Corporate Governance

Corporate governance refers to a system of practices, policies, and procedures that guide the conduct of business. These systems and procedures serve as guidelines for accountable and ethical decision making in organizations.

There is no single “best” model, but the crux of corporate governance is the relationships an organization has with its stakeholders, including shareholders and investors, the board of directors, management, employees, customers, suppliers, government, and financial institutions, as well as communities affected by the activities of the business. These stakeholders exist in a mutually reinforcing relationship, and aligning and balancing their interests, rights, and responsibilities is an important function of corporate governance.

This entry discusses the relevance of corporate governance and maps out the primary actors and the mechanisms and frameworks of corporate governance. Using illustrative cases from recent history, the entry delineates the reputation imperative and concludes with a holistic look at corporate governance.

Relevance of Corporate Governance

The business case for corporate governance is premised on its ability to contribute to sustained value creation by enabling access to capital, increasing investor confidence, improving economic efficiency, and managing risk. The Cadbury report published in the United Kingdom in 1992 is considered a turning point in the investigation of corporate governance. The report was the first to propose a Code of Best Practice for how companies should be directed and controlled.

Processes of globalization and the movement of business across geographic borders have made it imperative to understand how systems of governance affect competitive advantage and corporate performance. However, the growing incidence of management fraud and accounting scandals in several major corporations since the early 2000s (e.g., Enron, WorldCom, Parmalat) and, most recently, the global financial recession have intensified scrutiny of corporate behavior and decision making.

The case of Enron is entrenched as the modern face of corporate governance failure, conflicts of interest at the board and management levels, the pressure to maximize returns, and a culture of winning at all costs. The 2001 fraud revealed that Enron’s growth to the position of the largest energy trader in the United States was the result of inflated accounting (according to reports, Enron had overstated profits by $586 million for five years preceding the collapse) and refusal to disclose information to investors. The collapse of Enron jeopardized more than 20,000 jobs and the credibility of its auditors (the erstwhile Arthur Andersen), and the company’s share price tumbled from a high of US$90 to 61 cents. These and other corporate failures have highlighted the weaknesses in governance mechanisms, lack of regulatory oversight, ineffective board functioning, excessive executive remuneration, and questionable practices to circumvent rules and maximize returns.

Trust in corporations and corporate leaders has progressively declined as a result of corporate scandals. As a fallout of the Enron case, companies rushed to create codes of ethics, and the call for regulatory reform resulted in the introduction of the Sarbanes-Oxley Act of 2002, which has had mixed results. One of the major criticisms of the act was that the costs of compliance were much higher than the purported benefits. The growth of white-collar crime despite regulatory reform reaffirmed the relevance of corporate governance and highlighted the limitations of a purely legal perspective on corporate behavior. All firms are obligated to comply with the legal stipulations and legislations governing the countries in which they operate. However, compliance with the law or establishing codes of conduct without the accompanying effort to integrate these into corporate culture offers a limited “tick-in-the-box” approach.

The Ponzi scheme perpetrated by Bernard Madoff illustrates the case. Madoff ran a fake hedge fund for 16 years that lured investors with the promise of exceptional returns but ended up with thousands of investors losing much or all of their investment. Madoff’s ability to continue operations undetected is attributed to his professional experience in the finance industry and the fact that prior complaints raised with the Securities and Exchange Commission had been ignored or dismissed. Investigations illuminated the corporate-state nexus that ignored the warning signs and the red flags. So while compliance with the law is an important starting point, corporate governance is a matter of understanding the interdependencies among society, business, and government.

One of the important outcomes of corporate crises has been the focus on voluntary disclosure. Companies’ laws include some requirements on mandatory disclosure (e.g., the statement on compliance with the codes/laws), but voluntary reporting is based on the assumption that proactivity will build trust through transparency. Most corporate websites now offer insight into firm-level governance frameworks and structures. For example, in the Tata Group, an Indian business conglomerate with a global presence, a values-driven approach characterizes the way business is conducted. Founded in 1868, the Tata Group comprises more than 100 operating companies with a presence in 100-plus countries. The group’s core values (integrity, understanding, excellence, unity, and responsibility) are codified in a comprehensive, 25-clause code of conduct that addresses matters ranging from commitment to advancing national interests, to appropriate behavior in cases of conflict of interests, to reporting ethical violations. Likewise, in General Electric, the governance principles outline the roles and responsibilities of the board, board committees, and standards of conduct.

