Corporate governance

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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.

Corporation Separate legal entity that has been incorporated through a legislative or registration process established through legislation

A corporation is an organization—usually a group of people or a company—authorized by the state to act as a single entity and recognized as such in law for certain purposes. Early incorporated entities were established by charter. Most jurisdictions now allow the creation of new corporations through registration.

In a corporation, a stakeholder is a member of "groups without whose support the organization would cease to exist", as defined in the first usage of the word in a 1963 internal memorandum at the Stanford Research Institute. The theory was later developed and championed by R. Edward Freeman in the 1980s. Since then it has gained wide acceptance in business practice and in theorizing relating to strategic management, corporate governance, business purpose and corporate social responsibility (CSR). The definition of corporate responsibilities through a classification of stakeholders to consider has been criticised as creating a false dichotomy between the "shareholder model" and the "stakeholders model" or a false analogy of the obligations towards shareholders and other interested parties.

A conflict of interest (COI) is a situation in which a person or organization is involved in multiple interests, financial or otherwise, and serving one interest could involve working against another. Typically, this relates to situations in which the personal interest of an individual or organization might adversely affect a duty owed to make decisions for the benefit of a third party.

Contents

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).

Regulation is an abstract concept of management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slightly different meanings according to context. For example:

Enron Defunct American energy company

Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. It was founded in 1985 as a merger between Houston Natural Gas and InterNorth, both relatively small regional companies. Before its bankruptcy on December 3, 2001, Enron employed approximately 29,000 staff and was a major electricity, natural gas, communications and pulp and paper company, with claimed revenues of nearly $101 billion during 2000. Fortune named Enron "America's Most Innovative Company" for six consecutive years.

MCI Inc. subsidiary of Verizon Communications

MCI, Inc. was an American telecommunication corporation, and is currently a subsidiary of Verizon Communications, with its main office in Ashburn, Virginia. The corporation was formed originally as a result of the merger of WorldCom and MCI Communications corporations, and used the name MCI WorldCom, succeeded by WorldCom, before changing its name to the present version on April 12, 2003, as part of the corporation's ending of its bankruptcy status. The company traded on NASDAQ as WCOM (pre-bankruptcy) and MCIP (post-bankruptcy). The corporation was purchased by Verizon Communications with the deal finalizing on January 6, 2006, and is now identified as that company's Verizon Enterprise Solutions division with the local residential divisions being integrated slowly into local Verizon subsidiaries.

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 issue 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.

Principal–agent problem Agency Problem

The principal–agent problem, in political science and economics occurs when one person or entity, is able to make decisions and/or take actions on behalf of, or that impact, another person or entity: the "principal". This dilemma exists in circumstances where agents are motivated to act in their own best interests, which are contrary to those of their principals, and is an example of moral hazard.

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.

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] These models come from the way a country industrialized. Thus, they are different in the developing world where colonialism played a role. Corporate governance in emerging markets can reflect either the Anglo-American or Continental model, depending on the stock market's history with capitalist development. Emerging markets can also exhibit models of corporate governance through shareholders with different types of control attached to stock, introducing others--including the government--into the stakeholders included in making management decisions for the firm. [38]

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. [39] 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. [40]

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." [41] [42] 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. [43]

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". [44] [45] 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. [46] The number of US firms combining both roles is declining, however. [47]

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. [48] Individual rules for corporations are based upon the corporate charter and, less authoritatively, the corporate bylaws. [48] Shareholders cannot initiate changes in the corporate charter although they can initiate changes to the corporate bylaws. [48]

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). [49]

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:

An article published by the Australian Institute of Company Directors called 'Do Boards Need to become more Entrepreneurial?' written by Nigel Hennessy FAICD also considered the need for Founder Centrism behaviour at board level to appropriately manage disruption. [51]

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. [52]

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:

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. [54] This internationally agreed [55] benchmark consists of more than fifty distinct disclosure items across five broad categories: [56]

The OECD Guidelines on Corporate Governance of State-Owned Enterprises are complementary to the G20/OECD Principles of Corporate Governance, 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:

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. [57]

The World Business Council for Sustainable Development (WBCSD) has done work on corporate governance, particularly on Accounting and Reporting, and in 2004 released Issue Management Tool: Strategic challenges for business in the use of corporate responsibility codes, standards, and frameworks. This document offers general information and a perspective from a business association/think-tank on a few key codes, standards and frameworks relevant to the sustainability agenda.

