Corporate governance

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Corporate governance is the set of business process, customs, policies, laws, and institutions affecting the way a corporation (or company) is directed, administered or controlled. Corporate governance also includes the relationships among the many Stakeholder (corporate) involved and the goals for which the corporation is governed. The principal stakeholders are the shareholders, management, and the board of directors. Other stakeholders include employees, customers, creditors, suppliers, regulators, and the community at large.

Corporate governance is a multifaceted subject. An important theme of corporate governance is to ensure the accountability of certain individuals in an organization through mechanisms that try to reduce or eliminate the principal-agent problem. A related but separate thread of discussions focuses on the impact of a corporate governance system in economic efficiency, with a strong emphasis on shareholders' welfare. There are yet other aspects to the corporate governance subject, such as the stakeholder view and the corporate governance models around the world.

There has been renewed interest in the corporate governance practices of modern corporations since 2001, particularly due to the high-profile collapses of a number of large U.S. firms such as Enron Corporation and MCI Inc. (formerly WorldCom). In 2002, the U.S. federal government passed the Sarbanes-Oxley Act, intending to restore public confidence in corporate governance.

Definition

In A Board Culture of Corporate Governance, business author Gabrielle O'Donovan defines corporate governance as 'an internal system encompassing policies, processes and people, which serves the needs of shareholders and other stakeholders, by directing and controlling management activities with good business savvy, objectivity, accountability and integrity. Sound corporate governance is reliant on external marketplace commitment and legislation, plus a healthy board culture which safeguards policies and processes'.

O'Donovan goes on to say that 'the perceived quality of a company's corporate governance can influence its share price as well as the cost of raising capital. Quality is determined by the financial markets, legislation and other external market forces plus how policies and processes are implemented and how people are led. External forces are, to a large extent, outside the circle of control of any board. The internal environment is quite a different matter, and offers companies the opportunity to differentiate from competitors through their board culture. To date, too much of corporate governance debate has centered on legislative policy, to deter fraudulent activities and transparency policy which misleads executives to treat the symptoms and not the cause.'

It is a system of structuring, operating and controlling a company with a view to achieve long term strategic goals to satisfy shareholders, creditors, employees, customers and suppliers, and complying with the legal and regulatory requirements, apart from meeting environmental and local community needs.

Report of SEBI committee (India) on Corporate Governance defines corporate governance as the acceptance by management of the inalienable rights of shareholders as the true owners of the corporation and of their own role as trustees on behalf of the shareholders. It is about commitment to values, about ethical business conduct and about making a distinction between personal & corporate funds in the management of a company.” The definition is drawn from the Gandhian principle of trusteeship and the Directive Principles of the Indian Constitution. Corporate Governance is viewed as business ethics and a moral duty regarding employees who are driven by their sense of integrity (moral conscience) and duty to society. This notion stems from traditional philosophical ideas of virtue (or self governance) and represents a "bottom-up" approach to corporate governance (agency) which supports the more obvious "top-down" (systems and processes, i.e. structural) perspective.

Impact of Corporate Governance

The positive effect of corporate governance on different stakeholders ultimately is a strengthened economy, and hence good corporate governance is a tool for socioeconomic development.

Parties to corporate governance

Parties involved in corporate governance include the regulatory body (e.g. the Chief Executive Officer, the board of directors, management, shareholders and Auditors). Other stakeholders who take part include suppliers, employees, creditors, customers and the community at large.

In corporations, the shareholder delegates decision rights to the manager to act in the principal's best interests. This separation of ownership from control implies a loss of effective control by shareholders over managerial decisions. Partly as a result of this separation between the two parties, a system of corporate governance controls is implemented to assist in aligning the incentives of managers with those of shareholders. With the significant increase in equity holdings of investors, there has been an opportunity for a reversal of the separation of ownership and control problems because ownership is not so diffuse.

A board of directors often plays a key role in corporate governance. It is their responsibility to endorse the organization's strategy, develop directional policy, appoint, supervise and remunerate senior executives and to ensure accountability of the organization to its owners and authorities.

The Corporate Secretary, known as a Corporate Secretary in the US and often referred to as a Chartered Secretary if qualified by the Institute of Chartered Secretaries and Administrators (ICSA), is a high ranking professional who is trained to uphold the highest standards of corporate governance, effective operations, compliance and administration.

All parties to corporate governance have an interest, whether direct or indirect, in the effective performance of the organization. Directors, workers and management receive salaries, benefits and reputation, while shareholders receive capital return. Customers receive goods and services; suppliers receive compensation for their goods or services. In return these individuals provide value in the form of natural, human, social and other forms of capital.

A key factor is an individual's decision to participate in an organization e.g. through providing financial capital and trust that they will receive a fair share of the organizational returns. If some parties are receiving more than their fair return then participants may choose to not continue participating leading to organizational collapse.

