Corporate Governance

McEnally and Kim define corporate governance as "the system of principles, policies,
procedures, and clearly defined responsibilities and accountabilities used by stakeholders
to overcome conflicts of interest inherent in the corporate form." The lack of an effective
corporate governance system could threaten the eistence of a corporation and !eaken
the trust and confidence that is essential for effective financial markets.
The ob"ectives of corporate governance are to#
Eliminate or reduce conflicts of interest.
$se the company%s assets in a manner consistent !ith the best interests of
investors and other stakeholders.
&n effective corporate governance system !ill#
'efine the rights of shareholders and other important stakeholders.
'efine and communicate to stakeholders the oversight responsibilities of
managers and directors.
(rovide clear and measurable accountability for managers and directors in
assuming their responsibilities.
(rovide for fair and e)uitable treatment in all dealings bet!een managers,
directors, and shareholders.
*ave complete transparency and accuracy in disclosures regarding operations,
performance, risk, and financial position.
The primary responsibilities of a corporate board of directors are to institute corporate
values and establish long+term strategic ob"ectives that are in the best interests of
shareholders. & corporate governance system must be continuously monitored because of
changes in management and the board of directors.
Corporate governance systems !ill differ according to the legal environment, culture, and
industry in !hich a firm operates, so a list of best practices cannot simply be applied to
all firms !orld!ide !ith any epectation that the corporate governance structure !ill be
strengthened. There are, ho!ever, a number of common characteristics that all sound
corporate governance structures share.
& strong corporate governance system is essential for companies to operate efficiently,
!hile the lack of an effective corporate governance system can threaten the very
eistence of a firm. & strong corporate governance system is essential for companies and
financial markets to operate efficiently, !hile the lack of strong corporate governance
system represents a ma"or operational risk that can threaten the very eistence of a firm.
The t!o key ob"ectives of a corporate governance system# ,-. Eliminate or reduce
conflicts of interest ,particularly those bet!een managers and shareholders., and ,/.
Ensure that the assets of a company are used efficiently and productively and in the best
interests of its investors and other stakeholders.
There is potential for many conflicts of interest to arise in a corporation, but most
corporate governance systems focus on those bet!een management and shareholders.
Corporate governance policies attempt to eliminate the opportunity for management to
place their o!n interest ahead of other stakeholders, such as shareholders, creditors,
directors, employees, and customers.
&ll effective corporate governance systems share the follo!ing attributes#
'efine the rights of shareholders and other important stakeholders.
Clearly identify manager and director governance responsibilities to stakeholders.
(rovide clear and measurable accountability for managers and directors in
assuming their responsibilities.
(rovide for fair and e)uitable treatment in all dealings bet!een managers,
directors, and shareholders.
*ave complete transparency and accuracy in disclosures regarding operations,
performance, risk, and financial position.
& corporate governance system generally focuses on the elimination or reduction of
conflicts of interest, particularly bet!een management and shareholders, as !ell as the
prudent utili0ation of corporate assets for the benefit of investors and other stakeholders.
b There are three ma"or business forms#
1ole proprietorship.
(artnership.
Corporation.
Corporations differ from sole proprietorships and partnerships in that the corporation is a
separate legal entity from its o!ners.
Corporations are typically o!ned by shareholders !ho play no role in day+to+day
management decisions. 2nstead, managers are hired to control and deploy the assets of the
company, and supposedly do so in the shareholders% best interest. This separation bet!een
o!nership and management creates the potential for conflicts of interest.
&dvantages to the corporate form of business include the ease of raising capital, the ease
of the transferability of stock o!nership, and the lack of epertise needed by o!ners of a
corporation since managers control the business% assets. & disadvantage of corporations is
the fact that since corporations have many non+manager o!ners, they are sub"ect to a
great deal of legal re)uirements and regulations.
2n a sole proprietorship, there is no legal distinction bet!een the business and its o!ner.
2n the event of losses or bankruptcy, creditors could theoretically go after the o!ner%s
personal assets, resulting in unlimited liability.
1ole proprietorships have potentially unlimited liability, but the liability for a corporate
o!ner is limited to the amount of their investment.
1ole proprietorships and partnerships have fe!er corporate governance risks than
corporations.
2n most cases, there is no legal distinction bet!een the o!ner and the business !ithin a
sole+proprietor structure.
& partnership allo!s t!o or more people to start a business !ith fe! legal re)uirements.
'isadvantages of the partnership structure include a limited ability to raise capital,
unlimited liability for o!ners, and non+transferability of o!nership. & corporation is a
distinct legal entity that has rights similar to a person. Compared to a partnership, a
corporation has a nearly unlimited ability to raise capital, o!nership is easily transferable,
and the legal separation bet!een the business and its o!ners limits the liability of the
business o!ners. 'isadvantages to the corporate form include increase legal and
regulatory re)uirements and increased conflicts of interest as a result of the separation
bet!een o!ners and managers of the business.
c
1uccession planning for the CE3 is one of the duties of the board of directors, and should
not cause directors to align !ith management over shareholders. 4actors that could cause
directors to align more closely !ith management include#
5ack of independence ,i.e. family relationships, prior employment, or eisting
business relationships..
