There is no uniform definition as most are based on implicit or explicit assumptions about the main objective of the firm. However, there is no universal agreement as to what this objective should be. Below are several definitions that may help students understand the concept:
- Larcker and B. Tayan: “a collection of control mechanisms that an organization adopts to prevent potentially self-interested managers from engaging in activities detrimental to the shareholders and stakeholders”.
- Shleifer and R. Vishny “The ways in which suppliers of finance assure themselves of getting a return on their investment”
- Sir Adrian Cadbury (1999) “Corporate governance is concerned with holding the balance between economic and social goals and between individual and communal goals….the aim is to align as nearly as possible the interests of individuals, corporations, and society”
So what is corporate governance?
We can explain it as a set of principles and policies by which a company is directed, which influences the rights and relationships among stakeholders, and how a firm is managed. Usually, we can say if a firm has good corporate governance due to the presence of these characteristics:
- Firm is managed in the best interests of shareholders and other stakeholders;
- No single individual has too much power;
- Relationship between a firm’s management, the board of directors, shareholders, and other stakeholders are healthy and productive;
- There is an adequate and appropriate system of internal controls in place;
- Firm’s culture encourages transparency and accountability.
Many factors, internal and external, play a role in how corporate governance is set up. They include a firm’s internal structure, a firm’s role in the society, local capital markets, legal traditions, reliability of accounting standards, regulatory enforcement, cultural values, as well as relationships with regulators, external auditors, politicians, analysts, customers, suppliers, employee unions.
There are no universally agreed-upon standards of corporate governance, however, some regulations are considered as best practices or benchmarks.
- Cadbury Committee “Code of Best Practices”(1992), stock exchange listing requirements, Shareholders’ Bill of Rights, Dodd Frank (2010), GMI governance ratings;
- One of the most important pieces of formal legislation relating to governance is the Sarbanes–Oxley Act of 2002 (SOX);
- Yet there are numerous cases when companies followed the standards, were compliant with all laws and regulations, and still were found guilty of fraud, earnings manipulations, improper accounting practices, etc.
Corporate governance policies are typically concerned with the following aspects of a firm’s operations: how concentrated is the ownership, what is the structure and composition of the board of directors, how executive compensation is set up and monitored, how organizational structure reflects the relationships between different divisions. The key takeaway, however, is that governance is different from the firm’s management, and investors are willing to pay a premium for a well-governed firm. The governance mechanisms do not replace how a firm is managed, how decisions are made, orders are fulfilled and accounting reports are filed.
Governance ≠ Management
Some corporate governance issues remain debatable, for example:
- Should governance principles be unified/universal?
- Should the CEO ever be chairman of the board?
- Can outside directors and external auditors be truly independent?
- How to determine directors’ compensation?
- How to govern complex, dynamic, and global entities?
Disclaimer: my course is based on Larcker and Tanyan “Corporate Governance Matters” textbook, so I make sure my definitions are aligned with theirs. I also include links to demonstrate theoretical concepts using real-life examples.