Corporate Governance
Chapter Summary Show This chapter examines the challenges in maintaining an ethical culture within an organization. What policies and procedures should be put into place to ensure that the company conducts itself in an ethical manner, and what should be the consequences when evidence of unethical conduct is found? The chapter begins by explaining and defining corporate governance and how it should be organized in a firm. It discusses the roles and responsibilities of different executives, as well as major governance committees and the board of directors. Further, the two methodologies, “comply or explain” and “comply or else” are differentiated. Learning Outcomes After studying this chapter, the student should be able to:
Learning Outcome 1: Explain the Term 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. Corporate governance is the system by which business corporations are directed and controlled. o It is concerned with how well organizations meet their obligations to their stakeholders—their customers, their vendor partners, state and local entities, and the communities in which they conduct their business operations. Corporate governance is about the way in which boards oversee the running of a company by its managers, and how board members are, in turn accountable to shareholders and the company. Good corporate governance plays a vital role in underpinning the integrity and efficiency of financial markets. o Poor corporate governance weakens a company’s potential and at worst can pave the way for financial difficulties and even fraud. Learning Outcome 3: Explain the S ignificance of the “ King I ” and “King II” Reports. While the issue of corporate governance has reached new heights of media attention in the wake of recent corporate scandals, the topic itself has been receiving increasing attention for over a decade. In 1992, Sir Adrian Cadbury 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. 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 current governor of Bank of England, led a committee that published the “King Report on Corporate Governance” in 1994 o 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.” o “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 corporate 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. o The triple bottom line recognizes the economic, environmental, and social aspects of a company’s activities. o In the words of the King II report, companies must “comply or explain” or “comply or else.” Learning Outcome 4: Explain the Differences between the Following Two Governance Methodologies: “Comply or Explain” and “Comply or Else.” “ Comply or explain ” is a set of guidelines that require companies to abide by a set of operating standards or explain why they choose not to. o The Cadbury report argued for a guideline of comply or explain, which gave companies the flexibility to comply with governance standards or explain why they do not in their corporate documents. o The vagueness of what would constitute an acceptable explanation for not complying, combined with the ease with which such explanations could be buried in the footnotes of an annual report (if they were even there at all) raised concerns that comply or explain would not do much to help corporate governance. o The string of financial scandals that followed the report led many critics to argue that comply or explain offered no real deterrent to corporations. o The answer, they argued, was to move to a more aggressive approach of comply or else. “ Comply or else ” is a set of guidelines that require companies to abide by a set of operating standards or face stiff financial penalties. o The Sarbanes-Oxley Act of 2002 incorporates this approach. Learning Outcome 5: Identify an Appropriate Corporate Governance Model for an Organization. When corporations reach out to consultants, or are approached by consultants with new solutions to maximize the effectiveness of their corporate governance, the issues of finding an accepted benchmark and a comparative measure of one company’s corporate governance versus another’s inevitably arise. o Acronyms typically feature prominently in these measurement frameworks. For example, INSEAD, the European business school, offers the “CRAFTED” principles of governance—“good corporate governance is a culture and a climate of Consistency, Responsibility, Accountability, Fairness, Transparency, and Effectiveness that is Deployed throughout the organization.” The application of a commonly accepted numerical scoring template remains frustratingly elusive. The CRAFTED principles appear to be fairly self-explanatory, and, when questioned, most boards of directors would no doubt offer their wholehearted support for them. If the board is to serve its purpose in setting the operational tone for the organization, it should be comprised of members who represent professional conduct in their own organizations. o Proper authority should be granted, so that the board members can fulfill their responsibilities of oversight, guidance, and approval to the best of their abilities. Unfortunately, the CRAFTED principle of transparency is often foregone in favor of tightly managed information flow by the executive leadership of the organization; and the appointments to the board more often reflect the trading of professional favors and quid pro quo agreements than the utilization of the best available skills and experience. The board must be willing to work with the executive leadership to provide feedback and guidance in a detailed and timely manner.
The board of directors is 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.
The board of directors 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.
In 1992, Sir Adrian Cadbury 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.
