Define: Corporate Governance

Quick Summary of Corporate Governance

Corporate Governance refers to the rules, processes, and various laws by which all businesses are operated and regulated. Corporate governance can be defined by the internal clients such as officers, stockholders, or a board of directors within a corporation as well as external factors like consumer watchdogs or government and global agencies like the SEC or the World Bank.

Corporate governance is the set of processes, customs, policies, laws, and institutions affecting the way a corporation is directed, administered, or controlled. Corporate governance also includes the relationships among the many players involved (the stakeholders) and the goals for which the corporation is governed. The principal players are the shareholders, management, and the board of directors. Other stakeholders include employees, suppliers, customers, banks and other lenders, regulators, the environment, and the community at large.

Corporate governance is a multi-faceted subject. An important theme of corporate governance is to ensure the accountability of certain individuals in an organisation through mechanisms that try to reduce or eliminate the principal-agent problem. A related but separate thread of discussions focuses on the impact of a corporate governance system on economic efficiency, with a strong emphasis on shareholders’ welfare. There are yet other aspects to the corporate governance subject, such as the stakeholder view and the corporate governance models around the world (see Section 9 below).

There has been renewed interest in the corporate governance practices of modern corporations since 2001, particularly due to the high-profile collapses of a number of large U.S. firms such as Enron Corporation and WorldCom. In 2002, the US federal government passed the Sarbanes-Oxley Act, intending to restore public confidence in corporate governance.

Definition

In A Board Culture of Corporate Governance, business author Gabrielle O’Donovan defines corporate governance as ‘an internal system encompassing policies, processes, and people that serves the needs of shareholders and other stakeholders by directing and controlling management activities with good business savvy, objectivity, and integrity. Sound corporate governance is reliant on external marketplace commitment and legislation, plus a healthy board culture that safeguards policies and processes.

O’Donovan goes on to say that ‘the perceived quality of a company’s corporate governance can influence its share price as well as the cost of raising capital. Quality is determined by the financial markets, legislation, and other external market forces, plus the international organisational environment, how policies and processes are implemented, and how people are led. External forces are, to a large extent, outside the circle of control of any board. The internal environment is quite a different matter and offers companies the opportunity to differentiate from competitors through their board culture. To date, too much corporate governance debate has centred on legislative policy to deter fraudulent activities and transparency policy, which misleads executives to treat the symptoms and not the cause.

It is a system of structuring, operating, and controlling a company with a view to achieving long-term strategic goals to satisfy shareholders, creditors, employees, customers, and suppliers while complying with legal and regulatory requirements, apart from meeting environmental and local community needs.

The Report of the SEBI Committee (India) 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.” The definition is drawn from the Gandhian principle of trusteeship and the Directive Principle of the Constitution. Corporate governance is viewed as an ethical and moral duty.

History

In the 19th century, state corporation law enhanced the rights of corporate boards to govern without the unanimous consent of shareholders in exchange for statutory benefits like appraisal rights to make corporate governance more efficient. Since that time, and because most large publicly traded corporations in the US are incorporated under corporate administration-friendly Delaware law, and because the US’s wealth has been increasingly securitized into various corporate entities and institutions, the rights of individual owners and shareholders have become increasingly derivative and dissipated. The concerns of shareholders over administration pay and stock losses periodically have led to more frequent calls for corporate governance reforms.

In the 20th 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 the changing role of the modern corporation in society. Berle and Means’ monograph “The Modern Corporation and Private Property” (1932, Macmillan) continues to have a profound influence on the conception of corporate governance in scholarly debates today.

From the Chicago School of Economics, Ronald Coase’s “Nature of the Firm” (1937) introduced the notion of transaction costs into the understanding of why firms are founded and how they continue to behave. Fifty years later, Eugene Fama and Michael Jensen’s “The Separation of Ownership and Control” (1983, Journal of Law and Economics) firmly established agency theory as a way of understanding corporate governance: the firm is seen as a series of contracts. Agency theory’s dominance was highlighted in a 1989 article by Kathleen Eisenhardt (Academy of Management Review).

US expansion after World War II through the emergence of multinational corporations saw the establishment of the managerial class. Accordingly, the following Harvard Business School management professors published influential monographs studying their prominence: Myles Mace (entrepreneurship), Alfred D. Chandler, Jr. (business history), Jay Lorsch (organisational behaviour), and Elizabeth MacIver (organisational behaviour). According to Lorsch and MacIver, “many large corporations have dominant control over business affairs without sufficient accountability or monitoring by their board of directors.”

