In this essay we will discuss about:- 1. Introduction to Corporate Governance 2. Definition of Corporate Governance 3. Genesis 4. Role of Institutional Investors 5. Role of the Accountant 6. Actors 7. Principles 8. Corporate Governance Mechanisms and Controls 9. Key Challenges 10. Regulation/Self-Regulation.
Contents:
- Introduction to Corporate Governance
- Definition of Corporate Governance
- Genesis of Corporate Governance
- Role of Institutional Investors in Corporate Governance
- Role of the Accountant in Corporate Governance
- Actors in Corporate Governance
- Principles of Effective Corporate Governance
- Corporate Governance Mechanisms and Controls
- Key Challenges for Corporate Governance
- Regulation/Self-Regulation of Corporate Governance
Essay # 1. Introduction to Corporate Governance:
In common parlance, the system of checks and balances designed to ensure that corporate managers are just as vigilant on behalf of long-term shareholder value as they would be if it was their own money at risk. It is also the process whereby shareholders—the actual owners of any publicly traded firm—assert their ownership rights, through an elected board of directors and the CEO and other officers and managers they appoint and oversee.
In the heels of corporate scandals including the Enron debacle in 2002, a series of sweeping changes are being sought, such as forcing boards to have a majority of independent directors, granting audit committees power to hire and fire accountants, banning sweetheart loans to officers and directors, and requiring shareholder’s approval for stock option plans.
More specifically, the following principles constitute good governance:
1. To avoid conflicts of interest, a company’s board of directors should include a substantial majority of independent directors—independent meaning that directors don’t have financial or close personal ties to the company or its executives.
2. A company’s audit, nominating, and compensation committees should consist entirely of independent directors.
Corporate governance is the set of processes, customs, policies, laws and institutions affecting the way in which 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 at the community at large.
Corporate governance is a multi-faceted subject. An important theme of corporate governance deals with issue of accountability and fiduciary duty, essentially advocating the implementation of policies and mechanisms to ensure good behaviour and protect shareholders.
Another key focus is the economic efficiency view, through which the corporate governance system should aim to optimise economic results, with a strong emphasis on shareholders welfare. There are yet other aspects to the corporate governance subject, such as the stakeholder view, which calls for more attention and accountability to players other than the shareholders {e.g. the employees or the environment).
Recently there has been considerable interest in the corporate governance practices of modern corporations, particularly since the high-profile collapses of a number of large U.S. firms such as Enron Corporation and Worldcom. Board members and those with a responsibility for corporate governance are increasingly using the services of external providers to conduct anti-corruption auditing, due diligence and training.
Essay # 2. Definition
of Corporate Governance:
The term corporate governance has come to mean two things — the processes by which all companies are directed and controlled; a field in economics, which studies the many issues arising from the separation of ownership and control. Relevant, rules include applicable laws of the land as well as internal rules of a corporation.
Relationships include those between all related parties, the most important of which are the owners, managers, directors of the board, regulatory authorities and to a lesser extent employees and the community at large. Systems and processes deal with matters such as delegation of authority.
The corporate governance structure specifies the rules and procedures for making decisions on corporate affair. It also provides the structure through which the company objectives are set, as well as the means of attaining and monitoring the performance of those objectives.
Corporate governance is used to monitor whether outcomes are in accordance with plans and to motivate the organisation to be more fully informed in order to maintain or alter organisational activity. Corporate governance is the mechanism by which individuals are motivated to align their actual behaviours with the overall participants.
In A Board Culture of Corporate Governance, business author Gabrielle O’Donovan defines corporate governance as an internal system encompassing policies, processes and people, which serve 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 which 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 a 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 of 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 company with a view to achieve long-term strategic goals to satisfy shareholders, creditors, employees, customers and suppliers, and complying with the legal and regulatory requirements, apart from meeting environmental and local community needs.
Essay # 3. Genesis of Corporate Governance
:
In the 19th century, state corporation law enhanced the rights of corporate boards to govern without 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 securitised 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 has 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 on the changing role of the modern corporation society. Berle and Means’ monograph “The Modern Corporation and Private Property” continue 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 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 Maclver (organisational behaviour). According to Lorsch and Maclver “many large corporations have dominant control over business affairs without sufficient accountability or monitoring by their board of directors”.
Current preoccupation with corporate governance can be pinpointed at two events- The East Asian Financial Crisis of 1997 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.