In 2009, the International Finance Corporation and the UN Global Compact released a report, Corporate Governance - the Foundation for Corporate Citizenship and Sustainable Business, 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 [58] 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 ]

History

Replica of an East Indiaman of the Dutch East India Company/United East India Company (VOC) - the world's first formally listed public company. The 17th-century VOC shareholders and managers were possibly the first in recorded history to seriously consider corporate governance problems. Also, the practice of shareholder activism has its roots in the 17th-century Dutch Republic. Vereenigde Oostindische Compagnie spiegelretourschip Amsterdam replica.jpg
Replica of an East Indiaman of the Dutch East India Company/United East India Company (VOC) - the world's first formally listed public company. The 17th-century VOC shareholders and managers were possibly the first in recorded history to seriously consider corporate governance problems. Also, the practice of shareholder activism has its roots in the 17th-century Dutch Republic.

Early history

The modern practice of corporate governance has its roots in the 17th-century Dutch Republic. [59] [67] [63] [60] The first recorded corporate governance dispute in history [68] took place in 1609 between the shareholders/investors (most notably Isaac Le Maire) and directors of the Dutch East India Company (VOC), the world's first formally listed public company. [69]

United States of America

Robert E. Wright argues in Corporation Nation (2014) that the governance of early U.S. corporations, of which over 20,000 existed by the Civil War of 1861-1865, was superior to that of corporations in the late 19th and early 20th centuries because early corporations governed themselves like "republics", replete with numerous "checks and balances" against fraud and against usurpation of power by managers or by large shareholders. [70] (The term "robber baron" became particularly associated with US corporate figures in the Gilded Age - the late 19th century.)

In the immediate aftermath of the Wall Street Crash of 1929 legal scholars such as Adolf Augustus Berle, Edwin Dodd, and Gardiner C. Means pondered on the changing role of the modern corporation in society. [71] From the Chicago school of economics, Ronald Coase [72] introduced the notion of transaction costs into the understanding of why firms are founded and how they continue to behave. [73]

US economic expansion through the emergence of multinational corporations after World War II (1939-1945) saw the establishment of the managerial class. Several Harvard Business School management professors studied and wrote about the new class: Myles Mace (entrepreneurship), Alfred D. Chandler, Jr. (business history), Jay Lorsch (organizational behavior) and Elizabeth MacIver (organizational behavior). According to Lorsch and MacIver "many large corporations have dominant control over business affairs without sufficient accountability or monitoring by their board of directors".[ citation needed ]

In the 1980s, Eugene Fama and Michael Jensen [74] established the principal–agent problem as a way of understanding corporate governance: the firm is seen as a series of contracts. [75]

In the period from 1977 to 1997, corporate directors' duties in the U.S. expanded beyond their traditional legal responsibility of duty of loyalty to the corporation and to its shareholders. [76] [ vague ]

In the first half of the 1990s, the issue of corporate governance in the U.S. received considerable press attention due to a spate of CEO dismissals (for example, at IBM, Kodak, and Honeywell) by their boards. The California Public Employees' Retirement System (CalPERS) led a wave of institutional shareholder activism (something only very rarely seen before), as a way of ensuring that corporate value would not be destroyed by the now traditionally cozy relationships between the CEO and the board of directors (for example, by the unrestrained issuance of stock options, not infrequently back-dated).

