Corporate governance refers to the method by which a corporation is directed, administered, directed or controlled. It includes the laws and customs affecting that direction, as well as the goals for which it is governed. The principal participants are the shareholders, management and the board of directors.
As a result of the separation of ownership from control in modern corporations, a system of corporate governance controls is implemented on behalf of shareholders to reduce agency costs and information asymmetry. Corporate governance is also used to monitor whether outcomes are in accordance with plans; and to motivate the organisation to be more fully informed in order to maintain or alter organisational activity.
Recently there has been considerable interest in the corporate governance practices of modern corporations, particularly since the high-profile collapses of firms such as Enron Corporation.
Definition
It includes the laws governing the formation of firms, the bylaws established by the firm itself, and the structure of the firm. The corporate governance structure specifies the relations, and the distribution of rights and responsibilities, among a number of groups.
This system spells out the rules and procedures for making decisions on corporate affairs, it also provides the structure through which the company objectives are set, as well as the means of attaining and monitoring the performance of those objectives. The cheif aims of corporate governance are to:
- align the actions of the individual parts of the organisation toward aggregate mutual benefit
- provide the means by which each individual part of the organisation can trust that the remainder are each doing their part toward mutual benefit of the organisation and that none are unfairly gaining at the expense of others
- provide a means by which information can quickly flow between the various stakeholders to ensure that the changing nature of both the stakeholder needs and desires and the environment in which the organisation operates are effectively factored into decision processes.
Issues of fiduciary duty and accountability are often discussed within the framework of corporate governance.
History
In the 19th century, state corporation law enhanced the rights of corporate boards to govern without unanimous consent of shareholders in exchange for statutory benefits like appraisal rights, in order to make corporate governance more efficient. Since that time, and because most corporations in America are incorporated under corporate administration friendly Delaware law, and because America's wealth has been increasingly securitized into corporate entities, the rights of owners and shareholders have become derived and dissipated. The concerns of shareholders over administration pay and stock losses periodically has led to more frequent calls for Corporate Governance reforms.
Parties to corporate governance
Parties involved in corporate governance include the governing or regulatory body (e.g. the Securities and Exchange Commission in the United States), the Chief Executive Officer, the board of directors, management and shareholders. Other stakeholders who may also take part include suppliers, employees, creditors and the community at large.
It is the responsibility of the board of directors to formulate the organisation's strategy, develop policy, appoint, supervise and remunerate senior executives and to ensure accountability of the organisation to its owners.
The individuals within the above groups transact with the firm for their own individual purposes, so as the entire group can achieve more mutual benefit than any individual can alone. For instance directors, workers and management receive salary, benefits and reputation, whilst shareholders receive capital return. Customers receive goods and services and suppliers receive compensation for their goods or services. In return these individuals provide their time, labour, expertise, capital, goods, services, insurance, consent required for the organisation to achieve its purpose.
With the significant increase in equity holdings of institutional investors, there has been an opportunity for a reversal of the separation of ownership and control problems because ownership is not so diffuse.
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 organisation.
Of importance is how directors and management develop a model of governance that aligns the values of the corporate participants and then 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.
Issues involving coporate governance principles include:
- appropriate mix of executive and non-executive directors
- indepedence of non-executive directors
- oversight of the preparation of the entity's financial statements
- internal controls and the independence of the entity's auditors
- review of the compensation arrangements for the chief executive officer and other senior executives
- the way in which individuals are nominated for positions on the board
- the resources made available to directors in carrying out their duties
- oversight and management of risk
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' behaviour, an independent third party (the 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 monitor activities and then take corrective action to accomplish organisational goals. Examples include:
- board of directors
- remuneration committees
- audit committees
External corporate governance controls encompass the controls external stakeholders exercise over the organisation. Examples include:
- debt covenants
- external auditors
- government regulations
Corporate governance models around the world
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 tend 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. Both models have distinct competitive advantages, but in different ways. 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.
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 chief executive officer. 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/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 rubberstamp 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[1] 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 contrast, the guidelines issued by associations of directors, corporate managers and individual companies tend to be wholly voluntary. For example, The GM Board Guidelines reflect the company’s efforts to improve its own governance capacity. Such documents, however, may have a wider multiplying effect prompting other companies to adopt similar documents and standards of best practice.
Corporate governance and firm performance
In its 'Global Investor Opinion Survey' of over 200 institutional investors first undertaken in 2000 and updated in 2002, McKinsey found that 80% of the respondents would pay a premium for well-governed companies. They defined a well-governed company as one that had mostly out-side directors, who had no management ties, undertook formal evaluation of its directors, and was responsive to investors' requests for information on governance issues. The size of the premium varied by market, from 11% for Canadian companies to around 40% for companies where the regulatory backdrop was least certain (those in Morocco, Egypt and Russia).
Other studies have linked broad perceptions of the quality of companies to superior share price performance. In a study of five year cumulative returns of Fortune Magazine's survey of 'most admired firms', Antunovich et al found that those "most admired" had an average return of 125%, whilst the 'least admired' firms returned 80%. In a separate study Business Week enlisted institutional investors and 'experts' to assist in differentiating between boards with good and bad governance and found that companies with the highest rankings had the highest financial returns.
On the other hand, research into the relationship between specific corporate governance controls and firm performance has been mixed and often weak. The following examples are illustrative.
Board composition
Remuneration
Attention to corporate governance
Corporate governance issues are receiving greater attention in both developed and developing countries as a result of the increasing recognition that a firm’s corporate governance affects both its economic performance and its ability to access long-term, low-cost investment capital.
Corporate Governance concerns have been widely studied. For the United States, an analysis of these concerns has been published by the New York Society of Securities Analysts in their 2003 Corporate Governance Handbook. What constitutes good and bad corporate governance is an on-going debate in politics, civil society, and academia. For an international survey of the scientific literature see Becht, Bolton and Roell 2002.
See also
External sources
- International online Collection of Corporate Governance Codes (link)
- Information on Corporate Governance in Europe from the European Corporate Governance Institute
- Harvard Business School's Corporate Governance Initiative
Selected references
- Becht, Marco, Bolton, Patrick and Roell, Ailsa A., "Corporate Governance and Control" (October 2002). ECGI - Finance Working Paper No. 02/2002. SSRN 343461
- James A. Brickley, William S. Klug and Jerold L. Zimmerman, Managerial Economics & Organizational Architecture, ISBN 0072828099
- Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law, ISBN 0674235398
- Corporate Governance Handbook, New York Society of Securities Analysts, 2003 [2]