What Is Corporate Governance? Definition, Overview & How It Works

KEY TAKEAWAYS

• Corporate governance is a distinct set of processes, practices, and rules. They are used to help manage and direct a company.
• The board of directors is a primary force. This is behind influencing and implementing corporate governance.
• There are several principles of corporate governance. With some of the most common being responsibility, accountability, fairness, and transparency. 
• Corporate governance frameworks can include everything from corporate strategy and compensation. To risk management, and ethical behavior. 

What Is Corporate Governance?

Corporate governance is a broad system of control and direction. It helps direct a company’s board of directors in the way they govern and oversee the business. The system includes various processes, practices, and rules. As well, it involves the need to balance the interests of stakeholders in the company. 

These stakeholders can include senior management executives, shareholders, and customers. As well as financiers, suppliers, the community, and the government. The framework of corporate governance is wide-ranging. And it includes every element of management. For example, internal controls, performance measurement, and corporate disclosure. And the action plans all fall under the framework of corporate governance. 

What Is the Purpose of Corporate Governance? 

The concept of corporate governance relates to putting certain policies and controls. As well as rules, and resolutions. This is to help direct and dictate corporate conduct. The board of directors of a company plays a critical role in how it is governed. And it can play a big role in equity valuation. 

Investors see corporate governance as an incredibly important metric. This is to determine the business integrity and the direction the company is heading in. When a company has effective corporate governance, it establishes a level of trust. This is with the community as well as investors. 

Through this, corporate governance essentially promotes a sense of financial viability. This is done through long-term investment opportunities. A company will outline its corporate leadership. Including the board of directors and its executive team. As well, it will often provide an overview of its corporate governance. 

This will include details about company bylaws, stock ownership, and guidelines. As well as articles of incorporation, committee charts and governance documents. A company needs to aim for the highest level of corporate governance. It’s one thing for investors to be attracted to profitability. Yet having sound corporate governance can often be equally as important. 

Good environmental awareness, sound corporate governance practices, and good ethical behavior. These are a few areas that demonstrate corporate citizenship. Basically, this happens through a transparent set of controls and rules. These things align with shareholders, officers, and directors. 

Principles of Corporate Governance 

At the heart of every good corporate governance structure lie four main principles. These are accountability, transparency, fairness, and responsibility. Each of these principles will impact board member decisions. 

• Accountability: This principle requires taking the proper steps to own any decisions that get made. A business can discover risks and create effective internal control systems. Taking ownership of potential risks is critical for organizational success. 
• Transparency: It’s important to provide clear information to any stakeholders or shareholders. Having transparent processes will allow for more powerful and informed decisions. Ultimately, this helps lead to developing better strategies and keeping information accurate. 
• Fairness: Shareholders, no matter their share class, should always be treated equally. Essentially, being fair coincides with being ethical. Offering unequal treatment can contribute to a lack of interest or support. 
• Responsibility: It’s important to always be accountable to the actions that you make. When your company is responsible, it makes being accountable, fair, and transparent more effective. 

Benefits of Corporate Governance 

There can be a ton of benefits that come with good corporate governance. It could depend on the type of business that you operate or the industry you’re in. However, implementing effective practices will provide benefits no matter your business type. 

Here are some of the biggest benefits of corporate governance:

• It can reduce the cost of capital
• It can encourage more positive behavior 
• It can help create better, more effective internal controls 
• It will allow for better strategic planning 
• It will improve overall decision-making 
• It can attract directors with more experience or expertise 

Corporate Governance Models 

There can often be four corporate governance models that can be implemented by a corporation. Let’s take a closer look at what’s included in each.

The Anglo-American Model 

With this corporate governance model, shareholder rights become recognized. And these rights are given the highest importance. They elect board members and directors are rarely independent of management. There is a clear separation between ownership and management. With managers having a negligible ownership stake. 

The Anglo-American model is commonly used in corporate governance. This is in countries such as America, Canada, Britain, and Australia. 

The German Model 

Commonly referred to as the European model, the workers are one of the company’s key stakeholders. Any corporate governance is done through two separate boards, which include: 

• A supervisory board – Shareholders elect the members and employees elect their own representative. 
• A management board – The supervisory board appoints members of the management board. As well, they have the right to dismiss the entire management board and re-constitute it. 

