What Is Corporate Governance?
As the name must have given it away, corporate governance is a system of rules and regulations that decrees how a board of directors governs, supervise and administer an organization.
It is the blend of directions, laws, or practices through which businesses are run, regulated, and restricted. It institutes who has power, authority and who is in charge, as well as who makes decisions. It’s a toolset that helps management and the board of directors cope more successfully with the issues of running a business.
The board of directors has a crucial role to play in governance, and the company’s decisions and can have a momentous influence on share valuation.
It is different from daily operational activities carried out by the executives of an organization. It is much bigger than that. Factors, external as well as internal, affect the interests of a company’s stakeholders. It is important to maintain balance among all these stakeholders by creating the framework for corporate governance that best aligns with the company’s objectives. It is empirical that the community’s and investor’s relations are flourished and this only happens if a firm’s corporate governance is to be communicated.
Purpose of Corporate Governance
Corporate governance, as a process pursues a company’s objectives in the context of the social, regulatory, and market environment. Corporate governance’s main prospect is to achieve the company’s goals as well as be reliable to the company’s stakeholders, which is possible by following the strategies and methods set by the corporate governance structure.
Blueprint of Corporate Governance
This concept is of ubiquitous importance to the organization and because of that, it covers basically every aspect of management. These aspects range from action plans and internal controls to performance assessment, corporate transparency, etc. Disclosure methods, CEO remuneration decisions, dividend policies, procedures for resolving conflicts of interest, and explicit or implicit commitments between the company and stakeholders are all included in the corporate governance blueprint.
Goals of Corporate Governance
One of the many goals of corporate governance is to ensure the smooth sailing of business by setting up a system of checks and balances to prevent conflicts of interest. When executives and stockholders disagree, conflicts may arise. For example, stockholders will normally want to pursue just profit-generating activities, whereas the CEO may want to invest in stronger employee engagement efforts. If numerous stockholders disagree with one other, another sort of conflict may occur. It would be in charge of determining how these issues are resolved.
Corporate governance is vital because of a multitude of reasons including but not limited to accessing resources to improve the quality of decision making. Everyone has an interest in pursuing corporate governance. The investors value it as exhibits a company’s direction and business integrity, which helps the investors to make decisions regarding where to put their money at. Quality, ethical decision-making helps businesses become more sustainable and effective at creating long-term value. It also aids the companies in gaining investor and community trust. As a result, people can invest in companies as a legitimate long-term investment option.
Good and Bad Corporate Governance practices
A good corporate governance structure is followed when an organization works in a manner that is advantageous and profitable to everyone involved. This is carried out by following the company’s rules, ethical standards, regulations, and more. Bad corporate governance, on the other hand, is characterized by a lack of structure, ambiguity, and compliance, all of which can harm a company’s reputation and financial health. The following are considered poor governance practices:
- Companies that do not collaborate with auditors adequately or do not select auditors on a scale that is appropriate, resulting in the disclosure of fictitious or noncompliant financial documents
- Inadequate executive compensation packages that do not provide the best incentive for corporate officers
- Boards that are poorly formed, making it harder for shareholders to remove unproductive incumbents.
The majority of organizations strive for good corporate governance. Many shareholders hold the view and awareness that a company’s prosperity isn’t the only staple of an organization; it also needs to demonstrate good corporate citizenship through giving back to society, environmental awareness, ethical behavior, and strong corporate governance. A visible system of rules and regulations with commensurate incentives for shareholders, directors, and executives is the foundation of good corporate governance.
The Board Of Directors
A board of directors is a group of people who have been chosen to represent shareholders and to set and support management policies.
A board of directors is supposed to consist of a diverse collection of people with the required set of skills and knowledge such as business acumen and moral sense. Along with this, having a sense of creativity to contribute fresh ideas is also necessary.
The board of directors frequently consists of insiders and independent members. Insiders usually are formed of major stockholders, founders, and executives whereas independent directors match shareholder interests with those of insiders by diluting the concentration of power. If the outsiders lack in the area of connections and networks, they make up for it through their experience of managing huge corporations.
According to the board of directors, corporate governance must be carried out by strictly adhering to the principles of corporate governance.
“Corporate governance is the mechanism that directs and controls companies.”
“Company Governance is the connection between corporate management, directors, and equity suppliers, people, and institutions that save and invest their money in the hopes of making a profit. Corporate governance makes sure to hold the board of directors accountable for accomplishing corporate goals and complying with the rules and regulations of the company.”
“Corporate governance is a broad phrase that encompasses many aspects of the board of directors’ conceptions, philosophies, and practices, as well as those of its executive and nonexecutive directors.”
“It’s a line of work that focuses on how boards, stockholders, executive management, and other stakeholders interact.”
The structure and outline of corporate governance might vary for a different company, however, certain common elements are incorporated by most organizations. These key elements or principles of corporate governance include-
- Shareholders Supermacy- Recognition of shareholders is probably the most important principle. This happens in a two-fold process. For the first step, the importance of shareholders to the company is recognized. Shareholders are the people who buy a share of the company in the forms of equity, shares, etc. the second fold is the principle of responsibility to shareholders.
