Corporate Governance : How It Works

What Is Corporate Governance?

Corporate governance is the system of rules, practices, and processes by which a firm is directed and controlled. Corporate governance essentially involves balancing the interests of a company's many stakeholders, such as shareholders, senior management executives, customers, suppliers, financiers, the government, and the community.

Since corporate governance also provides the framework for attaining a company's objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.

Understanding Corporate Governance

Governance refers specifically to the set of rules, controls, policies, and resolutions put in place to dictate corporate behavior. Proxy advisors and shareholders are important stakeholders who indirectly affect governance, but these are not examples of governance itself. The board of directors is pivotal in governance, and it can have major ramifications for equity valuation.

A company’s corporate governance is important to investors since it shows a company's direction and business integrity. Good corporate governance helps companies build trust with investors and the community. As a result, corporate governance helps promote financial viability by creating a long-term investment opportunity for market participants.

Communicating a firm's corporate governance is a key component of community and investor relations. On Apple Inc.'s investor relations site, for example, the firm outlines its corporate leadership — its executive team, its board of directors — and its corporate governance, including its committee charters and governance documents, such as bylaws, stock ownership guidelines, and articles of incorporation.

Most companies strive to have a high level of corporate governance. For many shareholders, it is not enough for a company to merely be profitable; it also needs to demonstrate good corporate citizenship through environmental awareness, ethical behavior, and sound corporate governance practices. Good corporate governance creates a transparent set of rules and controls in which shareholders, directors, and officers have aligned incentives.

Corporate Governance and the Board of Directors

The board of directors is the primary direct stakeholder influencing corporate governance. Directors are elected by shareholders or appointed by other board members, and they represent shareholders of the company.

The board is tasked with making important decisions, such as corporate officer appointments, executive compensation, and dividend policy. In some instances, board obligations stretch beyond financial optimization, as when shareholder resolutions call for certain social or environmental concerns to be prioritized.

A board of directors should consist of a diverse group of individuals, those that have skills and knowledge of the business, as well as those who can bring a fresh perspective from outside of the company and industry.

Boards are often made up of inside and independent members. Insiders are major shareholders, founders, and executives. Independent directors do not share the ties of the insiders, but they are chosen because of their experience managing or directing other large companies. Independents are considered helpful for governance because they dilute the concentration of power and help align shareholder interests with those of the insiders.

The board of directors must ensure that the company's corporate governance policies incorporate the corporate strategy, risk management, accountability, transparency, and ethical business practices.

Examples of Corporate Governance

Volkswagen AG

Bad corporate governance can cast doubt on a company's reliability, integrity, or obligation to shareholders; all of which can have implications on the firm's financial health. Tolerance or support of illegal activities can create scandals like the one that rocked Volkswagen AG starting in September 2015.

The development of the details of "Dieselgate" (as the affair came to be known) revealed that for years the automaker had deliberately and systematically rigged engine emission equipment in its cars in order to manipulate pollution test results in America and Europe. Volkswagen saw its stock shed nearly half its value in the days following the start of the scandal, and its global sales in the first full month following the news fell 4.5%.

VW's board structure was a reason for how the emissions rigging took place and was not caught earlier. In contrast to a one-tier board system that is common in most companies, VW has a two-tier board system, which consists of a management board and a supervisory board. The supervisory board was meant to monitor management and approve corporate decisions; however, it lacked the independence and authority to be able to carry out these roles.

The supervisory board comprised a large portion of shareholders. Ninety percent of shareholder voting rights were controlled by members of the supervisory board. There was no real independent supervisor; shareholders were in control of the supervisory board, which canceled out the purpose of the supervisory board, which was to oversee management and employees and how they operate within the company, which of course, included rigging emissions.

Enron and Worldcom

Public and government concern about corporate governance tends to wax and wane. Often, however, highly publicized revelations of corporate malfeasance revive interest in the subject. For example, corporate governance became a pressing issue in the United States at the turn of the 21st century, after fraudulent practices bankrupted high-profile companies such as Enron and WorldCom.

The problem with Enron was that its board of directors waived many rules related to conflicts of interest by allowing the chief financial officer (CFO), Andrew Fastow, to create independent, private partnerships to do business with Enron. What actually happened was that these private partnerships were used to hide Enron's debts and liabilities, which would have reduced the company's profits significantly.

What happened at Enron was clearly a lack of corporate governance that should have prevented the creation of these entities that hid the losses. The company also had a corporate atmosphere that had dishonest people at the top (Fastow) down to its traders who made illegal moves in the markets.

Both the Enron and Worldcom scandals resulted in the 2002 passage of the Sarbanes-Oxley Act, which imposed more stringent recordkeeping requirements on companies, along with stiff criminal penalties for violating them and other securities laws. The aim was to restore public confidence in public companies and how they operate.

PepsiCo

It's common to hear of bad corporate governance examples, mainly because it is the reason some companies blow up and end up in the news. It's rare to hear of companies with good corporate governance because it is the good corporate governance that keeps them out of the news as no scandal has occurred.

One company that has consistently practiced good corporate governance and seeks to update it often is PepsiCo. In drafting its 2020 proxy statement, PepsiCo took input from investors to focus on six areas:

The company included in its proxy statement a side-by-side graphic that depicted the current leadership structure, which shows a combined chair and CEO along with an independent presiding director, and a link between the compensation of the company's "Winning With Purpose" vision and changes to the executive compensation program.

Special Considerations

As an investor, you want to ensure that the company you are looking to buy shares of practices good corporate governance, in the hope of avoiding losses in cases such as Enron and Worldcom. There are certain areas that an investor can focus on to determine whether a company is practicing good corporate governance or not.

These areas include disclosure practices, executive compensation structure (is it tied only to performance or other metrics?), risk management (what are the checks and balances of making decisions in the company?), policies and procedures on reconciling conflicts of interest (how does a company approach business decisions that might conflict with its mission statement?), the members of the board of the directors (do they have a stake in profits?), contractual and social obligations (how do they approach areas such as climate change?), relationships with vendors, complaints received from shareholders and how they were addressed, and audits (how often are internal and external audits conducted and how have issues been handled?).

Types of bad governance practices include:

These are all areas an investor can research before making an investment decision.

Corporate Governance FAQs

What Are the 4 Ps of Corporate Governance?

The four P's of corporate governance are people, process, performance, and purpose.

Why Is Corporate Governance Important?

Corporate governance is important because it creates a system of rules and practices that determine how a company operates and how it aligns the interest of all its stakeholders. Good corporate governance leads to ethical business practices, which leads to financial viability.

What Are the Basic Principles of Corporate Governance?

The basic principles of corporate governance are accountability, transparency, fairness, and responsibility.

What Are Examples of Corporate Governance?

Examples of corporate governance include the Anglo-US model, the German model, and the Japanese model.

The Bottom Line

Corporate governance consists of the guiding principles that a company puts in place to direct all of its operations, from compensation to risk management to employee treatment to reporting unfair practices to its impact on the climate, and more.

A strong, transparent corporate governance leads a company to make ethical decisions that benefit all of its stakeholders, allowing the company to place itself as an attractive option to investors if its financials are also healthy. Bad corporate governance leads to a breakdown of a company, often resulting in scandals and bankruptcy.