What is Corporate Governance?

Corporate governance is like the rules of a board game…

When you play a board game, you have to follow specific rules. Some are set forth by the creators. Others are unofficial rules that everyone agrees to abide by (no cheating, for example). There may be no official enforcer, but that doesn’t mean there aren’t repercussions (people probably won’t want to play board games with you if you cheat). Corporate governance is similar — Legal and ethical principles guide companies and their operations. Those that fail to comply might find themselves in legal trouble or discover that others don’t want to do business with them.

Corporate governance refers to all the principles, processes, and laws that guide a corporation. Basically, it’s the system through which companies are managed and controlled. Corporate governance starts at the top with the board of directors, which oversees the direction of the company and helps craft its vision. Shareholders, who have a financial stake in the company and often voting rights, also play a role in corporate governance. So does the management team, led by a chief executive officer (CEO), which executes long-term strategy and runs the company day-to-day.

Corporate governance is a balancing act between the interests of a company’s stakeholders, including shareholders, executives, managers, employees, customers, vendors, the government, and the larger community.

State and federal regulations guide a company’s corporate governance. One example is the Securities Exchange Act of 1934, which created the Securities and Exchange Commission to oversee securities markets. The law also requires corporations to disclose certain information relevant to shareholders and potential investors. Other aspects of corporate governance arise out of internal or industry guidelines.

Corporate governance has several purposes. First, it creates guardrails to help companies comply with state and federal regulations. With the right systems in place, companies can avoid violating laws and running into trouble with regulators.

Corporate governance also helps a company consider and balance the interests of all parties, including the board of directors, executives, shareholders, customers, and the community. Socially responsible practices can also drive brand loyalty or attract talent.

Finally, corporate governance helps create a framework that increases the likelihood that a company will achieve long-term success and ultimately increase profits.

At the very top of any corporation are the shareholders that own the company. Except for major shareholders, they generally don’t have a hands-on role in corporate governance. Instead, a committee within the company nominates board members, and shareholders approve them.

The board of directors doesn’t generally participate in business operations. Instead, It oversees the company and approves a strategic direction. One of the board’s essential duties is choosing the company’s chief executive officer (CEO).

The board also plays a key role through its committee structure. An audit committee oversees preparation of a firm’s financial statements, chooses an outside auditor, and manages an internal audit of financial reports. A compensation committee crafts the company’s executive compensation policy, and a nominating (or corporate governance) committee nominates members for the board and committees.

Management, led by the CEO, are responsible for running the company. They develop and execute the company’s business strategy, with the board’s approval. They allocate capital resources, prepare operating budgets, and ensure the accuracy and timeliness of the company’s financial statements.

Business Roundtable, an association of chief executives at leading US companies, lists eight guiding principles of corporate governance:

1. Boards of directors should set the tone for an ethically run company. They can do this by approving corporate strategies, choosing and overseeing a chief executive officer (CEO), managing risks, and allocating capital to ensure long-term growth.
2. The goal of a corporation is to create long-term value sustainably. A company’s management should keep this in mind as it creates and implements strategy.
3. Managers should issue honest and timely financial statements that accurately depict the company’s current condition.
4. The board’s audit committee should oversee the company’s risk management and compliance programs, its relationship with an outside auditor, and its internal financial reporting controls.
5. The company should prioritize engagement, diversity, and company needs when choosing people to sit on the board. The board should act as leaders for the rest of the company.
6. The board’s compensation committee should create executive compensation guidelines that it believes fit the company’s philosophy and motivates leaders to create long-term value.
7. Boards of directors should engage with shareholders on issues that affect the company’s long-term value. The company should prioritize transparency and accountability.
8. Boards of directors should consider the interests of customers, employees, suppliers, and other stakeholders when it comes to crafting the company’s strategy.

It’s important to note that each corporation adopts its own unique set of guiding principles. — There’s no single list for all to follow. Some corporations choose to place a higher premium on principles such as honesty and transparency, community engagement, corporate social responsibility, environmental consciousness, and sustainability.

The corporate governance of any particular company depends in large part on the laws and corporate culture of the country they’re based in.

Traditionally, there have been three primary models of corporate governance: the Anglo-US model, the Japanese model, and the German model. More recently, scholars at Oxford University identified a fourth: the founder-centric model.

The Anglo-US model of corporate governance is most common in the US and the United Kingdom. This model relies primarily on the equity financing (aka ownership by investors) method that corporations use to raise capital.

Corporations in the Anglo-US model have three primary stakeholders that run the show: the shareholders, the board of directors, and management.

The Anglo-US model is unique in that the people who own the company (the shareholders) are generally separate from the people who run the company (the management). The board of directors acts as the middleman, although the board has a fiduciary duty to the shareholders. That means the board has a legal and ethical responsibility to act in the best interest of the shareholders.

Companies in the Anglo-US model are accountable to plenty of other stakeholders, beyond the three primary parties. These include government regulators and stock exchanges where people buy and sell shares of the company.

Equity financing plays a critical role in corporations under this model, but not in the same way as it does in the US. Rather than being independent parties with voting power as shareholders, most shareholders in the Japanese model are insiders.

A bank is generally one of the primary shareholders in Japanese companies. Outside shareholders typically have less say in the company’s operations, while the bank and inside shareholders have a stronger voice. As in the Anglo-US model, the government is also a stakeholder as it regulates the country’s corporations.

The German model is a hybrid. Like the Anglo-US model, it involves a supervisory board of external stakeholders. Like the Anglo-US model, the board often includes shareholders. The German model also often includes labor union representatives.

Like the Japanese model, the German model includes a management board that consists of insiders such as company executives. Like Japanese corporations, German companies rely heavily on bank financing, along with a lesser amount of equity financing. As a result, outside shareholders own less of any given company.

In 2017, scholars at Oxford University’s law school introduced another model of corporate ownership.

Unlike many corporations, founder-centric companies often don’t have a large number of shareholders that all have a minority stake in the company. Instead they tend to have fewer, more dominant shareholders. Those individuals are often active members of the board and members of senior management. In these companies, the founder also often acts as the face of the company, taking on a far more public role than many other company leaders. Facebook is an example of a company that operates under this model.

Good corporate governance can be beneficial, not just for any single company, but for society as a whole. First, effective corporate governance can help companies avoid penalties and lawsuits. If a corporation has systems of oversight in place to ensure that it is following laws and regulations, it is less likely to violate them.

Next, good governance can improve a company’s reputation. Having a good brand image can help companies form relationships with business suppliers, nonprofit organizations, government agencies, business leaders, and the media. It can help a company stand out from its competitors and attract loyal customers.

In the long run, good corporate governance may help increase profits for a company. Corporations that can attract top talent because of their reputation and avoid legal and regulatory pitfalls are better set up for long-term success. Companies that demonstrate strong governance may also be more likely to attract investors.