In the early 2000s, the massive bankruptcies (and criminal malfeasance) of Enron and Worldcom, as well as lesser corporate scandals (such as those involving Adelphia Communications, AOL, Arthur Andersen, Global Crossing, and Tyco) led to increased political interest in corporate governance. This was reflected in the passage of the Sarbanes-Oxley Act of 2002. Other triggers for continued interest in the corporate governance of organizations included the financial crisis of 2008/9 and the level of CEO pay. [77]

East Asia

In 1997 the East Asian Financial Crisis severely affected the economies of Thailand, Indonesia, South Korea, Malaysia, and the Philippines through the exit of foreign capital after property assets collapsed. The lack of corporate governance mechanisms in these countries highlighted the weaknesses of the institutions in their economies.[ citation needed ]

Saudi Arabia

In November 2006 the Capital Market Authority (Saudi Arabia) (CMA) issued a corporate governance code in the Arabic language. [78] The Kingdom of Saudi Arabia has made considerable progress with respect to the implementation of viable and culturally appropriate governance mechanisms (Al-Hussain & Johnson, 2009). [79] [ need quotation to verify ]

Al-Hussain, A. and Johnson, R. (2009) found a strong relationship between the efficiency of corporate governance structure and Saudi bank performance when using return on assets as a performance measure with one exception - that government and local ownership groups were not significant. However, using stock return as a performance measure revealed a weak positive relationship between the efficiency of corporate governance structure and bank performance. [80]

List of countries by corporate governance

This is a list of countries by average overall rating in corporate governance: [81]

RankCountryCompaniesAverage overall rating
1Flag of the United Kingdom.svg  United Kingdom 3957.60
2Flag of Canada (Pantone).svg  Canada 1327.36
3Flag of Ireland.svg  Ireland 4217.21
4Flag of the United States.svg  United States 1,7617.16
5Flag of New Zealand.svg  New Zealand 1006.70
6Flag of Australia (converted).svg  Australia 1946.65
7Flag of the Netherlands.svg  Netherlands 306.45
8Flag of Finland.svg  Finland 286.38
9Flag of South Africa.svg  South Africa 436.09
10Flag of Sweden.svg  Sweden 405.88
11Flag of Switzerland.svg   Switzerland 515.86
12Flag of Germany.svg  Germany 795.80
13Flag of Austria.svg  Austria 225.77
14Flag of Italy.svg  Italy 525.25
15Flag of Poland.svg  Poland 145.11
16Flag of Norway.svg  Norway 264.90
17Flag of Singapore.svg  Singapore 524.82
18Flag of Denmark.svg  Denmark 244.79
19Flag of France.svg  France 1004.70
20Flag of India.svg  India 564.54
21Flag of Belgium (civil).svg  Belgium 244.35
22Flag of Greece.svg  Greece 244.25
23Flag of Malaysia.svg  Malaysia 284.21
24Flag of Thailand.svg  Thailand 154.20
25Flag of Portugal.svg  Portugal 114.14
26Flag of Hong Kong.svg  Hong Kong 724.06
27Flag of Spain.svg  Spain 433.97
28Flag of South Korea.svg  South Korea 883.93
29Flag of Brazil.svg  Brazil 673.91
30Flag of Russia.svg  Russia 253.90
31Flag of the Republic of China.svg  Taiwan 783.84
32Flag of Israel.svg  Israel 173.79
33Flag of Turkey.svg  Turkey 173.62
34Flag of the People's Republic of China.svg  China 913.37
35Flag of Japan.svg  Japan 3923.30
36Flag of Indonesia.svg  Indonesia 213.14
37Flag of Mexico.svg  Mexico 212.43
38Flag of Chile.svg  Chile 152.13

Stakeholders

Key parties involved in corporate governance include stakeholders such as the board of directors, management and shareholders. External stakeholders such as creditors, auditors, customers, suppliers, government agencies, and the community at large also exert influence. The agency view of the corporation posits that the shareholder forgoes decision rights (control) and entrusts the manager to act in the shareholders' best (joint) interests. Partly as a result of this separation between the two investors and managers, corporate governance mechanisms include a system of controls intended to help align managers' incentives with those of shareholders. Agency concerns (risk) are necessarily lower for a controlling shareholder.[ citation needed ]

