Introduction

Corporate governance is the system of rules, practices and processes by which a firm is directed and controlled. Corporate governance essentially involves balancing the interests of a company's many stakeholders, such as shareholders, management, customers, suppliers, financiers, government and the community. Since corporate governance also provides the framework for attaining a company's objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.

Corporate agency is based on the premise that employees, managers, and directors (i.e., agents) should behave in the best interests of owners or shareholders (i.e., principals). Two things get in the way of that ideal:

First, managers’ interests, while overlapping with those of shareholders, are distinct. Sometimes agents can help themselves in ways that hurt the firm and its shareholders. Examples include shirking, waste and, in extreme cases, fraud or other self-serving actions that can bring down the company, as have happened in numerous business scandals.

Second, shareholders have neither the specific knowledge nor skills possessed by management. That can create a dynamic where even well-intentioned managers may feel compelled to “short-termism,” i.e., acting in ways that look good to shareholders now, but actually undermine value creation over time. Various oversight, transparency, and incentive mechanisms have evolved, and continue to develop, to contain agency costs.

Social welfare is based on the premise that companies should engage in fair dealing with all of their stakeholders—including customers, employees, suppliers, and communities, as well as shareholders—in accordance with the expectations of the larger society in which they operate. The debate about what is “fair dealing” reflects the larger, ongoing debate about the purpose of corporations in society, but even a shareholder-centric model recognizes that companies benefit from at least nurturing their reputations among all stakeholders, and that minimizing their negative externalities (pollution, plant closures, etc.) preserves the freedom of companies to operate with otherwise minimal external constraints.