Question

What is meant by the term corporate governance?

Indicate 3 ways you can judge a firm’s corporate governance

Answer 1

Meaning of Corporate Governance:

Corporate governance refers to the accountability of the Board of Directors to all stakeholders of the corporation i.e. shareholders, employees, suppliers, customers and society in general; towards giving the corporation a fair, efficient and transparent administration.

Fundamentally, there is a level of confidence that is associated with a company that is known to have good corporate governance. The presence of an active group of independent directors on the board contributes a great deal towards ensuring confidence in the market. Corporate governance is known to be one of the criteria that foreign institutional investors are increasingly depending on when deciding on which companies to invest in. It is also known to have a positive influence on the share price.

Three ways to judge corporate governance:

The three pillars of corporate governance are: transparency, accountability, and security. All three are critical in successfully running a company and forming solid professional relationships among its stakeholders which include board directors, managers, employees, and most importantly, shareholders.

Trust is the foundation of sustainable development. As the world continues to get smaller, our mutual interdependence increases and we all need to be able to mobilise the resources and goodwill of others to achieve success. That can only be achieved through gaining their trust. Therefore, the ability to gain the trust of global financial markets and of all the stakeholders in the value chain is becoming the key to success.

The essence of good corporate governance is ensuring trustworthy relations between the corporation and its stakeholders. Therefore, good governance involves a lot more than compliance. Good corporate governance is a culture and a climate of Consistency, Responsibility, Accountability, Fairness, Transparency, and Effectiveness that is Deployed throughout the organisation (the ‘CRAFTED’ principles of governance).

Boards have the basic responsibility to ensure sustainable improvements in corporate valuations by providing strategic guidance and oversight regarding management decisions, as well as selecting and changing the management whenever necessary. Success can only be achieved on a sustainable basis, if boards behave as a role model for implementing the CRAFTED principles of governance in their own operations and ensure that the corporation follows these principles in making key decisions.

The board of directors is the most important element in corporate structures. The tone at the top determines the tune in the middle.*In particular, clear separation of management rights (taking initiative and implementation) and governance rights (guidance, approval, and oversight), is critical in minimising potential ‘agency’ risks of the management such as:
• fraud
• cronyism, building a personal fiefdom with company resources
• lethargy, focusing on excuses as opposed to results
• being too risk averse that may lead to overinvestment
• being too risk prone

Issues such as the composition of boards, their agenda and processes for decision-making, and how they Learn to continuously improve the governance of the corporation, critically influence the both the quality of decisions and of management.The main responsibilities of the board is to provide effective Oversight and strategic Guidance for the management. The quality of their decisions is critically dependent on the quality of the Information they have. Establishing a Culture that sets the right tone at the top is critical for establishing the ‘trust’ for the corporation with all its stakeholders (The ‘LOGIC’ of governance).

The success of the board depends on making sound judgments in numerous situations that involve balancing different interests:
• risk versus reward;
• short term versus long term;
• effective oversight versus motivating management;
• ethical considerations versus market practices; and
• competing interests of different stakeholders.

In short, good corporate governance is very important for sustainable development, not only for the individual company, but also for the economy as a whole. Therefore, the quality of governance should be continuously improved and good governance should be promoted. However, what is not measured, cannot be improved. Hence, there is a need for a model to measure the quality of corporate governance.

Most attempts to measure the quality of corporate governance focus on compliance-related issues. Numerous rating models also seem to focus on the inputs of governance, such as the composition of boards and the separation of the CEO and chairman roles. However, they do not pay sufficient attention to the quality of information, decision-making processes, nor link the effectiveness of governance to output measures such as the brand image, employee and customer satisfaction indices, or profitability and value creation. Also, most measures fail to deal with learning and development in governance.

First, what is more important than which demographic characteristics a board member possesses, is what kind of experience he/she has and what types of behaviour he/she portrays. Therefore, gender, nationality and age diversity are not sufficient to evaluate the effectiveness of a board. One should also evaluate the relevance of the experience of board members to address the main challenges the company is likely to face.

Another important issue is that the quality of the information that the board gets is a key determinant of its effectiveness. Whether relevant and timely information, presented in a context, with the benchmarks and alternatives identified, assumptions understood and stress-tested, or whether the potential effects of various alternatives on different stakeholders have been taken into account, would have a significant impact on the quality of the board’s decision.

Third, the impact of a board’s decisions on output measures should be evaluated, not just not inputs such as information quality. Governance is important for the sustainability of value creation. If the model that aims to measure effectiveness of governance does not evalute the linkages to output measures - not only financial performance, but also lead indicators such as customer, employee, or other stakeholder satisfaction - it would be missing an important dimension.

Boards should also be focusing not only on the business results, but also how business results are obtained. As an outstanding performance could sometimes be due to excessive risk-taking, resulting in a relatively good performance during a particular period, it may not be sustainable. Such an elaborate evaluation of management proposals requires an open and transparent culture, where members are encouraged to challenge assumptions and evaluate alternatives.

Also, as there is a time lag between decisions and their impacts, the board’s performance should be evaluated over a period of time, not at a specific time.

Finally, the purpose of measuring the effectiveness of governance should be to improve it continuously. Therefore, assessing how a board learns and invests in developing its own performance should be an important dimension of the model.