Science Fair Project Encyclopedia
Corporate governance refers to the method by which a corporation is directed, administered 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. Other participants include regulators, employees, suppliers, partners, customers, constituents (for elected bodies) and the general community.
As a result of the separation of stakeholder influence from control in modern organisations, a system of corporate governance controls is implemented on behalf of stakeholders to reduce agency costs and information asymmetry. Corporate governance is 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. Primarily though, corporate governance is the mechanism via which individuals are motivated to align their actual behaviours with the overall corporate good (ie maximum aggregate value generated by the organisation and shared fairly amongst all participants).
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.
The term "corporate governance" has come to mean many things. It may describe:
- the processes by which companies are directed and controlled
- encouragement of companies' compliance with codes
- investment technique based on active ownership
At its broadest, corporate governance comprehends the framework of rules, relationships, systems and processes within and by which fiduciary authority is exercised and controlled in corporations. Relevant rules include applicable laws of the land as well as internal rules of a corporation. Relationships include those between all related parties, the most important of which are the owners, managers, directors of the board (when such entity exists), regulatory authorities and to a lesser extent employees and the community at large. Systems and processes deal with matters such as delegation of authority, performance measures, assurance mechanisms, reporting requirements and accountabilities.
In this way, the corporate governance structure 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.
Issues of fiduciary duty and accountability are often discussed within the framework of corporate governance.
Whilst the term has a descriptive content, it is commonly used in an aspirational sense, by way of holding out a model which practice should seek to emulate. Reference can be made in this regard to various statements of corporate governance principles or guidelines, both hortatory and prescriptive.
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 take part include suppliers, employees, creditors, customers and the community at large.
In corporations, the principal (shareholder) delegates decision rights to the agent (manager) to act in the principal's best interests. This separation of ownership from control implies a loss of effective control by shareholders over managerial decisions. Partly as a result of this separation between the main two parties, a system of corporate governance controls is implemented to assist in aligning the incentives of managers with those of shareholders, in order to limit the self-satisfying opportunities for managers. 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.
A board of directors often plays a key role in corporate governance. It is their responsibility to endorse the organisation's strategy, develop directional policy, appoint, supervise and remunerate senior executives and to ensure accountability of the organisation to its owners and authorities.
All parties to corporate governance have an interest, whether direct or indirect, in the effective performance of the organisation. Directors, workers and management receive salaries, benefits and reputation; whilst shareholders receive capital return. Customers receive goods and services; suppliers receive compensation for their goods or services. In return these individuals provide value in the form of natural, human, social and other forms of capital.
A key factor in an individual's decision to participate in an organisation (e.g. through providing financial capital or expertise or labor) is trust that they will receive a fair share of the organisational returns. If some parties are receiving more than their fair return (e.g. exorbitant executive remuneration), then participants may choose to not continue participating...potentially leading to organisational collapse (e.g. shareholders withdrawing their capital). Corporate governance is the key mechanism through which this trust is maintained across all stakeholders.
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.
Commonly accepted principles of corporate governance include:
- Rights of, and equitable treatment of, shareholders: Organisations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by effectively communicating information that is understandable and accessible and encouraging shareholders to participate in general meetings.
- Interests of other stakeholders: Organisations should recognise that they have legal and other obligations to all legitimate stakeholders.
- Role and responsibilities of the board: The board needs a range of skills and understanding - to be able to deal with various business issues and have the ability to reivew and challenge management performance. It needs to be of sufficient size and have an appropriate level of commitment to fulfill its responsibilities and duties. There are issues about the appropriate mix of executive and non-executive directors. The key roles of chairperson ad CEO should not be shared.
- Integrity and ethical behaviour: Organisations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making. It is important to understand, though, that systemic reliance on integrity and ethics is bound to eventual failure.
- Disclosure and transparency: Organisations should clarify and make publicly known the roles and responsibilities of board and management to provide shareholders 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 organisation should be timely and balanced to ensure that all investors have access to clear, factual information.
Issues involving corporate governance principles include:
- 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
Internal corporate governance controls monitor activities and then take corrective action to accomplish organisational goals. Examples include:
- Monitoring by the board of directors: The board of directors, with its legal authority to hire, fire and compensate top management, safeguards invested capital. Regular board meetings allow potential problems to be identified, discussed and avoided. Whilst non-executive directors are thought to be more independent, they may not always result in mor effective corporate governance. Different board structures are optimal for different firms. Moreover, the ability of the board to monitor the firm's executives is a function of its access to information. Executive directors possess superior knowledge of the decision-making process and therefore evaluate top management on the basis of the quality of its decisions that lead to financial performance outcomes, ex ante. It could be argued, therefore, that executive directors look beyond the financial criteria.
- Remuneration: Performance-based remuneration is designed to relate some proportion of salary to individual performance. It may be in the form of cash or non-cash payments such as shares and share options , superannuation or other benefits. Such incentive schemes, however, are reactive in the sense that they provide no mechanism for preventing mistakes or opportunistic behaviour, and can elicit myopic behaviour.