In private for-profit corporations, shareholders elect the board of directors to represent their interests. In the case of nonprofits, stakeholders may have some role in recommending or selecting board members, but typically the board itself decides who will serve on the board as a 'self-perpetuating' board. [82] The degree of leadership that the board has over the organization varies; in practice at large organizations, the executive management, principally the CEO, drives major initiatives with the oversight and approval of the board. [83]

Responsibilities of the board of directors

Former Chairman of the Board of General Motors John G. Smale wrote in 1995: "The board is responsible for the successful perpetuation of the corporation. That responsibility cannot be relegated to management." [84] A board of directors is expected to play a key role in corporate governance. The board has responsibility for: CEO selection and succession; providing feedback to management on the organization's strategy; compensating senior executives; monitoring financial health, performance and risk; and ensuring accountability of the organization to its investors and authorities. Boards typically have several committees (e.g., Compensation, Nominating and Audit) to perform their work. [85]

The OECD Principles of Corporate Governance (2004) describe the responsibilities of the board; some of these are summarized below: [4]

Stakeholder interests

All parties to corporate governance have an interest, whether direct or indirect, in the financial performance of the corporation. Directors, workers and management receive salaries, benefits and reputation, while investors expect to receive financial returns. For lenders, it is specified interest payments, while returns to equity investors arise from dividend distributions or capital gains on their stock. Customers are concerned with the certainty of the provision of goods and services of an appropriate quality; suppliers are concerned with compensation for their goods or services, and possible continued trading relationships. These parties provide value to the corporation in the form of financial, physical, human and other forms of capital. Many parties may also be concerned with corporate social performance.[ citation needed ]

A key factor in a party's decision to participate in or engage with a corporation is their confidence that the corporation will deliver the party's expected outcomes. When categories of parties (stakeholders) do not have sufficient confidence that a corporation is being controlled and directed in a manner consistent with their desired outcomes, they are less likely to engage with the corporation. When this becomes an endemic system feature, the loss of confidence and participation in markets may affect many other stakeholders, and increases the likelihood of political action. There is substantial interest in how external systems and institutions, including markets, influence corporate governance. [42]

‘Absentee landlords’ vs. capital stewards

World Pensions Council (WPC) experts insist that “institutional asset owners now seem more eager to take to task [the] negligent CEOs” of the companies whose shares they own. [86]

This development is part of a broader trend towards more fully exercised asset ownership – notably from the part of the boards of directors (‘trustees’) of large UK, Dutch, Scandinavian and Canadian pension investors:

“No longer ‘absentee landlords’, [ pension fund ] trustees have started to exercise more forcefully their governance prerogatives across the boardrooms of Britain, Benelux and America: coming together through the establishment of engaged pressure groups […] to ‘shift the [whole economic] system towards sustainable investment’.” [86]

This could eventually put more pressure on the CEOs of publicly listed companies, as “more than ever before, many [North American,] UK and European Union pension trustees speak enthusiastically about flexing their fiduciary muscles for the UN’s Sustainable Development Goals”, and other ESG-centric investment practices. [87]

United Kingdom

In Britain, “The widespread social disenchantment that followed the [2008-2012] great recession had an impact” on all stakeholders, including pension fund board members and investment managers. [88]

Many of the UK's largest pension funds are thus already active stewards of their assets, engaging with corporate boards and speaking up when they think it is necessary. [88]

