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Fama and Jensen (1983) defined residual claimants as the ones who bear residual risk, i.e.,
the difference between stochastic inflows of resources and promised payment to agents. When
the managers, who take decisions, are not the major residual claimants, and hence do not bear
a major share of the financial effects of their decisions, agency problems arise.
To address agency problems, internal, as well as
external, corporate governance mechanisms have been put into
place, like the board of directors, proxy fights, large shareholders,
hostile takeovers and financial structure (Hart, 1995). The most important internal corporate
governance mechanism is the board of directors (Subramanian and Swaminathan, 2008). The role of the
board is not simply to fulfill its legal
requirements. The board of directors of a company
provides strategic guidance and leadership; objective
judgment, independent of management, to the
company; and exercises control over the company, while at all times remaining accountable
to the shareholders. An effective corporate governance system is one which allows the board
to perform these dual functions efficiently. However, shareholders do not escape agency
problems by leaving them to the board of directors, since the directors are themselves agents,
whose interests are not necessarily aligned with the shareholders (Hermalin and Weishbach,
1991). Although allowing management to choose their own overseers might lead to
agency problems related to independent directors,
nonetheless, there are many good reasons to believe
that outside directors will exhibit some checks on the top management. |
