12.2 Corporate Governance
Corporate governance concerns the mechanisms to direct and control an enterprise in order to ensure that it pursues its strategic goals successfully and legally. Corporate governance is about checks and balances and about asking the tough questions at the right time. The accounting scandals of the early 2000s and the global financial crisis of 2008 and beyond got so out of hand because the enterprises involved did not practice effective corporate governance.
Corporate governance attempts to address the principal-agent problem (introduced in Chapter 8), which can occur any time an agent performs activities on behalf of a principal. This problem can arise whenever a principal delegates decision making and control over resources to agents, with the expectation that they will act in the principal's best interest. We mentioned earlier that the separation of ownership and control is one of the major advantages of the public stock companies. This benefit, however, is also the source of the principal agent problem. In publicly traded companies, the stockholders are the legal owners of the company, but they delegate decision making authority to professional managers. The conflict arises if the agents pursue their own personal interests, which can he at odds with the principals' goals. For their part, agents may be more interested in maximizing their total compensation, including benefits job security, status, and power. Principals desire maximization of total returns to shareholders.
TI1e risk of opp01tunism on behalf of agents is exacerbated by information asymmetry: the agents arc generally better informed than the principals. Exhibit 12.5 depicts the principal agent relationship.