Potential Risks due to Poor Corporate Governance

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Weaknesses in corporate governance practices and stakeholder management processes expose a company and its stakeholders to several risks. The reverse scenario is that effective corporate governance and stakeholder management practices can create several benefits for a company and its stakeholders.

Potential Risks

• One stakeholder group may benefit unfairly at the expense of other stakeholder groups due to weaknesses in a company’s control systems.
• Managers could make poor investment decisions that benefit them but are detrimental to the company’s shareholders.
• A company’s exposure to legal, regulatory, and reputational risks could become heightened. For example, a company may be subject to an investigation by a regulatory authority due to a violation of laws and regulations. The company could also receive lawsuits from one of its stakeholders due to some form of impropriety. These could potentially damage the reputation of the company and lead to significant legal costs.
• A company’s ability to honor its debt obligations may become hindered. This exposes it to bankruptcy risk if its creditors decide to take legal action against it.

Potential Benefits

• Operational efficiency could be improved.
• A company’s control systems may be enhanced due to the proper functioning of its audit committee and the effectiveness of its audit systems.
• Operating and financial performance could be improved and this may lead to a reduction in the costs that are associated with weak control systems.
• Business and investment risk may be lowered, thus reducing a company’s cost of capital and its default risk.

Question

Which of the following is most likely a benefit of an effective corporate governance structure?

1. Default risk may increase.
2. Operating performance may improve.
3. Managers may make decisions which benefit them but not the shareholders.

Solution

The correct answer is B.

Improvement in operational and financial performance is a potential benefit of an effective corporate governance structure.

A is incorrect because effective corporate governance leads to a decrease, not increase in default risk.

C is incorrect due to the fact that when managers make decisions which only benefit them, they are not considering the interests of other stakeholders, namely shareholders.