Principles

Key elements of good corporate governance principles include honesty, trust and integrity, openness, performance orientation, responsibility and accountability, mutual respect, and commitment to the organization.

Of importance is how directors and management develop a model of governance that aligns the values of the corporate participants and then evaluate this model periodically for its effectiveness. In particular, senior executives should conduct themselves honestly and ethically, especially concerning actual or apparent conflicts of interest, and disclosure in financial reports.

Commonly accepted principles of corporate governance include:

  • Rights and equitable treatment of shareholders: Organizations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by effectively communicating information that is understandable and accessible and encouraging shareholders to participate in general meetings.
  • Interests of other stakeholders: Organizations should recognize that they have legal and other obligations to all legitimate stakeholders.
  • Role and responsibilities of the board: The board needs a range of skills and understanding to be able to deal with various business issues and have the ability to review and challenge management performance. It needs to be of sufficient size and have an appropriate level of commitment to fulfill its responsibilities and duties. There are issues about the appropriate mix of executive and non-executive directors.
  • Integrity and ethical behavior: Ethical and responsible decision making is not only important for public relations, but it is also a necessary element in risk management and avoiding lawsuits. Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making. It is important to understand, though, that reliance by a company on the integrity and ethics of individuals is bound to eventual failure. Because of this, many organizations establish Compliance and Ethics Programs to minimize the risk that the firm steps outside of ethical and legal boundaries.
  • Disclosure and transparency: Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide shareholders with a level of accountability. They should also implement procedures to independently verify and safeguard the integrity of the company's financial reporting. Disclosure of material matters concerning the organization should be timely and balanced to ensure that all investors have access to clear, factual information.


Issues involving corporate governance principles include:

  • internal controls and internal auditors
  • the independence of the entity's external auditors and the quality of their audits
  • oversight and management of risk
  • oversight of the preparation of the entity's financial statements
  • review of the compensation arrangements for the chief executive officer and other senior executives
  • the resources made available to directors in carrying out their duties
  • the way in which individuals are nominated for positions on the board
  • dividend policy


Nevertheless "corporate governance," despite some feeble attempts from various quarters, remains an ambiguous and often misunderstood phrase. For quite some time it was confined only to corporate management. That is not so. It is something much broader, for it must include a fair, efficient and transparent administration and strive to meet certain well defined, written objectives. Corporate governance must go well beyond law. The quantity, quality and frequency of financial and managerial disclosure, the degree and extent to which the board of Director (BOD) exercise their trustee responsibilities (largely an ethical commitment), and the commitment to run a transparent organization- these should be constantly evolving due to interplay of many factors and the roles played by the more progressive/responsible elements within the corporate sector. John G. Smale, a former member of the General Motors board of directors, wrote: "The Board is responsible for the successful perpetuation of the corporation. That responsibility cannot be relegated to management." However it should be noted that a corporation should cease to exist if that is in the best interests of its stakeholders. Perpetuation for its own sake may be counterproductive.

Mechanisms and controls

Corporate governance mechanisms and controls are designed to reduce the inefficiencies that arise from moral hazard and adverse selection. For example, to monitor managers' behavior, an independent third party (the external auditor) attests the accuracy of information provided by management to investors. An ideal control system should regulate both motivation and ability.

Internal corporate governance controls

Internal corporate governance controls monitor activities and then take corrective action to accomplish organizational goals.

Examples include:

  • Monitoring by the board of directors: The board of directors, with its legal authority to hire, fire and compensate top management, safeguards invested capital. Regular board meetings allow potential problems to be identified, discussed and avoided. Whilst non-executive directors are thought to be more independent, they may not always result in more effective corporate governance and may not increase performance. Different board structures are optimal for different firms. Moreover, the ability of the board to monitor the firm's executives is a function of its access to information. Executive directors possess superior knowledge of the decision-making process and therefore evaluate top management on the basis of the quality of its decisions that lead to financial performance outcomes, ex ante. It could be argued, therefore, that executive directors look beyond the financial criteria.
  • Internal control procedures and internal auditors: Internal control procedures are policies implemented by an entity's board of directors, audit committee, management, and other personnel to provide reasonable assurance of the entity achieving its objectives related to reliable financial reporting, operating efficiency, and compliance with laws and regulations. Internal auditors are personnel within an organization who test the design and implementation of the entity's internal control procedures and the reliability of its financial reporting
  • Balance of power: The simplest balance of power is very common; require that the President be a different person from the Treasurer. This application of separation of power is further developed in companies where separate divisions check and balance each others actions. One group may propose company-wide administrative changes, another group review and can veto the changes, and a third group check that the interests of people (customers, shareholders, employees) outside the three groups are being met.
  • Remuneration: Performance-based remuneration is designed to relate some proportion of salary to individual performance. It may be in the form of cash or non-cash payments such as share (finance) and share options, superannuation or other benefits. Such incentive schemes, however, are reactive in the sense that they provide no mechanism for preventing mistakes or opportunistic behavior, and can elicit myopic behavior.

