Corporate Governance

What Is Corporate Governance?

Corporate governance is the system of rules, practices, and processes by which a firm is directed and controlled. Corporate governance essentially involves balancing the interests of a company’s many stakeholders, such as shareholders, senior management executives, customers, suppliers, financiers, the government, and the community.

Since corporate governance provides the framework for attaining a company’s objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.

Understanding Corporate Governance

Governance refers specifically to the set of rules, controls, policies, and resolutions put in place to direct corporate behavior. A board of directors is pivotal in governance. Proxy advisors and shareholders are important stakeholders who can affect governance.

Communicating a firm’s corporate governance is a key component of community and investor relations. For instance, Apple Inc.’s investor relations site outlines its corporate leadership (its executive team and board of directors). It provides corporate governance information including its committee charters and governance documents, such as bylaws, stock ownership guidelines, and articles of incorporation.

Most companies strive to have exceptional corporate governance. For many shareholders, it is not enough for a company merely to be profitable. It also must demonstrate good corporate citizenship through environmental awareness, ethical behavior, and sound corporate governance practices.

Benefits of Corporate Governance

• Good corporate governance creates transparent rules and controls, provides guidance to leadership, and aligns the interests of shareholders, directors, management, and employees.
• It helps build trust with investors, the community, and public officials.
• Corporate governance can provide investors and stakeholders with a clear idea of a company’s direction and business integrity.
• It promotes long-term financial viability, opportunity, and returns.
• It can facilitate the raising of capital.
• Good corporate governance can translate to rising share prices.
• It can lessen the potential for financial loss, waste, risks, and corruption.
• It is a game plan for resilience and long-term success.

Corporate Governance and the Board of Directors

The board of directors is the primary direct stakeholder influencing corporate governance. Directors are elected by shareholders or appointed by other board members. They represent shareholders of the company.

The board is tasked with making important decisions, such as corporate officer appointments, executive compensation, and dividend policy.

In some instances, board obligations stretch beyond financial optimization, as when shareholder resolutions call for certain social or environmental concerns to be prioritized.

Boards are often made up of insiders and independent members. Insiders are major shareholders, founders, and executives. Independent directors do not share the ties that insiders have. They are chosen for their experience managing or directing other large companies. Independents are considered helpful for governance because they dilute the concentration of power and help align shareholder interests with those of the insiders.

The board of directors must ensure that the company’s corporate governance policies incorporate corporate strategy, risk management, accountability, transparency, and ethical business practices.

The Principles of Corporate Governance

While there can be as many principles as a company believes make sense, some of the more well-known include the following.

Fairness

The board of directors must treat shareholders, employees, vendors, and communities fairly and with equal consideration.

Transparency

The board should provide timely, accurate, and clear information about such things as financial performance, conflicts of interest, and risks to shareholders and other stakeholders.

Risk Management

The board and management must determine risks of all kinds and how best to control them. They must act on those recommendations to manage them. They must inform all relevant parties about the existence and status of risks.

Responsibility

The board is responsible for the oversight of corporate matters and management activities. It must be aware of and support the successful, ongoing performance of the company. Part of its responsibility is to recruit and hire a CEO. It must act in the best interests of a company and its investors.

Accountability

The board must explain the purpose of a company’s activities and the results of its conduct. It and company leadership are accountable for the assessment of a company’s capacity, potential, and performance. It must communicate issues of importance to shareholders.

Corporate Governance Models

The Anglo-American Model

This model can take various forms, such as the Shareholder Model, the Stewardship Model, and the Political Model. However, the Shareholder Model is the principal model.

The Shareholder Model is designed so that the board of directors and shareholders are in control. Stakeholders such as vendors and employees, though acknowledged, lack control.

Management is tasked with running the company in a way that maximizes shareholder interest. Importantly, proper incentives should be made available to align management behavior with the goals of shareholders/owners.

The model accounts for the fact that shareholders provide the company with funds and may withdraw that support if dissatisfied. This can keep management working efficiently and effectively.

The board should consist of both insiders and independent members. Although traditionally, the board chairman and the CEO can be the same person, this model seeks to have two different people hold those roles.

The success of this corporate governance model depends on ongoing communications between the board, company management, and the shareholders. Important issues are brought to shareholders’ attention. Important decisions to be made are put to shareholders for a vote.

U.S. regulatory authorities tend to support shareholders over boards and executive management.

The Continental Model

Two groups represent the controlling authority under the Continental Model. They are the supervisory board and the management board.

In this two-tiered system, the management board is comprised of company insiders, such as its executives. The supervisory board is made up of outsiders, such as shareholders and union representatives. Banks with stakes in a company also could have representatives on the supervisory board.

The two boards remain completely separate. The size of the supervisory board is determined by a country’s law. It can’t be changed by shareholders.

National interests have a strong influence on corporations with this model of corporate governance. Companies can be expected to align with government objectives.

This model also considers stakeholder engagement of great value, as they can support and  strengthen a company’s continued operations.

The Japanese Model

The key players in the Japanese Model of corporate governance are banks, affiliated entities, major shareholders called Keiretsu (who may be invested in common companies or have trading relationships), management, and the government. Smaller, independent, individual shareholders have no role or voice.