Control and ownership structures

Control and ownership structure refers to the types and composition of shareholders in a corporation. In some countries such as most of Continental Europe, ownership is not necessarily equivalent to control due to the existence of e.g. dual-class shares, ownership pyramids, voting coalitions, proxy votes and clauses in the articles of association that confer additional voting rights to long-term shareholders. [89] Ownership is typically defined as the ownership of cash flow rights whereas control refers to ownership of control or voting rights. [89] Researchers often "measure" control and ownership structures by using some observable measures of control and ownership concentration or the extent of inside control and ownership. Some features or types of control and ownership structure involving corporate groups include pyramids, cross-shareholdings, rings, and webs. German "concerns" (Konzern) are legally recognized corporate groups with complex structures. Japanese keiretsu (系列) and South Korean chaebol (which tend to be family-controlled) are corporate groups which consist of complex interlocking business relationships and shareholdings. Cross-shareholding is an essential feature of keiretsu and chaebol groups . Corporate engagement with shareholders and other stakeholders can differ substantially across different control and ownership structures.

Family control

Family interests dominate ownership and control structures of some corporations, and it has been suggested that the oversight of family-controlled corporations are superior to corporations "controlled" by institutional investors (or with such diverse share ownership that they are controlled by management). A recent study by Credit Suisse found that companies in which "founding families retain a stake of more than 10% of the company's capital enjoyed a superior performance over their respective sectorial peers." Since 1996, this superior performance amounts to 8% per year. [90] Forget the celebrity CEO. "Look beyond Six Sigma and the latest technology fad. One of the biggest strategic advantages a company can have is blood ties," according to a Business Week study. [91] [92]

Diffuse shareholders

The significance of institutional investors varies substantially across countries. In developed Anglo-American countries (Australia, Canada, New Zealand, U.K., U.S.), institutional investors dominate the market for stocks in larger corporations. While the majority of the shares in the Japanese market are held by financial companies and industrial corporations, these are not institutional investors if their holdings are largely with-on group.[ citation needed ]

The largest pools of invested money (such as the mutual fund 'Vanguard 500', or the largest investment management firm for corporations, State Street Corp.) are designed to maximize the benefits of diversified investment by investing in a very large number of different corporations with sufficient liquidity. The idea is this strategy will largely eliminate individual firm financial or other risk. A consequence of this approach is that these investors have relatively little interest in the governance of a particular corporation. It is often assumed that, if institutional investors pressing for changes decide they will likely be costly because of "golden handshakes" or the effort required, they will simply sell out their investment.[ citation needed ]

Proxy access

Particularly in the United States, proxy access allows shareholders to nominate candidates which appear on the proxy statement, as opposed to restricting that power to the nominating committee. The SEC had attempted a proxy access rule for decades, [93] and the United States Dodd–Frank Wall Street Reform and Consumer Protection Act specifically allowed the SEC to rule on this issue, however, the rule was struck down in court. [93] Beginning in 2015, proxy access rules began to spread driven by initiatives from major institutional investors, and as of 2018, 71% of S&P 500 companies had a proxy access rule. [93]

Mechanisms and controls

Corporate governance mechanisms and controls are designed to reduce the inefficiencies that arise from moral hazard and adverse selection. There are both internal monitoring systems and external monitoring systems. [94] Internal monitoring can be done, for example, by one (or a few) large shareholder(s) in the case of privately held companies or a firm belonging to a business group. Furthermore, the various board mechanisms provide for internal monitoring. External monitoring of managers' behavior occurs when an independent third party (e.g. the external auditor) attests the accuracy of information provided by management to investors. Stock analysts and debt holders may also conduct such external monitoring. An ideal monitoring and control system should regulate both motivation and ability, while providing incentive alignment toward corporate goals and objectives. Care should be taken that incentives are not so strong that some individuals are tempted to cross lines of ethical behavior, for example by manipulating revenue and profit figures to drive the share price of the company up. [73]

Internal corporate governance controls

Internal corporate governance controls monitor activities and then take corrective actions to accomplish organisational goals. Examples include:

In publicly traded U.S. corporations, boards of directors are largely chosen by the President/CEO and the President/CEO often takes the Chair of the Board position for him/herself (which makes it much more difficult for the institutional owners to "fire" him/her). The practice of the CEO also being the Chair of the Board is fairly common in large American corporations. [97]

