Corporate Governance

Chapter II
 Chapter Objectives:

• Identify the corporate governance developments in the post-SOX era.

• Understand how corporate governance is designed .
• Define corporate governance structure and its components of principles,
functions, and mechanisms.
• Illustrate how corporate governance has evolved from compliance function to
a strategic Imperative.
• Provide an overview of corporate governance aspects and principles.
• List and define the seven essential corporate governance functions.
• Identify significant improvements resulting from corporate governance
reforms in the United States.
• Become familiar with best practices of corporate governance.
• Become familiar with corporate governance reporting and its components as
well as corporate governance ratings.
 Key Terms
Corporate governance
Effectiveness
Corporate governance rating
Oversight board
External governance
Mechanisms
Integrated aspect
Internal governance
Transparency
Mechanisms
Oversight
Stakeholder aspect
Remuneration
Shareholder
Shareholder aspect
Stakeholder
 Definition of Corporate
Governance

The process affected by a set of legislative,

regulatory, legal, market mechanisms, listing
standards, best practices, and efforts of all corporate
governance participants, including the company’s
directors, officers, auditors, legal counsel, and
financial advisors, which creates a system of checks
and balances with the goal of creating and
enhancing enduring and sustainable shareholder
value, while protecting the interests of other
stakeholders.
 Aspects of Corporate
Governance
In the post-SOX era, Corporate Governance further evolved to
the integrated aspects of meeting both compliance requirements
and promoting a strategic business imperative. There are three
aspects: shareholder aspect, stakeholder aspect, and an
integrated aspect.
Shareholder Aspect
This aspect is based on the premise that shareholders provide
capital to the corporations that exists for their benefit.
Stakeholder Aspect
Stakeholders are now becoming more engaged in a company
performance on a variety of economic, governance, ethical,
social and environment issues.
Integrated Aspect
Modern corporate governance emphasizes BOTH financial
aspects of increasing shareholders value AND an integrated
approach that considers the rights and interests of all
stakeholders.
 Corporate Governance
Structure
 Corporate governance is based on three interrelated
components: corporate governance principles, functions
and mechanisms.
 Corporate Governance Principles

HONESTY. Corporate communications with both internal and

external audiences, including public financial reports, should
be accurate, fair, transparent, and trustworthy

RESIELNCE. A resilient corporate governance structure is

sustainable and enduring in the sense that it will easily
recuperate from setbacks and abuses.

RESPONSIVENESS. Effective corporate governance

responsive to the interests and desires of all stakeholders, as
well as responsive to emerging initiatives, and changes in
political, regulatory, social, and environmental issues.

TRANSPARENCY. Transparency means that the company is

not hiding relevant information, and disclosures are fair,
accurate, and reliable.
What are the other principles corporate governance structure should be developed on?
They are the following:
 
- Value-adding philosophy
- Ethical conduct
- Accountability
- Shareholder democracy and fairness
- Integrity of the financial reporting
- Transparency
- Independence
 
Corporate Governance Functions
 Corporate Governance
Functions
OVERSIGHT FUNCTION. The board of directors should provide strategic advice to
management and oversee managerial performance, yet avoid micromanaging.
MANAGERIAL FUNCTION. The effectiveness of this function depends on the
alignment of management’s interests with those of shareholders.
COMPLIANCE FUNCTION. The set of laws, regulations, rules, standards, and best
practices developed by state and federal legislators, regulators, standard-setting
bodies, and professional organizations to create a compliance framework for
public companies in which to operate and achieve their goals.
INTERNAL AUDIT FUNCTION. Assurance and consulting services to the company
in the areas of operational efficiency, risk management, internal controls,
financial reporting, and governance processes.
LEGAL AND FINANCIAL ADVISORY FUNDTIONS. Legal advice and assists the
company, its directors, officers, and employees in complying with applicable
laws and other legal obligations and fiduciary duties.
EXTERNAL AUDIT FUNCTION. External auditors lend credibility to the company’s
financial reports and thus add value to its corporate governance through their
integrated audit of both internal control over financial reporting and financial
statements.
MONITORING FUNCTION. Shareholders, particularly institutional shareholders,
empowered to elect and, if warranted, remove directors.
 .
 
Corporate Governance Mechanisms

The corporate governance structure is shaped by internal

and external governance mechanisms, as well as policy
interventions through regulations. Both internal and
external corporate governance mechanisms of the
company have evolved over time to monitor, bond and
control management.
Examples of internal governance mechanisms:
 
- board of directors, particularly
- independent directors
- audit committee
- management
- internal controls
- internal audit functions
Examples of external mechanisms:
 

- market for corporate control

- capital market
- labor market
- federal and state statutes
- court decisions
- shareholders proposals
- best practices of investors activists
 
  Standards of Professional Conduct
for Management
PEJMAR
Priority - Your client's interests always come first.
Encourage - Practice and encourage others to act professionally
and ethically to reflect credit on yourself and the profession.
Judgment - use reasonable care and judgment when performing
all professional activities.
Maintain - keep your knowledge up to date and encourage other
professionals to do the same.
Actions - employ integrity, competence, diligence, and respect in
an ethical manner with everyone.
Rules - promote the integrity of capital markets by following the
rules.
 Corporate Governance Reports

To restore investor’s confidence after the collapse of the

dotcom market, the economic downturn, reported financial
scandals, and numerous earnings restatements of high-profile
companies several corporate governance reforms in the
United States have been established, including SOX, SEC-
related implementation rules, listing standards of national
stock exchanges, auditing standards of the PCAOB, guiding
principles of professional organizations (The Conference
Board, Council of Institutional Investors, and National
Association of Corporate Directors), and best practices.
 Sources of Corporate Governance

