Corporate governance is the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome the conflicts of interest inherent in the corporate form.
Corporate governance has two major objectives:
1. Eliminate or reduce conflicts of interest. Although many conflicts of interest exist in a corporation, most corporate governance systems focus on the conflict between management and shareholders.
2. Use the company's assets in a manner consistent with the best interests of investors and other stakeholders.
Corporate governance systems will differ according to the legal environment, culture, and industry in which a firm operates; however, there are core attributes that all effective corporate governance systems share. An effective corporate governance system will:
1. Define the rights of shareholders and other important stakeholders.
2. Define and communicate to stakeholders the oversight responsibilities of managers and directors.
3. Provide fair and equitable treatment in all dealings between managers, directors, and shareholders.
4. Have complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position.
Sole proprietorship are businesses owned and operated by a single individual. Setting up a sole proprietorship is relatively easy and has few legal requirements, thus making it the most common form of business in the world. From a legal standpoint, there is no distinction between the business and its owner, resulting in liability for the owner that is potentially unlimited.
Conflict of interest concerns. Since the owner and manager of a sole proprietorship is the same, conflicts between management and owners don't exist. Conflicts of interest for a sole proprietorship typically involve creditors and suppliers.
Partnerships are composed of two or more owners/managers, but are otherwise similar to a sole proprietorship in that there is no legal distinction between the business and its owners. Liability is limited, but is shared among the partners. The primary advantage of the partnership structure is that partners can pool knowledge and capital, as well as share in business risks.
Conflict of interest concerns. The conflicts for partnerships are similar to those of sole proprietorship, involving creditors and suppliers. Potential conflicts between partners are typically addressed by creating partnership contracts that delineate the roles and responsibilities of each partner.
Corporations are distinct legal entities that have rights similar to those of an individual person. The top managers of a corporation are empowered to act as agents of the company and control all corporate activities, including signing contracts, on behalf of the business.
Compared to sole proprietorship or partnerships, corporations have several advantages:
1. It is much easier to raise large amounts of capital. The corporation can raise capital by issuing common stock to the public, selling ownership interests to private investors in exchange for cash, or borrow money from creditors.
2. There is no need for owners to be industry experts. Any individual with sufficient capital can become a shareholder.
3. Ownership stakes are easily transferable, which allows the corporation to have an unlimited life.
4. Corporate shareholders have limited liability. Since there is a legal distinction between a corporation and its shareholders, the most a shareholder can lose is the amount invested best.
Conflict of interest concerns. Corporate shareholders typically have no input in day-to-day management of the firm and usually have difficulty monitoring a firm's operations and the actions of management. Separation of ownership and control creates the potential for conflicts between management and shareholders.
An agency relationship occurs when an individual, who is referred to as the agent, acts on behalf of another individual, who is referred to as the principal. Such a relationship creates the potential for a principal agent problem where the agent may act for his own well-being rather than that of the principal.
Managers and shareholders. The managers (the agents) make the day-to-day business decisions on behalf of the shareholders (the principals). Therefore, managers are effectively trustees of the capital belonging to the shareholders who, in turn, rely on management to use the funds efficiently to generate profits. Shareholders want management to make decisions that maximize shareholder wealth, but managers, left on their own, may well make decisions that maximize their own wealth. Examples of ways that management may act for their own interests rather than those of shareholders include:
> Using funds to expand the size of the firm. A larger firm may increase the managers' job security, power, and compensation without benefiting the shareholders.
> Granting excessive compensation and perquisites. Managers may give themselves high salaries and perquisites, such as corporate jets and lavish apartments that are expensed as normal business expenses, forcing shareholders to bear the costs.
> Investing in risky ventures. This is one of the key criticisms leveled against excessive use of executive stock options. By virtue of the nature of their position, managers often stand to reap benefits if the risky venture succeeds, but do not share in losses if the venture fails.
> Not taking enough risk. Conversely, extremely risk-averse managers who have the bulk of their wealth tied to the firm stock may only invest in conservative projects to protect that wealth and avoid potentially risky projects that would do a better job of maximizing value for shareholders.
Directors and shareholders. The purpose of the board of directors of a corporation is to serve as an intermediary between shareholders and management to help ensure that management is acting in the shareholders' best interest. The conflict between directors and shareholders occur when directors align more with management interests rather than those of shareholders. The following factors may cause directors to align more closely with managers than shareholders:
> Lack of independence. Board members that are tied to the company or that may themselves be managers are less likely to identify with shareholder concerns.
> Board members have personal relationships with management. Board members may be asked to join the board because of a friendship or family ties with senior management.
> Board members have consulting or other business agreements with the firm. Business agreements may give the boardmember a duel responsibility of answering to management as a consultant while also supervising management as a board member.
