocate for their interests, so reporting is required and governed through legal, regulatory, and quasi-regulatory means, exchange listing rules among them. For a public company, investors obtain financial and non-financial information from sources such as annual reports, proxy statements, company disclosures, and investor relations material, spanning operations, strategy, audited statements, governance and ownership structure, pay policy, related-party transactions, and risk factors. Across most jurisdictions and exchanges, listed companies must have their annual statements audited and their interim statements reviewed by independent third-party auditors.
Private companies disclose to the public only as far as regulation requires or as they choose, though they share information confidentially with their own investors on negotiated rather than standardized terms. Most jurisdictions do not require private-company disclosures to be audited, but a private company may obtain an audit voluntarily to improve its terms with investors. Investors draw on corporate reports to gauge performance, reach valuation and investment judgments, cast votes on key matters, and check compliance with debt covenants. Because individual bondholders cannot practically track every covenant, a financial intermediary called a trustee is engaged to report on and administer payments for bondholders.
Shareholder mechanisms
As residual owners, shareholders protect their claims through several control mechanisms, many of them written into securities law and enforced by regulators. Although no single global standard of shareholder rights exists, a common set recurs across markets. General meetings are central. An annual general meeting (AGM), usually held once a year, lets shareholders discuss and vote on matters not delegated to the board. An extraordinary general meeting (EGM) is called for other resolutions needing shareholder approval, or when a specified minimum of shareholders (or proportion of stock) requests one.
| Annual general meeting (AGM) | Extraordinary general meeting (EGM) |
|---|---|
| Board member elections | Special board elections, generally put forward by shareholders |
| Appointment of the independent auditor | Amendments to bylaws or articles of association |
| Approval of annual statements, dividends, and director and auditor pay | Mergers, acquisitions, takeovers, and asset sales |
| Approval of equity-based compensation plans | Capital increases |
| Non-binding say on pay votes on compensation | Voluntary liquidation of the firm |
A shareholder unable to attend generally appoints someone else to vote on their behalf via proxy voting, casting a ballot by mail or electronically; this is the single most common way investors take part in general meetings. Beyond voting, shareholder activism involves strategies to push a company to act in a desired way. The main aim is usually to lift shareholder value quickly, although some activism targets social, political, or environmental goals, and tactics include proxy fights, shareholder resolutions, and publicizing points of contention. Hedge funds are among the leading activists, because they base most of their fees on returns and face fewer investment restrictions, letting them take large, sometimes borrowed, positions; regulated vehicles such as mutual funds face limits on position size, leverage, and holdings of distressed or illiquid securities that constrain such campaigns.
Activists may also litigate. A prominent form is the shareholder derivative lawsuit (unrelated to financial derivatives), brought against directors, management, or controlling shareholders by a shareholder acting on behalf of the company when its officers have failed to act in its interest. Many countries restrict these suits by setting minimum ownership thresholds or barring them outright.
Changes in corporate control offer another channel. In a proxy contest (or proxy fight), a group seeking board control tries to persuade shareholders to vote for it. Management can also be displaced through a tender offer, an invitation to shareholders to sell their shares directly to a group seeking control, or a hostile takeover, an attempt to acquire the company without management consent. Such contests can attract arbitrageurs and takeover specialists who buy shares from existing holders and later sell to the highest bidder. The threat of removal helps focus directors and managers on shareholder wealth, but it can also trigger anti-takeover defenses that weaken governance: staggered board elections, which stop shareholders from replacing the whole board at once, and a shareholder rights plan (a poison pill), which lets shareholders buy extra shares at a discount when an outsider crosses a set ownership threshold, raising the cost to any bidder.
Creditor mechanisms
Creditors, including private lenders such as banks and public bondholders, protect their interests through rights set by law and by contract. The central contract is the bond indenture, a legal agreement describing the bond’s structure, the company’s obligations, and the bondholders’ rights; its provisions either oblige the company to take specified actions or satisfy specified conditions, or else forbid particular actions, and it may require assets to be pledged as security. When a firm enters bankruptcy, some countries establish official creditor committees, particularly for unsecured bondholders, to represent them in restructuring or liquidation. Separately, if a company finds it hard to satisfy its indenture obligations, bondholders may band together into an ad hoc committee to approach it with restructuring options; such a committee does not officially represent all bondholders, but its interests usually align with the broader group.
Board and management mechanisms
The board sits at the center of governance, and it routinely delegates specific functions to committees drawn from its own members. Three core committees are recommended by most governance codes and required by some exchanges.
| Committee | Key oversight functions |
|---|---|
| Audit committee | Financial reporting integrity, accounting policies, internal audit, and appointment and pay of the external auditor. |
| Nominating / governance committee | Director selection and the board election process, plus governance codes, charters, the code of ethics, and conflict-of-interest policy. |
| Compensation / remuneration committee | Remuneration policy for directors and key executives, performance criteria, and evaluation of manager performance. |
Delegating to a committee does not discharge the board of its ultimate responsibility; the board must review, challenge, and assure any committee report and make the final decisions. Among these, the audit committee is required most widely, and best practice holds that it should be made up only of independent directors, including at least one with accounting or financial management expertise. It monitors financial reporting and the choice of accounting policies, oversees the internal audit function and safeguards its independence, recommends the external auditor and its pay, and follows up on issues the auditors raise; in some cases it also oversees information technology security.