Making shareholders active members of the decision-making to elect a board of directors is a vital policy. The “primary directive” of the board is to always lookout for the best interests of shareholders. The board of directors appoints and supervises the executives that make up the team in charge of a company’s day-to-day operations. This promotes the shareholders to have a direct and impactful say in the workings of the company.
- Shareholder’ Rights- Making sure shareholders are informed of their rights and how to exercise them is one part of the basic requirement of treating everyone equally and fairly.
- Transparency- This principle ensures that anyone inside or outside the company can review and authenticate the company’s actions if they wished to do so. Through this, everyone can have a comprehensive understanding of the company’s objectives, techniques, and overall performance. This builds trust and is likely to attract more people to use the company’s services and possibly become shareholders.
- Non shareholders Stakeholders- non-shareholder stakeholders also have an impact on the company and their rights need to be protected as well. This includes their legal, contractual, social, and other commitments being met. This includes sharing important information with employees, investors, vendors, and community members at all times.
- Security- Security is becoming an increasingly significant part of corporate governance. Shareholders and customers/clients must have confidence that their personal information is not leaked or accessed by unauthorized individuals. It’s also critical to keep the company’s proprietary procedures and trade secrets private. If the data of a company is breached, it is excruciatingly costly and it also undermines public trust in the firm. This results in the stock prices of the company going haywire. When investors lose faith in a company, it loses access to the funding it needs to grow.
- Code Of Conduct- Organizations should establish a code of conduct for board members and executives, and new members should only be appointed if they fulfill that level.
- Competent BOARD OF DIRECTORS- Within corporate governance, the board of directors must retain a commitment to ensuring accountability, justice, diversity, and openness. Members of the board must also have the required abilities to evaluate management practices.
Regulations Of Corporate Governanace
Because of high-profile crises involving corporate power abuse or alleged criminal conduct by company leaders, corporate governance has gotten a lot of attention. As a result, rules and regulations addressing the elements of corporate governance have been enacted.
- Sarbanes-Oxley Act: The Sarbanes-Oxley Act was enacted after it was discovered that high-profile firms and their executives were defrauding the public. As a result, corporate governance has become a focal point for restoring public company trust.
- Gramm-Leach-Bliley Act: The Gramm-Leach-Bliley Act governed how financial institutions handled personal information, making it critical for corporate governance to consider how to manage financial organizations and stakeholders.
- Basel II: Base II is a business standard that aims to reduce the impact, especially the financial impact of risky operational decisions. This standard covers shareholder rights, which, as already discussed has a direct impact on corporate governance.
Examples Of Corporate Governance
Volkswagen ag is an example of how bad corporate governance can bring a company’s reliability, integrity, and responsibilities to shareholders to shambles which can consequently harm a firm’s financial health. Volkswagen was part of a scandal and was rocked in September 2015 when they were found tolerating and supporting illegal activities.
The situation was called “Diesel gate”. It was uncovered that the carmaker had modified engine emission devices in its automobiles for years to falsify pollution test results in the United States and Europe. In the days following the commencement of the scandal, Volkswagen’s stock lost over half of its value, and global sales fell 4.5 percent in the first full month after the announcement.
VW’s board structure was a part of the fiasco and contributed to the rigging of the emissions. VW has a two-tier board arrangement that is divided into management board and supervisory board. The supervisory board was supposed to keep an eye on management and approve company actions, but it lacked the independence and authority to do so.
A high number of shareholders were represented on the supervisory board. Members of the supervisory board were in control of about 90% of shareholders’ right to vote. There was no actual independent supervisor; the supervisory board was controlled by shareholders, which negated the supervisory board’s duty of overseeing management and personnel and how they operated within the corporation, which included, of course, fixing emissions.
Eron And Worldcom
After high-profile businesses like Enron and WorldCom went bankrupt due to fraudulent tactics, corporate governance became a major problem in the United States at the turn of the twenty-first century.
Enron’s problem was that its board of directors allowed Andrew Fastow, the company’s chief financial officer (CFO), to construct separate, private partnerships to do business with the corporation, circumventing various conflict-of-interest rules. When in reality, these private partnerships were used by Enron to cover up its debts and liabilities, which would have led to the falling of the company’s revenues.
What happened at Enron was the result of a lack of corporate governance, which should have prohibited the formation of these shell companies to hide the losses. The organization also had a corporate culture that included dishonest personnel from the top (Fastow) and down to traders who conducted unlawful market moves.
As a consequence of this entire blunder concerning Enron and WorldCom, an act called the Sarbanes-Oxley Act was passed in 2002. This act laid down more rigorous recordkeeping standards on businesses as well as hefty criminal penalties for breaking them and other securities laws. The goal of this act was to rebuild the public’s trust in public companies and their operations.
It’s frequent to hear about weak corporate governance, mainly since it’s the reason why some businesses fail and make the headlines. It’s uncommon to hear about organizations that have outstanding corporate governance since it’s the good corporate governance that keeps them out of the headlines because no controversy has occurred.
