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CORPORATE GOVERNANCE

CORPORATE GOVERNANCE

Corporate governance is the collection of mechanisms, processes and relations by which corporations are controlled and operated.[1] Governance structures and principles identify the distribution of rights and responsibilities among different participants in the corporation (such as the board of directors, managers, shareholders, creditors, auditors, regulators, and other stakeholders) and include the rules and procedures for making decisions in corporate affairs.[2] Corporate governance is necessary because of the possibility of conflicts of interests between stakeholders,[3] primarily between shareholders and upper management or among shareholders.

Corporate governance includes the processes through which corporations’ objectives are set and pursued in the context of the social, regulatory and market environment. These include monitoring the actions, policies, practices, and decisions of corporations, their agents, and affected stakeholders. Corporate governance practices can be seen as attempts to align the interests of stakeholders.[4][5]

Interest in the corporate governance practices of modern corporations, particularly in relation to accountability, increased following the high-profile collapses of a number of large corporations in 2001–2002, many of which involved accounting fraud; and then again after the recent financial crisis in 2008.

Corporate scandals of various forms have maintained public and political interest in the regulation of corporate governance. In the U.S., these include scandals surrounding Enron and MCI Inc. (formerly WorldCom). Their demise led to the enactment of the Sarbanes–Oxley Act in 2002, a U.S. federal law intended to improve corporate governance in the United States. Comparable failures in Australia (HIH, One.Tel) are associated with the eventual passage of the CLERP 9 reforms there, that similarly aimed to improve corporate governance.[6] Similar corporate failures in other countries stimulated increased regulatory interest (e.g., Parmalat in Italy).

Background

The need for corporate governance follows the need to mitigate conflicts of interests between stakeholders in corporations.[3] These conflicts of interests appear as a consequence of diverging wants between both shareholders and upper management (principal–agent problems) and among shareholders (principal–principal problems),[7] although also other stakeholder relations are affected and coordinated through corporate governance.

Principal–agent conflict

In large firms where there is a separation of ownership and management, the principal–agent problem can arise between upper-management (the “agent”) and the shareholder(s) (the “principal(s)”). The shareholders and upper management may have different interests, where the shareholders typically desire profit, and upper management may be driven at least in part by other motives, such as good pay, good working conditions, or good relationships on the workfloor, to the extent that these are not necessary for profits. Corporate governance is necessary to align and coordinate the interests of the upper management with those of the shareholders.

One more specific danger that demonstrates possible conflict between shareholders and upper management materializes through stock purchases. Executives may have incentive to divert firm profit towards buying shares of own company stock, which will then cause the share price to rise. However, retained earnings will then not be used to purchase the latest equipment or to hire quality people. As a result, executives can sacrifice long-term profits for short-term personal benefits, which shareholders may find difficult to spot as they see their own shares rising rapidly.

Principal–principal conflict (the multiple principal problem)

The principal–agent problem can be intensified when upper management acts on behalf of multiple shareholders—which is often the case in large firms (see Multiple principal problem).[7] Specifically, when upper management acts on behalf of multiple shareholders, the multiple shareholders face a collective action problem in corporate governance, as individual shareholders may lobby upper management or otherwise have incentives to act in their individual interests rather than in the collective interest of all shareholders.[8] As a result, there may be free-riding in steering and monitoring of upper management,[9] or conversely, high costs may arise from duplicate steering and monitoring of upper management.[10] Conflict may break out between principals,[11] and this all leads to increased autonomy for upper management.[7]

Ways of mitigating or preventing these conflicts of interests include the processes, customs, policies, laws, and institutions which affect the way a company is controlled—and this is the challenge of corporate governance.[12][13] To solve the problem of governing upper management under multiple shareholders, corporate governance scholars have figured out that straightforward solution of appointing one or more shareholders for governance is likely to lead to problems because of the information asymmetry it creates.[14][15][16] Shareholders’ meetings are necessary to arrange governance under multiple shareholders, and it has been proposed that this is the solution to the problem of multiple principals due to median voter theorem: shareholders’ meetings lead power to be devolved to an actor that approximately holds the median interest of all shareholders, thus causing governance to best represent the aggregated interest of all shareholders.[7]