The nominating or governance committee, also composed of independent members under best practice, appraises director and manager candidates, oversees the election process, sets nomination criteria, and maintains governance policies such as the governance code, board and committee charters, the code of ethics, and the conflict-of-interest policy, which requires directors and managers to disclose actual or potential conflicts and material interests in transactions. The compensation or remuneration committee develops pay policy for directors and key executives, sets performance criteria, and evaluates managers; best practice and most laws require all its members to be independent, since management should not assess its own performance.
Pay design matters for alignment. Variable pay, typically profit sharing, stock, or options, is tied to corporate or share-price performance, but stock-based pay fails its purpose if managers can boost personal gains at the company’s expense while limiting their exposure to weak performance. To discourage short-termism and excessive risk-taking, companies increasingly grant shares rather than options and restrict vesting or sale for a number of years, in some cases up to retirement, while a long-term incentive plan holds back pay until strategic performance targets are reached. Driven in part by legislation like the Dodd-Frank Act in the USA, and sometimes by choice, issuers now often gather shareholder opinion via non-binding say on pay votes held at the AGM, curbing directors’ discretion to award excessive or inadequate pay. Beyond the core three, companies may run other committees, often industry specific, such as risk committees (common, and sometimes required, in financial services) that set risk appetite and oversee enterprise risk management, and investment committees at insurers that ensure prudent investment and capital policies.
An analyst is sorting governance events by the meeting at which they occur.
A compensation committee wants to discourage excessive risk-taking by managers.
Employee, customer, supplier, and government mechanisms
Managing employee relationships, sometimes called human capital management, helps a firm attract and retain talent, respect employee rights, and avoid legal or reputational harm. Employee rights rest mainly on jurisdiction-specific labor laws covering work hours, post-employment terms, health care and other benefits, and paid leave, and in most countries employees may form unions that bargain over pay and conditions. In some countries, employees sit on the board or supervisory board of companies that meet size or ownership criteria, examples being Germany, Austria, and Luxembourg. Individually, an employment contract lays out the rights and responsibilities of each party, and some firms run an employee stock ownership plan (ESOP), a fund of shares or cash granted on service or performance criteria and often subject to vesting, to retain staff and align their interests with the company.
Customers and suppliers relate to the firm through contracts that specify the products or services, prices and payment terms, each party’s rights and responsibilities, after-sale terms, guarantees, and the recourse available if either side breaches. Customers, owners, and other stakeholders now turn more and more to social media to express or protect their interests, since negative attention can quickly damage a company’s reputation at little cost to the sender. Governments and regulators, for their part, write and enforce the laws companies must follow, protecting property and contract rights and specific groups such as consumers or the environment; industries more likely to affect the public, such as financial services, health care, food, and defense, tend to face heavier regulation.
Many regulators have adopted corporate governance codes, sets of guiding principles for listed companies enforced through a comply or explain approach, under which a company must either disclose that it follows a recommended practice or explain why it does not. In Japan, for instance, a company with no outside directors must justify that choice. Some jurisdictions rely instead on national laws (Chile) or listing requirements (India). The USA has no national governance code but has national securities laws, such as the Securities Act and the Sarbanes-Oxley Act, enforced by the Securities and Exchange Commission; its exchanges impose listing requirements such as majority-independent boards, and because most US companies incorporate in Delaware, that state’s corporate law effectively fills the role of a national code.
Governance and stakeholder management shape the success or failure of corporations. Weak governance, unmanaged conflicts, or inadequate stakeholder management can leave a firm at a competitive disadvantage, while strong practices and a proper balance among interests tend to show up as greater competitiveness and operational efficiency, better controls, and improved performance. The effect reaches past operations into legal, regulatory, reputational, and financial risk.
| Category | Risk if governance is weak | Benefit if governance is strong |
|---|---|---|
| Operational | Weak controls and poor monitoring let one group benefit at others’ expense and open the door to fraud and mismanagement. | Scrutiny at all levels, an effective independent audit committee, and clear authority mitigate fraud and improve decision-making. |
| Legal, regulatory, reputational | Compliance gaps invite investigations, lawsuits, and reputational harm, whose costs can be large. | A reputation for respecting stakeholder rights helps attract talent, secure capital, lift sales, and win better supplier terms. |
| Financial | Poor management of creditor interests raises default risk and can spread distress to employees, suppliers, and society. | Restrictions that protect creditors, transparent reporting, and independent audit lower default risk and the cost of debt. |
Operational risks and benefits
When controls, decision-making, or monitoring are weak, results, performance, and value suffer, and where controls are inadequate, one stakeholder group can profit at the others’ expense. When managers know more than the board or the shareholders, when audit procedures are weak, or when oversight is thin, they can make choices solely for their own benefit. Strong practices apply proper scrutiny and control at every level, mitigating risks such as fraud or at least catching them early, and controls are stronger still when an effective independent audit committee oversees them. Formal procedures covering conflicts of interest and related-party transactions promote fair dealing, clear delegation of authority and reporting lines gives employees a firm grasp of their responsibilities, and the governance, risk, and compliance (GRC) functions work together to align interests. Internal auditors, compliance, and legal departments form an equally important pillar, improving operational efficiency by keeping activities monitored and controlled.