- Audit committees
External corporate governance controls
External corporate governance controls encompass the controls external stakeholders exercise over the organisation. Examples include:
- debt covenants
- external auditors
- government regulations
Systemic problems of corporate governance
- Supply of accounting information: Financial accounts form a crucial link in enabling providers of finance to monitor directors. Imperfections in the financial reporting proces will cause imperfections in the effectiveness of corporate governance. This should, ideally, be corrected by the working of the external auditing process, but lack of auditor independence may prevent this.
- Demand for information: A barrier to shareholders using good information is the cost of processing it, especially to a small shareholder. The traditional answer to this problem is the efficient market hypothesis, which suggests that the small shareholder will free-ride on the judgements of larger professional invetsors. However, there is an expanding empiricial literature on apparent departures from this.
- Monitoring costs: In order to influence the directors, the shareholders must combine with others to form a significant voting group which can pose a real threat of carrying resolutions or appointing directors at a general meeting. The costs of combining in this way might well be prohibitive relative to the benefits.
Role of the accountant
Financial reporting is a crucial element necessary for the corporate governance system to function effectively. Accountants and auditors are the primary providers of information to capital market participants. The directors of the company should be entitled to expect that management prepare the financial information in compliance with statutory and ethical obligations, and rely on auditors' competence.
Current accounting practice allows a degree of choice of method in determining the method of measurement, criteria for recognition, and even the definition of the accounting entity. The exerfcise of this choice to improve apparent performance (popularly known as creative accounting) imposes extra information costs on users. In the extreme, it can involve non-disclosure of information.
One area of concern is whether the accounting firm acts as both independent auditor and management consultant to the firm they are auditing. This may result in a conflict of interest which places the integrity of financial reports in doubt due to client pressure to appease management.
The Enron collapse is an example of misleading financial reporting. Enron concealed huge losses by creating illusions that a third party was contractually obliged to pay the amount of any losses. However, the third party was an entity in which Enron had a substantial economic stake. In discussions of accounting practices with Arthur Andersen, the partner in charge of auditing, views inevitably led to the client prevailing.
However, good financial reporting is not a sufficient condition for the effectivenss of corporate governance if users don't process it, or if the informed user is unable to exercise a minotring role due to high costs (see Systemic problems of corporate governance above).
Rules versus principles
Rules are typically thought to be simpler to follow than principles, demarcating a clear line between acceptable and unacceptable behaviour. Rules also reduce discretion on the part of individual managers or auditors.
In practice rules can be more complex than principles. They may ill-equipped to deal with new types of transactions not covered by the code. Moreover, even clear rules can be manipulated whilst circumventing its underlying purpose.
Enforcement can affec the overall credibility of a regulatory system. They both deter bad actors and level the competitive playing field. Nevertheless, greater enforcement is not always better, for taken too far it can dampen valuble risk-taking.
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 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.
Some researchers have found support for the relationship between frequency of meetings and profitability. Others have found a negative relationship between the proportion of external directors and firm performance, while others found no relationship between external board membership and performance. In a recent paper Bagahat and Black found that companies with more independent boards do not perform better than other companies. It is unlikely that board composition has a direct impact on firm performance.
The results of previous research on the relationship between firm performance and executive compensation have failed to find consistent and significant relationships between executives' remuneration and firm performance. Low average levels of pay-performance alignment do not necessarily imply that this form of governance control is inefficient. Not all firms experience the same levels of agency conflict, and external and internal monitoring devices may be more effective for some than for others.
Some researchers have found that the largest CEO performance incentives came from ownership of the firm's shares, while other researchers found that the relationship between share ownership and firm performance was dependent on the level of ownership. The results suggest that increases in ownership above 20% cause management to become more entrenched, and less interested in the welfare of their shareholders.
Firm performance has been found to be positively associated with share option plans. These plans direct managers' energies and extend their decision horizons toward the long-term, rather than the short-term, performance of the company.
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. In response to calls by OECD ministers, a revised version of its "Principles of Corporate Governance" was produced in 2004.
Numerous high-profile cases of corporate governance failure have focused the minds of governments, companies and the general public on the threat posed to the integrity of financial markets, although it is not clear that any system will or should prevent business failures, or that it is possible to provide a guarantee against fraud.
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.
- 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 
- Whittington, G. "Corporate Governance and the Regulation of Financial Reporting", Accounting and Business Research, Vol. 2, 1993, Corporate Governance Special Issue, pp. 311-319.
- Sarbanes-Oxley Act
- Securities and Exchange Commission
- Takeovers and poison pills
- Golden Parachute
- Legal Origins Theory
- Corporate Law Economic Reform Program
- OECD Principles of Corporate Governance - First issued in 1999, this paper has provided the framework for regional corporate governance roundtables in cooperation with the World Bank around the world. It has been endorsed as one of the Financial Stability Forum 's 12 key standards, and form the basis for the World Bank's Review of Observance of Standards and Codes.
- 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
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