Corporate Governance, Shareholder Conflicts, and Audit Quality

A string of high profile corporate failures over the past years have led to strong regulatory responses for corporate governance, some of which are aimed at strengthening the audit function of the governance process. This paper introduces an analytical model investigating the desirability of mandatory corporate governance requirements in the presence of shareholder conflicts. In this model, investment in governance and audit serves to protect outside shareholders' claim from decisions made by a dominant shareholder (entrepreneur) with conflicting preferences. The paper provides conditions under which an entrepreneur requiring equity financing selects weak as opposed to strong corporate governance. We find no evidence of governance failure and hence no case for intervention as long as the market for audit services is fully competitive. In contrast, when this market is not fully competitive, governance failures, in which the entrepreneur selects the weak governance regime when the strong governance regime maximizes economic welfare, may arise. Mandating strong governance may however have an adverse effect on economic welfare as weak governance can be welfare-maximizing.