In recent years, the issue of corporate governance has generated much debate. The term is used to describe the ways in which businesses are directed and controlled. The issue of corporate governance is important because, in businesses of any size, those who own the company (that is, the shareholders) are usually divorced from the day-today
control of the business. The shareholders employ professional managers (known as directors) to manage the business for them. These directors may, therefore, be viewed as agents of the shareholders (who are the principals).
Given this agent–principal relationship, it may seem reasonable to assume that the best interests of shareholders will guide the directors’ decisions. In other words, the directors will seek to maximise the wealth of the shareholders. However, in practice this does not always occur. The directors may be more concerned with pursuing their own interests, such as increasing their pay and perks (such as expensive cars, overseas visits and so on) and improving their job security and status. As a result, a conflict can occur between the interests of shareholders and the interests of directors.
It can be argued that in a competitive market economy, this agency problem, as it is termed, should not persist over time. The competition for the funds provided by shareholders, and competition for directors’ jobs referred to earlier, should ensure that the interests of the shareholders will prevail. However, if competitive forces are weak, or if information concerning the directors’ activities is not available to shareholders, the risk of agency problems will be increased. Shareholders must be alert to such risks and should take steps to ensure that the directors operate the business in a manner that is consistent with shareholder needs.
Where directors pursue their own interests at the expense of the shareholders, it is clearly a problem for the shareholders. However, it may also be a problem for society as a whole. If investors feel that their funds are likely to be mismanaged, they will be reluctant to commit those funds. A shortage of funds will mean that businesses can make fewer investments. Also, the costs of finance will increase as businesses compete for what funds are available. Thus, a lack of concern for shareholders can have a profound effect on the performance of individual businesses and, with this, the health of the economy. To avoid these problems, most competitive market economies have a framework of rules to help monitor and control the behaviour of directors.