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BUSINESS

CORPORATE FINANCE & ACCOUNTING

Corporate Governance
By
JAMES CHEN

Reviewed by
MARGARET JAMES
| on July 04, 2021

TABLE OF CONTENTS
What Is Corporate Governance? Understanding Corporate Governance
Board of Directors Examples of Corporate Governance
Special Considerations Corporate Governance FAQs
The Bottom Line

What Is Corporate Governance?

Corporate governance is the system of rules, practices, and processes by which a firm is
directed and controlled. Corporate governance essentially involves balancing the interests Advertisement
of a company's many stakeholders, such as shareholders, senior management executives,
customers, suppliers, financiers, the government, and the community.

Since corporate governance also provides the framework for attaining a company's
objectives, it encompasses practically every sphere of management, from action plans and
internal controls to performance measurement and corporate disclosure.

KEY TAKEAWAYS
Corporate governance is the structure of rules, practices, and processes used to
direct and manage a company.
A company's board of directors is the primary force influencing corporate
governance.
Bad corporate governance can cast doubt on a company's operations and its
ultimate profitability.
Corporate governance entails the areas of environmental awareness, ethical
behavior, corporate strategy, compensation, and risk management.
The basic principles of corporate governance are accountability, transparency,
fairness, and responsibility.

Understanding Corporate Governance

Governance refers specifically to the set of rules, controls, policies, and resolutions put in
place to dictate corporate behavior. Proxy advisors and shareholders are important
stakeholders who indirectly affect governance, but these are not examples of governance
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itself. The board of directors is pivotal in governance, and it can have major ramifications for
equity valuation.

A company’s corporate governance is important to investors since it shows a company's

direction and business integrity. Good corporate governance helps companies build trust
with investors and the community. As a result, corporate governance helps promote
financial viability by creating a long-term investment opportunity for market participants.
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Communicating a firm's corporate governance is a key component of community

and investor relations. On Apple Inc.'s investor relations site, for example, the firm outlines
its corporate leadership—its executive team, its board of directors—and its corporate
governance, including its committee charters and governance documents, such as bylaws,
stock ownership guidelines, and articles of incorporation. [1] 

Most companies strive to have a high level of corporate governance. For many shareholders,
it is not enough for a company to merely be profitable; it also needs to demonstrate good
corporate citizenship through environmental awareness, ethical behavior, and sound
corporate governance practices. Good corporate governance creates a transparent set of
rules and controls in which shareholders, directors, and officers have aligned incentives.

Corporate Governance and the Board of Directors

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The board of directors is the primary direct stakeholder influencing corporate governance.
Directors are elected by shareholders or appointed by other board members, and they
represent shareholders of the company.

The board is tasked with making important decisions, such as corporate officer
appointments, executive compensation, and dividend policy. In some instances, board
obligations stretch beyond financial optimization, as when shareholder resolutions call for
certain social or environmental concerns to be prioritized.

Important: A board of directors should consist of a diverse group of individuals,
those that have skills and knowledge of the business, as well as those who can
bring a fresh perspective from outside of the company and industry.

Boards are often made up of inside and independent members. Insiders are major
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shareholders, founders, and executives. Independent directors do not share the ties of the
insiders, but they are chosen because of their experience managing or directing other large
companies. Independents are considered helpful for governance because they dilute the
concentration of power and help align shareholder interests with those of the insiders.

The board of directors must ensure that the company's corporate governance policies
incorporate the corporate strategy, risk management, accountability, transparency, and
ethical business practices.

Examples of Corporate Governance

Volkswagen AG
Bad corporate governance can cast doubt on a company's reliability, integrity, or obligation
to shareholders; all of which can have implications on the firm's financial health. Tolerance
or support of illegal activities can create scandals like the one that rocked Volkswagen AG
starting in September 2015.

The development of the details of "Dieselgate" (as the affair came to be known) revealed
that for years the automaker had deliberately and systematically rigged engine emission
equipment in its cars in order to manipulate pollution test results in America and Europe.
Volkswagen saw its stock shed nearly half its value in the days following the start of the
scandal, and its global sales in the first full month following the news fell 4.5%. [2]

VW's board structure was a reason for how the emissions rigging took place and was not
caught earlier. In contrast to a one-tier board system that is common in most companies,
VW has a two-tier board system, which consists of a management board and a supervisory
board. The supervisory board was meant to monitor management and approve corporate
decisions; however, it lacked the independence and authority to be able to carry out these
roles. [3]

The supervisory board comprised a large portion of shareholders. Ninety percent of

shareholder voting rights were controlled by members of the supervisory board. There was
no real independent supervisor; shareholders were in control of the supervisory board,
which canceled out the purpose of the supervisory board, which was to oversee
management and employees and how they operate within the company, which of course,
included rigging emissions. [3]

Enron and Worldcom

Public and government concern about corporate governance tends to wax and wane. Often,
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however, highly publicized revelations of corporate malfeasance revive interest in the
subject. For example, corporate governance became a pressing issue in the United States at
the turn of the 21st century, after fraudulent practices bankrupted high-profile companies
such as Enron and WorldCom.