External corporate governance controls

External corporate governance controls encompass the controls external stakeholders exercise over the organization.

Examples include:

  • competition
  • debt covenants
  • demand for and assessment of performance information (especially financial statements)
  • government regulations
  • managerial labor market
  • media pressure
  • takeovers

Systemic problems of corporate governance

  • Demand for information: In order to influence the directors, the shareholders must combine with others to form a significant voting group which can pose a real threat of carrying resolutions or appointing directors at a general meeting.
  • Monitoring costs: A barrier to shareholders using good information is the cost of processing it, especially to a small shareholder. The traditional answer to this problem is the efficient market hypothesis (in finance, the efficient market hypothesis (EMH) asserts that financial markets are efficient), which suggests that the small shareholder will free ride on the judgments of larger professional investors.
  • Supply of accounting information: Financial accounts form a crucial link in enabling providers of finance to monitor directors. Imperfections in the financial reporting process will cause imperfections in the effectiveness of corporate governance. This should, ideally, be corrected by the working of the external auditing process.

Role of the accountant

Financial reporting is a crucial element necessary for the corporate governance system to function effectively. Accountants and auditors are the primary providers of information to capital market participants. The directors of the company should be entitled to expect that management prepare the financial information in compliance with statutory and ethical obligations, and rely on auditors' competence.

Current accounting practice allows a degree of choice of method in determining the method of measurement, criteria for recognition, and even the definition of the accounting entity. The exercise of this choice to improve apparent performance (popularly known as creative accounting) imposes extra information costs on users. In the extreme, it can involve non-disclosure of information.

One area of concern is whether the auditing firm acts as both the independent auditor and management consultant to the firm they are auditing. This may result in a conflict of interest which places the integrity of financial reports in doubt due to client pressure to appease management. The power of the corporate client to initiate and terminate management consulting services and, more fundamentally, to select and dismiss accounting firms contradicts the concept of an independent auditor. Changes enacted in the United States in the form of the Sarbanes-Oxley Act prohibit accounting firms from providing both auditing and management consulting services. Similar provisions are in place under clause 49 of SEBI Act in India.

The Enron collapse is an example of misleading financial reporting. Enron concealed huge losses by creating illusions that a third party was contractually obliged to pay the amount of any losses. However, the third party was an entity in which Enron had a substantial economic stake. In discussions of accounting practices with Arthur Andersen, the partner in charge of auditing, views inevitably led to the client prevailing.

However, good financial reporting is not a sufficient condition for the effectiveness of corporate governance if users don't process it, or if the informed user is unable to exercise a monitoring role due to high costs.

Rules versus principles

Rules are typically thought to be simpler to follow than principles, demarcating a clear line between acceptable and unacceptable behavior. Rules also reduce discretion on the part of individual managers or auditors.

In practice rules can be more complex than principles. They may be ill-equipped to deal with new types of transactions not covered by the code. Moreover, even if clear rules are followed, one can still find a way to circumvent their underlying purpose - this is harder to achieve if one is bound by a broader principle.

Principles on the other hand is a form of self regulation. It allows the sector to determine what standards are acceptable or unacceptable. It also preempts over zealous legislation that might not be practical.

Enforcement

Enforcement can affect the overall credibility of a regulatory system. They both deter bad actors and level the competitive playing field. Nevertheless, greater enforcement is not always better, for taken too far it can dampen valuable risk-taking. In practice, however, this is largely a theoretical, as opposed to a real, risk. There are various integrated governance, risk and compliance solutions available to capture information in order to evaluate risk and to identify gaps in the organization’s principles and processes. This type of software is based on project management style methodologies such as the ABACUS methodology which attempts to unify the management of these areas, rather than treat them as separate entities.

Action Beyond Obligation

Enlightened boards regard their mission as helping management lead the company. They are more likely to be supportive of the senior management team. Because enlightened directors strongly believe that it is their duty to involve themselves in an intellectual analysis of how the company should move forward into the future, most of the time, the enlightened board is aligned on the critically important issues facing the company.

Unlike traditional boards, enlightened boards do not feel hampered by the rules and regulations of the Sarbanes-Oxley Act. Unlike standard boards that aim to comply with regulations, enlightened boards regard compliance with regulations as merely a baseline for board performance. Enlightened directors go far beyond merely meeting the requirements on a checklist. They do not need Sarbanes-Oxley to mandate that they protect values and ethics or monitor CEO performance.

At the same time, enlightened directors recognize that it is not their role to be involved in the day-to-day operations of the corporation. They lead by example. Overall, what most distinguishes enlightened directors from traditional and standard directors is the passionate obligation they feel to engage in the day-to-day challenges and strategies of the company. Enlightened boards can be found in very large, complex companies, as well as smaller companies.