2nterlinked boards.
'irectors are overcompensated.
2n a principal+agent relationship, one party ,the agent. acts on behalf of another party ,the
principal.. & principal+agent problem arises !hen the agent places his o!n interests
ahead of the principal.
&n agency relationship eists !hen an individual ,the agent. acts on behalf of another
individual ,the principal.. 1uch a relationship creates the potential for a principal+agent
problem !here the agent may act for his o!n !ell being rather than that of a principal.
The key test of !hether a principal+agent problem may eist is if one party is responsible
for acting in the best interest of the other.
6hile managers are hired to make decisions to maimi0e shareholder !ealth, they may
make decisions to maimi0e their o!n !ealth. Eamples of !ays that management may
act for their o!n interests include epanding the si0e of the firm, !hich can increase the
manager%s "ob security and po!er, and managers compensated largely by stock option
taking large risks that !ill generate huge payoffs for the managers if successful, but cost
the managers nothing if they do not.
Corporate governance systems attempt to minimi0e or eliminate any potential agent
problems that may arise bet!een t!o groups# ,-. directors and shareholders and ,/.
managers and shareholders.
Eecutive compensation in the form of large amounts of stock options can cause
managers to take on too much risk as the asymmetric payoff of those options means that
managers can reap huge re!ards if the risks pay off, but !ill not share in the losses if the
risky pro"ects fail. 7ote that managers taking too little risk is also a concern, but taking
too little risk is a symptom of managers holding too much stock 89: not stock options. 2f
the manager has the bulk of their !ealth tied to company stock, the manager may !ant to
avoid risky pro"ects to protect the value of the stock even though the risky pro"ects may
do a better "ob of maimi0ing value for the firm%s shareholders.
The most important roles for the board of directors is to institute long+term strategic
ob"ectives for the company and institute corporate values that !ill insure that business is
conducted in an ethical and fair manner. The board needs to determine management
compensation !ith shareholders% best interest as their sole consideration.
d
The audit committee should consist entirely of independent board members.
The audit committee should directly oversee the internal audit staff of the company.
The audit committee should have full access to and the cooperation of management in
order to perform their duties.
Making disclosures about company operations is the responsibility of management. 2t is
the responsibility of the board to make sure management is acting in the best interests of
shareholders, !hich may entail appointing;serving on the audit committee to revie! those
disclosures.
'irectors should al!ays address all proy issues that have received a ma"ority of
shareholder votes. <esponsibilities of directors include hiring the firm%s CE3 and
determining the CE3%s compensation, and establishing corporate values and governance
structures to ensure that business is conducted in an ethical, fair, and professional manner.
e
3n the audit committee, t!o or more members should have relevant financial eperience.
The audit committee should have at least an annual meeting !ith auditors, but
management should NOT be present.
'irectors should have access to independent, not in+house legal counsel for any )uestions
related to the company%s compliance !ith regulatory re)uirements.
&ny insider or related+party transactions, such as making a personal loan to a company
CE3 should be approved in advance by the board of directors. 7ote that for purposes of
the eam, global best practice calls for =>? of board members to be independent, board
members do not serve on more than /+@ boards total, and that all directors are elected
annually.
A==-A
f
& corporate code of ethics should articulate the values, responsibilities, and ethical
conduct of an organi0ation and should be included in a statement of governance policies.
&lso, a statement of directors% oversight, monitoring, and revie! responsibilities should
include information regarding internal controls, risk management, accounting disclosure,
compliance, nominations, and compensation a!ards. A=BA@
g
Environmental, social, and governance ,"E1G". risk eposures are the nontraditional
business factors that are no! recogni0ed as critical to a company%s long+term
sustainability.
h
3ver the last fe! years, most of the ma"or corporate scandals ,i.e. Enron, 6orldcom.
have involved attempts to hide or falsify financial information provided to investors.
1ince investors rely on information provided by management to make investment
decisions, having misinformation can result in the mispricing of securities, misallocation
of capital, and ultimately a lack of confidence that can reduce the efficiency and
effectiveness of financial markets. &s a result, one of the most critical roles an analyst can
play in the corporate governance process is to evaluate the )uantity ,more is better. and
)uality of financial data that companies provide.
Companies !ith strong corporate governance systems have been sho!n to have higher
profitability and generate higher returns than companies !ith !eaker corporate
governance systems in both developed and emerging markets. 2n etreme cases, the lack
of an effective corporate governance system could lead to a company%s bankruptcy such
as the case of Enron in /CC-.
1trategic policy risk is the risk that managers may enter into transactions or incur other
business risks that !ould not be in the best long+term interests of shareholders, but !ould
result in large payoffs for managers or directors.
The primary risks of an ineffective corporate governance system include financial
disclosure risk, asset risk, liability risk, and strategic policy risk.