At the heart of the Cadbury Committee’s recommendations is a Code of Best Practice designed to achieve the necessary high standards of corporate behavior. By adhering to the Code, listed companies will strengthen both 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.
The King I report 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 of 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. The King II report 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.
The comply or explain is a set of guidelines that require companies to abide by a set of operating standards or explain why they choose not to. The comply or else is a set of guidelines that require companies to abide by a set of operating standards or face stiff financial penalties.
The argument in favor of merging the roles of chairman and CEO is one of efficiency—by putting the leadership of the board of directors and the senior management team in the hands of the same person, the potential for conflict is minimized and, it is argued, the board is given the benefit of leadership from someone who is in touch with the inner workings of the organization rather than an outsider who needs time to get up to speed.
The argument against merging the roles of chairman and CEO is an ethical one. Governance of the corporation is now in the hands of one person, which eliminates the checks and balances process that the board was created for in the first place. As time passes, the CEO slowly populates the board with friends who are less critical of the CEO’s policies and more willing to vote larger and larger salary and benefits packages. With a rubber-stamp board in place to authorize every wish, the CEO now becomes a law unto himself or herself. The independence of the board is compromised, and the power of the stockholders is minimized. The CEO can pursue policies that are focused on maintaining a high share price in the short term without any concern for the long-term stability of the organization.
In the short-term view in the governance of a corporation, the CEO focuses on the numbers for the next quarter. In the long-term view in the governance of a corporation, the CEO focuses on the numbers for the next five or more years. Do the outside directors meet without management on a regular basis? Meeting on a regular basis without management provides an atmosphere in which persuasion by management’s interests are not present. Is the performance of each of your directors periodically reviewed? Evaluation is an important task of any committee or organization.
Students’ answers will vary. Some of them may give the example of Enron. Enron separated the roles of Chairman (Kenneth Lay) and Chief Executive Officer (Jeffrey Skilling)—at least until Skilling’s surprise resignation. The company maintained a roster of independent directors with flawless résumés. It maintained an audit committee consisting exclusively of nonexecutives. However, the true picture was a lot less appealing. Many of the so-called independent directors were affiliated with organizations that benefited directly from Enron’s operations. The directors enjoyed substantial “benefits” that continued to grow as Enron’s fortunes grew. Their role as directors of Enron, a Wall Street darling, guaranteed them positions as directors for other companies—a career package that would jeopardize if they chose to ask too many awkward questions and gain reputations as troublemakers.
Student answers may vary. Possible answers may include: A Deutsche Bank study of Standard & Poor’s 500 firms showed that companies with strong or improving corporate governance outperformed those with poor or deteriorating governance practices by about 19 percent over a two-year period. A Harvard-Wharton study showed that if an investor purchased shares in U. firms with the strongest shareholder rights and sold shares in the ones with the weakest shareholder rights, the investor would have earned abnormal returns of 8 percent per year. o The same study also found that U.-based firms with better governance have faster sales growth and was more profitable than their peers. In a 2002 McKinsey survey, institutional investors said they would pay premiums to own well- governed companies. Premiums averaged 30 percent in Eastern Europe and Africa and 22 percent in Asia and Latin America. Key Terms 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. Board of Directors: A group of individuals who oversee governance of an organization. Elected by vote of 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. 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. “Comply or Else” : A set of guidelines that require companies to abide by a set of operating standards or face stiff financial penalties. “Comply or Explain” : A set of guidelines that require companies to abide by a set of operating standards or explain why they choose not to. Corporate Governance: The system by which business corporations are directed and controlled. Corporate Governance Committee: Committee (staffed by board members and specialists) that 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. Which of the following is true of corporate governance?Which of the following is true concerning corporate governance? Corporate governance provides rules for making decisions on corporate affairs.
What are the four approaches to corporate governance?Study four different approaches to corporate governance, (1) agency theory, (2) the stockholder approach, (3) the stakeholder approach, and (4) stewardship theory.
What are the three main approaches to 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.
Which of the following is not a true statement about corporate governance?Answer and Explanation: The correct answer is D) Its sole objective is to maximize the value of the company in the short-term. The purpose of corporate governance is not restricted to the short term.
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Which of the following is true of the comply or else approach to corporate governance?
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