But does effective corporate governance lead to improved firm performance? The answer is inconclusive, at least in empirical research, largely due to differences of opinion about how best to evaluate the relationship between corporate governance variables and firm performance. Some scholars caution against drawing conclusions about future performance and quality of governance based on an organization’s ranking on singular measures in a “one-size-fits-all” approach, and they propose that the context and circumstance need to be taken into consideration. Moreover, there is growing recognition of the potential, reputational benefits of good governance and an understanding of the impact of fraudulent practices in engendering stakeholder distrust.

Key Actors in the Corporate Governance Framework

Shareholders

They are the owners of a business. In addition to individual shareholders, the role of institutional investors in capital markets is important to note. By virtue of the capital they can invest (or withhold), these financial institutions and fund management companies have the potential to exercise significant influence on the workings of an organization. Investigations of the current global financial crisis have found that institutional investors did not exercise active oversight, ignored established principles of governance, and allowed risky financial strategies to go unchecked in the hope of higher returns.

Board of Directors

The board is generally seen as the apex of internal governance mechanisms. It is elected by the shareholders and historically considered an “agent” of the shareholders to direct the company. To mitigate the “agency problem” that treats the board as merely agents to execute the will of the business owners, the appointment of independent directors has become an integral part of corporate governance. Although board structures may vary by country, a minimum ratio for a majority of independent outsiders (independent of management and shareholders) on the board is generally recommended or stipulated; in some cases, the frameworks also encourage separation of the positions of board chair and CEO. Simply having outside directors is not enough, however; they have to be able to exercise independent judgment without interference from the shareholders, management, and/or inside directors.

The board is responsible for the strategic oversight of business, and members serve on specific board-level committees (e.g., audit, compensation/remuneration, nomination, risk management) to oversee the ethical and compliant conduct of business. Some scholars note that the dominant narrative of monitoring and oversight as the primary function of directors may obscure other roles that directors may perform, such as conflict resolution among relevant stakeholders in the corporation.

CEO and Management

Although some frameworks encourage the separation of the CEO from the board, in most cases, the CEO serves as the chairman of the board. The CEO—along with the management team and employees—is responsible for executing corporate strategy with a view to sustainable value creation. The CEO is also the interface and liaison between the board and the management of the company. The World Bank posits that transparency, accountability, fairness, and responsibility ought to be the pillars underscoring the foundation of trust among key stakeholder groups (shareholders, directors, and managers).

Employees

Most leading corporations recognize the value of a positive reputation in attracting and retaining talent. By extension, businesses are responsible to account for the interests of employees and to engage them in decision making. For example, a European Union directive (first introduced in 1994 and modified in 2009) requires that companies with 1,000 or more employees within member states or 150 employees each in two different states appoint a Works Council, comprising worker representatives, as a mechanism for information and consultation of employees. To counter fraud, it is also recommended that companies establish codes of conduct, undertake frequent audits, and institute whistleblower protection policies to encourage employees to report corrupt, unethical, and questionable business practices. Following stakeholder consultation, Transparency International has proposed a set of principles for whistleblowing legislation, including incentivizing internal reporting, ensuring anonymity, protection from retribution, and the appointment of a public body to review, discuss, and promote the framework and all related matters.

Government

Government is responsible for macroeconomic and social policy. Although governments have the power to make and enforce governance legislation, regulation by itself may be inadequate. Likewise, only having self-regulation and voluntary standards is not likely to be effective (as recent corporate failures have demonstrated); hence, the discussion about the form, design, and enforcement of regulation continues to be relevant.

Corporate Governance Frameworks and Mechanisms

Roughly speaking, two models of corporate governance are found in scholarship—the “outsider” and “insider” models. The primacy of shareholders has characterized the so-called Anglo-Saxon, principal-agent, or outsider model of corporate governance, in which ownership and control are separated between shareholders and managers, respectively. To ensure that managers function in a manner that best serves the interests of the shareholders, this model relies on external control mechanisms to mitigate managerial discretion. That managers are self-serving individuals whose interests may not always align with those of the shareholders is the central premise of agency theory, which has been a dominant perspective in extant scholarship as well as the practice of corporate governance. In this view, corporate governance mechanisms—both external and internal—serve to assure stakeholders of favorable outcomes. By contrast, an insider model, generally equated with a stakeholder model, posits a purpose beyond maximization of shareholder value in favor of operating in the interest of stakeholders. Stakeholders are entities that have an interest in the organization. That said, there is growing agreement that these dichotomous models do not account for the variations in cross-national approaches to corporate governance.

