According to Investopedia, corporate governance is the system of rules, practices, and processes by which a firm is directed and controlled.
Corporate governance essentially involves balancing the interests of a company's many stakeholders, such as shareholders, management, customers, suppliers, financiers, government and the community.
Since corporate governance also provides the framework for attaining a company's objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.
The simplest and most concise definition of corporate governance was provided by the Cadbury Report in 1992 according to 2012 ACCA, which stipulates that corporate governance is the system by which companies are directed and controlled.
Though simplistic, this definition provides an understanding of the nature of corporate governance and the vital role that leaders of organizations have to play in establishing effective practices. For most companies, those leaders are the directors, who decide the long-term strategy of the company in order to serve the best interests of the owners (members or shareholders) and, more broadly, stakeholders, such as customers, suppliers, providers of long-term finance, the community and regulators.
It is important to recognize that effective corporate governance relies to some extent on compliance with laws, but being fully compliant does not necessarily mean that a company is adopting sound corporate governance practices.
Below is an example of the Organisation for Economic Co-operation and Development which published its ‘Principles of Corporate Governance’ in 2004. These include:
Rights of shareholders: The corporate governance framework should protect shareholders and facilitate their rights in the company. Companies should generate investment returns for the risk capital put up by the shareholders.
Equitable treatment of shareholders: All shareholders should be treated equitably (fairly), including those who constitute a minority, individuals and foreign shareholders. Shareholders should have redress when their rights are contravened or where an individual shareholder or group of shareholders is oppressed by the majority.
Stakeholders: The corporate governance framework should recognise the legal rights of stakeholders and facilitate cooperation with them in order to create wealth, employment and sustainable enterprises.
Disclosure and transparency: Companies should make relevant, timely disclosures on matters affecting financial performance, management and ownership of the business.
Board of directors: The board of directors should set the direction of the company and monitor management in order that the company will achieve its objectives. The corporate governance framework should underpin the board’s accountability to the company and its members.
Significantly, the Cadbury Report was published in the UK shortly after the collapse of Maxwell Communications plc, a large publishing company. Many of the actions that brought about the collapse, such as the concentration of power in the hands of one individual and the company borrowing from its pension fund in order to achieve leveraged growth, were legal at the time. It is instructive to note that a few months ago in Ghana, we witnessed in part or whole how some organizations were faulted by the Regulator for some of the actions enumerated above.
Governance refers specifically to the set of rules, controls, policies and resolutions put in place to dictate corporate behavior. Proxy advisors and shareholders are important stakeholders who indirectly affect governance, but these are not examples of governance itself. The Board of Directors is pivotal in governance, and it can have major ramifications for equity valuation.
Communicating a firm's corporate governance is a key component of community and investor relations. On Apple's investor relations site, for example, the firm outlines its leadership and governance, including its executive team, its board of directors and also the firm's committee charters and governance documents, such as bylaws, stock ownership guidelines and Apple's articles of incorporation.
Corporate Governance and the Board of Directors
The Board of Directors is the primary direct stakeholder influencing corporate governance. Directors are elected by shareholders or appointed by other board members, and they represent shareholders of the company. The board is tasked with making important decisions, such as corporate officer appointments, executive compensation, and dividend policy. In some instances, board obligations stretch beyond financial optimization, when shareholder resolutions call for certain social or environmental concerns to be prioritized.
Boards are often made up of inside and independent members. Insiders are major shareholders, founders and executives. Independent directors do not share the ties of the insiders, but they are chosen because of their experience managing or directing other large companies. Independents are considered helpful for governance because they dilute the concentration of power and help align shareholder interest with those of the insiders.
Good and Bad Governance
Bad corporate governance can cast doubt on a company's reliability, integrity or obligation to shareholders — which can have implications on the firm's financial health. Tolerance or support of illegal activities can create scandals like the one that rocked Volkswagen AG in 2015, when it was revealed that the firm had rigged engine emissions tests in America and Europe. Volkswagen saw its stock shed nearly half its value in the days following the start of the scandal, and its global sales in the first full month following the news fell 4.5%. In Ghana, the story of various illegal acts by the Board of Directors of certain firms leading to the collapse of those firms is still fresh in our minds.
Companies that do not co-operate sufficiently with auditors or do not select auditors with the appropriate scale can publish spurious or noncompliant financial results. Bad executive compensation packages fail to create optimal incentive for corporate officers. Poorly structured boards make it too difficult for shareholders to oust ineffective incumbents. In most cases, it appears that some members of the Board were selected solely based on their ‘grey hairs’ to give credence or legitimacy to their being on the Board. Others were also selected because of the influence they wielded and not necessarily their competence or ability to positively drive their respective firms.
Corporate governance became a pressing issue following the 2002 introduction of the Sarbanes-Oxley Act in the United States, which was ushered in to restore public confidence in companies and markets after accounting fraud bankrupted high-profile companies such as Enron and WorldCom.
Good corporate governance creates a transparent set of rules and controls in which shareholders, directors and officers have aligned incentives. Most companies strive to have a high level of corporate governance. For many shareholders, it is not enough for a company to merely be profitable; it also needs to demonstrate good corporate citizenship through environmental awareness, ethical behavior and sound corporate governance practices.
To whom is corporate governance relevant?
Corporate governance is important in all but most importantly the smallest organizations. After all, tall oaks from little acorns grow!. Limited companies have a primary duty to their shareholders, but also to other stakeholders as described above. Not-for-profit organizations must also be directed and controlled appropriately, as the decisions and actions of a few individuals can affect many individuals, groups and organizations that have little or no influence over them. Public sector organizations have a duty to serve the State but must act in a manner that treats stakeholders fairly.
Most of the attention given to corporate governance is directed towards public limited companies whose securities are traded in recognized capital markets. The reason for this is that such organizations have hundreds or even thousands of shareholders whose wealth and income can be enhanced or compromised by the decisions of senior management. This is often referred to as the agency problem. Potential and existing shareholders take investment decisions based on information that is historical and subjective, usually with little knowledge of the direction that the company will take in the future. They therefore place trust in those who take decisions to achieve the right balance between return and risk, to put appropriate systems of control in place, to provide timely and accurate information, to manage risk wisely, and to act ethically at all times.
The agency problem becomes most evident when companies fail. In order to make profits, it is necessary to take risks, and sometimes risks that are taken with the best intentions – and are supported by the most robust business plans – result in loss or even the demise of the company. Sometimes corporate failure is brought about by inappropriate behaviours of directors and other senior managers.
As already mentioned, in the UK, corporate governance first came into the spotlight with the publication of the Cadbury Report, shortly after two large companies (Maxwell Communications plc and Polly Peck International plc) collapsed. Ten years later, in the US, the Sarbanes-Oxley Act was passed as a response to the collapse of Enron Corporation and WorldCom. All of these cases involved companies that had been highly successful and run by a few very powerful individuals, and all involved some degree of immoral activity on their part.
The recent banking sector challenges have brought about renewed concern about corporate governance, specifically in the financial sector. Although the roots of the crisis were mainly financial and originated with adverse conditions in the wholesale money markets, subsequent investigations and reports have called into question the policies, processes and prevailing cultures in many banking and finance-related organizations.
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