Theranos, founded in 2003, drew more than USD700 million from venture capital and private backers and reached a valuation of USD10 billion in 2014, promising to identify many medical conditions from a single drop of blood. Its board carried famous names, including former US Secretaries of State, but most had little knowledge of medical technology. In 2015, questions surfaced publicly, whistleblowers raised concerns, and the technology proved flawed with falsified results. In 2018 the US SEC charged the company along with CEO Elizabeth Holmes and COO Ramesh Balwani with massive fraud, the company ceased operations, and shareholders lost everything; in 2022 Holmes was convicted on four counts of fraud. Investigators traced the collapse to governance failures: a board lacking medical expertise that never hired an independent expert to validate the technology or noticed the absence of peer-reviewed publications, silence on the conflict of interest around the Holmes-Balwani relationship, dismissal of whistleblower allegations, and senior posts left unfilled, including CFO and global compliance officer.
Legal, regulatory, and reputational risks and benefits
Weak compliance or poor reporting can expose a company to investigation by government or regulatory authorities and to lawsuits from shareholders, employees, creditors, or others for breach of contract, bylaws, or legal rights. Mishandled conflicts of interest or governance failures can inflict reputational harm whose costs are significant, and the risk is sharpest for listed companies under constant scrutiny by investors and analysts. A reputation built on strong governance and protection of stakeholder interests helps a firm draw talent, raise capital, grow sales, and negotiate better terms with suppliers, and ethics training for key stakeholders reinforces these practices.
Volkswagen’s diesel scandal illustrates the reputational danger. In 2014 an independent study found that certain Volkswagen diesel cars emitted far above legal limits. Volkswagen insisted for a year that the cause was technical before conceding to the US Environmental Protection Agency in 2015 that it had deliberately rigged test results using illegal software; that software sat in up to 11 million Volkswagen and Audi vehicles around the world, 500,000 of them sold within the USA. Whether executives knew of the software remains unanswered, but the reputational damage was severe. The share price fell by more than a third in the days after the announcement, CEO Martin Winterkorn stepped down in 2015 and faced criminal indictment in both the USA and Germany, the company booked over EUR32 billion (USD37.7 billion) in recalls, fines, and legal costs, and shareholder lawsuits sought several billion euros more in damages.
Financial risks and benefits
Poor governance, including weak management of creditor interests, can damage a company’s financial position and its ability to honor debt, and a higher chance of default reaches well beyond creditors and shareholders to managers, employees, suppliers, and even to society and the wider environment. Governance that manages creditor conflicts restricts actions that would impair repayment and so lowers default risk, which is also reduced by sound audit systems, transparent earnings reporting, and control of information asymmetry between the firm and its capital providers. Lower default risk brings a lower cost of debt, because creditors accept a smaller return once their money is more secure and their rights safeguarded.
On the equity side, strong practices at shareholder meetings and effective board committees assure investors that their capital is well managed and their rights to participate, vote, and receive fair treatment are protected. Timely disclosure of material information, reporting integrity, and independent audit build trust in the quality of reported earnings and the fair representation of financial position. Such controls reduce how much risk investors attach to well-governed firms, and therefore the return they demand, which enhances the firms’ attractiveness, improves valuations and stock performance, and reduces the cost of equity. Studies reinforce the pattern: better governance increases the chance that a credit rating moves from speculative to investment grade, which lowers the cost of debt; listed firms with experienced, financially expert audit committees tend to perform better in a crisis; and independence and diversity on the board look like important drivers of firm valuation.
When assessing governance and stakeholder management, analysts should consider a company’s ownership and voting structure; whether board members’ skills and experience match current and future needs; how closely management pay and incentives align with the drivers of company results; who the significant investors are; how strong shareholder rights are versus peers; and how effectively the company manages long-term risks and sustainability. For these questions, a good place to begin is the material a company already publishes: its sustainability reports, annual reports, and proxy statements.
Kobe Steel Ltd., a large Japanese steelmaker dating to 1905, put out a report in March 2018 that apologized for having falsified data on the strength and durability of its aluminum, copper, and steel products and its iron ore powder. In the wake of the scandal, the stock dropped to a five-year low while the cost of debt climbed to record levels. An independent committee traced the misconduct to a profit-focused management style with inadequate governance and a culture that put winning orders and meeting deadlines ahead of quality. Among its remedies, the company set up an audit and supervisory committee with five members, of whom two were internal directors and three were independent.