The corporation allows for the separation of management and ownership (Investor). This creates a clear conflict of interest and this conflict between the investors and managers creates the need for investors to devise a system of checks on managers—the system of corporate governance.
The corporate organizational form allows those who have the capital to fund an enterprise to be different from those who have the expertise to manage the enterprise.
This separation comes at a cost—the managers will act in their own best interests, not in the best interests of the shareholders who own the firm.
The board of directors is the primary internal control mechanism and the first line of defense to prevent fraud, agency conflicts, and mismanagement. The board is empowered to hire and fire managers, set compensation contracts, approve major investment decisions, etc.
A long-standing CEO can maneuver the nomination process (nominated friend to the board). Additionally, board members representing customers will sometimes compromise their fiduciary duty in order to keep the management of the firm happy. This desire to keep the CEO happy or a reluctance to challenge him or her interferes with the board’s primary function of monitoring the management.
By knowing a company and its industry as well as possible, they are in a position to uncover irregularities. They also participate in earnings calls with the CEO and CFO, asking difficult and probing questions.
Auditors are important to corporate governance. Auditors ensure that the financial picture of the firm presented to outside investors is clear and accurate. Part of the role of auditors is to detect financial fraud before it threatens the viability of the firm. Sarbanes-Oxley included measures designed to reduce conflicts of interest among auditors and to increase the penalties for fraud.
Trading is how prices come to reflect all material information about a company’s prospects. By restricting a set of investors from trading, we decrease the efficiency of the prices because it will take longer for the prices to reflect that private information. We rely on efficient prices to make sure that capital is allocated to its best use.
In order for a capital market to fulfill its function, uninformed investors must be willing to invest their money—providing liquidity and lowering the cost of capital. If investors thought that the stock market was just a fools’ game where they lost to insiders, they would be unwilling to invest or would price their expected loss into their required return. This increases the cost of capital for companies and slows economic growth.
They are better protected in the United States. The U.S. legal system is based on British common law, which offers considerably more protection to minority shareholders than French civil law does.
Because pyramidal structures allow a controlling family to control firms in which they have little actual cash flow rights, the family can use their control to move profits away from firms where they get a small percentage of the cash flows to firms in which they can claim a larger fraction of the cash flows. For example, they can have one firm sell to another at a reduced price.
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