Corporate Governance

What Is Corporate Governance?

Corporate governance is defined as the structures and processes by which companies are directed and controlled. It involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance provides the structure through which the objectives of the company are set, and the means of attaining those objectives.

Good corporate governance helps companies operate more efficiently, improve access to capital, mitigate risk, and safeguard against mismanagement. It makes companies more accountable and transparent to investors and gives them the tools to respond to stakeholder concerns.

Corporate governance also contributes to development. Increased access to capital encourages new investments, boosts economic growth, and provides employment opportunities.

Although corporate governance is a key topic in boardrooms today, achieving best practices has been hindered by a patchwork system of regulation, a mix of public and private policy makers, and the lack of an accepted metric for determining what constitutes successful corporate governance.

Corporate Governance Best Practices

Good corporate governance is not an end in itself. It is a means to create market confidence and business integrity, which in turn is essential for companies that need access to equity capital for long-term investment. Access to equity capital is particularly important for growth oriented companies.

Today, millions of households around the world have their savings invested in public companies, both directly and indirectly. Good corporate governance protects the rights of these stakeholders and their ability to participate in corporate value creation.

The quality of corporate governance affects the cost for corporations to access capital for growth and the confidence with which those that provide capital can participate and share in their value creation on fair and equitable terms.

The body of corporate governance rules and best practices provides a framework that helps to bridge the gap between household savings and investment in the real economy. As a consequence, good corporate governance will reassure shareholders and other stakeholders that their rights are protected and make it possible for corporations to decrease the cost of capital and to facilitate their access to institutional investors. This is of significant importance in today’s globalized capital markets.

International flows of capital enable companies to access financing from a much larger pool of investors. If companies and countries are to reap the full benefits of public markets, and if they are to attract “patient” capital, corporate governance arrangements must be credible, well understood across borders and adhere to internationally accepted principles.

Even if corporations do not rely primarily on foreign sources of capital, a credible corporate governance framework, supported by effective supervision and enforcement mechanisms, will help improve the confidence of domestic investors, reduce the cost of capital, underpin the good functioning of financial markets, and ultimately induce more stable sources of long-term financing.

Corporate Governance Issues

Corporate governance became a pressing issue following the introduction of the Sarbanes-Oxley Act in the United States, which was enacted to restore confidence in companies and public markets as a reaction to a number of major corporate and accounting scandals.

Most companies strive to have a high level of corporate governance. These days, it is not enough for a company to merely be profitable; it also needs to demonstrate good corporate citizenship through environmental awareness, ethical behavior and sound corporate governance practices.

While investor protection is a primary goal of securities regulation, it cannot be viewed in isolation. As a regulatory goal, investor protection has value in that it provides positive value to capital formation and the long-term contributions of viable corporations to the economy.

A closely related issue concerns the balance in governance roles and responsibilities between shareholders and boards. Two theories of corporate governance failures have emerged in the past 15 years. The first theory is that there is too little active and objective board involvement. This theory is reflected in the Sarbanes-Oxley Act and its focus on:

• Improving board attention to financial reporting and compliance.
• U.S. Securities and Exchange Commission (SEC) rules and listing rules on independent audit committees and their function.
• Director and committee independence and function.

The second theory is that there is not enough accountability to shareholders. This concern is expressed by the focus of the Dodd-Frank Act, and related SEC rules and rule interpretations, on providing greater influence to shareholders to nominate director candidates.

Directors should bear in mind when communicating with shareholders that the board has a fiduciary duty to act in the best interests of the company and shareholders as a whole. Shareholder views are important and should be considered by the board, but director duties may not be abdicated nor delegated to shareholders, even if an activist investor has a clear preference on an issue.

Corporate Governance Examples

Build a strong, qualified board and evaluate performance. Boards should be comprised of directors who are knowledgeable and have expertise relevant to the business and are qualified and competent, and have strong ethics and integrity, diverse backgrounds and skill sets, and sufficient time to commit to their duties.

• Identify gaps in the current director complement and the ideal qualities and characteristics, and keep an ever-green list of suitable candidates to fill board vacancies.
• The majority of directors should be independent and without any direct or indirect material relationship that could interfere with their judgment.
• Develop an engaged board where directors ask questions and challenge management and don’t just rubber-stamp management’s recommendations.
• Regularly review board mandates to assess whether directors are fulfilling their duties and undertake meaningful evaluations of their performance.

Define roles and responsibilities. Establish clear lines of accountability among the board and management:

• Create written mandates for the board and each committee setting out their duties and accountabilities.
• Delegate certain responsibilities to a sub-group of directors. Typical committees include: audit, nominating, compensation and corporate governance committees and special committees formed to evaluate proposed transactions or opportunities.
• Separate the roles of the board chair and the CEO. The chair leads the board and ensures it’s acting in the company’s long-term best interests. The CEO leads management, develops and implements business strategy and reports to the board.

Evaluate performance and make principled compensation decisions. The board should:

• Set directors’ compensation that will attract suitable candidates, but won’t create an appearance of conflict in a director’s independence or discharge of her duties.
• Establish measurable performance targets for executive officers (including the CEO), regularly assess and evaluate their performance against them and tie compensation to performance.
• Establish a compensation committee comprised of independent directors to develop and oversee executive compensation plans (including equity-based ones like stock option plans).

What works well in one company, for one investor or a particular stakeholder may not necessarily be generally applicable to corporations, investors and stakeholders that operate in another context and under different circumstances.

As new experiences accrue and business circumstances change, the different provisions of the corporate governance framework should be reviewed and, when necessary, adjusted in order to preempt likely concerns from proxy advisors and institutional shareholders.