Corporate Governance

Corporate governance refers to the systems, principles, and processes by which organizations are directed and controlled. It encompasses the relationships among various stakeholders, including the board of directors, management, shareholders, and other interested parties. Effective corporate governance ensures transparency, accountability, and fairness in a company's operations, ultimately contributing to its long-term success and sustainability.

Key elements of corporate governance include the establishment of a clear organizational structure, adherence to ethical standards, and compliance with laws and regulations. This framework helps to mitigate risks, enhance performance, and protect the interests of stakeholders. Moreover, strong corporate governance practices can foster investor confidence and attract capital, which is essential for growth and innovation.

In today’s globalized economy, diverse perspectives on corporate governance are increasingly important, as different cultures may emphasize various aspects of governance. As companies navigate complex challenges, ongoing discussions about the role of corporate governance continue to evolve, highlighting the need for adaptive and inclusive practices to meet the demands of all stakeholders.

Published in: 2021

By: Long, Janet

Subject Terms

Corporate Governance

Abstract

Businesses have always been governed by principles designed to support a company's purpose, ensure its financial health, and keep it growing for the foreseeable future. Integrity and stability were historically perceived to go hand in hand; innovation complemented risk management to drive profits. Good governance was built on these assumptions. Publicly traded companies further operate under a mandate that holds shareholder interests as the first priority. Formal protocols were developed in the 1990s in response to executive corruption that resulted in massive corporate failures.

Overview

Corporate governance refers to the structures, policies, and procedures by which a company governs itself. Without defined and exercised internal controls backed by external checks, companies are vulnerable to error, negligence, malfeasance, and fraud. Best practices for corporate governance were developed in the 1990s in reaction to a spate of high-profile company failures that culminated in the bankruptcy of Maxwell Communications. Systemic fraud in these international giants resulted in bankruptcies that harmed the interests of thousands of employees and shareholders. To restore investor confidence and ensure the health of large companies, the concept of corporate governance was formally revisited and codified.

Publicly held corporations have internal and external stakeholders. Internal stakeholders include employees and a board of directors. External stakeholders include creditors, suppliers, customers, and shareholders. Traditionally, corporate governance has sought to protect shareholders from the unscrupulous or incompetent actions of managers by the appointment of guardians—or directors—over the assets of the company. The board of directors oversees the running of the company and promotes the interests of shareholders, especially the maximization of share values and dividends.

The underlying approach to traditional corporate governance is embodied in agency theory. Shareholders own the company, and directors are beholden to them for their positions on the company board. Directors have a fiduciary duty only to the shareholders; other stakeholders have contractual or other relationships with the company. Employees, for example, engage with the company under the conditions of their employment contracts. Customers are protected by warranties and by government regulations. Communities are protected by zoning ordinances and laws governing property rights, environmental regulations, and so on. Where interests are in conflict, the board must direct the company's actions in deference to the best interests of the shareholders.

Ultimately, however, a poorly run company cannot benefit its shareholders over the long term, regardless of short-term profits in the form of climbing share, or stock, prices. This was amply demonstrated by the fall of Enron, a US energy company that claimed to generate $111 billion in 2000, a claim that turned out to be highly inflated. The structure of the company and makeup of its board provided opportunity for reckless malfeasance, which was shielded by accounting practices that were inherently compromised by the accounting firm's relationship with the company. Because Enron was wildly popular with investors, its sudden collapse had a profound effect on shareholders, mutual funds and pensions, and on the wider economy.

Actions taken by a company that result in detriments to society or the environment are referred to as corporate crime by detractors. Exploration and development activities, for example, may involve population displacement or oil spills, undeniable harms to external stakeholders to whom company directors are not beholden under agency theory. While even successful lawsuits rarely affect a company's bottom line significantly, a negative public image may, over time, erode a company's profitability. A reputation as a bad neighbor or an untrustworthy player may cause a company to meet future resistance on many fronts, in addition to the possible loss of customers, investors, and business partners.

With globalization, many companies became international organizations operating under the laws of multiple localities and with scattered centers of decision making. The nature of multinational corporations made them unwieldy and hard to govern. The Report of the Committee on Financial Aspects of Corporate Governance (1992), better known as the Cadbury Report, followed by the Organisation for Economic Co-Operation and Development (OECD) Principles of Corporate Governance (2004), attempted to codify best practices. The recommendations of these reports are considered voluntary, but compliance is in many arenas considered essential. Scrutiny by the media and by investors acts as both driver and incentive, and companies generally consider it in their own best interest to exercise a high level of corporate governance. The London Stock Exchange, for example, requires some level of compliance (or disclosure of noncompliance) to The UK Corporate Governance Code, derived from the Cadbury Report, in order to be listed on the exchange (Cronin, Murphy, & Slaughter, 2012).