Other themes

An important theme of governance is the nature and extent of corporate accountability. A related discussion at the macro level focuses on the effect of a corporate governance system on economic efficiency, with a strong emphasis on shareholders’ welfare.[17] This has resulted in a literature focused on economic analysis.[18][19][20]

Other definitions

Corporate governance has also been more narrowly defined as “a system of law and sound approaches by which corporations are directed and controlled focusing on the internal and external corporate structures with the intention of monitoring the actions of management and directors and thereby, mitigating agency risks which may stem from the misdeeds of corporate officers”.[21]

Corporate governance has also been defined as “the act of externally directing, controlling and evaluating a corporation”[22] and related to the definition of Governance as “The act of externally directing, controlling and evaluating an entity, process or resource”.[23] In this sense, governance and corporate governance are different from management because governance must be EXTERNAL to the object being governed. Governing agents do not have personal control over, and are not part of the object that they govern. For example, it is not possible for a CIO to govern the IT function. They are personally accountable for the strategy and management of the function. As such, they “manage” the IT function; they do not “govern” it. At the same time, there may be a number of policies, authorized by the board, that the CIO follows. When the CIO is following these policies, they are performing “governance” activities because the primary intention of the policy is to serve a governance purpose. The board is ultimately “governing” the IT function because they stand outside of the function and are only able to externally direct, control and evaluate the IT function by virtue of established policies, procedures and indicators. Without these policies, procedures and indicators, the board has no way of governing, let alone affecting the IT function in any way.

One source defines corporate governance as “the set of conditions that shapes the ex post bargaining over the quasi-rents generated by a firm”.[24] The firm itself is modelled as a governance structure acting through the mechanisms of contract.[25][17] Here corporate governance may include its relation to corporate finance.[26]

Principles

Contemporary discussions of corporate governance tend to refer to principles raised in three documents released since 1990: The Cadbury Report (UK, 1992), the Principles of Corporate Governance (OECD, 1999, 2004 and 2015), and the Sarbanes–Oxley Act of 2002 (US, 2002). The Cadbury and Organisation for Economic Co-operation and Development (OECD) reports present general principles around which businesses are expected to operate to assure proper governance. The Sarbanes–Oxley Act, informally referred to as Sarbox or Sox, is an attempt by the federal government in the United States to legislate several of the principles recommended in the Cadbury and OECD reports.

  • Rights and equitable treatment of shareholders:[27][28][29] Organizations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by openly and effectively communicating information and by encouraging shareholders to participate in general meetings.
  • Interests of other stakeholders:[30] Organizations should recognize that they have legal, contractual, social, and market driven obligations to non-shareholder stakeholders, including employees, investors, creditors, suppliers, local communities, customers, and policy makers.
  • Role and responsibilities of the board:[31][32] The board needs sufficient relevant skills and understanding to review and challenge management performance. It also needs adequate size and appropriate levels of independence and commitment.
  • Integrity and ethical behavior:[33][34] Integrity should be a fundamental requirement in choosing corporate officers and board members. Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making.
  • Disclosure and transparency:[35][36] Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide stakeholders 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.

Models

Different models of corporate governance differ according to the variety of capitalism in which they are embedded. The Anglo-American “model” tends to emphasize the interests of shareholders. The coordinated or multistakeholder model associated with Continental Europe and Japan also recognizes the interests of workers, managers, suppliers, customers, and the community. A related distinction is between market-oriented and network-oriented models of corporate governance.[37]

Continental Europe (Two-tier board system)

Some continental European countries, including Germany, Austria, and the Netherlands, require a two-tiered board of directors as a means of improving corporate governance.[38] In the two-tiered board, the executive board, made up of company executives, generally runs day-to-day operations while the supervisory board, made up entirely of non-executive directors who represent shareholders and employees, hires and fires the members of the executive board, determines their compensation, and reviews major business decisions.[39]

Germany, in particular, is known for its practice of co-determination, founded on the German Codetermination Act of 1976, in which workers are granted seats on the board as stakeholders, separate from the seats accruing to shareholder equity.