Corporate Laws May vary from state to state. But most adopted
Model Business Corporation Act as their
corporate law

The Federal Securities Laws
Listing Standards
Fundamental are: the Securities Act of 1933 and
Securities Exchange Act of 1934
SOX expanded the role of federal statutes by
providing measures to improve corporate
governance, financial reports, and audit
activities.
Adopted by national stock exchanges, these
standards are applicable to all public companies
listing their equity shares with some exceptions

Best Practices Recommended by professional organizations

(e.g. The
Conference Board, the Business Roundtable
Institute) and investor activists (e.g. Council of
 Sarbanes-Oxley Act of 2002

SOX was signed into law on July 30, 2002, to reinforce

corporate accountability and rebuild investor confidence in
public financial reports. It was designed to:

(1) establish an independent regulatory structure for the

accounting profession,
(2) set high standards and new guiding principles for
corporate governance,
(3) improve the quality and transparency of financial
reporting,
(4) improve the objectivity and credibility of audit functions
and empower the audit committee,
(5) create more severe civil and criminal remedies for
violations of federal securities laws,
(6) increase the independence of securities analysts.
 SARBANES-OXLEY ACT Of
2002
SOX provisions, SEC-related rules, and listing standards
influence corporate governance structure in at least three
ways:
 Auditors, analysts, and legal counsel are now brought into
the realm of internal governance as gatekeepers

 Legal status and fiduciary duty of company directors and

officers, (audit committee and CEO), have been more clearly
defined and in some instances, significantly enhanced

 Certain aspects of state corporate law were preempted and

federalized (For example, Section 402 of SOX prohibits loans
to directors and officers, whereas state law permits such
loans)
 Cost Benefit Of Sarbanes-
Oxley

A 2007 survey of 2000 corporate executives reveals that:

(1) The compliance costs of SOX for the second consecutive

year declined substantially;
(2) The cost dropped 23 percent in 2006;
(3) Total compliance costs decreased to an average $2.9
million per company in 2006, which is down 35 percent from
the $4.51 million average costs in 2006;
(4) There was no significant change in audit fees;
(5) The majority of surveyed executives (78 percent) reported
that the costs to comply with section 404 still outweigh any
benefits.
 
More manageable and cost-effective Section 404 compliance
is currently being addressed by the SEC and the PCAOB.
 Corporate Governance
Rating
National and international organizations, including
Institutional Shareholder Services (ISS), the Corporate
Library, Standard & Poor’s, Moody’s Investment Service,
Core Ratings, Governance Metrics International (GMI), and
Glass Lewis & Co., have developed and published variations
of corporate governance ratings that are often used by
shareholders in assessing their stock returns and
bondholders in determining the costs of lending.
 
Example: GMI established its scoring algorithm with
hundreds of metrics relevant to the governance quality and
risk assessment of each rated company into six categories
of board accountability, financial disclosure, shareholder
rights, executive compensation, takeover defenses, and
reputation/regulatory problems.
 Corporate Governance
Reporting
Corporate Governance Reporting (CGR) entails assessing the
quality and effectiveness of the organization’s corporate
governance and reporting findings to interested stakeholders,
including the board of directors, executives, auditors, regulatory
agencies, and shareholders.

Corporate Governance Reporting:

(1) Disclose all relevant information about the effectiveness of the

company’s corporate governance
(2) Focus on the company’s sustainability performance
(3) Provide transparent information about the company’s
performance and its impacts on all stakeholders
(4) Assess the company’s responsiveness to the needs of its
stakeholders.
 Global Convergence in
Corporate Governance
There are no globally accepted corporate governance reforms and
best practices. Differences are mainly driven by the country’s
statutes, corporate structures, and culture. Country statutes could
pose challenges for regulators in adopting corporate governance
reforms and financial reporting disclosures for home companies, as
well as multinational corporations. The United States and the UK,
for example, operate under common law, which tends to give more
antidirector privileges to minority shareholders compared to
countries under code law (e.g., Germany), in the sense that
regulators allow too many or too few rights to minority
shareholders.
 
Hint: Find a Differences between US and UK Corporate Governance
 
 Conclusion
• Corporate governance participants must structure the process to
ensure the goals of both shareholder value creation and stakeholder
value protection for public companies.
• The corporate governance structure is shaped by internal and
external governance mechanisms, as well as policy interventions
through regulations.
• Corporate governance mechanisms are viewed as a nexus of
contracts that is designed to align the interests of management with
those of the shareholders.
• The effectiveness of both internal and external corporate
governance mechanisms depends on the cost–benefit trade-offs
among these mechanisms and is related to their availability, the
extent to which they are being used, whether their marginal benefits
exceed their marginal costs, and the company’s corporate
governance structure.
 Conclusion
• There are three aspects of corporate governance: the shareholder
aspect, the stakeholder aspect, and the integrated aspect.
• Corporate governance structure should be based on the principles of
value-adding philosophy, ethical conduct, accountability, shareholder
democracy and fairness, integrity of financial reporting, transparency,
and independence.
• A well-balanced operation of the seven corporate governance
functions—oversight, managerial, compliance, internal audit, legal and
financial advisory, external audit, and monitoring— can contribute
toward effective corporate governance.
• Corporate governance effectiveness is defined as the extent to
which the company’s corporate governance is achieving its objectives
in three categories: (1) promoting efficient and effective operational,
financial, and social performance; (2) creating shareholder value while
protecting the interests of other stakeholders (employees, suppliers,
customers, and creditors); and (3) ensuring the integrity, quality,
reliability, and transparency of financial reporting.