Business organizations have different frameworks and structures for corporate governance that are a result of firm-level (e.g., vision, mission, values, corporate strategy, leadership) and institutional (e.g., social, political, legal, economic) considerations. Internally, one can think of corporate governance as a system of checks and balances whereby company management is supervised and monitored by a board of directors, who, in turn, are accountable to the company and the owners/shareholders. These internal mechanisms operate within a system of rules and legislation, as part of company laws or securities laws, laid down by regulatory actors and government authorities. In the United States, the Securities and Exchange Commission is the primary federal regulator, although state law constitutes the primary legal source for corporate governance. In India, the Securities and Exchange Board of India regulates capital markets, and the Ministry of Corporate Affairs is responsible for the Companies Act as well as enforcement of governance issues. In the Netherlands, the role of the public regulator is limited to issues of disclosure or the securities law; in principle, civil rules on corporate governance are the domain of the supervisory board and the shareholders. Some countries may supplement laws and regulations with national codes and principles. China’s legal framework of governance has a multitiered, four-layer system of (1) basic laws, (2) administrative regulations, (3) regulatory provisions, and (4) self-disciplinary rules.

While variations in form and structure manifest at the firm and country levels, international institutions such as the Organisation for Economic Co-operation and Development (OECD) play an important role in defining broad-based standards and guidelines. In 2004, the OECD outlined six principles of corporate governance:

1. A corporate governance framework should be established that enables transparent, efficient, and legally compliant business processes and clarifies the division of power and responsibility among relevant entities.
2. The rights of shareholders should be protected in the corporate governance framework.
3. All shareholders (including minority and foreign shareholders) should be treated in an equitable manner and have equal opportunity to redress grievances.
4. The legal and agreed-on role and rights of stakeholders must be recognized and upheld in the corporate governance framework, and corporations should encourage stakeholder involvement in matters relating to the conduct of business (“creating wealth, jobs, and the sustainability of financially sound enterprises” [OECD, p. 21]).
5. Transparency and timely and accurate disclosure about all matters relevant to governance should be a cornerstone of the corporate governance framework.
6. The responsibilities of the board include providing strategic direction to the organization and performing the dual role of monitoring management while being accountable to the shareholders and the company.

Of course, the specific form and application of national or transnational frameworks may vary owing to differences in ownership structures (e.g., public, private, family owned), national and cultural contexts, the role and commitment of leaders and managers, as well as the power of institutional mechanisms to monitor and enforce these standards.

Ownership structures and institutional variations play a very important role in shaping corporate governance systems across the world. Especially in emerging markets, the preponderance of state-owned/public sector enterprises as well as family-owned firms presents a unique set of conditions and risks for corporate governance. In family firms, the overlap between owners and managers may create conflict and result in a lack of professionalism, interference of personal relationships in business decisions, and nepotism in matters of promotion and/or succession. Likewise, management in state-owned enterprises may suffer from unclear or multiple lines of accountability when negotiating political and bureaucratic interests, which may affect their competitive edge and responsiveness. Therefore, these forms of ownership necessitate the examination of cross-national differences while also presenting opportunities to develop strategies to promote clarity in control, transparency in reporting, professionalism, and accountability.

The Reputation Imperative for Corporate Governance

Just as tangible resources constitute an organization’s assets, corporate reputation is perhaps the most important intangible asset for an organization. The Reputation Institute includes (1) governance as one of the seven drivers—along with (2) innovation, (3) workplace practices, (4) products and services, (5) citizenship, (6) financial performance, and (7) leadership—that constitute a firm’s reputation. Reputational capital is positively related to the ability to attract and retain talent and to generate high brand loyalty and positive word of mouth, and is a source of competitive advantage.

