Why Corporate Governance?
Muhammad Ehsan Khan
I have always been an avid lover of cricket, watching and playing cricket for years now. Twenty-five years ago, I bought a cricket kit. It was the Eid holiday (an important Islamic holiday celebrated by Muslims throughout the world). I had been able to gather enough money from my elders on Eid to buy a kit for myself. When my father came to know about this, he was infuriated. At that time I was not sure why he was getting angry. It was not the money aspect; he used to spend a lot for our family. It was not the cricket kit; he was a cricket lover himself.
I realize now that I acted in a manner that was noncompliant with the governance framework that ran in our family. There were certain items that we could buy without asking permission from our father. However, buying a cricket kit was a decision where he needed to intervene and grant permission. If I had consulted with him, he would have taken me to the shop and gotten one for me. Too late, money spent and wrath bought.
It is understandable that every institution, whether family or corporation, needs some sort of a framework under which people can operate and make decisions. This is the reason why corporate governance has been around for years; however, because of a number of corporate failures during the 2000s (e.g., Enron in North America and Parmalat in Europe), it has become a discipline in its own right.
Corporations realized that even though sustainable financial results are the core of progressive organizations, they could not be achieved with a singular focus on financial aspects. People also began to realize that the existing controls in an organization, which were thought to be sufficient to safeguard the interests of shareholders, were not adequatehence some reforms were required.
Corporate governance has a significant impact on the economic health of corporations and society. Corporate fraud, scandal, and malpractice have renewed interest in corporate governance.
Principal–agent relationships, or in other words, the separation of ownership and control, seem to be one of the fundamental reasons for having a corporate governance framework in place. The purpose is to ensure that the interests of the owner or shareholder (principal) are safeguarded by the executive management (agent). The Organization for Economic Cooperation and Development (OECD) principles of corporate governance focus on the problems that arise because of separation of ownership and control. These principles also refer to the protection of shareholder interests as a major aspect of corporate governance.
The principal–agent relationship cannot be managed by introducing an excessive monitoring mechanism, but a combined mechanism of incentive-based contracts and a monitoring system may be needed, which requires the forming of a corporate governance framework.
The focus of corporate governance should not only be to manage an organization's current state, but it should also focus on taking the organization to a better future state. Governance board members act as stewards to the principal as they have the role of protecting the interests of the stakeholders in the corporation.
Defining Corporate Governance
The initial focus of corporate governance was on shareholder interests; however, increasing shareholder value may result in affecting the wider range of stakeholders who will be affected directly or indirectly. Organizations have an ethical obligation to consider the society they are operating in, and hence they have social obligations toward a wider range of stakeholders. This results in greater focus toward "stakeholder theory" instead of "shareholder theory." OECD, while setting up the principles of corporate governance, also focuses on a wider range of stakeholders. Thus, stakeholder interests are at the core of corporate governance. Corporate governance is defined by the OECD (2004):
Corporate governance is one key element in improving economic efficiency and growth as well as enhancing investor confidence. Corporate governance involves a set of relationships between a company's management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring. (p. 11)
This definition shows that corporate governance is not just focused on the interests of the organization and its shareholders; rather, that it considers the relationship with all stakeholders as well as their interests. It also shows that corporate governance at the organizational level results in improving economic conditions of the market. Corporate governance is a system that defines how the organization should be directed and controlled. It has to be understood that corporate governance is not simply an internal-looking regulatory function; rather that it involves consideration for external stakeholders, such as the market, as well as the industry standards.
From a principal–agent relationship perspective, corporate governance focuses on streamlining the relationship between the principal and the agent through monitoring mechanisms, such as transparency, compliance, and reporting, as well as board and shareholder composition.
Corporate governance is also about allowing managers to drive the company forward; however, this freedom is under a framework of control mechanisms and accountability, decision-making process, and clear distribution of power (remember my cricket kit!).
Corporate governance at the organization level is thus concerned with:
- Setting up policies, controls, and procedures for provisioning and the management of organizational assets (including employees) and services in order to maximize organizational benefits.
- Creating a decision-making mechanism and assigning decision rights to the correct level.
- Establishing practices to meet internal and external requirements related to effectiveness, efficiency, confidentiality, integrity, availability, compliance, and reliability for its information and information-based services.
In addition, the legitimate rights of the shareholders, in particular, and the stakeholders, in general, should be clearly defined within the governance framework. Chau (2011) summarizes corporate governance framework by mentioning that "The heart of all instruments and mechanisms should be directed to proper stewardship, integrity, openness, transparency and accountability without excessive surveillance and bureaucracy" (p. 10).