Since the late 1970s, corporate governance has been the subject of significant debate in the U.S. and around the globe. The needs and wants of shareowners to exercise their corporate ownership rights and to increase the value of their shares and, consequently, their wealth have been a driving force behind bold, comprehensive efforts to reform corporate governance. Over the past three decades, corporate directors’ duties have expanded greatly beyond their traditional legal responsibility of loyalty to the corporation and its shareowners.

In the first half of the 1990s, the issue of corporate governance in the U.S. received considerable press attention due to the wave of CEO dismissals (e.g.: IBM, Kodak, Honeywell) by their boards. 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 cosy relationships between the CEO and the board of directors (e.g., by the unrestrained issuance of stock options, not infrequently back-dated).

In 1997, the East Asian Financial Crisis saw the economies of Thailand, Indonesia, South Korea, Malaysia, and The Philippines severely affected by 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.

In the early 2000s, the massive bankruptcies (and criminal malfeasance) of Enron and WorldCom, as well as lesser corporate debacles, such as Adelphia Communications, AOL, Arthur Andersen, Global Crossing, Tyco, and, more recently, Fannie Mae and Freddie Mac, led to increased shareholder and governmental interest in corporate governance. This culminated in the passage of the Sarbanes-Oxley Act of 2002. But, since then, the stock market has greatly recovered, and shareholder zeal has waned accordingly.

Impact of Corporate Governance

The positive effect of good corporate governance on different stakeholders ultimately results in a strong economy, and hence, good corporate governance is a tool for socio-economic development. After the East Asian economy collapsed in the late 20th century, the World Bank president warned those countries that for sustainable development, corporate governance must be good. The economic health of a nation depends substantially on how sound and ethical businesses are.

Enlightened Corporate Governance

Corporate governance, the unwieldy name given to the systems that guide the control and management of corporations, is a relatively recent term that came into being in the 1970s. Because corporate governance structures and processes specify the various roles and duties of corporate directors, senior executives, shareholders, and other stakeholders in the corporation, they play a large role in determining how responsible and accountable a corporation’s leaders will be in exercising their authority. When properly designed, governance processes guide companies towards useful objectives and help them monitor and measure their progress in achieving those objectives; when poorly designed, these processes permit companies to drift towards painful losses for shareholders and everyone else with a stake in the company.

A company’s board of directors determines its corporate governance, good or bad. Ideally, these directors will be energetic, experienced people deeply concerned about the company’s welfare. Because the board’s most pivotal responsibilities are to hire and supervise the company’s chief executive officer (CEO), these directors should not be company employees who work under the CEO’s direction; instead, they should be independent of the company’s management. When independent directors know how to work effectively with the company’s senior management team, they are likely to produce a corporate climate that accelerates the growth of long-term shareholder value.

Role of Institutional Investors

Many years ago, worldwide, buyers and sellers of corporation stocks were individual investors, such as wealthy businessmen or families, who often had a vested personal and emotional interest in the corporations whose shares they owned. Over time, markets have become largely institutionalised: buyers and sellers are largely institutions (e.g., pension funds, insurance companies, mutual funds, hedge funds, investor groups, and banks).

The rise of the institutional investor has brought with it some increase in professional diligence, which has tended to improve regulation of the stock market (but not necessarily in the interest of the small investor or even of the naïve institutions, of which there are many). Note that this process occurred simultaneously with the direct growth of individuals investing indirectly in the market (for example, individuals have twice as much money in mutual funds as they do in bank accounts). However, this growth occurred primarily by way of individuals turning over their funds to ‘professionals’ to manage, such as in mutual funds. In this way, the majority of investment now is described as “institutional investment,” even though the vast majority of the funds are for the benefit of individual investors.

Programme trading, the hallmark of institutional trading, averaged over 60% a day in 2007.

Unfortunately, there has been a concurrent lapse in the oversight of large corporations, which are now almost all owned by large institutions. The Board of Directors of large corporations used to be chosen by the principal shareholders, who usually had an emotional as well as monetary investment in the company (think Ford), and the Board diligently kept an eye on the company and its principal executives (they usually hired and fired the President, or Chief executive officer— CEO).