> Interlinked boards. Senior managers of Firm A may serve as directors in Firm B, while Firm B's senior managers are on the board of Firm A.
> Directors are overcompensated. The goal of maintaining their excessive compensation may cause directors to accommodate management wishes rather than protect the best interests of shareholders.
The board of directors for a corporation has the responsibility to:
1. Institute corporate values and corporate governance mechanisms that will ensure business is conducted in a proficient, ethical, and fair manner.
2. Ensure that the firm meets and complies with all legal and regulatory requirements in a timely manner.
3. Create long-term strategic objectives for the company that are consistent with the shareholders' best interests.
4. Determine management's responsibilities and how managers will be held accountable. Performance should be measured in all areas of a company's operations.
5. Hire, appropriately compensate, and regularly evaluate the performance of the chief executive officer.
6. Require management to supply the board with complete and accurate information in order for the board to make decisions for which it is responsible and adequately monitor company management.
7. Meet regularly to conduct its normal business, and attend extraordinary sessions when necessary.
8. Ensure board members are adequately trained to perform board functions.
In order to determine the effectiveness of the board of directors, investors or investment analyst must assess:
1. The composition of the board of directors and whether or not directors are independent. In order to assure the directors are serving shareholders, global best practice recommends that at least three-quarters of board members should be independent.
2. Whether the board has an independent chairman. Many companies have a single individual serve the dual role of CEO and chairman of the board. Some arguments support the dual role as providing the board with in-depth knowledge and experience regarding company strategy and operations. However, others claim that having the CEO chairing board meetings allows the CEO to control the board's agenda and diminishes the role of independent board members, particularly when determining management compensation. For the exam, remember that having the CEO and Chairman as separate positions is considered a strong corporate governance practice.
3. Qualifications of directors. Corporate governance best practice is for board members to have the requisite industry, strategic planning, and risk management knowledge, not serve on more than two or three boards, and show a commitment to investor interests and ethical management and investing principles.
4. How the board is elected. Strong corporate governance practice says that staggered elections limits the power of shareholders and doesn't allow changes to the board composition to occur quickly. Annual elections force directors to make more careful decisions and be more attentive to shareholders because they can cast a vote to keep or eliminate a director each year.
5. Board self-assessment practices. Boards should evaluate and assess their effectiveness at least annually. The focus of the self assessment should be on member participation, committee activities, and future needs of the board.
6. Frequency of separate sessions for independent directors. Best practice requires independent board members to meet at least annually, preferably quarterly, in separate sessions without management in attendance.
7. Audit committee and audit oversight. Best practice mandates that the audit committee consists only of independent directors, has expertise in financial and accounting matters, has full access to and the cooperation of management, and meets with auditors at least once annually.
8. Nominating committee. The nominating committee is responsible for establishing criteria for identifying and evaluating candidates for the board of directors as well senior management. Corporate governance best practice requires that the nominating committee consist only of independent directors.
9. Compensation committee and the compensation awarded to management. A common industry practice that is considered poor corporate governance is to use the salary at other companies as a reference point rather than on company performance. Another poor practice is the repricing of stock options, which allows management to recoup losses after stock price decline. Best practice would have base salary and perquisites as a small percentage of compensation, with bonuses, stock options, and grants of restricted stock awarded for exceeding performance goals making up the majority of the senior manager's income.
10. Use of independent or expert legal counsel. A common practice is for internal corporate counsel to advise the board of directors, but this is considered weak governance, because of the potential for conflict of interest. Corporate governance best practice is for the board to use independent, outside counsel whenever legal counsel is required.
11. Statement of governance policies. Statements provided in shareholder materials about corporate governance policies, and how those policies change over time, can be a great tool for analysts and investors in evaluating a firm's corporate governance system.
12. Disclosure and transparency. In general, best practice supports the conclusion that more disclosure is better. The company should provide information about organization structure, corporate strategy, insider transactions, compensation policies, and changes to governance structures.
13. Insider or related party transactions. Best practice for any related party transaction is to have the transaction approved by the board of directors.
14. Responsiveness to shareholder proxy votes.
Investors and analysts should assess the following policies of corporate governance:
1. Codes of ethics. A corporate code of ethics articulates the values, responsibilities, and ethical conduct of an organization.
2. Directors' oversight, monitoring, and review responsibilities. These include statements regarding internal controls, risk management, audit and accounting disclosure policies, regulatory compliance, nominations, and compensation.
3. Management's responsibility to the board. These include management's responsibility to provide complete and timely information to board members, and to provide directors with direct access to the company's control and compliance functions.
4. Reports of directors' oversight and review of management.
5. Board self assessments.
6. Management performance assessments.
7. Director training. Includes training that is provided to directors before they join the board as well as ongoing training.