While this practice is common in the U.S., it is relatively rare elsewhere. In the U.K., successive codes of best practice have recommended against duality.[ citation needed ]

External corporate governance controls

External corporate governance controls the external stakeholders' exercise over the organization. Examples include:

Financial reporting and the independent auditor

The board of directors has primary responsibility for the corporation's internal and external financial reporting functions. The chief executive officer and chief financial officer are crucial participants, and boards usually have a high degree of reliance on them for the integrity and supply of accounting information. They oversee the internal accounting systems, and are dependent on the corporation's accountants and internal auditors.

Current accounting rules under International Accounting Standards and U.S. GAAP allow managers some choice in determining the methods of measurement and criteria for recognition of various financial reporting elements. The potential exercise of this choice to improve apparent performance increases the information risk for users. Financial reporting fraud, including non-disclosure and deliberate falsification of values also contributes to users' information risk. To reduce this risk and to enhance the perceived integrity of financial reports, corporation financial reports must be audited by an independent external auditor who issues a report that accompanies the financial statements.

One area of concern is whether the auditing firm acts as both the 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 power of the corporate client to initiate and terminate management consulting services and, more fundamentally, to select and dismiss accounting firms contradicts the concept of an independent auditor. Changes enacted in the United States in the form of the Sarbanes-Oxley Act (following numerous corporate scandals, culminating with the Enron scandal) prohibit accounting firms from providing both auditing and management consulting services. Similar provisions are in place under clause 49 of Standard Listing Agreement in India.

Systemic problems

Issues

Executive pay

Increasing attention and regulation (as under the Swiss referendum "against corporate rip-offs" of 2013) has been brought to executive pay levels since the financial crisis of 2007–2008. Research on the relationship between firm performance and executive compensation does not identify consistent and significant relationships between executives' remuneration and firm performance. 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. [77] [99] 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. [99]

Some argue that firm performance is positively associated with share option plans and that these plans direct managers' energies and extend their decision horizons toward the long-term, rather than the short-term, performance of the company. However, that point of view came under substantial criticism circa in the wake of various security scandals including mutual fund timing episodes and, in particular, the backdating of option grants as documented by University of Iowa academic Erik Lie [100] and reported by James Blander and Charles Forelle of the Wall Street Journal. [99] [101]

Even before the negative influence on public opinion caused by the 2006 backdating scandal, use of options faced various criticisms. A particularly forceful and long running argument concerned the interaction of executive options with corporate stock repurchase programs. Numerous authorities (including U.S. Federal Reserve Board economist Weisbenner) determined options may be employed in concert with stock buybacks in a manner contrary to shareholder interests. These authors argued that, in part, corporate stock buybacks for U.S. Standard & Poor's 500 companies surged to a $500 billion annual rate in late 2006 because of the effect of options. A compendium of academic works on the option/buyback issue is included in the study Scandal by author M. Gumport issued in 2006.

A combination of accounting changes and governance issues led options to become a less popular means of remuneration as 2006 progressed, and various alternative implementations of buybacks surfaced to challenge the dominance of "open market" cash buybacks as the preferred means of implementing a share repurchase plan.

Separation of Chief Executive Officer and Chairman of the Board roles

Shareholders elect a board of directors, who in turn hire a Chief Executive Officer (CEO) to lead management. The primary responsibility of the board relates to the selection and retention of the CEO. However, in many U.S. corporations the CEO and Chairman of the Board roles are held by the same person. This creates an inherent conflict of interest between management and the board.