Nowadays, if the owning institutions don’t like what the President/CEO is doing and they feel that firing them will likely be costly (think “golden handshake”) and/or time-consuming, they will simply sell out their interest. The Board is now mostly chosen by the President/CEO and may be made up primarily of their friends and associates, such as officers of the corporation or business colleagues. Since the institutional shareholders rarely object, the President/CEO generally takes the Chair of the Board position for himself or herself, which makes it much more difficult for the institutional owners to “fire” him/her. Occasionally, but rarely, institutional investors support shareholder resolutions on such matters as executive pay and anti-takeover measures.

Finally, 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 simply to invest in a very large number of different companies with sufficient liquidity, based on the idea that this strategy will largely eliminate individual company financial or other risk and, therefore, these investors have even less interest in a particular company’s governance.

Since the marked rise in the use of Internet transactions from the 1990s, both individual and professional stock investors around the world have emerged as a potential new kind of major (short-term) force in the direct or indirect ownership of corporations and in the markets: the casual participant. Even as the purchase of individual shares in any one corporation by individual investors diminishes, the sale of derivatives (e.g., exchange-traded funds (ETFs), Stock market index options, etc.) has soared. So, the interests of most investors are now increasingly rarely tied to the fortunes of individual corporations.

But, the ownership of stocks in markets around the world varies; for example, the majority of the shares in the Japanese market are held by financial companies and industrial corporations (there is a large and deliberate amount of cross-holding among Japanese keiretsu corporations and within S. Korean chaebol ‘groups’), whereas stocks in the USA, the UK, and Europe are much more broadly owned, often still by large individual investors.

Parties To Corporate Governance

Parties involved in corporate governance include the regulatory body (e.g., 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 shareholder delegated decision-making rights to the manager, who acted 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 two parties, a system of corporate governance controls is implemented to assist in aligning the incentives of managers with those of shareholders. With the significant increase in investor equity holdings, 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.

The company secretary, known as a corporate secretary in the US and often referred to as a chartered secretary if qualified by the Institute of Chartered Secretaries and Administrators (ICSA), is a high-ranking professional who is trained to uphold the highest standards of corporate governance, effective operations, compliance, and administration.

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, while shareholders receive capital returns. 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, is trust that they will receive a fair share of the organisational returns. If some parties are receiving more than their fair return, then participants may choose not to continue participating, leading to organisational collapse.

Principles

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 with the values of the corporate participants and then evaluate 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 the following:

• Rights and equitable treatment of shareholders: Organisations should respect the rights of shareholders and help shareholders 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 review and challenge management performance. It needs to be of sufficient size and have an appropriate level of commitment to fulfil its responsibilities and duties. There are issues about the appropriate mix of executive and non-executive directors. The key roles of the chairperson and CEO should not be held by the same person.
• 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. Because of this, many organisations establish compliance and ethics programmes to minimise the risk that the firm steps outside of ethical and legal boundaries.
• Disclosure and transparency: Organisations should clarify and make publicly known the roles and responsibilities of the 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
• dividend policy

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 more effective corporate governance and may not increase performance. 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, for example. 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.

External Corporate Governance Controls

External corporate governance controls encompass the controls external stakeholders exercise over the organisation.

Examples include:

• debt covenants
• government regulations
• media pressure
• takeovers
• competition
• managerial labour market
• telephone tapping

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 process will cause imperfections in the effectiveness of corporate governance. This should, ideally, be corrected by the working of the external auditing process.
• 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 (in finance, the efficient market hypothesis (EMH) asserts that financial markets are efficient), which suggests that the shareholder will free ride on the judgements of larger professional investors.
• 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 to carrying resolutions or appointing directors at a general meeting.

Role Of The Accountant

Financial reporting is a crucial element that is necessary for the corporate governance system to function effectively. Accountants and auditors are the primary providers of information to participants in the capital market. 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 exercise 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 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 (in response to the Enron situation, as noted below) prohibit accounting firms from providing both auditing and management consulting services. Similar provisions are in place under clause 49 of the SEBI Act in India.

The Enron collapse is an example of misleading financial reporting. Enron concealed huge losses by creating the illusion 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 effectiveness of corporate governance if users don’t process it or if the informed user is unable to exercise a monitoring role due to high costs.

Regulation

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 be ill-equipped to deal with new types of transactions not covered by the code. Additionally, even when following clear rules, one can still find a way to defeat their fundamental purpose; however, doing so is more challenging when one is subject to a wider principle.

