Corporate Governance

The business world has seen an increasing number of scandals in recent years, and numerous
organizations have been exposed for poor management practices and fraudulent financial reporting. When
we review those scandals, several questions come to mind:
• Who was minding the store?
• How were these senior executives allowed to get away with this?
• Aren’t companies supposed to have a system of checks and balances to prevent such behavior?
• When did the CEO of an organization suddenly become answerable to no one?

In seeking answers to these questions, we come to the issue of who really carries the authority in an
organization—that is, who has the final say? In other words, are corporations governed in the same
manner as our society? And if they’re not, are these examples of unethical corporate behavior evidence
that they should be?

Corporate governance is the process by which organizations are directed and controlled. However, when
we examine who is control- ling the corporation, and for whom, the situation gets a little more
complicated. Before the development of large corporations, which are separate legal entities, managers
and owners of organizations were the same people. As the organizations grew, wealthy owners started to
hire professional managers to run the businesses on their behalf, which raised interesting questions:
• Could the managers be trusted to run the businesses in the best interests of the owners?
• How would they be held accountable for their actions?
• How would absentee owners keep control over these managers?

The development of a separate corporate entity allowed organizations to raise funds from individual
shareholders to enlarge their operations. The involvement of individual shareholders diluted the
ownership of the original owners and also brought in a new group to which the managers of the business
would now be accountable. As the corporations grew in size, and pension funds and other institutional
investors purchased larger blocks of shares, the potential impact of the individual shareholder was greatly
diminished, and the managers were presented with a far more powerful “owner” to whom they were now
accountable.

As we discussed in Chapter 4, some argue that in addition to the interests of the company owners,
managers are accountable to the public interest—or, more specifically, to their stakeholders: their
customers, their vendor partners, state and local entities, and the communities in which they conduct their
business operations.

So corporate governance is concerned with how well organizations meet their obligations to all these
people. Ideally, mechanisms are in place to hold them accountable for that performance and to introduce
corrective action if they fail to live up to that performance expectation.

Corporate governance is about the way in which boards oversee the running of a company by its man-
agers, and how board members are, in turn, account- able to shareholders and the company. This has
implications for company behavior toward employees, shareholders, customers, and banks. Good
corporate governance plays a vital role in underpinning the integrity and efficiency of financial markets.
Poor corporate governance weakens a company’s potential and at worst can pave the way for financial
difficulties and even fraud. If companies are well governed, they will usually outperform other companies
and will be able to attract investors whose support can finance further growth.
Corporate Governance The system by which business corporations are directed and controlled.

Board of Directors A group of individuals who oversee governance of an organization. Elected

by vote of the shareholders at the annual general meeting (AGM), the true power of the board
can vary from institution to institution from a powerful unit that closely monitors the
management of the organization to a body that merely rubber-stamps the decisions of the chief
executive officer (CEO) and executive team.

>> What Does Corporate Governance Look Like?

The owners of the corporation (at the top of Figure 5.1) supply equity or risk capital to the company by
purchasing shares in the corporation. They are typically a fragmented group, including individual public
share- holders, large blocks of private holders, private and public institutional investors, employees,
managers, and other companies.

The board of directors, in theory, is elected by the owners to represent their interests in the effective
running of the corporation. Elections take place at annual shareholders’ meetings, and directors are
appointed to serve for specific periods of time. The board is typically made up of inside and outside
members—inside members hold management positions in the company, whereas outside members do not.
The term outside director can be misleading because some outside members may have direct connections
to the company as creditors, suppliers, customers, or professional consultants.

The audit committee is staffed by members of the board of directors plus independent or outside
directors. The primary responsibilities of the audit committee are to oversee the financial reporting
process, monitor internal controls (such as how much spending authority an executive has), monitor the
choice of accounting policies and procedures, and oversee the hiring and performance of external auditors
in producing the company’s financial statements.

The compensation committee is also staffed by members of the board of directors plus independent or
outside directors. The primary responsibility of the compensation committee is to oversee compensation
packages for the senior executives of the corporation (such as salaries, bonuses, stock options, and other
benefits such as, in extreme cases, personal use of company jets). Compensation policies for the
employees of the corporation are left to the management team to oversee.

Audit Committee An operating committee staffed by members of the board of directors plus
independent or outside directors. The committee is responsible for monitoring the financial
policies and procedures of the organization—specifically the accounting policies, internal
controls, and the hiring of external auditors.

Compensation Committee An operating committee staffed by members of the board of

directors plus independent or outside directors. The committee is responsible for setting the
compensation for the CEO and other senior executives. Typically, this compensation will consist
of a base salary, performance bonus, stock options, and other perks.
The corporate governance committee represents a more public demonstration of the
organization’s commitment to ethical business practices. The committee (staffed by board
members and specialists) monitors the ethical performance of the corporation and oversees
compliance with the company’s internal code of ethics as well as any federal and state
regulations on corporate conduct.

>> In Pursuit of Corporate Governance

While the issue of corporate governance has reached new heights of media attention in the wake
of corporate scan- dals, the topic itself has been receiving increasing attention for more than a
decade. In 1992 Sir Adrian Cad- bury led a committee in Great Britain to address financial
aspects of corporate governance in response to public concerns over directors’ compensation at
several high- profile companies in Great Britain. The subsequent financial scandals surrounding
the Bank of Credit and Commerce International (BCCI) and the activities of publishing magnate
Sir Robert Maxwell generated more attention for the committee’s report than was originally
anticipated. In the executive summary of the report, Cadbury outlined the committee’s position
on the newly topical issue of corporate governance:

At the heart of the Committee’s recommendations is a Code of Best Practice designed to achieve
the necessary high standards of corporate behaviour. . . . By adhering to the Code, listed
companies will strengthen both their control over their businesses and their public accountability.
In so doing they will be striking the right balance between meeting the standards of corporate
governance now expected of them and retaining the essential spirit of enterprise.
Two years after the release of the Cadbury report, attention shifted to South Africa, where
Mervyn King, a corporate lawyer, former High Court judge, and the governor of the Bank of
England at the time, led a committee that published the “King Report on Corporate Governance”
in 1994. In contrast to Cadbury’s focus on internal governance, the King report “incorporated a
code of corporate practices and conduct that looked beyond the corporation itself, taking into
account its impact on the larger community.”

“King I,” as the 1994 report became known, went beyond the financial and regulatory
accountability upon which the Cadbury report had focused and took a more integrated approach
to the topic of corporate governance, recognizing the involvement of all the corporation’s
stakeholders—the shareholders, customers, employees, vendor partners, and the community in
which the corporation operates—in the efficient and appropriate operation of the organization.

Even though King I was widely recognized as advocating the highest standards for corporate
governance, the committee released a second report eight years later, referred to as “King II,”
which formally recognized the need to move the stakeholder model forward and consider a triple
bottom line as opposed to the traditional single bottom line of profitability. The triple bottom line
recognizes the economic, environmental, and social aspects of a company’s activities. In the
words of the King II report, companies must “comply or explain” or “comply or else.”
According to King II, . . . successful governance in the world in the 21st century requires
companies to adopt an inclusive and not exclusive approach. The company must be open to
institutional activism and there must be greater emphasis on the sustainable or non-financial
aspects of its performance. Boards must apply the tests of fairness, accountability, responsibility,
and trans- parency to all acts or omissions and be accountable to the company but also
responsive and responsible towards the company’s identified stakeholders. The correct balance
between conformance with gover- nance principles and performance in an entrepre- neurial
market economy must be found, but this will be specific to each company.6