Critics of combined roles argue the two roles that should be separated to avoid the conflict of interest and more easily enable a poorly performing CEO to be replaced. Warren Buffett wrote in 2014: "In my service on the boards of nineteen public companies, however, I’ve seen how hard it is to replace a mediocre CEO if that person is also Chairman. (The deed usually gets done, but almost always very late.)" [102]

Advocates argue that empirical studies do not indicate that separation of the roles improves stock market performance and that it should be up to shareholders to determine what corporate governance model is appropriate for the firm. [103]

In 2004, 73.4% of U.S. companies had combined roles; this fell to 57.2% by May 2012. Many U.S. companies with combined roles have appointed a "Lead Director" to improve independence of the board from management. German and UK companies have generally split the roles in nearly 100% of listed companies. Empirical evidence does not indicate one model is superior to the other in terms of performance. However, one study indicated that poorly performing firms tend to remove separate CEOs more frequently than when the CEO/Chair roles are combined. [104]

See also

Related Research Articles

Board of directors Board composed of directors

A board of directors is a group of people who jointly supervise the activities of an organization, which can be either a for-profit business, nonprofit organization, or a government agency. Such a board's powers, duties, and responsibilities are determined by government regulations and the organization's own constitution and bylaws. These authorities may specify the number of members of the board, how they are to be chosen, and how often they are to meet.

Corporate titles or business titles are given to company and organization officials to show what duties and responsibilities they have in the organization. Such titles are used by publicly and privately held for-profit corporations. In addition, many non-profit organizations, educational institutions, partnerships, and sole proprietorships also confer corporate titles.

Financial statement formal record of the financial activities and position of a business, person, or other entity

Financial statements are formal records of the financial activities and position of a business, person, or other entity.

Corporate social responsibility is a type of international private business self-regulation. While once it was possible to describe CSR as an internal organisational policy or a corporate ethic strategy, that time has passed as various international laws have been developed and various organisations have used their authority to push it beyond individual or even industry-wide initiatives. While it has been considered a form of corporate self-regulation for some time, over the last decade or so it has moved considerably from voluntary decisions at the level of individual organisations, to mandatory schemes at regional, national and international levels.

Information and technology (IT) governance is a subset discipline of corporate governance, focused on information and technology (IT) and its performance and risk management. The interest in IT governance is due to the ongoing need within organizations to focus value creation efforts on an organization's strategic objectives and to better manage the performance of those responsible for creating this value in the best interest of all stakeholders. It has evolved from The Principles of Scientific Management, Total Quality Management and ISO 9001 Quality management system.

Corporate law body of law that applies to the rights, relations, and conduct of persons, companies, organizations and businesses

Corporate law is the body of law governing the rights, relations, and conduct of persons, companies, organizations and businesses. It refers to the legal practice relating to, or the theory of corporations. Corporate law often describes the law relating to matters which derive directly from the life-cycle of a corporation. It thus encompasses the formation, funding, governance, and death of a corporation.

In a U.S. publicly traded company, an audit committee is an operating committee of the board of directors charged with oversight of financial reporting and disclosure. Committee members are drawn from members of the company's board of directors, with a Chairperson selected from among the committee members. A qualifying audit committee is required for a U.S. publicly traded company to be listed on a stock exchange. Audit committees are typically empowered to acquire the consulting resources and expertise deemed necessary to perform their responsibilities.

Shareholder value is a business term, sometimes phrased as shareholder value maximization or as the shareholder value model, which implies that the ultimate measure of a company's success is the extent to which it enriches shareholders. It became popular during the 1980s, and is particularly associated with former CEO of General Electric, Jack Welch.

An agency cost is an economic concept concerning the fee to a "principal", when the principal chooses or hires an "agent" to act on its behalf. Because the two parties have different interests and the agent has more information, the principal cannot directly ensure that its agent is always acting in its best interests.

Clause 49 of the Listing Agreement to the Indian stock exchange that came into effect from 31 December 2005. It has been formulated for the improvement of corporate governance in all listed companies.

Internal audit An audit of accounting for audiences within a firm

Internal auditing is an independent, objective assurance and consulting activity designed to add value to and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes. Internal auditing achieves this by providing insight and recommendations based on analyses and assessments of data and business processes. With commitment to integrity and accountability, internal auditing provides value to governing bodies and senior management as an objective source of independent advice. Professionals called internal auditors are employed by organizations to perform the internal auditing activity.