Principles, on the other hand, is a form of self-regulation. It allows the sector to determine what standards are acceptable or unacceptable. It also preempts overzealous legislation that might not be practical.

Enforcement

Enforcement can affect 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; if taken too far, it can dampen valuable risk-taking. In practice, however, this is largely a theoretical, as opposed to a real, risk.

Action Beyond Obligation

Enlightened boards regard their mission as helping management lead the company. They are more likely to be supportive of the senior management team. Because enlightened directors strongly believe that it is their duty to involve themselves in an intellectual analysis of how the company should move forward into the future, most of the time, the enlightened board is aligned on the critically important issues facing the company.

Enlightened boards do not feel constrained by the Sarbanes-Oxley Act’s rules and regulations, in contrast to conventional boards. Unlike standard boards that aim to comply with regulations, enlightened boards regard compliance with regulations as merely a baseline for board performance. Enlightened directors go far beyond merely meeting the requirements on a checklist. They do not need Sarbanes-Oxley to mandate that they protect values and ethics or monitor CEO performance.

At the same time, enlightened directors recognise that it is not their role to be involved in the day-to-day operations of the corporation. They lead by example. Overall, what most distinguishes enlightened directors from traditional and standard directors is the passionate obligation they feel to engage in the day-to-day challenges and strategizing of the company. Enlightened boards can be found in very large, complex companies, as well as smaller companies.

Corporate Governance Models Around The World

Although the US model of corporate governance is the most notorious, there is a considerable variation in corporate governance models around the world. The intricate shareholding structures of Keiretsus in Japan, the heavy presence of banks in the equity of German firms, the chaebols in South Korea, and many others are examples of arrangements that try to respond to the same corporate governance challenges as in the US.

Anglo-American Model

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 tends to give priority to the interests of shareholders. The coordinated model that one finds in Continental Europe and Japan also recognises 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. However, there are important differences between the U.S. recent approach to governance issues and what has happened in the U.K.

In the United States, a board of directors oversees a corporation and has the authority to select an executive officer, also 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 CEOs of other corporations, which some see as a conflict of interest.

The U.K. has pioneered a flexible model of regulation of corporate governance known as the “comply or explain” code of governance. This is a principle-based code that lists a dozen of recommended practices, such as the separation of CEO and Chairman of the Board, the introduction of a time limit for CEOs’ contracts, the introduction of a minimum number of non-executive directors and independent directors, the designation of a senior non-executive director, the formation and composition of remuneration, audits, and nomination committees. Publicly listed companies in the U.K. have to either apply those principles or, if they choose not to, explain in a designated part of their annual reports why they decided not to do so. The monitoring of those explanations is left to shareholders themselves. The tenet of the Code is that one size does not fit all in matters of corporate governance and that instead of a statuary regime like the Sarbanes-Oxley Act in the U.S., it is best to leave some flexibility to companies so that they can make choices most adapted to their circumstances. If they have good reasons to deviate from the sound rule, they should be able to convincingly explain those to their shareholders.

The code has been in place since 1993 and has had drastic effects on the way firms are governed in the U.K. A study by Arcot, Bruno, and Faure-Grimaud from the Financial Markets Group at the London School of Economics shows that in 1993, about 10% of the UK companies members of the FTSE 350 were compliant on all dimensions, while they were more than 60% in 2003. The same success was not achieved when looking at the explanation part for non-compliant companies. Many deviations are simply not explained and a large majority of explanations fail to identify specific circumstances justifying those deviations. Still, the overall view is that the U.K.’s system works fairly well and, in fact, is often branded as a benchmark, followed by several countries.

Non-Anglo-American Model

In East Asian countries, family-owned companies dominate. A study by Claessens, Djankov, and Lang (2000) investigated the top 15 families in East Asian countries and found that they dominated listed corporate assets. In countries such as Pakistan, Indonesia, and the Philippines, the top 15 families controlled over 50% of publicly owned corporations through a system of family cross-holdings, thus dominating the capital markets. Family-owned companies also dominate the Latin model of corporate governance, that is, companies in Mexico, Italy, Spain, France (to a certain extent), Brazil, Argentina, and other countries in South America.

Europe and Asia exemplify the insider system: Shareholder and stakeholder

• a small number of listed companies,
• an illiquid capital market where ownership and control are not frequently traded
• high concentration of shareholding in the hands of corporations, institutions, families, or government.
• The insider model uses a system of interlocking networks and committees.