The second event was the US corporate crises, which saw the collapse of two big corporations- Enron and WorldCom, and the ensuing scandals and collapses in other organisations such as Arthur Andersen, Global Crossing and Tyco.
Essay # 4. Role of Institutional Investors in Corporate Governance:
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 institutionalized- 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 of professional diligence which has tended to improve regulation of the stock market (but not necessarily in the interest of the small investors or even of the naive 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 have 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. Program trading, the hallmark of institutional trading, was averaging 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/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-take-over measures.
Finally, the largest pools of invested money (such as the mutual fund ‘Vanguard 500’, or the largest investment management film 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 (Bhagat & Black)—, whereas stock in the USA or the UK and Europe are much more broadly owned, often still by large individual investors.
In the latter half of the 1990s, during the Asian financial crisis, a lot of attentions fell upon the corporate governance systems of the developing world, which turn heavily into cronyism and nepotism. In the 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 corporation value would not be destroyed by the now traditionally cozy relationships between the CEO and the board of directors (e.g., by the unrestrained issuance of stock options, not infrequently back dated).
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.
Essay # 5. Role of the Accountant
in Corporate Governance:
Financial reporting is a crucial element necessary for the corporate governance system to function effectively. Accountants and auditors are the primary providers of information to capital market participants. The director 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 improved 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 both as 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 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 form of the Sarbanes-Oxley Act (in response to the Enron situation) prohibit accounting firms from providing both auditing and management consulting services.
The Enron collapse is an example of misleading financial reporting. Enron concealed huge losses by creating illusions 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 Arth 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.
Essay # 6. Actors in Corporate Governance:
Actors 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 delegates decision rights to the manager to act 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 equity holdings of investors, 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 in the organisation. Directors, workers and management receive salaries, benefits and reputation, while shareholders receive capital return. 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 and trust that they will receive a fair share of the organisational returns. If some parties are receiving more of their fair return, then participants may choose not to continue participating leading to organisational collapse.
Essay # 7. Principles of Effective Corporate Governance
:
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 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 at conflict of interest, and disclosure in financial reports.
Commonly accepted principles of corporate governance include:
1. Rights and Equitable Treatment of Shareholders:
Organisations should respect the rights of shareholders and help shareholders to 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.
2. Interests of Other Stakeholders:
Organisations should recognise that they have legal and other obligations to all legitimate stakeholders.
3. 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 chairperson and CEO should not be held by the same person.
4. 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 Programs to minimise the risk that the firm steps outside ethical and legal boundaries.
5. Disclosure and Transparency:
Organisations should clarify and make publicly known the roles and responsibilities of 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:
a. Oversight of the preparation of the entity’s financial statements,
b. Internal controls and the independence of the entity’s auditors,
c. Review of the compensation arrangements for the chief executive officer and other senior executives,
d. The way in which individuals are nominated for positions on the board,
e. The resources made available to directors in carrying out their duties,
f. Oversight and management of risk, and
g. Dividend policy.
Essay # 8. Corporate Governance
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:
1. 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, ex ante. It could be argued, therefore, that executive directors look beyond the financial criteria.
2. 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 myopical behaviour.
External Corporate Governance Controls:
External corporate governance controls encompass the controls external stakeholders exercise over the organisation.
Examples include:
a. Debt covenants,
b. Government regulations,
c. Media pressure, take-overs,
d. Competition,
e. Managerial labour market, and
f. Telephone tapping.
Essay # 9. Key Challenges for Corporate Governance
:
1. 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.
2. 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 judgments of larger professional investors.
3. Monitoring Costs:
In order to influence the directors, the shareholders must combine with others to form significant voting group which can pose a real threat of carrying resolutions or appointing directors at a general meeting.
Essay # 10. Regulation/Self-Regulation of Corporate Governance:
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. Moreover, even if clear rules are followed, one can still find a way to circumvent their underlying purpose— this is harder to achieve if one is bound by a broader principle.
Principles, on the other hand, are a form of self-regulation. It allows the sector to determine what standards are acceptable or unacceptable. It also pre-empts over zealous legislations, that might not be practical.
Enforcement:
Enforcement can affect the overall credibility of a regulatory system. They deter both—bad actors and level the competitive playing field. Nevertheless, greater enforcement is not always better, for taken too far it can dampen valuable risk-taking. In practice, however, this is largely a theoretical, as opposed to a real risk.