In the United States, the Public Company Accounting Reform and Investor Protection Act of 2002, better known as the Sarbanes-Oxley Act, legislated some of the recommendations of the Cadbury Report in response to the Enron and Worldcom collapses. Chief executive and financial officers were required by law to sign off on all Securities and Exchange Commission disclosures, including financial statements, vouching for their accuracy and completeness. The auditing process and internal controls, including risk assessment, became the responsibility of the CEO and CFO, who were held legally accountable for the institution and integrity of all systems necessary to produce disclosure statements. An external auditor was required to review the company's internal controls and provide an opinion as to their reliability.

The subsequent wave of company failures, especially in the banking and finance sector, that led to the 2007-2008 Great Recession, inspired further examination of corporate governance protocols. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 addresses risk assessment and financial transparency in financial institutions but did not otherwise legislate significant changes in corporate governance practices. The OECD concluded that the existing protocols were in themselves not at fault and in fact did provide sound guidance. The challenge was in convincing companies to faithfully implement them. Linking remuneration to share price (as a measure of performance) was thought to be a way of aligning executive and shareholder interests, a cornerstone of good governance. Rather than protecting the interests of shareholders, however, this kind of compensation arrangement instead fostered the temptation to drive up stock values by any means.

Applications

The general principles of corporate governance are to minimize conflicts of interest for decision makers, ensure independent review of company actions and claims, and align company policies and procedures with applicable laws and regulations. These principles are enshrined in a number of documents that outline best practices for publicly traded companies, which, though tailored to individual economies and localities, are generally similar in their specific recommendations.

Recommendations emphasize agency theory by urging transparency with shareholders. The timely disclosure of financial reports, at least annually, is essential. Shareholders should also be kept abreast of any other information having to do with the state of the company, including ownership and performance issues. Annual shareholder meetings are encouraged, and companies are expected to facilitate shareholder participation in board elections and policies.

The composition of boards of directors is a major focus of corporate governance best practices. Boards are to include executive and non-executive members, as well as independent members—that is, members who are not employed or in some way dependent on the company or on other members of the board. The mix should include those with intimate knowledge of the company's operations and the industry and those from outside the field, who bring a broader range of expertise and alternative perspectives. Directors may have financial, product, or policymaking backgrounds.

Leadership roles are key to responsible corporate governance. The dual role of chief executive and chair of the board, which is common in large companies where the CEO is believed to be in the best position to direct company actions, is discouraged. The conflation of the two top leadership positions in a single person creates a powerful company head who is difficult to challenge and may have too free a run of the company. Even if such a leader should avoid deserving the application of the adage "power corrupts," he or she may make decisions based on a personally held set of data and perspectives without seriously consulting opposing viewpoints and knowledge bases. It is important, not only for the chair but also for the other directors, to be as free as possible from conflicts of interest and to be transparent where conflicts are unavoidable.

As directors of the company, board members take responsibility for establishing company strategy, articulating its aims, and overseeing management. By approving financial statements, the board cannot claim that they are not accountable for inaccuracies. The heightened accountability called for in corporate governance best practices codes is backed by recommendations for producing accurate financial statements. Audit committees, like boards, should be composed of both the company employees best placed to provide and scrutinize data, independents, and experts. Internal auditors should receive verification by external auditors. If fraud is suspected by an internal auditor, the audit committee addresses the suspicions and decides whether further investigation is warranted. Where collusion is suspected among senior management, it is important that auditors should be able to go to investigative authorities outside of company to report suspected fraud without fear of legal retaliation by the client in the form of a lawsuit for breach of confidentiality or charges of defamation.

"Creative accounting" refers to the practice of hiding or shading certain aspects of a financial statement to make it appear to say something positive in contradiction to its real import. This can done by using variations on accounting practices that are not necessarily illegitimate but are more or less useful according to the wishes of the client. Additionally, accounting practices vary among countries and bringing together financial information from many profit centers is extremely challenging. The common use of a single standard of accounting practices, such as the International Financial Reporting Standards developed for international companies by the International Accounting Standards Board, is strongly recommended.

In a departure from pure agency theory, some corporate governance practices call for consideration of all stakeholders, including creditors, suppliers, customers, employees, communities, and policy makers. Including a code of ethics in regard to being a good corporate citizen polishes a company's image and seeks to prevent gross negligence or disregard of human life, health, or property. Such a statement appeals to socially conscious investors and helps to mitigate the qualms of policy makers and regulators.

Viewpoints

The Cadbury Report was initially controversial, though over time its recommendations have proven beneficial to companies by articulating structures and policies that tend toward stability and risk reduction. Good governance is seen as a means to greater financial access with lower interest rates, better overall performance, a better corporate citizen image, and higher stock prices. Much research is being done on the long-term effects of the corporate governance best practices codes in real companies.

