7 MIN READ
Keeping Organizations Accountable
When you see company scandal, corruption, and fraud splashed across the headlines, you can be pretty sure that the term "corporate governance" will follow.
It's a phrase we've been familiar with since the high-profile collapse of energy company Enron and communications giant WorldCom in 2001 and 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 hold top managers and executives accountable for their decisions and actions.
In this article, we look at how corporate governance began, its implications in today's world, and the people and processes that support it.
What Is Corporate Governance?
When companies first began to form during the industrial age, greed and a lack of ethics were common. Company executives often got rich – while customers were taken advantage of, workers remained poor, and investors lost money. It became clear that laws were needed to protect the interests of stakeholders.
With the rise of public corporations, corporate governance was born. People at the highest levels of organizations were made accountable to a group of elected representatives: the board of directors. The board became the head of the organization – responsible for hiring professional managers to run the company, overseeing the corporate systems, and protecting investors' interests.
This system of representation is the basis of corporate governance – the system by which organizations are directed and controlled today.
Corporate Governance Today
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 United States government passed the Sarbanes-Oxley Act (SOX) in 2002, to help prevent similar corporate catastrophes in future. And recent financial crises in the U.S. and the U.K. have created an even stricter regulatory environment.
Now, more than ever, there's an increasing emphasis on improving corporate processes, accountabilities, and controls – all in an effort to decrease abuses of power, and increase the integrity of decision making within corporations. This is part of a more general trend toward more openness 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 shareholders rights.
- Encourages investment.
- Increases accountability.
- Increases transparency.
- Ensures disclosure.
- Creates better relationships with stakeholders.
Who's Who in Corporate Governance
Corporate governance is carried out by people – and each has duties and responsibilities that ensure open, honest, and compliant corporate behavior. The key individuals and groups are as follows:
- Board of directors – The shareholders 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 him or her accountable for the company's daily operations.
Independence 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. In the U.K., the 2003 Higgs Report said that non-executive directors – who are not involved in the day-to-day running of the business – should monitor and challenge company strategy and managerial performance.
- Chief executive officer (CEO) – The board hires this individual to manage the corporation'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 to avoid and detect misconduct.
- Shareholders – These are the 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.
- Stakeholders – These are other organizations and people who are affected by a company's operations. Stakeholders can include people the organization does day-to-day business with, such as 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 increasingly global.
- Audit committee – This team of independent directors oversees the corporation's financial reporting. At least one of these committee members should be an accountant. The committee meets regularly to make sure the outside auditors perform their duties, 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 recommends board nominees, ensures that board members remain independent, and reviews governance practices for effectiveness.
- Compensation committee – This team of independent directors oversees senior management compensation packages, as well as compensation policies in general. 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 assure the following:
- Effective and efficient operations.
- Reliable financial reporting.
- Compliance with applicable laws and regulations.
This is a formal system to identify, measure, and control risk. It should assess both financial and nonfinancial risk.
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.
This refers to the company's overall commitment to be accountable to customers, workers, shareholders, and communities through activities like these:
- Business ethics.
- Brand management.
- Investor relations.
- Stakeholder communications.
- Environmental affairs.
- Socially responsible investing.
- Corporate philanthropy.
For more on corporate social responsibility, listen to our Expert Interview on the subject with Andrew Crane.
Corporate Governance Around the World
The governance practices described above are typical of North American corporations (although we've also touched on U.K. practice). The Organisation for Economic Cooperation and Development (OECD) prepared Principles of Corporate Governance in 1999 to set global standards, mostly because investors in the United States and the United Kingdom wanted reform. This resulted in two different models of corporate governance:
Outsider Systems – here the owners of the company (shareholders) are not involved in management decisions, and individual investors own very little of the company. This model relies on the strength of the markets to allocate resources correctly. The market is very liquid, meaning that shares can be sold easily if investors aren't happy. Incentives and external control systems are used to align management's interests with those of the shareholders. This system is found in countries like the U.K., U.S., Canada, and Australia.
Insider Systems – here the owners exercise control from inside the company. Owners typically have large stakes, and they actively cooperate with the company's managers. However, as these owners are focusing their capital in one organization, as opposed to spreading their investment across a portfolio, they face higher risks, and so will expect greater returns from their investment than outside investors would. The markets for insider ownership are relatively illiquid. The large owners are often banking institutions, industrial firms, large family networks, or even "the State." Insider systems may be more motivated by broader obligations to all the stakeholders of a company.
Member countries of the OECD are Austria, Belgium, Canada, Denmark, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom, the United States, Japan, Finland, Australia, New Zealand, Mexico, the Czech Republic, Hungary, Poland, Korea, and the Slovak Republic. You can read the Principles of Corporate Governance (updated in 2015) here.
Here are a few examples of global differences:
- Outsider system.
- No insider trading allowed.
- Sarbanes Oxley Act (SOX) passed in 2002, outlining a demanding set of rules and regulations for compliance.
- Outsider system.
- No insider trading allowed.
- The UK has pioneered a flexible form of regulation that asks companies either to comply with a set of best practices, or to explain why, if they do not apply those principles.
Continental Europe (Germany, France, Italy)
- Stakeholder claims are typically taken into account in top management decisions.
- Subtype of an insider system – no insider trading is allowed.
- High employee/stakeholder consideration in corporate decision making.
- Public trading is regulated by the government, and it can be suspended if uncertainty is high.
The gap between insider and outsider systems is decreasing. The underpinning legal, political, and social structures are key determinants of the type of corporate governance system used. Regardless of the system used, as the world's markets rely more on one another, the need for high global standards is clear.
The European Corporate Governance Institute has a web guide to governance reports from countries all around the world.
Corporate governance refers to both the structure and the relationships that determine corporate direction and performance. The board of directors is typically central to corporate governance. Its relationship to stakeholders – including shareholders, managers, workers, customers, and society in general – is critical. The corporate governance framework also depends on the legal, regulatory, institutional, and ethical environment of the community.
Good corporate governance ensures transparency, fairness, and accountability. It's necessary for the integrity and credibility of all kinds of organizations – public, private, nonprofit, and institutional. Good governance builds confidence and trust. It allows the corporation to have access to investor financing, and it assures creditors and workers that the company is reliable and sustainable. Corporate governance is the foundation of trust in our market economy, so it's important to evaluate the performance of directors and corporations to ensure that the governance system is working.
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