At the same time that developing countries are undergoing a process of economic growth and transformation, they are also experiencing a revolution in the business and political relationships that characterise their private and public sectors. Establishing good corporate governance practices is essential to sustaining long-term development and growth as these countries move from closed, market-unfriendly, undemocratic systems towards open, market-friendly, democratic systems. Good corporate governance systems will allow organisations to realise their maximum productivity and efficiency, minimise corruption and abuse of power, and provide a system of managerial accountability. These goals are equally important for both private corporations and government bodies.

Because of the implicit relationship between private interests and the larger government, good corporate governance practices are essential to establishing good governance at the national level in developing countries. A number of ties keep the public and private sectors closely linked. On the one hand, the judiciary and regulatory bodies, as well as legislatures, play a role in corporate management and oversight. At the same time, cartels and large corporate interests use their size to exert not only economic but also political power. These two sectors are so intertwined that a country cannot significantly change one without simultaneously instituting changes in the other.

According to Nicolas Meisel, there are four priorities that developing countries should concentrate on while experimenting with new forms of corporate and public governance. The first is to focus on improving the quality of information and increasing the speed at which it is created and distributed to the public. Good communication is important to the functioning of any organisation. The second is to allow individual actors more autonomy while at the same time maintaining or increasing accountability. Thirdly, if a hierarchical organisation is used to orient private activities towards the general interest, new countervailing powers should be encouraged to fill this role. Finally, the role the state plays and how government officials are selected must be considered if a developing economy is to achieve sustainable growth. This may involve making it easier for newcomers with new ideas to replace incumbents who may hold older, possibly outdated, models.

Codes And Guidelines

Corporate governance principles and codes have been developed in different countries and issued by stock exchanges, corporations, institutional investors, or associations (institutes) of directors and managers with the support of governments and international organisations. The codes linked to stock exchange listing requirements may have a coercive effect, but generally speaking, compliance with these governance recommendations is not required by law.

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 significant pressure on listed companies for compliance.

Companies in the United States are primarily subject to state regulation, but they are also subject to federal regulation and, if they are public, to stock exchange regulation. The highest number of companies are incorporated in Delaware, including more than half of the Fortune 500. This is due to Delaware’s generally business-friendly corporate legal environment and the existence of a state court dedicated solely to business issues (Delaware Court of Chancery).

Most states’ corporate law generally follows the American Bar Association’s Model Business Corporation Act. While Delaware does not follow the Act, it still considers its provisions, and several prominent Delaware justices, including former Delaware Supreme Court Chief Justice E. Norman Veasey, participate on ABA committees.

One issue that has been raised since the Disney decision in 2005 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 (see Section 3 above), 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.

One of the most influential guidelines has been the 1999 OECD Principles of Corporate Governance. This was revised in 2004. The OECD remains a proponent of corporate governance principles throughout the world.

The World Business Council for Sustainable Development (WBCSD) has also done substantial work on corporate governance, particularly on accountability and reporting, and in 2004 created an Issue Management Tool: Strategic Challenges for Business in the Use of Corporate Responsibility Codes, Standards, and Frameworks. This document aims to provide general information, a “snap-shot” of the landscape, and a perspective from a think-tank/professional association on a few key codes, standards, and frameworks relevant to the sustainability agenda.

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 outside directors who had no management ties, undertook a 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 the five-year cumulative returns of Fortune Magazine’s survey of most admired firms’, Antunovich et al. found that those “most admired” firms had an average return of 125%, while 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.

Board Composition

Some researchers have found support for the relationship between the 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 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.

Remuneration/Compensation

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.

Some argue that firm performance is positively associated with share option plans and that these plans direct managers’ energies and extend their decision horizons towards 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 and reported by James Blander and Charles Forelle of the Wall Street Journal.

The use of options was subject to various criticisms even before the backdating scandal in 2006 had a negative impact on public opinion. A particularly forceful and long-running argument concerned the interaction of executive options with corporate stock repurchase programmes. Numerous authorities (including U.S. Federal Reserve Board economist Weisbenner) have determined that 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 the U.S. Standard & Poor’s 500 companies surged to a $500 billion annual rate in late 2006 because of the impact 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.

As 2006 went on, changes in accounting and problems with governance made options a less popular way to pay employees. At the same time, different ways of doing buybacks started to appear, competing with “open market” cash buybacks as the most popular way to carry out a share repurchase plan.

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This glossary post was last updated: 8th April, 2024.