A Complete Guide to Corporate Governance
Corporate governance is a key term to understand because it is an increasingly important part of running a successful company. The system has evolved over the years, guided by the challenges and misjudgments of the corporate world. In today’s tough corporate culture, investors and consumers alike make decisions based on corporate culture and the way a company operates in the wider community.
The following guide will help you look into the history and the meaning of corporate governance and find out about the core principles of it. You can also read about the key models and guidelines helping companies implement strong corporate governance in the demanding and competitive business world.
In this article, you will learn 1) what corporate governance is, 2) the benefits of good corporate governance, 3) the key principles of corporate governance, 4) corporate governance models, 5) guidelines for corporate governance, and 6) conclusion.
WHAT IS CORPORATE GOVERNANCE?
Corporate governance refers to a set of rules, practices and processes that control a company and which provide it with a direction. It helps to ensure a balance between the different stakeholders within the company. These stakeholders typically involve:
- the management team,
- the company’s customers,
- different suppliers,
- the government, and
- the wider community.
Corporate governance allows aspects of the management of the company to be defined, from action plans to corporate disclosure. It guarantees a set of operational procedures for the above stakeholders, as well as the framework for monitoring these aspects.
It is an integral part of how companies operate, and proper corporate governance can be the difference between a successful and a failing company. Studies have consistently shown that companies with good governance also perform better in commercial terms.
History of corporate governance
The emergence of corporate governance highlights its importance for corporate success. As the corporate culture began changing at the start of the 20th century, scholars began looking into the influence corporations have on the modern society.
The Wall Street Crash of 1929 was a catalyst for many scholars, such as Adolf Augustus Berle and Gardiner C. Means. Furthermore, Ronald Coase, from the famous Chicago School of Economics introduced concepts of corporate behavior and corporate birth to the public.
Further studies into the issue became more mainstream and corporate governance became big news in the US during the 1990s, as the country’s corporations were hit by a wave of big chief executive officer (CEO) dismissals.
Major corporate scandals and economic crises have further deepened the development and focus on corporate governance around the world. In Asia, the East Asian Financial Crisis of 1997 highlighted the importance of strong corporate governance, and the strengthening of institutions became an important aspect of the business world around the globe.
THE BENEFITS OF GOOD CORPORATE GOVERNANCE
Corporate governance provides the framework for how the company operates and the direction it takes, which in turn brings about benefits for the corporation. The key advantages of a strong corporate governance culture include the following:
Clear roles and clarity with power distribution
With an established framework, the company can benefit from clarity. As corporate governance is mainly involved in defining the distribution of power between the three key stakeholders (board of directors, shareholders and management), the clarity in roles helps regain focus and ensure each group can concentrate on their own specific roles.
Fewer legal problems
Corporate governance provides a better operational framework for a company also in terms of compliance. It ensures the company operates in accordance with national, regional and even international laws. Therefore, the company reduces the risk of legal problems.
Better public image
The company in question is not just benefitting from a better legal and operational system, but also from an improved public image. A company with strong corporate governance provides more transparency and this is especially important at a time when trust in companies is low.
The new aspects of social and environmental responsibility are also increasingly popular and can improve the company’s public image. If the company has created a framework to enhance its responsibility toward the wider community, its public image is likely going to benefit from it.
Reduced risk of fraud
As well as limiting the amount of legal challenges, corporate governance can also limit the risk of fraud. Transparency, guidelines and clearly defined roles make it harder for stakeholders to engage in fraudulent behavior and improve safeguards against outside fraud.
Potential increase in the performance of a company
Many corporations unfortunately can sometimes see strong corporate governance as a hindrance to operations because of the increased amount of rules and regulations. But studies have repeatedly shown good corporate governance improves the performance of a company.
Strict guidelines, clear power structures and improved transparency can help the management and employees focus on increasing profit margins. Corporate governance can also help outline possible problems before they start hurting the company.
THE KEY PRINCIPLES OF CORPORATE GOVERNANCE
As the importance in terms of benefits has been established, it is good to look at the key principles of corporate governance. The general principles below are considered an integral part of corporate operations and typically help corporations streamline their operations.