Within the conformance, performance, and relating responsibility (CPR) framework, Pultorak (2005) focuses on the board ownership of corporate governance and mentions that "corporate governance must be ordered within a framework established by the board that aligns and informs day-to-day decision-making, objective setting, achievement monitoring and, communication" (p. 292).
Corporate governance and organizational well-being is the responsibility of the board. Good governance is not just about compliance and transparency; rather, it benefits organizations by increasing the confidence level of the market on the organization, which eventually results in higher profitability. Thus, corporate governance should be seen as a strategic tool instead of an audit mechanism.
Factors Affecting Corporate Governance and Its Evolution
Only one thing is observed to be constant in our world: change. It implies that the requirements of governance have to evolve to meet stakeholders' needs. The core of the governance perspective is its capacity to accommodate to a changing environment and to use processes of governance within an organization.
Various environmental, external, and internal factors have contributed toward the continuous evolution of the concepts that form the foundation of corporate governance. Organizational complexity is increasing as most contemporary organizations regularly interact with multiple interfaces, such as vendors, partners, and other legal entities, where each entity might be working toward increasing value for the organization. This rise in complexity and interdependence results in a greater need for corporate governance. The relationship between entities also creates the question: Who should perform governance?
Historically, corporate governance's focus has been on financial measures and management. Even though the financial bottom line still remains the main business objective, factors other than financial ones may have an impact on an organization. Th s, corporate governance measures should include those nonfinancial aspects as well.
Globalization has opened new avenues for organizations to expand in multiple directions, thus markets are better managed, and governed organizations have a higher probability of success as they may seem more attractive to foreign markets. Even for organizations working in local markets, corporate governance plays a significant role in setting up the operating structure and policies, which results in higher profitability.
An increased awareness by the general public has heightened the expectations from organizations, and they are expected to do more for the betterment of people and society based on their location. There seems to be an understanding that organizations are part of the social system and should not focus solely on their profitability; rather, organizations should address the concerns of related constituents as well. Thus, the social responsibility perspective has been added to the corporate governance mechanism.
Availability of technology has increased information availability and communication frequency between all stakeholders. This has caused organizations, especially their executive management, to always be in a state where they have ensured that precise controls are in place to safeguard the interests of the stakeholders. Efficient and aligned corporate governance practices can help organizations achieve this control.
The Sarbanes–Oxley Act of 2002 (SOX) and other regulations have had a major impact on the way that organizations are being governed. Some of these regulations are mandatory in certain countries; however, organizations tend to adapt to other codes and standards as well, due to the belief that such adaptation will result in the establishment of goodwill in the market. However, laws and regulations may have loopholes, which can be exploited. Corporate governance creates mechanisms of self-regulation and reduces dependency on state-level legal options, which are not always in the best interest of the corporation.
Recent corporate debacles and scandals have undermined the confidence of investors and questioned the ability of organizations to protect the interests of their stakeholders. As a result, the focus of organizations as well as regulators shifted to the tightening of regulatory requirements, and revisions in corporate governance frameworks have started to take place. According to the OECD, the following factors have an influence on the evolution and implementation of a governance framework within an organization (OECD 2004):
- Macroeconomic policies of the environment
- Degree of competition in the product and factor markets
- Legal and regulatory requirements
- Institutional culture and environment
- Business ethics prevalent in the society within which the organization is operating
- Corporate awareness and interest that the society is taking in the organization
- Relationships among participants of the corporate governance framework, their influence, and their special demands, for example, investors wanting a certain reporting mechanism to be in place.
Corporate Governance Institutions
The Board of Directors
The board of directors acts as the main driving force within the corporate governance framework. The board's performance has implications on the way corporations operate as well as perform. Recent tragedies, such as the British Petroleum (BP) oil spill in 2010, required organizations to reexamine and evaluate corporate governance practices and performance. The focus should now be on improving board performance to provide better accountability and transparency in order to enhance corporate performance. Setting up metrics to measure board performance is another key aspect that corporations should consider. This will provide a quantitative assessment tool to evaluate how the board is contributing to the overall board objectives.
The board of directors can be seen as a controlling entity, which is formed by the shareholders and their nominating committee to oversee the activities of the management team. The presence of independent directors on the board may result in lowering the probability of self-seeking behavior of the management team.
Boards play a vital role in reviewing, recommending, and approving strategic plans. They have the responsibility of ensuring that the organization is investing in the right direction and that the investments are generating the desired results. Corporate accountability is another board-level function, and boards have to ensure that the company discloses relevant and reliable financial and nonfinancial information to various internal and external stakeholders. The corporate board has to create a working environment that promotes governance, transparency, and ethical behavior within the corporation. Boards are also responsible for senior level hiring, compensation, and succession planning.
