Corporate Governance: A Comprehensive Guide

Posted on Jun 18, 2024 in Law & Jurisprudence

CORPORATE ENTITIES

Profit-oriented companies: Private and public companies / Joint ventures/cooperatives/Partnerships

Not-for-profit orgs: Voluntary and community organizations, charities, academic institutions, government corporate entities, etc.

Governance

The way that organizations or countries are managed at the highest level, and the systems for doing this.

Corporate Governance

Corporate governance concerns the way power is exercised over corporate entities. Corporate governance codes arrived in 1992 with the Cadbury Report, based on recognized good practice. They included:

• Wider use of independent non-executive directors
• The introduction of an audit committee of the board with independent members
• Division of responsibilities between the chairman of the board and the chief executive
• A remuneration committee of the board to oversee executive rewards
• A nomination committee to propose new board members
• Reporting publicly that the corporate governance code had been complied with or, if not, explaining why

How Corporate Governance Has Evolved

• All corporate entities need governing.
• Corporate governance is old, only the phrase is new.
• The early days – merchants and monopolists
• The invention of the limited-liability company
• The separation of ownership from operations
• Developments in the 1970s, 80s, and 90s
• Corporate collapses
• Corporate governance codes arrive
• Developments early in the 21st century – yet more collapses
• Corporate governance and the global financial crisis
• New frontiers for corporate governance

Corporate governance is necessary whenever ownership or membership is separated from management control.

Starting a Limited Company

Companies Registrar/Memorandum:

• Name of company
• Objectives
• Registered office
• Share capital
• Liability of shareholders limited

Articles of Association: Detailed rules for running the entity.

Executive management is responsible for running the organization. The governing body ensures that it is running in the right direction and being run well.

BOD Responsibilities:

• Setting the organization’s direction
• Formulating strategy
• Policy making
• Supervising management
• Being accountable

Operational Corporate Governance

Operational corporate governance is the process by which companies are directed and controlled.

Relationship: The relationship among various participants in determining the direction and performance of corporations. The primary participants are the shareholders, the management, and the board of directors.

Stakeholder: Corporate governance is the process by which corporations are made responsive to the rights and wishes of stakeholders.

Financial economics perspective: Corporate governance deals with the way suppliers of finance assure themselves of getting a return on their investment.

Societal: The whole set of legal, cultural, and institutional arrangements that determine what (public) corporations can do, who controls them, how that control is exercised, and how the risks and return from the activities they undertake are allocated.

Overall

Corporate governance is the exercise of power over corporate entities.

Constitution

A body of fundamental principles or established precedents according to which a state or other organization is acknowledged to be governed.

Shareholders’ Rights

• Determined by company law and a company’s articles of association
• Share ownership typically gives the right:
  • To receive notice, attend and vote at shareholders’ meetings
  • To inspect the shareholder register and the register of directors and officers
  • To regular information such as receive the formal company accounts, directors’ and auditors’ reports and other statutory notices
  • To receive dividends

In shareholders’ annual general meetings (AGM), shareholders vote for:

• Approval of the accounts presented by the directors
• Approval of the re-appointment of auditors
• Payment of dividends proposed by the directors
• Approval of transactions between the company and connected persons
• Appointment and re-appointment of directors

Shareholders Could:

• Challenge excessive director remuneration
• Oppose schemes and predatory behavior to protect the company
• Highlight unsatisfactory performance

Shareholder relation activities take many forms:

• Routine and special reports
• Interactive websites
• Newsletters
• Shareholder meetings
• Press conferences
• Road shows
• One-on-one communication and meetings with individual shareholders to resolve questions and explore issues about the company’s strategies, policies, and financial standing

Shareholder Activism

• Media campaigns
• Blogging to change corporate practices
• Proxy battles advancing shareholder resolutions to force change
• Calling shareholder meetings
• Litigation against companies or their directors

The Legal Duties of a Director

Directors’ responsibilities derive from the nature of the joint-stock limited liability company and are enshrined in statute law, case law, and regulation. Details vary, but the essential duties are:

• A duty of trust – to exercise a fiduciary responsibility to the shareholders/Act honestly – for the benefit of members
  • Show independence of judgment
  • Avoid conflict of interest
  • Act fairly
• A duty of care – to exercise reasonable care, diligence, and skill

A related party transaction is one between a company and a party closely related to it, such as a director or a major shareholder.

Insider trading, that is trading in a listed company’s shares on the basis of privileged, share-price sensitive insider information is a breach of a director’s fiduciary duty.

LEGISLATION, REGULATION, AND CG CODES

• Being a creation of the law, limited liability companies depend on company law for their existence, continuity, and winding-up
• Companies must follow the company law of the jurisdiction in which they are incorporated, and the laws of other places where they do business
• Penalties for failure to obey company law can be heavy on the company, its directors, and its officers

Corporate Regulation in the USA

• Each state in the United States has its own companies’ law
• Federal oversight of companies is provided by the Securities and Exchange Commission (SEC)
• The SEC’s mission is to protect investors, to maintain fair, orderly, and efficient markets, and to facilitate capital formation. To achieve this protection for investors, the SEC requires public companies to disclose information that is then made publicly available
• The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds

SOX:

• Required certification of internal auditing
• Increased financial disclosure
• Applied criminal and civil penalties on directors for non-compliance
• Required annual report on internal accounting controls to the SEC
• Created Public Company Oversight Board
• Listed companies must have an audit committee with entirely independent outside directors or an entirely outside board
• Regulation of auditors – one year cooling off before employment of audit staff or partner of auditor; rotate audit partner every 5 years
• Restrictions on non-audit work: management, investment, legal services. No work that will be audited
• Disclosure of all fees paid to the auditor
• SEC requires US Exchanges to reflect SOX (2003)
• Boards must have a majority of independent outside directors. They must also establish a corporate governance committee tasked with developing corporate governance principles and ensuring board and director evaluation. Additionally, a compensation (remuneration) committee is required to ensure CEO rewards are aligned with corporate objectives. Moreover, an audit committee must produce and disclose corporate governance guidelines and codes of business conduct, as well as review external auditor’s reports on internal controls

Corporate regulation in the UK mandates adherence to the UK Companies Acts. The UK Cadbury Report of 1992, crafted in response to corporate failures, established the world’s inaugural corporate governance code, focusing on financial aspects. It advocated for the increased use of independent non-executive directors and the formation of an audit committee with a minimum of three non-executive directors, a majority of whom should be independent. The report also emphasized the separation of roles between the chairman and the chief executive, recommending a strong independent element on boards where these roles are combined.

Furthermore, it introduced the necessity of a remuneration committee to oversee executive rewards and a nomination committee with independent directors to propose new board members, alongside adherence to a detailed code of best practice.

Differences between the governance of not-for-profit and profit-oriented sectors include variations in names, constitutions, and board composition, particularly in terms of the presence of executive and non-executive members.

The Anglo-American approach to corporate governance is characterized by a unitary board structure, comprising both executive and non-executive directors, prevailing in common law jurisdictions. In contrast, the Continental European approach follows a two-tier system with separate supervisory and executive boards, typical of civil law jurisdictions.

THE AGENCY PROBLEM

The directors of companies, being managers of other people’s money, cannot be expected to watch over it with the same vigilance with which they watch over their own.

In today’s public companies, agency relationships can involve complex chains of intermediaries. For instance, an individual owner might entrust their funds to a financial adviser, who then invests in a mutual fund or investment trust. These funds, in turn, may diversify their portfolio by investing in a hedge fund, which further allocates resources across various assets such as equities, property, commodities, and other hedge funds. Tracing the agency chain in such cases can be challenging, and determining the exposure to agency risk can be nearly impossible.

Responses to the agency dilemma include demands for reporting and transparency, requirements for accountability and audit, the appointment of independent directors, the separation of chairman and CEO roles, adherence to corporate governance codes and principles, and compliance with other regulations and legal requirements.

Agency theory posits that shareholders engage directors to act on their behalf, but if both parties are utility maximizers, agents may prioritize their own interests over those of their principals. Another challenge is asymmetrical access to information, with directors typically possessing more knowledge about the corporate situation than shareholders. Shareholders must rely on directors to determine the information they receive beyond the regulatory minimums mandated by law.

Agency theory posits a view on human nature, suggesting that individuals are inherently self-interested rather than altruistic, and therefore, directors may prioritize their own interests over those of their shareholders, leading to a lack of trust. Anecdotal evidence supports this perspective. In contrast, stewardship theory underlies the legal concept of the company, aiming to resolve conflicting societal objectives through mechanisms such as free markets and legislation. Legislation protects various stakeholders, including employees (e.g., employment and safety laws), consumers (e.g., consumer protection laws), suppliers (e.g., contract laws), and society at large (e.g., environmental laws).

Under the law, directors have a fiduciary duty to their shareholders and are trusted to act as stewards for their interests, as advocated by stewardship theorists. While most directors fulfill this duty, critics argue that the modern corporate landscape differs significantly from the naive 19th-century model. In listed companies, shareholders are often distant from the company’s operations, lacking influence over director nominations and facing challenges in understanding financial reports due to their complexity. Moreover, complex corporations may lack transparency, and directors may not be adequately accountable to shareholders, especially in cases of consolidated group accounts.

Systems theory provides a framework with boundaries, levels of abstraction, and functions, offering context for understanding various perspectives on corporate governance. It encompasses different viewpoints on the relationship between individuals, enterprises, and the state, advocating for a broader definition of corporate entities to cover organizations where governance and management are separate from the members. It involves mapping out all elements affecting and affected by governance, including the expectations, requirements, and demands of each participant, as well as their duties, responsibilities, powers, sanctions, and accountabilities.

Main Functions of the Board

The responsibilities of a board of directors encompass strategy formulation, accountability, policy-making, and supervising executive activities. Strategy formulation is crucial, as without a shared corporate vision, effective corporate strategies cannot be developed, rendering strategies mere statements of intent.

Strategies need to be translated into operational plans to be effective. Policy-making and supervising executives involve the creation of policies, procedures, plans, and projects to operationalize strategies. These policies provide criteria for the board to monitor management’s performance and fulfill its duty to supervise executive management. Policies serve as rules, systems, and procedures established by the board to guide and supervise executive management and its activities.

Accountability is a fundamental aspect of a board’s responsibilities. The entities to which a board is accountable vary depending on factors such as the company’s constitution, the laws governing its incorporation, and the requirements of regulatory authorities. Beyond providing audited historical financial accounts to shareholders, companies are expected to offer comprehensive insights into their performance. This includes not only explaining how the company is currently performing but also providing the story behind its performance and anticipating its future trajectory.