Together, these key players establish and control corporate governance.

The board of directors is usually comprised of insiders, including company executives. Keiretsu may remove directors from the board if profits wane.

The government affects the activities of corporate management via its regulations and policies.

In this model, corporate transparency is less likely due to the concentration of power and the focus on interests of those with that power.

How to Assess Corporate Governance

As an investor, you want to select companies that practice good corporate governance in the hope of avoiding losses and other negative consequences such as bankruptcy.

You can research certain areas of a company to determine whether or not it’s practicing good corporate governance. These areas include:

• Disclosure practices
• Executive compensation structure (whether it’s tied only to performance or also to other metrics)
• Risk management (the checks and balances on decision-making)
• Policies and procedures for reconciling conflicts of interest (how the company approaches business decisions that might conflict with its mission statement)
• The members of the board of the directors (their stake in profits or conflicting interests)
• Contractual and social obligations (how a company approaches areas such as climate change)
• Relationships with vendors
• Complaints received from shareholders and how they were addressed
• Audits (the frequency of internal and external audits and how issues have been handled)

Types of bad governance practices include:

• Companies that do not cooperate sufficiently with auditors or do not select auditors with the appropriate scale, resulting in the publication of spurious or noncompliant financial documents
• Bad executive compensation packages that fail to create an optimal incentive for corporate officers
• Poorly structured boards that make it too difficult for shareholders to oust ineffective incumbents

Be sure to include corporate governance in your due diligence before making an investment decision.

Examples of Corporate Governance

Volkswagen AG

Bad corporate governance can cast doubt on a company’s reliability, integrity, or obligation to shareholders. All can have implications for the firm’s financial health. Tolerance or support of illegal activities can create scandals like the one that rocked Volkswagen AG starting in September 2015.

The details of « Dieselgate » (as the affair came to be known) revealed that for years, the automaker had deliberately and systematically rigged engine emission equipment in its cars in order to manipulate pollution test results in America and Europe.

Volkswagen saw its stock shed nearly half of its value in the days following the start of the scandal. Its global sales in the first full month following the news fell 4.5%.

VW’s board structure facilitated the emissions rigging and was a reason it wasn’t caught earlier. In contrast to a one-tier board system that is common in most companies, VW has a two-tier board system, which consists of a management board and a supervisory board.

The supervisory board was meant to monitor management and approve corporate decisions. However, it lacked the independence and authority to carry out these roles appropriately.

The supervisory board included a large portion of shareholders. Ninety percent of shareholder voting rights were controlled by members of the board. There was no real independent supervisor. As a result, shareholders were in control and negated the purpose of the supervisory board, which was to oversee management and employees, and how they operated. This allowed the rigged emissions to occur.

Enron

Public and government concern about corporate governance tends to wax and wane. Often, however, highly publicized revelations of corporate malfeasance revive interest in the subject.

For example, corporate governance became a pressing issue in the United States at the turn of the 21st century, after fraudulent practices bankrupted high-profile companies such as Enron and WorldCom.

The problem with Enron was that its board of directors waived many rules related to conflicts of interest by allowing the chief financial officer (CFO), Andrew Fastow, to create independent, private partnerships to do business with Enron.

These private partnerships were used to hide Enron’s debts and liabilities. If they’d been accounted for properly, they would have reduced the company’s profits significantly.

Enron’s lack of corporate governance allowed the creation of the entities that hid the losses. The company also employed dishonest people, from Fastow down to its traders, who made illegal moves in the markets.

The Enron scandal and others in the same time period resulted in the 2002 passage of the Sarbanes-Oxley Act. It imposed more stringent recordkeeping requirements on companies, along with stiff criminal penalties for violating them and other securities laws. The aim was to restore public confidence in public companies and how they operate.

PepsiCo

It’s common to hear about examples of bad corporate governance. In fact, it’s often why companies end up in the news. You rarely hear about companies with good corporate governance because their corporate guiding policies keep them out of trouble.

One company that has consistently practiced good corporate governance and seeks to update it often is PepsiCo. In drafting its 2020 proxy statement, PepsiCo sought input from investors in six areas:

• Board composition, diversity, and refreshment, plus leadership structure
• Long-term strategy, corporate purpose, and sustainability issues
• Good governance practices and ethical corporate culture
• Human capital management
• Compensation discussion and analysis
• Shareholder and stakeholder engagement

The company included in its proxy statement a graphic of its current leadership structure. It showed a combined chair and CEO along with an independent presiding director and a link between the company’s « Winning With Purpose » vision and changes to the executive compensation program.

The Bottom Line

Corporate governance consists of the guiding principles that a company puts in place to direct all of its operations, from compensation, risk management, and employee treatment to reporting unfair practices, dealing with impact on the climate, and more.

Corporate governance that calls for upstanding, transparent company behavior leads a company to make ethical decisions that benefit all of its stakeholders. It can underscore a potential investment for investors. Bad corporate governance leads to a breakdown of a company, often resulting in scandals and bankruptcy.