Management is a type of labor but with a special role-coordinating the activities of inputs and carrying out the contracts agreed among inputs, all of which can be characterized as "decision making." Managers usually face disciplinary forces by making themselves irreplaceable in a way that the company would lose without them. A manager has an incentive to invest the firm's resources in assets whose value is higher under him than under the best alternative manager, even when such investments are not value-maximizing.

The King Report on Corporate Governance is a booklet of guidelines for the governance structures and operation of companies in South Africa. It is issued by the King Committee on Corporate Governance. Three reports were issued in 1994, 2002, and 2009 and a fourth revision in 2016. The Institute of Directors in Southern Africa (IoDSA) owns the copyright of the King Report on Corporate Governance and the King Code of Corporate Governance. Compliance with the King Reports is a requirement for companies listed on the Johannesburg Stock Exchange. The King Report on Corporate Governance has been cited as "the most effective summary of the best international practices in corporate governance".

The UK Corporate Governance code, formerly known as the Combined Code is a part of UK company law with a set of principles of good corporate governance aimed at companies listed on the London Stock Exchange. It is overseen by the Financial Reporting Council and its importance derives from the Financial Conduct Authority's Listing Rules. The Listing Rules themselves are given statutory authority under the Financial Services and Markets Act 2000 and require that public listed companies disclose how they have complied with the code, and explain where they have not applied the code – in what the code refers to as 'comply or explain'. Private companies are also encouraged to conform; however there is no requirement for disclosure of compliance in private company accounts. The Code adopts a principles-based approach in the sense that it provides general guidelines of best practice. This contrasts with a rules-based approach which rigidly defines exact provisions that must be adhered to. In 2017, it was announced that the Financial Reporting Council would amend the Code to require companies to "comply or explain" with a requirement to have elected employee representatives on company boards.

A celebrity board director is an officer with significant influence in the company's governance decision-making process and who possesses one or more celebrity traits including credibility, goodwill, rights, image, influence, liability, and standard of value. A director's leadership and decision-making affects the governance and wealth maximization of shareholders’ wealth.

Environmental, social and governance (ESG) refers to the three central factors in measuring the sustainability and ethical impact of an investment in a company or business.

The chief governance officer (CGO) is normally a senior vice executive reporting to the CEO, however in the not-for-profit sector when an organization uses Policy Governance the Chair of the Board often takes on the role of CGO, who is tasked with directing the people, business processes and systems needed to enable good governance from inside the corporation in support of the board of directors. In some geographies the role is assumed by the chief counsel, in others by a corporate or company secretary.

Corporate law in Vietnam

Corporate law in Vietnam was originally based on the French commercial law system. However, since Vietnam's independence in 1945, it has largely been influenced by the ruling Communist Party. Currently, the main sources of corporate law are the Law on Enterprises, the Law on Securities and the Law on Investment.

Executive compensation in the United States

In the United States, the compensation of company executives is distinguished by the forms it takes and its dramatic rise over the past three decades and wide-ranging criticism leveled against it. In the past three decades in America executive compensation or pay has risen dramatically beyond what can be explained by changes in firm size, performance, and industry classification. It is the highest in the world in both absolute terms and relative to median salary in the US. It has been criticized not only as excessive, but also for "rewarding failure"—including massive drops in stock price, and much of the national growth in income inequality. Observers differ as to how much of the rise in and nature of this compensation is a natural result of competition for scarce business talent benefiting stockholder value, and how much is the work of manipulation and self-dealing by management unrelated to supply, demand, or reward for performance. Federal laws and Securities and Exchange Commission (SEC) regulations have been developed on compensation for top senior executives in the last few decades, including a $1 million limit on the tax deductibility of compensation not "performance-based", and a requirement to include the dollar value of compensation in a standardized form in annual public filings of the corporation.

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