Corporate governance is the set of processes, 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 stakeholders involved and the goals for which the corporation is governed. In contemporary business corporations, the main external stakeholder groups are shareholders, debt holders, trade creditors, suppliers, customers and communities affected by the corporation’s activities. Internal stakeholders are the board of directors, executives, and other employees.
Corporate governance is a process that aims to allocate corporate resources in a manner that maximizes value for all stakeholders – shareholders, investors, employees, customers, suppliers, environment and the community at large and holds those at the helms to account by evaluating their decisions on transparency, inclusivity, equity and responsibility. The World Bank defines governance as the exercise of political authority and the use of institutional resources to manage society’s problems and affairs.
Corporations are created as legal persons by the laws and regulations of a particular jurisdiction. These may vary in many respects between countries, but a corporation’s legal person status is fundamental to all jurisdictions and is conferred by statute. This allows the entity to hold property in its own right without reference to any particular real person. It also results in the perpetual existence that characterizes the modern corporation. The statutory granting of corporate existence may arise from general purpose legislation or from a statute to create a specific corporation, which was the only method prior to the 19th century.
In addition to the statutory laws of the relevant jurisdiction, corporations are subject to common law in some countries, and various laws and regulations affecting business practices. In most jurisdictions, corporations also have a constitution that provides individual rules that govern the corporation and authorize or constrain its decision-makers. This constitution is identified by a variety of terms; in English speaking jurisdictions, it is usually known as the Corporate Charter or the [Memorandum and] Articles of Association. The capacity of shareholders to modify the constitution of their corporation can vary substantially.
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, Toronto and Australian Stock Exchanges formally need not follow the recommendations of their respective 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.
One of the most influential guidelines has been the 1999 OECD(Organisation for Economic co-operation and Development) Principles of Corporate Governance. This was revised in 2004. The OECD guidelines are often referenced by countries developing local codes or guidelines. 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 their Guidance on Good Practices in Corporate Governance Disclosure.
This internationally agreed benchmark consists of more than fifty distinct disclosure items across five broad categories:
- 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 released Issue Management Tool: Strategic challenges for business in the use of corporate responsibility codes, standards, and frameworks. This document offers general information and a perspective from a business association/think-tank on a few key codes, standards and frameworks relevant to the sustainability agenda.
In the United States, corporations are directly governed by state laws, while the exchange (offering and trading) of securities in corporations (including shares) is governed by federal legislation. Many U.S. states have adopted the Model Business Corporation Act, but the dominant state law for publicly-traded corporations is Delaware, which continues to be the place of incorporation for the majority of publicly-traded corporations. Individual rules for corporations are based upon the corporate charter and, less authoritatively, the corporate bylaws. Shareholders cannot initiate changes in the corporate charter although they can initiate changes to the corporate bylaws.
US expansion after World War II through the emergence of multinational corporations saw the establishment of the managerial class. According to Lorsch and MacIver “many large corporations have dominant control over business affairs without sufficient accountability or monitoring by their board of directors.” Over the past three decades, corporate directors’ duties in the U.S. have expanded beyond their traditional legal responsibility of duty of loyalty to the corporation and its shareholders.
In the first half of the 1990s, the issue of corporate governance in the U.S. received considerable press attention due to the wave of CEO dismissals (e.g.: IBM, Kodak, Honeywell) by their boards. The California Public Employees’ Retirement System (CalPERS) led a wave of institutional shareholder activism, as a way of ensuring that corporate value would not be destroyed by the now traditionally cozy relationships between the CEO and the board of directors.
In, 1997, the East Asian Financial Crisis saw the economies of Thailand, Indonesia, South Korea, Malaysia and The Philippines severely affected by the exit of foreign capital after property assets collapsed. The lack of corporate governance mechanisms in these countries highlighted the weaknesses of the institutions in their economies. In the early 2000s, the massive bankruptcies (and criminal malfeasance) of Enron and WorldCom, as well as lesser corporate scandals, such as Adelphia Communications, AOL, Arthur Andersen, Global Crossing, Tyco, led to increased political interest in corporate governance. This is reflected in the passage of the Sarbanes-Oxley Act of 2002.
Parties to corporate governance
The most influential parties involved in corporate governance include government agencies and authorities, stock exchanges, management (including the board of directors and its chair, the Chief Executive Officer or the equivalent, other executives and line management, shareholders and auditors).Other influential stakeholders may include lenders, suppliers, employees, creditors, customers and the community at large.
A board of directors is expected to play a key role in corporate governance. The board has the responsibility of endorsing the organization’s strategy, developing directional policy, appointing, supervising and remunerating senior executives, and ensuring accountability of the organization to its investors and authorities.
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.
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 other’s 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.
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 shares 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 behaviour, and can elicit myopic behaviour.
In publicly-traded U.S. corporations, boards of directors are largely chosen by the President/CEO and the President/CEO often takes the Chair of the Board position for his/herself (which makes it much more difficult for the institutional owners to “fire” him/her). The practice of the CEO also being the Chair of the Board is known as “duality”. While this practice is common in the U.S., it is relatively rare elsewhere. It is illegal in the U.K.
External corporate governance controls
External corporate governance controls encompass the controls external stakeholders exercise over the organization. Examples include:
- debt covenants
- demand for and assessment of performance information (especially financial statements)
- government regulations
- managerial labour market
- media pressure
Issues in Corporate Governance
- Asymmetry of power
- Asymmetry of information
- Interests of shareholders as residual owners
- Role of owner management
- Theory of separation of powers
- Division of corporate pie among stakeholders
Current status on corporate governance
- Governance and performance
- Good governance leads to good performance
- It creates an open and transparent system
- It improves communication and breaks down systematic barriers to flow of information
- Good governance allows decision making based on data. It reduces risk
- Good governance helps in creating a brand and creates comfort for all stakeholders and society
Investing in Corporate Governance
Companies need to invest in good governance Corporate governance has a direct bearing on business performance and thereby ROI Leverage the power of IT On average, businesses with superior governance practices generate 20 percent greater profits than other companies.
The above background paper covers the basic concepts of Corporate Governance, as they have emerged, mainly during the last two decades; it is intended as background study for the Global Convention on Corporate Governance and Sustainability challenges.
Sunny Kumar, Pursuing Ph.d,
Mewar University, Chittorgarh