The problem with Enron was that its board of directors waived many rules related to
conflicts of interest by allowing the chief financial officer (CFO), Andrew Fastow, to create
independent, private partnerships to do business with Enron. What actually happened was
that these private partnerships were used to hide Enron's debts and liabilities, which would
have reduced the company's profits significantly. [4]

What happened at Enron was clearly a lack of corporate governance that should have
prevented the creation of these entities that hid the losses. The company also had a
corporate atmosphere that had dishonest people at the top (Fastow) down to its traders
who made illegal moves in the markets.

Both the Enron and Worldcom scandals resulted in the 2002 passage of the Sarbanes-Oxley
Act, which imposed more stringent recordkeeping requirements on companies, along with
stiff criminal penalties for violating them and other securities laws. The aim was to restore
public confidence in public companies and how they operate.

PepsiCo
It's common to hear of bad corporate governance examples, mainly because it is the reason
some companies blow up and end up in the news. It's rare to hear of companies with good
corporate governance because it is the good corporate governance that keeps them out of
the news as no scandal has occurred.

One company that has consistently practiced good corporate governance and seeks to
update it often is PepsiCo. In drafting its 2020 proxy statement, PepsiCo took input from
investors to focus on six areas:

Board composition, diversity, and refreshment, and leadership structure

Long-term strategy, corporate purpose, and sustainability issues
Good governance practices and ethical corporate culture
Human capital management
Compensation discussion and analysis
Shareholder and stakeholder engagement [5]

The company included in its proxy statement a side-by-side graphic that depicted the
The company included in its proxy statement a side-by-side graphic that depicted the
current leadership structure, which shows a combined chair and CEO along with an
independent presiding director, and a link between the compensation of the company's
"Winning With Purpose" vision and changes to the executive compensation program. [5]

Special Considerations
As an investor, you want to ensure that the company you are looking to buy shares of
practices good corporate governance, in the hope of avoiding losses in cases such as Enron
and Worldcom. There are certain areas that an investor can focus on to determine whether a
company is practicing good corporate governance or not.

These areas include disclosure practices, executive compensation structure (is it tied only to
performance or other metrics?), risk management (what are the checks and balances of
making decisions in the company?), policies and procedures on reconciling conflicts of
interest (how does a company approach business decisions that might conflict with its
mission statement?), the members of the board of the directors (do they have a stake in
profits?), contractual and social obligations (how do they approach areas such as climate
change?), relationships with vendors, complaints received from shareholders and how they
were addressed, and audits (how often are internal and external audits conducted and how
have issues been handled?).

Types of bad governance practices include:

Companies that do not cooperate sufficiently with auditors or do not select auditors with
the appropriate scale, resulting in the publication of spurious or noncompliant financial
documents
Bad executive compensation packages that fail to create an optimal incentive for
corporate officers
Poorly structured boards that make it too difficult for shareholders to oust ineffective
incumbents

These are all areas an investor can research before making an investment decision.

Corporate Governance FAQs

What Are the 4 Ps of Corporate Governance?
The four P's of corporate governance are people, process, performance, and purpose.

Why Is Corporate Governance Important?

Corporate governance is important because it creates a system of rules and practices that
determine how a company operates and how it aligns the interest of all its stakeholders.
Good corporate governance leads to ethical business practices, which leads to financial
viability.

What Are the Basic Principles of Corporate Governance?

The basic principles of corporate governance are accountability, transparency, fairness, and
responsibility.

What Are Examples of Corporate Governance?

Examples of corporate governance include the Anglo-US model, the German model, and the
Japanese model.

The Bottom Line

Corporate governance consists of the guiding principles that a company puts in place to
direct all of its operations, from compensation to risk management to employee treatment
to reporting unfair practices to its impact on the climate, and more.

A strong, transparent corporate governance leads a company to make ethical decisions that
benefit all of its stakeholders, allowing the company to place itself as an attractive option to
investors if its financials are also healthy. Bad corporate governance leads to a breakdown
of a company, often resulting in scandals and bankruptcy.
o a co pa y, o te esult g sca dals a d ba uptcy.

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ARTICLE SOURCES

Related Terms
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The practice of interlocking directorates may affect more than one company's board of directors, find out when this can happen and when it's illegal.
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Board of Directors (B of D)
A board of directors (B of D) is a group of individuals elected to represent shareholders and establish and support the execution of management policies.
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Understanding Independent Outside Directors

An independent outside director is a member of a company's board of directors whom the company brings in from outside the company.
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Market-Based Corporate Governance System

A market-based corporate governance system defines the responsibilities of the different participants in the company, including shareholders and
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Proxy Statement Definition

A proxy statement is a document the SEC requires companies to provide shareholders that includes information needed to make decisions at
shareholder meetings.
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Boardroom Definition
A boardroom is where a group of people conducts meetings, often the board of a company. Learn about virtual boardrooms and how to hold a meeting.
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