PepsiCo is an example of a corporation that has consistently adopted solid corporate governance and strives to update it regularly. PepsiCo used investor feedback to construct its proxy statement for 2020, focusing on six areas:
- The long-term plan, company resolution, and sustainability experiments
- Board structure, assortment, and refreshment, and leadership arrangement
- Shareholder and stakeholder involvement
- Good governance procedures and ethical business culture
- Human capital management
- Compensation debate and analysis
In its proxy statement, the company included graphic visuals to show the present leadership structure, which comprises of a combined chair and CEO as well as other things along with the company’s vision and a program as to how to achieve the vission and a program as to how to achiece the vision
Importance OF corporate Governanace
Some businesses may see corporate governance as a waste of time and money. A worthy corporate governance arrangement exhibits quite a handful of benefits. While corporate governance can be beneficial to businesses, its value is determined by how they employ it. Corporate governance, as previously said, defines the rules, concepts, and regulations that businesses can utilize to regulate and direct their operations. However, things to be effective, businesses must implement them correctly.
- Minimize Agency Problems- When one entity serves as the agent of another, this is known as agency. A sort of agency relationship exists in businesses where management works on behalf of the shareholders. In a few exceptional situations, it is imaginable to witness the board of directors choose to act against the best interests of the shareholders. Corporate governance addresses this issue by ensuring that the shareholders’ and management’s goals are aligned.
- Protect Stakeholders- Corporate governance safeguards a company’s other interests as well as minimizes agency concerns. Internal and external stakeholders may be included. The relationship that firms must have with their stakeholders is defined by corporate governance. It ensures that each stakeholders’ rights are clear for corporations to fulfill in this way.
- Attracts Investors- Corporate governance is a structure that allows businesses to follow best practices. It ensures that a company’s operations are efficient as a result of this. As mentioned, it even protects the interests of the stakeholders. Investors would always choose companies with solid corporate governance when looking for companies to invest in. Corporate governance can attract new investors in this way.
- Promotes Accountability- A competent, transparent, and reliable financial reporting system is ensured by a good corporate governance structure. Corporate governance contributes to a company’s accountability in this way. This accountability can also help with the aforementioned elements, such as attracting additional investors and safeguarding stakeholders.
- Mitigate Risks- Companies’ risk minimization is also a focus of corporate governance. The audit committee or risk committee is one area that can help with this. These committees are in charge of controlling and reducing the risks that a firm faces from a variety of sources. Corporate governance guarantees that the risks that organizations confront are minimized by establishing such bodies.
- Ensure Compliance- Companies have intricate organizational frameworks. As a result, they must follow a variety of rules and regulations. Corporate governance relates to this area as well, as it guarantees that firms fulfill their responsibilities. A company’s risk management approach also includes adherence to norms and regulations. Companies can prevent unneeded problems by adhering to laws and regulations.
- Improve Efficiency- Corporate governance also aids businesses in improving their operational and organizational efficiency. Many businesses have inadequate governance, which results in below-average results. It establishes the foundation for a company’s operations, resource allocation, innovation, and strategy implementation. It also boasts a company’s efficiency as a result of these.
- Corporate Social Responsibility Is Ensured- This is one of the areas that corporate governance grants. It mainly refers to how businesses engage with their surrounding environment. Corporate social responsibility helps companies to assess their operations’ environmental impact. It also emphasizes social responsibility and sustainability.
Aftermath Of Poor Corporate Governanace
One of the most important goals of corporate governance is to establish a system of rules, policies, and practices for a corporation, or to hold people accountable. Everyone belonging to the company, directly or indirectly, is held accountable by and is answerable to by the other members of the “government.” These members of the company include the shareholders, the board of directors, the managerial team, etc. This accountability manifests itself in parts through the process of reporting financial information to shareholders by the board of directors regularly. This represents and promotes the idea of openness.
Responsible and actionable accounting practices were given up in the case of Enron Corp. This snowballed into uncontrollable debt and liabilities that the stockholders were unaware of. The company went bankrupt after the executives were charged with several offenses. It obliterated employee pensions and wreaked havoc on stockholders.
When a company’s good corporate governance is ignored, it stands the risk of collapsing, and shareholders stand to lose a lot of money.
Corporate governance refers to the governing principles that a corporation creates to direct all of its activities, including compensation, risk management, employee treatment, reporting unfair practices, environmental effects, and more. Most businesses take corporate governance for granted, which can cause a company’s market value to plummet, resulting in the selling of the majority of its stock.
It runs on the foundation of four Ps. These 4 Ps are-
Corporate governance as we have established is indispensable for a range of reasons. These include minimizing agency issues, protecting a company’s interests, enticing investors, and many other things. Strong and apparent corporate governance guides an organization towards being ethical and being profitable to all its stakeholders. This leads to good finances and ultimately to the organization being an attractive investment gamble. A company’s collapse is caused by poor corporate governance, which frequently leads to scandals and bankruptcy.