Effective and reliable management reporting improves as the board performs, and accurate reports result because of the facilitation of board-level decisions. In one of my recent assignments, while performing the as-is analysis, it was clear that the board members were obtaining information that was irrelevant, presented ineffectively, or overloaded with details. This approach means that board members make decisions based on their understanding of information, which may not be complete or wholly correct. Therefore, it is important that reports be timely, accurate, and presentable, and they should also contain quality information.
In terms of board member selection, the independence of the board of directors seems to be a logical preference as they will act as a monitoring function over the management team. There appears to be a conflict of interest if the CEO plays a significant role in the selection of board members, as the selected board members might be expected to reciprocate the favor in some form. That might be the reason why the SOX Act has assigned more responsibility to the nomination committee for board member selection.
There is, however, the possibility that even after the selection, the independent board member might not want to alienate senior management and will try to work out suboptimal solutions, especially if they feel that their reelection to the board might be hindered. We can thus argue here that boards should not be considered as the only option when designing control frameworks, and complementary approaches should be used in conjunction with a focus on corporate social responsibility as well.
Auditors and Their Independence
Auditors play an important role in the corporate governance mechanism. External auditors tend to play a dual role, that is, partners to the board and independent monitors. On the one hand, they work as partners to the board of directors to ensure that the management team, in particular, and the organization, in general, is complying with standards and regulations. On the other hand, they may report issues, which if made public, can result in organizational loss.
Standards and regulations require the appointment of external independent auditors. Researchers and practitioners have, however, questioned the independence of external auditors because of the assumption that external auditors will always remain unbiased while reviewing the client's reports and books. This bias would be created perhaps because of financial incentives as well as nonfinancial reasons, such as personal affiliation, which may be due to a long-term association with the client. Bias is not a synonym for fraud, but it affects the auditing process as external auditors might ignore certain inconsistencies in the reports. However, such ignorance on a consistent basis might present an opportunity for a self-seeking opportunist to commit irregularities. Marnet (2005) mentions certain mandatory requirements that may help in reducing such bias and mutually supporting behavior.
- Mandatory rotation of external auditors.
- Distance and anonymity between an organization's employees and external auditors.
Functions of Corporate Governance
Reporting and Disclosure
Efficient, effective, and comprehensive reporting is at the core of corporate governance. A governance mechanism can have its strategic value in the reporting system, and the information contained within the reports. The objectives of transparency and full disclosure, which are important to stakeholders, can truly be achieved through timely, comprehensive, clear, and accurate reporting.
Resource management as an activity is a management level responsibility; however, corporate governance should set up the framework under which management makes the investment decisions. Also in certain cases, such as executive level hiring, the corporate governance institutions, such as the board of directors, act as an approving authority.
Risk management is a key attribute of corporate governance. Effective risk management helps organizations to mitigate potential risks to an acceptable level. Without an effective risk management framework, corporate governance is viewed by the market as risky. Therefore good governance, which includes risk management as a practice, results in instilling a sense of belief in the creditors and investors.
Performance of the organization should be a key function of the governance framework. Performance is measured in terms of effectiveness and efficiency in maximizing the value for all stakeholders with a special focus on shareholders. Governance should be carried out beyond the financial indicators. Thus, performance is not just about financial performance, even though it matters the most. It is also related to nonfinancial matters such as effective human resource management and organizational process efficiency.
Managing the relationships with all stakeholders is a governance responsibility. Pultorak (2005) calls this relating responsibility and states that the governance function should be there to work with the stakeholders, pay attention to their needs, manage expectations, and balance their requirements from the corporation.
Corporate social and ethical responsibility to society should also be considered. This function of governance is related to all the other functions, as one of the major reasons for the other governance focus is to sustain and build a clear and transparent relationship with the shareholders, in particular, and all stakeholders, in general.
Strategic oversight is a major function of corporate governance. The development and implementation of strategic plans is a management responsibility; however, corporate governance institutions, such as corporate boards, have a major role to play in terms of reviewing, approving, and overseeing the implementation of strategic plans.
Compliance is a concept that deals with how organizations work under a framework of principles, values, policies, and codes. Regulations, such as SOX, focus on accountability of the executive management and the board of directors. Such regulations also focus on the independence of auditors and disclosure of financial and nonfinancial reports to all stakeholders. Compliance with such standards helps in reducing the probability of issues related to fraudulent and opportunistic behavior of the executives. Compliance with these standards is no longer a matter of choice, and organizations have to adapt if they want to operate, especially in progressing markets. Pultorak (2005) refers to this dimension as conformance to legislative requirements. Legal compliance, which is related to complying with standards and codes, should go hand in hand with ethical compliance, which is concerned with the values and norms of people.
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