The Japanese Model 

In the Japanese model, both the shareholders and the main banks will appoint the President as well as the board of directors. Japanese companies raise most of their capital through financial institutions. Ultimately, the banks end up working closely with company management. 

The Social Control Model 

This is the corporate governance model that aims to have full stakeholder representation on the board. It can be a good way to improve internal control systems overall. Since there would be a stakeholders board acting above the board of directors determined by the shareholders. 

The board would be made up of representation from employees and shareholders. As well as suppliers, lenders, and major consumers. 

The Board of Directors and Corporate Governance 

Within a company, the board of directors is the primary stakeholder. They help direct and influence the framework of corporate governance from within. The directors are elected by the shareholders of the company. Or they could also be appointed by current board members. 

At its core, the board of directors is representative of the shareholders of the company. They are put in place to help move it forward. They are tasked with making some of the most important and necessary decisions for the company. These can include areas such as executive compensation and dividend policy. As well as corporate officer appointments. 

Shareholders can even take it further. Though this depends on the company, the industry, or the main priorities to focus on various environmental or social concerns. Usually, the board of directors is made up of a combination of inside and also independent members. 

When an independent director is appointed, they don’t usually have any links to inside directors. They are rather chosen because of their knowledge and experience of managing or directing other companies. Independent directors can be incredibly effective when it comes to governance. As they can balance power and align shareholder interests. 

The board of directors has the primary role of guiding the corporate governance of a company. This includes corporate governance policies. Including risk management, accountability, corporate strategy, ethical business practices, and transparency. 

Examples of Corporate Governance 

Corporate governance plays an integral role in the direction of a company. However, you might have seen or heard of a few bad corporate governance examples. Although this could be down to the fact that you don’t often hear of companies that practice good corporate governance. They don’t have scandals or end up in the news. 

A company that has long had good corporate governance is PepsiCo and it often updates its policies. A few years ago, the company updated its corporate governance by receiving input from investors. Through this, there were new areas to focus on moving forward. 

By issuing a proxy statement, PepsiCo was able to include a graphic. This graphic outlined the current leadership structure of the company. As well as the new direction, and described how leadership would implement the vision and the changes.

The new areas the company outlined and stated it would be focusing on moving forward include:

• New shareholder and stakeholder engagement 
• A compensation discussion and analysis 
• The addition of human capital management 
• Good governance practices and ethical corporate culture 
• A new long-term strategy, focus on sustainability, and corporate purpose 
• The composition of the board of directors, leadership structure, and diversity 

By taking the time to gather input and develop a framework for moving forward, PepsiCo showed two things. Firstly, it showed that they had the right leadership in place to move the company forward. Secondly, it showed that it was also implementing good corporate governance practices. 

Consequences of Bad Corporate Governance 

Corporate governance matters for several reasons. All of which are aimed at avoiding bad governance practices. One of the biggest roles of corporate governance advisors is to develop and set up a system of practices, policies, and rules for a company. 

Essentially, this is all intended to account for accountability. Bad corporate governance standards are best explained through examples of governance. For example, let’s say a company’s executives implement some shady tactics and dishonest accounting methods. This is done to hide the fact they’re stealing from the company. 

False or outrageous figures could be passed on to the board of directors. They can then fail to report the information to the shareholders of the company. There are no responsible accounting methods. So the shareholders wouldn’t be aware that debts and liabilities were piling up. Ultimately, it could reach a point that the company wouldn’t be able to repay. 

From this, executives could be charged with felonies. This would most likely also lead to the company going bankrupt. Thereby removing any possibility of employee pensions and devastating shareholders. All in all, the consequences of bad corporate government would reach every single person that’s associated with the company. 

Summary 

Corporate governance is made up of a set of guiding principles that are established to direct operations. This includes areas such as risk management and employee treatment. As well as compensation, and reporting unfair practices. 

The board of directors of a company helps guide corporate governance and they are responsible to the shareholders. Having strong and transparent corporate governance frameworks benefits everyone. Leading to more investment and healthier finances.