Corporate Governance

© GettyImages
Maor Winetrob

Good corporate governance builds investor and stakeholder trust.

When you see company scandal, corruption, and fraud splashed across the headlines, you can be pretty sure that the term "corporate governance" will follow very soon after.

It's a phrase we've been familiar with since the high-profile collapse of energy company Enron in 2001 and communications giant WorldCom in 2002, which exposed the inner workings of these companies to public scrutiny.

Their downfalls also shone the spotlight on how other companies are governed – and how managers are kept accountable.

Companies are typically governed according to a set of rules and regulations – rules that have been subject to tighter control since the Enron scandal. These rules are expected to protect the assets and resources of the company and to hold top managers and executives accountable for their decisions and actions.

In this article, we look at why corporate governance is important, its implications in today's world, and the people and processes that support it.

Corporate Governance Definition

Corporate governance refers to the rules, practices and processes used to govern a company. It also identifies key stakeholders who are accountable for decision making and work practices. In general, corporate governance is there to ensure that all stakeholders (including shareholders, board members, employees, customers, suppliers and the wider market) are protected.

Corporate governance processes are there to ensure that a company is run in an accountable and transparent way that enables it to fulfil its key objectives, and to ensure trust is maintained by shareholders.

Why Is Corporate Governance Important?

In the modern world, corporate governance protects more than investors' interests. It also represents the public interest, through environmental and social standards and practices. Post-Enron, the U.S. government passed the Sarbanes-Oxley Act (SOX) in 2002, to prevent similar corporate catastrophes occurring in the future.

In recent years, growing concerns have been raised about executive pay and a lack of diversity on boards, as well as poor work practices that mean issues such as sexual harassment, racism and exploitation of workers are not managed correctly.

Now, more than ever, there's an increasing emphasis on improving corporate processes, accountabilities, and controls – all in an effort to reduce abuses of power, and increase the integrity of decision making within corporations. This is part of a more general trend toward transparency and accountability for all organizations in the public and private sector.

Corporate governance is a major factor in overall organizational health and sustainability because it does the following:

• Protects shareholder and other stakeholder rights.
• Encourages investment.
• Increases accountability.
• Increases transparency.
• Ensures disclosure.
• Creates better relationships with stakeholders.

Who Is Responsible for Corporate Governance?

In order to be truly effective, corporate governance must be managed from the top down in an organization to ensure open, honest, and compliant corporate behavior. The key individuals and groups involved in complying with corporate governance include:

• Shareholders – Financial investors in the organization. They don't directly participate in corporate operations, so they need to elect informed, qualified, and independent directors to protect their interests.
• Board of directors – The shareholders should elect this group to oversee corporate performance on their behalf. Directors should be independent, and they should have the incentive to create value within the corporation. Their main task is to appoint a chief executive officer, and to hold them accountable for the company's daily operations.

  Note:

  Independence here means freedom from material ties to the company, managers, and external auditors.

  Independent directors theoretically act in the best interests of the company and its shareholders, because they have no ties to prevent objective decision making and behavior.

• Chief executive officer (CEO) – The board hires this individual to manage the organization's day-to-day operations – including strategic planning, financial reporting, and risk management. The CEO is also responsible for keeping the board informed of what's happening in the organization.
• Senior managers – The CEO hires these people to manage the various functions of the business. They're responsible for creating and supervising internal control systems; developing an effective corporate structure; setting a "tone at the top" that emphasizes integrity and ethical behavior; and ensuring that processes are in place that ensure compliance, and avoid and detect misconduct.
• Stakeholders – These are other organizations and people who are affected by a company's operations. Stakeholders can include employees, customers, and suppliers. They can also include people outside the organization who have a particular interest in how the company operates, such as lobbying and campaigning organizations. For example, social and environmental concerns are now part of the responsibility of corporate governance, so the stakeholders' overall area of influence is becoming increasingly global.

The board may also decide to delegate some governance responsibilities to committees. These usually include an:

• Audit committee – This committee oversees the corporation's financial reporting. At least one of these committee members should have relevant financial accounting training. The committee meets regularly to make sure that outside auditors are performing their duties correctly, and to review internal controls and financial systems for reliability.
• Governance committee – This group of several independent directors oversees the corporation's governance activities. It may select and recommend board nominees, and ensures that board members remain independent. It also regularly reviews governance practices for effectiveness.
• Compensation/Remuneration committee – This committee oversees senior management compensation packages, as well as compensation policies in general. Increasingly, it may also look into fair pay and pay reporting across the organization. Its key role is to ensure that overall compensation is competitive, and that performance incentives are good value for the corporation.

How Does Corporate Governance Work?

Managers and directors can use a variety of tools and strategies to support corporate governance activities.

Internal control systems

These processes are designed to ensure the following:

• Effective and efficient operations.
• Reliable financial reporting.
• Compliance with applicable laws and regulations.

Risk management

This is a formal system to identify, measure, and control risk. It should assess both financial and non-financial risk.

Disclosure systems

A disclosure policy should encourage a culture of openness and transparency. It often includes elements such as these:

• Anonymous disclosure – often referred to as "whistleblowing   ."
• No negative consequences for disclosure.
• Independent review of disclosures.
• Regular audits of disclosure risks.

Corporate Responsibility

This refers to a company's commitment to be accountable and transparent to its customers, employees, shareholders, and communities. This can be typically illustrated by and through:

• Business ethics.
• Brand management.
• Investor relations.
• Stakeholder communications.
• Environmental affairs.
• Community and social activities.
• Corporate philanthropy.

For more on corporate social responsibility, read our article here   .

Corporate Governance Examples

Wells Fargo

In 2013, a story began to unfold of unethical cross-selling practices at U.S. bank, Wells Fargo, which had led to the creation of millions of unauthorized and fraudulent accounts. It was revealed that these practices, along with overly-demanding sales targets and an unhealthy sales environment, had caused the problem. [3]

Originally, the blame had largely been put on sales managers. But it was later found to be caused by "top down" pressure from higher-level management, as well by the board, which had failed to fully investigate the matter properly.

The scandal ended in the resignation of a number of senior executives, as well as the CEO. And it resulted in Wells Fargo being fined a combined $185m for its illegal activity.

Since the scandal, the bank has attempted to improve its corporate governance processes. Bylaws were amended to ensure that the chairperson is an independent director, and a mechanism of self-review for directors has been introduced, assisted by a third party. The bank has also set up a stakeholder advisory council, which is tasked with giving feedback to the board from the perspective of various stakeholders.

Volkswagen

In 2015, German car manufacturer Volkswagen admitted to installing "defeat devices" on at least 11 million of its vehicles to ensure that they passed emissions tests. The cars actually emitted up to 40 times above recommended levels in the U.S. [4]

Although senior management admitted fault, Volkswagen's supervisory board have shown an unwillingness to accept any blame. Even though governing boards do have a responsibility to be well informed, provide oversight and be involved in key decisions.

One of the main reasons cited as a cause of the scandal is the lack of independent directors on the company's board. The board also failed to set up robust compliance and risk management processes, that would have been able to detect and investigate such issues.