The keystones of corporate governance—a sufficiently independent board of directors and the separation of chairman and CEO duties—were seen by early advocates as critical to good governance. Misangyi & Acharya (2014) found that such measures by themselves did not have much of an effect either way. Using profitability as a measure, successful governance depended rather on how the practices were applied. It was not enough to have a mixed board or an independent chair—other factors, such as appropriate expertise—came into play. The dual CEO-chair was not necessarily an obstacle to good governance, provided all power did not in fact reside in a single person. Incentivizing good behavior among executives to align their interests monetarily with those of the shareholders, for example, by tying compensation to company performance was effective; adequate monitoring, however, was found to be equally important.

Joseph, Ocasio & McDonnell (2014) warned that the trend toward more independent boards has in some cases resulted in boards of company outsiders run by the sole insider—the CEO. Seen as an end run around the mandate for truly independent boards, the paradoxical effect of boards strongly dominated by independents is to concentrate real power in the CEO as there are no other insiders to challenge or contradict from a position of company knowledge. Limiting board access to lower-ranking executives further diminishes the power of potential rivals and undermines shareholder interests.

While the focus of board responsibility has historically been on shareholder interests, long-term stability, especially for international companies, suggests the need for an expansion of corporate responsibility to include other stakeholders. Some have gone so far as to suggest that company boards should act as an autonomous fiduciary for all stakeholders, including employees and local community members. This would be accomplished by expanding the board to include representatives from various stakeholding groups. Critics point to the potential unwieldiness of extremely large boards and the essential problem that directors, no matter who they supposedly represent, are nominated by company executives (Zeitoun, Osterloh & Frey, 2015). The notion of truly independent board members is at its root suspect.

Terms & Concepts

Agency theory: The concept describing the traditional approach underlying corporate governance, that is, that the primary responsibility of the board of directors of a publically traded company is to protect shareholders from the harmful actions of company executives and managers

Cadbury Report: A document issued by the Financial Reporting Council, which was charged by the Corporate Governance Committee of the United Kingdom with investigating the structural faults of publically traded companies that enabled catastrophic levels of corruption in a number of high profile bankruptcies; the best practices outlined in the report provided the foundation for modern corporate governance codes

Fiduciary: A person entrusted with the assets of another; a corporate board of directors has a fiduciary duty to the company owners (shareholders) to profitably manage the assets of the company

Shareholders: Owners of shares of publically traded stock; companies raise money by dividing ownership into individual shares and selling them to investors, who then become part owners of the company with other shareholders. Investors are rewarded with dividends, or divisions of company profit, and ultimately with higher resale value for their shares.

Stakeholders: All parties who stand to be effected, positively or negatively, by actions of the company

Bibliography

Blanc, S. (2016). Are Rawlsian considerations of corporate governance illiberal? Business Ethics Quarterly, 26(3), 407-421. Retrieved December 27, 2016 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=117759531&site=ehost-live&scope=site

Cronin, P., Murphy, F., & Slaughter & May. (2012). Corporate governance for main market and AIM companies. London, UK: WhitePage.

Feldman, E. R. (2016). Dual directors and the governance of corporate spinoffs. Academy of Management Journal, 59(5), 1754-1776. Retrieved December 27, 2016 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=118666036&site=ehost-live&scope=site

Joseph, J., Ocasio, W., & McDonnell, M. (2014). The structural elaboration of board independence: Executive power, institutional logics, and the adoption of CEO-only board structures in U.S. corporate governance. Academy of Management Journal, 57, 1834-1858. Retrieved March 22, 2015 from EBSCO Online Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=99846867&site=ehost-live

Misangyi, V. F., & Acharya, A. G. (2014). Substitutes or complements? A configurational examination of corporate governance mechanisms. Academy of Management Journal, 57, 1681-1705. Retrieved March 22, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=99846861&site=ehost-live

OECD Principles of Corporate Governance. (2004). Paris, France: OECD. Retrieved April 20, 2015 from http://www.oecd.org/daf/ca/corporategovernanceprinciples/ 31557724.pdf

The Report of the Committee on Financial Aspects of Corporate Governance. (1992). London, UK: Gee. Retrieved April 1, 2015 from http://www.ecgi.org/codes/ documents/cadbury.pdf

Tricker, R. I. (2015). Corporate Governance: Principles, Policies, and Practices. 3rd edition. New York, NY: Oxford University Press.

Zeitoun, H., Osterloh, M., & Frey, B. S. (2015). Learning from ancient Athens: Demarchy and corporate governance. Academy of Management Perspectives, 3015, 4-18. Retrieved March 22, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=101296977&site=ehost-live

Corporate Governance

On this Page

Subject Terms

Corporate Governance

Abstract

Overview

Applications

Viewpoints

Terms & Concepts

Bibliography

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