Corporate governance is the collection of mechanisms, processes and relations by which corporations are controlled and operated. Governance structures and principles identify the distribution of rights and responsibilities among different participants in the corporation (such as the board of directors, managers, shareholders, creditors, auditors, regulators, and other stakeholders) and include the rules and procedures for making decisions in corporate affairs. Corporate governance is necessary because of the possibility of conflicts of interests between stakeholders, primarily between shareholders and upper management or among shareholders.
Corporate governance includes the processes through which corporations’ objectives are set and pursued in the context of the social, regulatory and market environment. These include monitoring the actions, policies, practices, and decisions of corporations, their agents, and affected stakeholders. Corporate governance practices can be seen as attempts to align the interests of stakeholders.
Interest in the corporate governance practices of modern corporations, particularly in relation to accountability, increased following the high-profile collapses of a number of large corporations in 2001–2002, many of which involved accounting fraud; and then again after the recent financial crisis in 2008.
Corporate scandals of various forms have maintained public and political interest in the regulation of corporate governance. In the U.S., these include scandals surrounding Enron and MCI Inc. (formerly WorldCom). Their demise led to the enactment of the Sarbanes-Oxley Act in 2002, a U.S. federal law intended to improve corporate governance in the United States. Comparable failures in Australia (HIH, One.Tel) are associated with the eventual passage of the CLERP 9reforms there, that similarly aimed to improve corporate governance. Similar corporate failures in other countries stimulated increased regulatory interest (e.g., Parmalat in Italy).
The need for corporate governance follows the need to mitigate conflicts of interests between stakeholders in corporations. These conflicts of interests appear as a consequence of diverging wants between both shareholders and upper management (principal-agent problems) and among shareholders (principal-principal problems), although also other stakeholder relations are affected and coordinated through corporate governance.
In large firms where there is a separation of ownership and management, the principal–agent issue can arise between upper-management (the “agent”) and the shareholder(s) (the “principal(s)”). The shareholders and upper management may have different interests, where the shareholders typically desire profit, and upper management may be driven at least in part by other motives, such as good pay, good working conditions, or good relationships on the workfloor, to the extent that these are not necessary for profits. Corporate governance is necessary to align and coordinate the interests of the upper management with those of the shareholders.
One more specific danger that demonstrates possible conflict between shareholders and upper management materializes through stock purchases. Executives may have incentive to divert firm profit towards buying shares of own company stock, which will then cause the share price to rise. However, retained earnings will then not be used to purchase the latest equipment or to hire quality people. As a result, executives can sacrifice long-term profits for short-term personal benefits, which shareholders may find difficult to spot as they see their own shares rising rapidly.
Principal-principal conflict (the multiple principal problem)
The principal-agent problem can be intensified when upper management acts on behalf of multiple shareholders – which is often the case in large firms (see multiple principal problem). Specifically, when upper management acts on behalf of multiple shareholders, the multiple shareholders face a collective action problem in corporate governance, as individual shareholders may lobby upper management or otherwise have incentives to act in their individual interests rather than in the collective interest of all shareholders. As a result, there may be free-riding in steering and monitoring of upper management, or conversely, high costs may arise from duplicate steering and monitoring of upper management. Conflict may break out between principals, and this all leads to increased autonomy for upper management.
Ways of mitigating or preventing these conflicts of interests include the processes, customs, policies, laws, and institutions which affect the way a company is controlled – and this is the challenge of corporate governance. To solve the problem of governing upper management under multiple shareholders, corporate governance scholars have figured out that straightforward solution of appointing one or more shareholders for governance is likely to lead to problems because of the information asymmetry it creates. Shareholders’ meetings are necessary to arrange governance under multiple shareholders, and it has been proposed that this is the solution to the problem of multiple principals due to median voter theorem: shareholders’ meetings lead power to be devolved to an actor that approximately holds the median interest of all shareholders, thus causing governance to best represent the aggregated interest of all shareholders.
An important theme of governance is the nature and extent of corporate accountability. A related discussion at the macro level focuses on the effect of a corporate governance system on economic efficiency, with a strong emphasis on shareholders’ welfare. This has resulted in a literature focused on economic analysis.
Corporate governance has also been more narrowly defined as “a system of law and sound approaches by which corporations are directed and controlled focusing on the internal and external corporate structures with the intention of monitoring the actions of management and directors and thereby, mitigating agency risks which may stem from the misdeeds of corporate officers.”
Corporate governance has also been defined as “the act of externally directing, controlling and evaluating a corporation” and related to the definition of Governance as “The act of externally directing, controlling and evaluating an entity, process or resource”. In this sense, governance and corporate governance are different from management because governance must be EXTERNAL to the object being governed. Governing agents do not have personal control over, and are not part of the object that they govern. For example, it is not possible for a CIO to govern the IT function. They are personally accountable for the strategy and management of the function. As such, they “manage” the IT function; they do not “govern” it. At the same time, there may be a number of policies, authorized by the board, that the CIO follows. When the CIO is following these policies, they are performing “governance” activities because the primary intention of the policy is to serve a governance purpose. The board is ultimately “governing” the IT function because they stand outside of the function and are only able to externally direct, control and evaluate the IT function by virtue of established policies, procedures and indicators. Without these policies, procedures and indicators, the board has no way of governing, let alone affecting the IT function in any way.
One source defines corporate governance as “the set of conditions that shapes the ex post bargaining over the quasi-rents generated by a firm.” The firm itself is modelled as a governance structure acting through the mechanisms of contract. Here corporate governance may include its relation to corporate finance.
Contemporary discussions of corporate governance tend to refer to principles raised in three documents released since 1990: The Cadbury Report (UK, 1992), the Principles of Corporate Governance (OECD, 1999, 2004 and 2015), and the Sarbanes-Oxley Act of 2002 (US, 2002). The Cadbury and Organisation for Economic Co-operation and Development (OECD) reports present general principles around which businesses are expected to operate to assure proper governance. The Sarbanes-Oxley Act, informally referred to as Sarbox or Sox, is an attempt by the federal government in the United States to legislate several of the principles recommended in the Cadbury and OECD reports.
- Rights and equitable treatment of shareholders: Organizations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by openly and effectively communicating information and by encouraging shareholders to participate in general meetings.
- Interests of other stakeholders: Organizations should recognize that they have legal, contractual, social, and market driven obligations to non-shareholder stakeholders, including employees, investors, creditors, suppliers, local communities, customers, and policy makers.
- Role and responsibilities of the board: The board needs sufficient relevant skills and understanding to review and challenge management performance. It also needs adequate size and appropriate levels of independence and commitment.
- Integrity and ethical behavior: Integrity should be a fundamental requirement in choosing corporate officers and board members. Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making.
- Disclosure and transparency: Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide stakeholders 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 organization should be timely and balanced to ensure that all investors have access to clear, factual information.