Potential Risks of Poor Corporate Governance

Weaknesses in corporate governance practices and stakeholder management processes expose a company and its stakeholders to several risks. On the contrary, effective corporate governance and stakeholder management practices can benefit a company’s stakeholders.

Adopting effective rules and implementing acceptable control is critical in corporate governance. It breeds stronger business connections, operational efficiency, improved control procedures, and improved financial performance.

Operational Risks and Benefits

Weak Control Systems, Ineffective Decision-making

Businesses with higher inherent risks require more robust controls in order to minimize residual risks. Otherwise, one stakeholder may gain from a company’s inadequate control mechanisms and lack of board oversight at the expense of other stakeholders.

(Adequate) Scrutiny and Control

At all business levels, practical methods for oversight and control are established through solid governance standards. These strategies make it possible to reduce risk factors and fraudulent actions.

Adopting policies for handling conflicts of interest enables a business to maintain fairness. In addition, it prevents any unintended expenses that could result from favoring related parties.

(Improved) Operating Performance

Employees are aware of their obligations in organizations that practice effective governance. This is because there is clarity regarding the delegation of authority and reporting lines in such organizations. Decision-making is easier in such organizations, and managers have the autonomy to seize opportunities.

Legal, Regulatory, or Reputational Risks and Benefits

A company with compliance issues may be subject to legal, regulatory, or reputational concerns, including litigation for contract violations and government or regulatory investigations. These risks might cause the company to incur expensive penalties besides reputation damage.

Financial Risks and Benefits

Debt Default and Bankruptcy

Poor corporate governance can impact a corporation’s financial condition and result in inferior handling of creditors’ interests. This can make it difficult for a firm to repay its debts, and failure to settle debts can lead to default and bankruptcy.

(Lower) Default Risk and Cost of Debt

Sound corporate governance maximizes shareholder value and reduces financial and investment risks. Governance structures that aim to address creditor conflicts of interest typically include covenants and restrictions designed to protect creditors’ interests, such as limiting corporate actions that could increase the risk of default or insolvency. Note that higher credit ratings result from decreased credit risk, which lowers the cost of borrowing.

(Enhanced) Valuation and Stock Performance

Thanks to governance systems such as the board of directors and its committees, investors are certain that their money is safe. Disclosing important information promptly and suitably boosts investor confidence and a company’s credibility.

Question

Which of the following is likely an operational risk of poor corporate governance?

1. Default risks.
2. Stock performance.
3. Weak control systems.

The correct answer is C.

Weak control systems may result in managers accessing more information than directors and shareholders. This may result in them taking actions that benefit them at the expense of the shareholders.

A is incorrect. Default risk is a financial risk resulting from a company’s inability to pay debt. Companies may take actions that conflict with creditors’ interest and ability to make timely debt payments.

B is incorrect. Stock performance may be poor if the disclosure of the information is neither done in a timely nor suitable manner. This is a type of financial risk.