Corporate governance models around the world

Although the US model of corporate governance is the most notorious, there is a considerable variation in corporate governance models around the world. The intricate shareholding structures of keiretsus in Japan, the heavy presence of banks in the equity of German firms [1], the chaebols in South Korea and many others are examples of arrangements which try to respond to the same corporate governance challenges as in the US.

In the United States, the main problem is the conflict of interest between widely-dispersed shareholders and powerful managers. In Europe, the main problem is that the voting ownership is tightly-held by families through pyramidal ownership and dual shares (voting and nonvoting). This can lead to "self-dealing", where the controlling families favor subsidiaries for which they have higher cash flow rights.

Anglo-American Model

There are many different models of corporate governance around the world. These differ according to the variety of capitalism in which they are embedded. The liberal model that is common in Anglo-American countries tends to give priority to the interests of shareholders. The coordinated model that one finds in Continental Europe and Japan also recognizes the interests of workers, managers, suppliers, customers, and the community. Each model has its own distinct competitive advantage. The liberal model of corporate governance encourages radical innovation and cost competition, whereas the coordinated model of corporate governance facilitates incremental innovation and quality competition. However, there are important differences between the U.S. recent approach to governance issues and what has happened in the UK. In the United States, a corporation is governed by a board of directors, which has the power to choose an executive officer, usually known as the CEO. The CEO has broad power to manage the corporation on a daily basis, but needs to get board approval for certain major actions, such as hiring his or her immediate subordinates, raising money, acquiring another company, major capital expansions, or other expensive projects. Other duties of the board may include policy setting, decision making, monitoring management's performance, or corporate control.

The board of directors is nominally selected by and responsible to the shareholders, but the bylaws of many companies make it difficult for all but the largest shareholders to have any influence over the makeup of the board; normally, individual shareholders are not offered a choice of board nominees among which to choose, but are merely asked to rubber-stamp the nominees of the sitting board. Perverse incentives have pervaded many corporate boards in the developed world, with board members beholden to the chief executive whose actions they are intended to oversee. Frequently, members of the boards of directors are CEO's of other corporations, which some see as a conflict of interest.

Codes and guidelines

Corporate governance principles and codes have been developed in different countries and issued from stock exchanges, corporations, institutional investors, or associations (institutes) of directors and managers with the support of governments and international organizations. As a rule, compliance with these governance recommendations is not mandated by law, although the codes linked to stock exchange listing requirements may have a coercive effect.

For example, companies quoted on the London and Toronto Stock Exchanges formally need not follow the recommendations of their respective national codes. However, they must disclose whether they follow the recommendations in those documents and, where not, they should provide explanations concerning divergent practices. Such disclosure requirements exert a significant pressure on listed companies for compliance.

In the United States, companies are primarily regulated by the state in which they incorporate though they are also regulated by the federal government and, if they are public, by their stock exchange. The highest number of companies are incorporated in Delaware, including more than half of the Fortune 500. This is due to Delaware's generally business-friendly corporate legal environment and the existence of a state court dedicated solely to business issues (Delaware Court of Chancery).

Most states' corporate law generally follow the American Bar Association's Model Business Corporation Act. While Delaware does not follow the Act, it still considers its provisions and several prominent Delaware justices, including former Delaware Supreme Court Chief Justice E. Norman Veasey, participate on ABA committees.

One issue that has been raised since the Disney decision in 2005 is the degree to which companies manage their governance responsibilities; in other words, do they merely try to supersede the legal threshold, or should they create governance guidelines that ascend to the level of best practice. Such documents, however, may have a wider multiplying effect prompting other companies to adopt similar documents and standards of best practice.

One of the most influential guidelines has been the 1999 OECD Principles of Corporate Governance. This was revised in 2004. The OECD remains a proponent of corporate governance principles throughout the world.

Building on the work of the OECD, other international organizations, private sector associations and more than 20 national corporate governance codes, the United Nations Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR) has produced voluntary Guidance on Good Practices in Corporate Governance Disclosure. This internationally agreed benchmark consists of more than fifty distinct disclosure items across five broad categories:

  • Auditing
  • Board and management structure and process
  • Corporate responsibility and compliance
  • Financial transparency and information disclosure
  • Ownership structure and exercise of control rights


The World Business Council for Sustainable Development WBCSD has done work on corporate governance, particularly on accountability and reporting, and in 2004 created an Issue Management Tool: Strategic challenges for business in the use of corporate responsibility codes, standards, and frameworks. This document aims to provide general information, a "snap-shot" of the landscape and a perspective from a think-tank/professional association on a few key codes, standards and frameworks relevant to the sustainability agenda.

See also

External links

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