India

The Securities and Exchange Board of India Committee 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.”[40][41] India is a growing economy and it is quite important to safeguard the interests of investors and also ensure that the responsibility of management is fixed. The Satyam scandal, also known as India’s Enron, wiped off billions of shareholders’ wealth and threatened foreign investment in India. This is the reason that corporate governance in India has taken the centre stage.[42]

United States, United Kingdom

The so-called “Anglo-American model” of corporate governance emphasizes the interests of shareholders. It relies on a single-tiered board of directors that is normally dominated by non-executive directors elected by shareholders. Because of this, it is also known as “the unitary system”.[43][44] Within this system, many boards include some executives from the company (who are ex officio members of the board). Non-executive directors are expected to outnumber executive directors and hold key posts, including audit and compensation committees. In the United Kingdom, the CEO generally does not also serve as Chairman of the Board, whereas in the US having the dual role has been the norm, despite major misgivings regarding the effect on corporate governance.[45] The number of US firms combining both roles is declining, however.[46]

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 US states have adopted the Model Business Corporation Act, but the dominant state law for publicly traded corporations is Delaware General Corporation Law, which continues to be the place of incorporation for the majority of publicly traded corporations.[47] Individual rules for corporations are based upon the corporate charter and, less authoritatively, the corporate bylaws.[47] Shareholders cannot initiate changes in the corporate charter although they can initiate changes to the corporate bylaws.[47]

It is sometimes colloquially stated that in the US and the UK “the shareholders own the company”. This is, however, a misconception as argued by Eccles & Youmans (2015) and Kay (2015).[48]

Founder centrism

Recent scholarship from the University of Oxford outlines a new theory of corporate governance, founder centrism, which is premised upon a narrowing in the separation between ownership and control. Through the lens of concentrated equity ownership theory, a new theory of the firm, the traditional checklist of best practices are inapplicable, as evidenced by the significant outperformance of technology companies with dual-class share structures and integrated CEO/Chairman positions:

Founder-run companies, such as Facebook, Netflix and Google are at the forefront of a new wave of organizational structure better suited to long-term value creation. Founder centrism, an inclusive concept within CEO theory, integrates the capacity of founder and non-founder senior leadership to adopt an owner’s mindset in traditionally structured corporations, such as Thomas J. Watson Sr. and Thomas Watson Jr. with IBM, Steve Jobs and Tim Cook with Apple, Jamie Dimon with JPMorgan Chase, Lloyd Blankfein with Goldman Sachs, Rick George with Suncor Energy, and many others. In substance, all fall within the ambit of founder centrism—leaders with a founder’s mindset, an ethical disposition towards the shareholder collective, and an intense focus on exponential value creation without enslavement to a quarter-by-quarter upward growth trajectory. In traditionally structured firms, high performing executives gain deference, become highly influential, and take on the qualities of concentrated equity owners. To the extent these leaders embrace founder centrism, their companies will experience efficiency advantages relative to competitors operating within traditional parameters.[49]

An article published by the Australian Institute of Company Directors called “Do Boards Need to become more Entrepreneurial?” also considered the need for founder centrism behaviour at board level to appropriately manage disruption.[50]

Regulation

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 (which is the general case) or from a statute to create a specific corporation, which was the only method prior to the 19th century.[citation needed]

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.[citation needed]

The U.S. passed the Foreign Corrupt Practices Act (FCPA) in 1977, with subsequent modifications. This law made it illegal to bribe government officials and required corporations to maintain adequate accounting controls. It is enforced by the U.S. Department of Justice and the Securities and Exchange Commission (SEC). Substantial civil and criminal penalties have been levied on corporations and executives convicted of bribery.[51]

The UK passed the Bribery Act in 2010. This law made it illegal to bribe either government or private citizens or make facilitating payments (i.e., payment to a government official to perform their routine duties more quickly). It also required corporations to establish controls to prevent bribery.

