Corporate Governance Definition
WRITTEN BY PAUL BOYCE | Updated 2 February 2021
What is Corporate Governance
Corporate governance is the set of rules and relationships which seek to align the interest of the board of directors, and the businesses owners. As the board of directors may have different interests and incentives from the shareholders, it is important to align these to ensure the longevity of the firm.
For example, the board of directors may look to boost the share price in the short-term. However, this may affect the long-term stability of the firm. Whilst the board of directors make a profit – shareholders may be left with a failing company.
Corporate governance is therefore the legal and voluntary compliance that is enforced in order to ensure the board of directors’ work in the interest the firm’s owners and stakeholders. This can come through either legal rules set by the government, or those which are agreed upon mutually by the board and its owners.
- Corporate governance is a set of rules and restrictions placed upon the board of directors in order to align their interests with that of the firm’s stakeholders.
- Each firm will have a different corporate governance framework, but will center itself on transparency and accountability of the board of directors.
Corporate governance has become increasingly popular after notable financial scandals such as that of Enron in 2001. As a result of inaccurate and misleading financial information, many investors invested millions of dollars into the firm. However, these figures were falsified by management in order to boost the share price. Yet when the pyramid scheme collapsed, it was the shareholders who lost out rather than those who devised the scheme.
Responsibilities of the Board of Directors
- Setting the companies aims and objectives
- Determining strategy
- Providing the leadership
- Supervise management
- Reporting to shareholders
Corporate Governance Framework
Corporate governance is the framework by which management have to follow with relation to the decisions and procedures that they make. At the same time, it holds those same individuals accountable for their decisions. This framework will vary from country to country and firm to firm, but the basic principles apply.
The very purpose of corporate governance is to ensure that the firm is directed and controlled in a way that is beneficial to its stakeholders. That not only includes the firm’s shareholders, but also its suppliers and customers.
Structure refers to the organization shape of the firm. In other words, who reports to who. Is there a regional management? Is there a two-tiered management system, or is the organization very flat. Furthermore, the structure looks at the committee structure and how they can adhere to corporate governance. So how those board members can implement the other targets highlighted.
Who oversees the actions and decisions of the board? How are management held accountable? Who holds them accountable? Such questions are important to ensuring those managing the company are held accountable and take responsibility for poor decisions. At the same time, it is important to clarify who has authority to make certain decisions. For instance, can a middle-manager make a purchase over $1 million using the firms account? Such decisions may need to go through an appropriate approval flow.
There are also factors such as corruption which need to be prevented. Many companies have ‘gift’ restrictions in their corporate governance guidelines. This is where employees cannot take a gift from a third party that is in excess of a certain amount – perhaps $50. The purpose of such is so that decision makers are not unduly influenced by free tickets and other hospitality.
Talent and Culture
How are employees paid and rewarded for their efforts? Is there a work-late culture? How does the firm attract talent? Such questions are important to ensuring employees join as well as stay at the firm. A company with a high turnover of staff can be seen as undesirable, but also becomes expensive due to having to train new staff every few months.
The firm may have a specific culture which promotes inclusivity, as well as development programs. It may offer staff training in order to help them move up in the company – or, perhaps between different departments.
As part of corporate governance, there needs to be a feedback loop by which management can identify and respond to issues that the firm faces. This may be competitive, operational, new business opportunities, or changes in regulation.
There are also other factors such as work place bullying or inappropriate behavior/use of work equipment. The firm may have strict rules to prevent such, with equally strict punishments. It may implement mandatory training which highlights what employees should not be doing in the workplace, and the consequences for such.
Importance of Corporate Governance
Enhance Investor Confidence
Corporate governance creates a framework by which corporations are run. This helps align the interests of management and those of its stakeholders. In turn, investors can invest safe in the knowledge that those who run the company are doing so on their behalf.
Companies that trade on the likes of the Dow Jones and S&P 500, all have corporate governance policies. This is to give investors a greater insight into how the company functions. It demonstrates how decisions and procedures are made, thereby giving investors’ confidence that it is run efficiently, but also demonstrates transparency.
Makes Management Accountable
Corporate governance sets clear rules on the organizations structure and accountability. For instance, the board are required to present a fair and unbiased representation of the company’s position. This creates transparency which is key to accountability. By having a transparent and clear reporting system, the relationships between stakeholders and the board are improved. Being honest about what the company is not doing well at, and highlighting areas for improvement holds management accountable.
In legal terms, a corporation is one single entity. However, it often comprises itself of thousands of individuals, and those individuals can make detrimental decisions that affect the whole corporation. Yet they can hide behind the corporate mask. This is exactly what corporate governance tries to combat.
The board of directors are accountable for explain decisions they have made which have gone wrong. They are also required to identify risks to the business and how they are being addressed. This is then presented to shareholders – usually at an annual meeting. In turn, by allowing for greater transparency, shareholders are able to make an objective decision on the firm whilst making the board accountable.
Minimize Corruption and Waste
Many firms operate a strict policy regarding corruption and ‘gift’ giving. Some countries make this enshrined in law to prevent employees taking gifts from third parties in excess of $50. This is to protect the integrity of the firm, but also remove corruption. After all, a new car may be enough to help convince a decision making to give the project to company A instead of B.
There are also financial procedures that help to reduce waste. For instance, most firms have a list of pre-approved suppliers. If employees need supplies or equipment, these often have to go through an approval process. Whilst this can be time consuming, it helps shore up the firms accounting procedures and limit its expenditures where possible.
Improves Economic Efficiency
Corporate governance improves economic efficiency as it holds management accountable. Decisions must go through an approval process by which they are critiqued and analyzed – thereby reducing the number of bad decisions a firm takes.
As corporate governance is about improving transparency and accountability, better decisions are taken and shares are priced more appropriately.
FAQs on Corporate Governance
The role of corporate governance is to ensure transparency and accountability. By doing so, management align their interests with that of the shareholders. If they are not held accountable, they may be incentivized by short-term gains at the cost of long-term stability for the firm. Examples include the likes of Enron.
The four pillars of corporate governance include: accountability, fairness, transparency, and, leadership and stakeholder management.
Corporate governance is the framework which establishes the relationship between management and the board, and those of the various stakeholders such as suppliers, employees, and shareholders. It sets the basis for how the firm operates and makes decisions.