Lecture 12: Corporate Governance and Business Ethics
Introduction to Corporate Governance
Corporate Governance: Mechanisms, processes, and structures that direct and control a company to ensure pursuit of strategic goals legally and successfully.
Offers checks and balances.
Addresses the principal-agent problem (Agency Theory).
Principal-Agent Problem (Agency Theory)
Principal: Can be an individual or entity hiring, monitoring, and compensating.
Agent: Performs work, provides time and talents.
Not just individual relationships; can involve groups, companies, or governments.
Conflict: Principals and agents have different self-interests.
Information Asymmetry: One party has more information than the other.
Examples of Principal-Agent Problems
Employee and Boss Scenario: Employees may underreport working hours due to information asymmetry.
Governance Mechanisms
Aim to resolve the principal-agent problem.
Include work tasks design, incentives, employee contracts, and structure.
Try to minimize issues like adverse selection and moral hazard.
Agency Problems
Adverse Selection: Occurs when one party withholds information, influencing the other party's decision.
Example: Not disclosing car issues before sale.
Moral Hazard: One party takes more risks because the costs fall on another party.
Example: 2008 financial crisis where banks took risks knowing bailouts would occur.
Principal-Agent Relationship in Companies
Shareholders (Principal) vs. Managers (Agent):
Shareholders prefer related constrained diversification for better returns.
Managers prefer unrelated diversification for job security.
Agency Costs
Incentive Costs: Payments to motivate agents (e.g., salary, bonuses).
Monitoring Costs: Costs to ensure agents are doing their job (e.g., cameras, reviews).
Enforcement Costs: Costs when enforcing actions (e.g., discipline, firing).
Financial Losses: Costs when agents act in self-interest.
Role of the Board of Directors
Centerpiece of Corporate Governance:
Act as principal to the CEO and management.
Select, evaluate, and compensate the CEO.
Oversee strategic initiatives and risk assessment.
Inside Directors: Employees who are also on the board.
Outside Directors: Non-employees on the board.
Responsibilities
Provide oversight, guidance, and monitor top management.
Ensure alignment between management actions and shareholder interests.
Corporate Governance and External Mechanisms
Executive Compensation: Aligns incentives to motivate agents.
Financial Auditors, Government Regulators, Industry Analysts: Serve as external monitors to ensure compliance and prevent fraud.
Conclusion
Effective corporate governance is crucial to manage principal-agent issues and align incentives between various stakeholders.
Ensures successful and ethical business practices.