Sarbanes–Oxley Act

The Sarbanes–Oxley Act of 2002 was enacted in the wake of a series of high-profile corporate scandals. It established a series of requirements that affect corporate governance in the U.S. and influenced similar laws in many other countries. The law required, along with many other elements, that:

  • The Public Company Accounting Oversight Board (PCAOB) be established to regulate the auditing profession, which had been self-regulated prior to the law. Auditors are responsible for reviewing the financial statements of corporations and issuing an opinion as to their reliability.
  • The chief executive officer (CEO) and chief financial officer (CFO) attest to the financial statements. Prior to the law, CEOs had claimed in court they hadn’t reviewed the information as part of their defense.
  • Board audit committees have members that are independent and disclose whether or not at least one is a financial expert, or reasons why no such expert is on the audit committee.
  • External audit firms cannot provide certain types of consulting services and must rotate their lead partner every 5 years. Further, an audit firm cannot audit a company if those in specified senior management roles worked for the auditor in the past year. Prior to the law, there was the real or perceived conflict of interest between providing an independent opinion on the accuracy and reliability of financial statements when the same firm was also providing lucrative consulting services.[52]

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.

Organisation for Economic Co-operation and Development principles

One of the most influential guidelines on corporate governance are the G20/OECD Principles of Corporate Governance, first published as the OECD Principles in 1999, revised in 2004 and revised again and endorsed by the G20 in 2015.[4] The Principles 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 formed the United Nations Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR) to produce their Guidance on Good Practices in Corporate Governance Disclosure.[53] This internationally agreed[54] benchmark consists of more than fifty distinct disclosure items across five broad categories:[55]

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

The OECD Guidelines on Corporate Governance of State-Owned Enterprises[56] are complementary to the G20/OECD Principles of Corporate Governance,[57] providing guidance tailored to the corporate governance challenges unique to state-owned enterprises.

Stock exchange listing standards

Companies listed on the New York Stock Exchange (NYSE) and other stock exchanges are required to meet certain governance standards. For example, the NYSE Listed Company Manual requires, among many other elements:

  • Independent directors: “Listed companies must have a majority of independent directors … Effective boards of directors exercise independent judgment in carrying out their responsibilities. Requiring a majority of independent directors will increase the quality of board oversight and lessen the possibility of damaging conflicts of interest.” (Section 303A.01) An independent director is not part of management and has no “material financial relationship” with the company.
  • Board meetings that exclude management: “To empower non-management directors to serve as a more effective check on management, the non-management directors of each listed company must meet at regularly scheduled executive sessions without management.” (Section 303A.03)
  • Boards organize their members into committees with specific responsibilities per defined charters. “Listed companies must have a nominating/corporate governance committee composed entirely of independent directors.” This committee is responsible for nominating new members for the board of directors. Compensation and Audit Committees are also specified, with the latter subject to a variety of listing standards as well as outside regulations.

Other guidelines

The investor-led organisation International Corporate Governance Network (ICGN) was set up by individuals centered around the ten largest pension funds in the world 1995. The aim is to promote global corporate governance standards. The network is led by investors that manage 18 trillion dollars, and members are located in fifty different countries. ICGN has developed a suite of global guidelines ranging from shareholder rights to business ethics.[58]

The World Business Council for Sustainable Development (WBCSD) has done work on corporate governance, particularly on accounting and reporting.[59] In 2009, the International Finance Corporation and the UN Global Compact released a report, “Corporate Governance: the Foundation for Corporate Citizenship and Sustainable Business”,[60] linking the environmental, social and governance responsibilities of a company to its financial performance and long-term sustainability.

Most codes are largely voluntary. An issue raised in the U.S. since the 2005 Disney decision[61] 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. For example, the guidelines issued by associations of directors, corporate managers and individual companies tend to be wholly voluntary, but such documents may have a wider effect by prompting other companies to adopt similar practices.[citation needed]