With respect to corporate governance, what are the mechanisms that can mitigate the likelihood that management will act in its own self-interest?

Question

What will be an ideal response?

Answer 1

The mechanisms (that can mitigate the likelihood that management will act in its own
self-interest) fall into two general categories. The first category involves strongly aligning the interests of management with those of shareholders. This can be accomplished by granting management an economically meaningful equity interest in the company. Also, manager compensation can be linked to the performance of the company's long-run common stock price. The second category involves the company's internal corporate control systems, which can provide a way for effectively monitoring the performance and decision-making behavior of management. For example, it would allow the timely removal of the CEO by the board of directors who believe that a CEO's performance is not in the best interest of the shareholders. In general, there are several critical features of an internal corporate control system that are necessary for the effective monitoring of management. What has been clear in corporate scandals is that there was a breakdown of the internal corporate control systems that lead to corporate difficulties and the destruction of shareholder wealth. More details are given below.

Because of the important role played by the board of directors, the structure and composition of the board are critical for effective corporate governance. The key is to remove the influence of the CEO and senior management on board members. This can be done in several ways. First, although there is no optimal board size, the more members there are, the less likely the influence of the CEO. With more board members, a larger number of committees can be formed to deal with important corporate matters. At a minimum, there should be an auditing committee, a nominating committee (for board members), and a compensation committee.

Second, the composition of the committee should have a majority of independent directors, and the committees should include only independent directors. There are two classes of members of the board of directors. Directors who are employees of management or have some economic interest as set forth by the SEC (for example, a former employee with a pension fund, the relative of senior management, or an employee of an investment banking firm that has underwritten the company's securities) are referred to as "inside directors." Board members who do not fall into the category of inside directors are referred to as "outside directors" or "independent directors."

Finally, there are corporate governance specialists who believe that the CEO should not be the chairman of the board of directors because such a practice allows the CEO to exert too much influence over board members and other important corporate actions. This is a position that has been taken by the Securities and Exchange Commission.