The set of principles have changed throughout the history of corporate governance, with the current key principles being established since the 1990s. The following principles are recommended by most corporate governance guidelines such as the OECD guideline.
Corporate governance looks into the leadership position within the company and helps define how the power structures are composed within the company. One of the main aspects of leadership principles include the:
- Role, composition and responsibilities of the board – the board plays an important role in the company, as it is responsible for the direction the company takes. More importantly, the framework of corporate governance needs to look into the:
- Size of the board – the board has to find a balance between having too few and too many board members.
- Leadership of the board – it is crucial to focus on the leadership of the board and to ensure the independence of the director of the board.
- Possibility of conflict of interest – many board members in today’s corporate culture are also involved in either other businesses through direct operation in them or through investments. It is important to ensure guidelines are in place to limit the risk of conflict of interest.
There is also a focus on the capability of the company to implement its objectives and to reach goals. Capability is an especially important aspect of the board selection, which needs to prioritize:
- Independence – independence is an important principle, which is established a little bit differently in each company. In general, the aim is to ensure the board of directors is not directly or indirectly in material relationship with the company.
- Selection criteria – the selection criteria should also be included in the principles and is related to the work of the board. This naturally differs for each company, but it is based on what is expected from the members of the board and the future of the company.
- Time limitations – there are often limits to how long a board can remain unchanged. This can help ensure the company isn’t stuck in its ways, but continues to be challenged.
Among the most important principles of corporate governance is accountability. It is important to ensure there is a strong framework in place to ensure accountability in all sectors of the company.
Part of accountability involves defining the:
- Rights and equitable treatment of shareholders – it is important to ensure the rights of the shareholders are clearly defined and justified. In addition, the monetary compensation must also be clearly outlined and equality between different shareholders must be achieved.
- Interests of other stakeholders – in addition to outlining the rights and equitable treatment of shareholders, companies need to look into the management of other stakeholders. You don’t want to create an unjust and unfair system and you want to be transparent in the accountability of these different players.
Sustainability has become an increasingly important principle for corporate governance. The sustainability aspect needs to look at the company’s role in environmental preservation but also in terms of social responsibility.
Investors are increasingly focused on issues around sustainability, so it is crucial the company’s management outlines a clear set of rules and regulations to define the company’s aims.
Finally, the principle of integrity is another important aspect of good corporate governance. This ensures the company has a framework of:
- Corporate ethics and integrity – the company must operate within its own set of ethics, which should be outlined in connection to company goals. Corporate ethics involve legal compliance, but also honesty and integrity in the way the company and the management operate in the wider community.
- Forms of disclosure and transparency – Integrity also involves the framework of disclosure and transparency. The company must be clear about its approach on disclosure and which company actors are able to receive information and regarding which aspects.
CORPORATE GOVERNANCE MODELS
The corporate governance models differ depending on countries. The legal and regulatory framework in each country naturally means there is some variation in what companies need to focus on or keep in mind.
But there are also plenty of similarities between different countries and certain characteristics have come into the forefront. Most researchers and experts of corporate governance agree that there are three specific models used in the world today.
#1. The Anglo-US model
The Anglo-US model is perhaps the most prevalent of the three models. The model has a strong relationship between equity financing and how it has affected the development of the corporate governance system.
The Anglo-US model involves a number of different players including: management, directors, shareholders, government agencies, stock exchanges, self-regulatory organizations and consulting firms.
From these, the three of the most important in terms of corporate governance are: management, shareholders and board of directors.
There is a strong division between investors and the ownership (in terms of legal liability) of the company. This is mostly down to the development of the corporate governance framework in a free market economy.
In the past, the stock ownership was strongly in the hands of individual shareholders, but in today’s market, institutional investors play a more important role.
The increase in ownership by institutions has meant that corporate governance structures have to respond to the increasing influence of institutions and the possibility of conflict of interest that arises from this.
Composition of the board of directors
Board of directors in the Anglo-US model include both company employees (executives or managers, for instance) and institutions or people who don’t have a direct relationship to the company.
In the past there have been problems with concentration of power, something which corporate governance frameworks are now hoping to eradicate. This has meant that the composition of the board of directors doesn’t remain the same for too long and disclosure and transparency mechanisms have improved.