Some scholars posit that reputation may act as a social control mechanism that deters opportunistic behavior in favor of collaborative, exchange relationships. By this logic, both managers and firms that engage in “controversial” or “self-serving” governance practices should suffer reputational penalties. The flipside may be that fear of loss of reputation could act as a deterrent, discouraging firms from reporting governance problems for fear of repercussions. Encouraging and providing a safe space for reporting questionable practices, then, becomes important for creating a corporate culture that values transparency and ethical behavior.

For the reputational imperative to be fully appreciated and translated into practice, there needs to be a clear understanding of the internal organizational processes that result in a positive reputation. Ways in which these goals may be accomplished include being consistent, authentic, and transparent in corporate communication; ensuring that ethical conflicts are reported, addressed, and not silenced; and equipping managers to deal with crises. The role of the CEO is paramount in building corporate reputation and fostering internal alignment and coordination. Frequent and thorough assessments of the state of the firm’s reputation, staying attuned to evolving stakeholder beliefs and expectations, and making reputation a top priority at the highest levels of the organization are considered good practices in managing and addressing reputational risks.

Moreover, reputation and firm performance exist in a symbiotic relationship such that reputational capital is both an outcome of corporate behavior and an antecedent to corporate success. Studies have shown that the state of governance, specifically disclosure, transparency, and quality of management teams, is a key criterion in making investment decisions. Highly reputed organizations generally benefit from low-risk and superior financial performance relative to firms that do not enjoy positive reputations. In the wake of the global economic crisis, trust and transparency have superseded financial performance as a driver of reputation.

Loss of trust has serious implications. A prime example is the financial services sector, which globally ranks among the least trusted of all industries since 2011, according to the Edelman Trust Barometer. Accounting for regional variation, the general lack of trust, especially in developed countries, corresponds with the demand for more regulation of this sector. Creating trust in organizations is indeed a herculean task. Once lost, trust and reputation are not easily restored or regained. The Edelman Trust Barometer has identified five clusters of behaviors—(1) engagement, (2) integrity, (3) products and services, (4) purpose, and (5) operations—that help build trust. Although integrity and respect have been among the most cited corporate values, often arousing skepticism, there is evidence to suggest that (employee) perceptions of integrity are positively correlated with improved productivity, higher levels of identification, and profitability. Thus, firms that develop a corporate culture resting on values such as integrity are likely to reap long-term benefits.

A Holistic Perspective on Corporate Governance

The embeddedness of business in systems of formal and informal rules highlights the linkages with political and social considerations in a given context such that corporate governance systems are a reflection of policy decisions. There is now agreement that the agendas of corporate governance and corruption are closely aligned and a microenvironment of corruption has a significant impact on national competitiveness and development, the ability to attract foreign capital, the cost and ease of doing business, and socioeconomic equality. There is evidence to show that as emerging economies compete to secure international business and foreign direct investment, the state of political governance is a decision factor. To illustrate, a survey of the World Economic Forum in 2014 finds that in spite of being among the top four global markets for retail investment, the attractiveness of India as a retail destination is undermined by the risk of corruption and bribery being a prerequisite for running a business.

In terms of scholarship and research, there is an effort to extend the theoretical and disciplinary perspectives on corporate governance. Whereas agency theory has been a dominant paradigm, institutional perspectives provide a much-needed macroperspective and situate the conduct of business organizations in an interdependent context of institutional domains, policies, ideologies, and processes. Deploying an institutional lens to examine how the political economy and institutional configurations affect firm-level corporate governance is also suited to the analysis and understanding of cross-national variations.

Despite variations in models and structures, adopting an inclusive approach to governance and to the conduct of business, more generally, is considered best practice. The attention to balancing and aligning the interests of relevant stakeholders, including shareholders, is prompting organizations to integrate matters of corporate social responsibility into business strategy and to participate in global, voluntary reporting initiatives such as the Global Reporting Initiative. Good corporate governance is not limited to improving organizational accountability and performance but also involves addressing broader societal and environmental issues.

In addition to the role of formal institutional actors (e.g., government), the role of the media and advocacy groups/watchdog groups in influencing corporate behavior is increasingly becoming a focus in the study of corporate governance. Moreover, the role of organizational leadership in facilitating ethical cultures and modeling socially responsible behavior is considered an integral dimension in furthering the governance agenda.

In sum, corporate governance needs to be viewed as a systemic issue. The future of corporate governance lies in a holistic approach involving individual, organizational, and sociopolitical reforms.