Corporate Governance

Corporate Governance

In this lesson, you’re expected to learn about:
– the pillars and goals of corporate governance
– the major groups in a corporation
– the agency problem
What is Corporate Governance?

Corporate governance is the set of legal and non-legal principles and practices affecting the control of publicly-held companies.

It affects not only who controls the corporation and for what purpose but also the allocation of risk and returns to all its stakeholders, including shareholders, managers, creditors, suppliers, financiers, employees, costumers, government, and even communities.

Just twenty years ago, the term “corporate governance” was seldom discussed in the corporate world. Today, however, it is a topic of substantial public interest and has become a subject of legislative and regulatory reappraisal worldwide.

During the past decade, starting in 2002 in particular, the governance of public companies in the U.S. has come under severe criticism as a consequence of the revelations of massive financial frauds and scandalous executive self-dealing at companies such as Enron, WorldCom, and dozens of other major public firms.

Observers asked, “where were the directors?” And the answer was that they just shut their eyes to management wrongdoing until it was too late. The firms failed, shareholders lost billions in savings, and the stock market crashed.

In response, the American federal government passed the Sarbanes-Oxley Act of 2002 (also called just SOX) that mandated specific corporate governance structures for public companies, making mandatory some of the board of directors’ structure, composition, responsibility etc.

In 2008, the financial market experienced another, even more costly crisis which generated renewed political support for corporate governance reform, now focusing especially on enhancing shareholders’ value and powers by means of, for example, nominating the directors on the corporations’ ballots and having a greater voice in approving executive compensation.

[Optional] The Governance Problem: How it Started
Watch this 4-minute video to learn more:
https://www.youtube.com/watch?v=V0zemSfMWSQ
The success of running a corporation and forming solid professional relationships between its stakeholders are based on the following pillars:

 Accountability
• Fairness
• Disclosure & Transparency
• Independence

1) Accountability

The corporate governance framework should provide effective monitoring of management by the board, and the board’s accountability to the company and shareholders.

2) Fairness

Fairness protects shareholder rights and ensures the reasonable and equitable treatment of all stakeholders, including minority and foreign shareholders.

3) Disclosure & Transparency

A good corporate governance regime should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company.

Transparency requires that all of the firm’s actions can be checked at any given time by an outside observer which makes its processes and transactions verifiable.

4) Independence

A corporation should assure that procedures and structures are in place so as to minimize, or avoid completely, conflicts of interest.

That can be achieved by appointing independent directors, independent advisers, and external auditors who have no influence from other members or managers inside the corporation.

The Three Major Groups in a Corporation

Although corporate governance takes all stakeholders into account, it focuses primarily on three principal groups:

1) Shareholders
2) Board of Directors
3) Officers

1) Shareholders: provide capital and must approve major firm transactions. Their role in governance is to appoint the directors and the auditors, and to make sure that an appropriate governance structure is in place.
2) Board of Directors: its responsibilities include setting the company’s strategic aims, providing the leadership to put them into effect, overseeing the management of the business, managing risks, and making reports to shareholders.
3) Officers (also called managers or executives): employees of the company responsible for operating the firm and making the day-to-day business decisions, in some cases with the board’s advice.
Good corporate governance provides proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders.
[Optional] An Introduction to Corporate Governance
Watch this 2-minute introductory video about corporate governance:
https://www.youtube.com/watch?v=0sD0WrnXw-I
The Agency Problem
One of the functions of corporate law is to control conflicts of interest among corporate constituencies, including those between “insiders”, such as controlling shareholders and top managers, and “outsiders”, such as minority shareholders and creditors.

These conflicts correspond to what economists refer to as “agency problems” or “principal-agent problems” and it lies in motivating the agent to act in the principal’s interest rather than simply in the agent’s own interest.

Usually, three agent problems arise in business firms and they relate to conflicts between:

• The firm’s owners (seen as principals here) and its hired managers (seen as agents here).

• Owners who possess the controlling interest in the firm (agents) and the minority or non-controlling owners (principals).

• The firm itself, including its owners (agents), and the other parties with whom the firm contracts, such as creditors, employees, and customers (principals).

NOTE: To assure the quality of the agent’s performance, the principal must monitor the agent directly or indirectly. As a consequence, the value of the agent’s performance to the principal will be reduced due to the creation of this “agency cost”.
Mechanisms Used to Reduce Agency Problems in Corporations

Corporate governance and the law play an important role in reducing agency cost by creating rules and procedures that enhance disclosure by agents or facilitate enforcement actions brought by principals against dishonest or negligent agents. Some of the mechanisms used by corporations to try to avoid agent problems are:

• Shareholders’ appointment right and the power to select and remove directors.

• Shareholders’ decision right to initiate or ratify management decisions in certain circumstances – i.e., most fundamental corporate decisions (such as mergers or charter amendment) require the ratification of shareholders.

• Minority shareholders enjoy veto rights in relation to particular decisions.

• Shareholders’ right to sue – by means of “derivative suits”, the corporate law from some countries entitles shareholders to sue “derivatively”, on behalf of the firm, against managers or directors profiting at the company’s expense.

• Monetary incentives – such as payment of proportional dividends to both the minority shareholders and controlling shareholders (agents in comparison with the former) or bonus paid to directors (agents in comparison with the shareholders) – motivate loyalty from the agent by tying the agent’s returns directly to those of the principal.

• Independent committees made up of members of the board with specified sets of duties to assist in the discharge of the board’s responsibilities.

• Shareholder’s appraisal rights which permit the principal (dissenter shareholder) to leave the corporation in some situations of disagreement with the agent’s (board or controlling shareholder) decision.

• Corporate codes and policies such as code of ethics, whistleblower policy, insider trading policy, related party transaction policy etc.

The Goal of Corporate Governance

A good corporate governance regime helps to develop financial markets and spur economic growth because it:

• Contributes to competitiveness.
• Creates long-term value for shareholders.
• Facilitates corporate access to capital markets.
• Improves the corporate performance and accountability.
• Promotes market confidence.
• Guides the behaviour of corporate management and avoids massive disasters before they occur.
• Ensures that corporations operate for the benefit of society as a whole and induces stable business development and growth, lower risk, and sustainability.

[Optional] What is Good Governance?
Watch this 3-minute video to learn more:
https://www.youtube.com/watch?v=bTyE5BRuokU
Jim Rohn