The number of people on the board of directors is relatively small in the Anglo-US model.
Regulatory framework of the model
There is a wide range of laws and regulations governing the relationship between the three different players.
National, and in the case of the US, state legislation define the framework for a company’s rights and responsibilities. The stock exchange is also an essential part of corporate governance and generally, the disclosure and transparency framework requirements are extremely strong.
#2. The Japanese Model
The Japanese model is influenced the most by the high level of stock ownership, with the banking system having long-term relationships with the corporation. The number of outside shareholders is almost non-existent.
The Japanese model centers around a network called keiretsu, which is a financial and industrial network, and the main bank. The bank plays a crucial role in helping the corporation manage equity issues and other consulting and regulatory problems.
While the Anglo-US model has three key players, the Japanese model has four. These are: the main bank, the affiliated company (keiretsu), management and the government. Unlike the Anglo-US model, these are serving a non-balance of power relationship.
Composition of the board of directors
The composition involves mainly insiders like executive managers. The main role of the executive management is to keep the financial performance up to scratch. If this doesn’t happen, the bank or the keiretsu remove the management team.
The board is usually larger in size compared to the Anglo-US model.
Regulatory framework of the model
Japanese corporations are less influenced by national laws and regulations, mostly due to the internationalization of the companies.
Nonetheless, the disclosure requirements are relatively stringent under the model. Disclosure often takes place after a longer period of time. The disclosure often occurs once or twice a year, while under the Anglo-US model disclosure takes place quarterly. There’s also no need to disclose information about all the shareholders of the company, only the largest.
#3. The German Model
Finally, the German model governs a number of continental European corporations. While it has certain similarities, especially to the Japanese model, the German model is quite different from the three models.
In the German model there are two key players: the banks and the corporate shareholders.
Other corporations are also shareholders under the German model. As you’ll see below, the composition of the board is very different and influences the key players in the system. For example, labor representatives on supervisory boards are mandatory.
Composition of the board
What distinguishes the German model the most from the other two is the composition of the board. This is because the board consists of two separate entities: the management board and the supervisory board. Both are set by law.
The management board is set by the supervisory board and helps it to make the right decisions. The management board only includes the executives, while the supervisory board has no ‘insiders’ involved. The numbers in the supervisory board are set by law.
The German model is strongly influenced by the government and its regulatory requirements. In Germany, specifically, the federal law plays an important role.
While disclosure rules are quite extensive, they aren’t as tough as under the US-Anglo model.
GUIDELINES FOR CORPORATE GOVERNANCE
The above core principles and models have also helped developed a number of different guidelines. While these guidelines are not mandatory, they are often used as a reference point when countries and corporations develop their own codes and guidelines.
The following guidelines are the most frequently used in the corporate world:
- Organization for Economic Co-operation and Development (OECD) guideline: The OECD published Principles of Corporate Governance in 1999 and 2004. These have been the building block behind many national corporate governance models. The organization is currently in the process of updating the guidelines, with the new report expected to be published in September 2015.
- Stock exchange guidelines: in addition to the OECD guideline, many stock exchanges provide listing standards, which are often used as a guideline for corporate governance. These focus on the board’s composition and have been essential in establishing independent supervision in corporations.
- Other guidelines: there are other notable guidelines influencing corporate governance. These include the investor-led International Corporate Governance Network (ICGN), which has developed a range of guidelines to make shareholder rights and business ethics the core of corporate governance.
Then there is the World Business Council for Sustainable Development (WBCSD), which has focused especially on the accounting and disclosure issues of corporate governance.
The above codes are not enforced, but they have become extremely important in helping companies define their own set of practices.
Corporate governance has become an important part of the business world. The development has been influenced by many problematic encounters in the corporate world. Scandals have helped many investors, corporations and national governments to understand the need for strict guidelines and regulations involving how corporations are run.
The above information helps you to see the differences and similarities in corporate governance. Over the years, the core principles have been developed, but different regions still have some differences in the principles they emphasize. Regardless, the importance is widely understood: strong corporate governance can help a company succeed in the modern world.