Rules are critically important in business. A quick look at scandals like Enron and WorldCom shows just what can happen when a business goes too far in pursuing its self-interest and breaks its own internal guidelines. Corporate governance, encompassing all the principles of open and responsible management, is a way of ensuring that a company keeps within clear ethical lines. It has been top of the policymaker's agenda for some time now, but can be a challenge for businesses on several levels.

What Is Corporate Governance?

If you understand a company as a union of some extremely diverse interest groups – employees, owners, investors, managers, business partners, creditors and customers – then it's clear that you're going to need a system for realizing the best possible handling of relationships between the individual groups so no one gets cheated or exploited. That's essentially the idea behind corporate governance. The technical definition is a system of processes, policies and rules that direct and control a company's behavior. Essentially, it's a code of conduct in business for the good management of companies.

What Are the Basic Principles of Corporate Governance?

Originally, corporate governance was put in place to stop entrepreneurs and owners acting abusively or even criminally on behalf of a company. This is still a key objective today, but the concept has evolved to include all the ways a company should behave in order to foster the trust of investors and other stakeholders. Some of the key aims of corporate governance include:

  • Giving stakeholders confidence that the business is being run to important legal standards so that it never violates applicable laws or regulations, including the unwritten rules of good, ethical behavior.
  • Providing transparency in the company's decision-making processes both in good and bad times.
  • Regulating efficient cooperation between a supervisory board of directors and the management of a company.
  • Ensuring the company exercises prudence in strategy-setting and decision-making so that the best interests of all stakeholders are taken into account.
  • Providing a framework for action if there's a violation of the company's code of conduct.
  • Ensuring the company is geared toward long-term value creation, not short-term gains.

When the company's management works according to a well-defined corporate governance structure, the well-being of everyone involved in the company should automatically be taken care of.

What Are the Key Elements of Corporate Governance?

The key principles of good corporate governance differ depending on the country, industry, regulator and stock exchange. However, most codes of governance include several major characteristics:

Independent leadership: Companies should have an independent leadership to oversee and guide management, such as an independent chairperson or a lead independent director. An owner who selects friends and family members to sit on the board with him runs the risk of nepotism and prejudice. Independent judgement is almost always in the best interest of the company and its stakeholders.

Transparency: One of the fundamental objectives of corporate governance is for organizations to develop transparent business practices and a solid structure and organization so that it can trace all the company's dealings effectively. Another aspect of transparency is the company should provide free and easy-to-understand information to everyone who may be affected by the company's corporate governance policies, such as clear financial reports. That way, everyone can understand the company's strategies and track its financial performance.

Consensus building/ stakeholder relations: The company should consult with the different categories of stakeholders in an ongoing discourse to reach a consensus of how it can best serve everyone's needs sustainably.

Accountability: Consensus building goes hand-in-hand with the principle of accountability, which says the company must be accountable to those who are affected by its decisions. Precisely who is accountable for what should be written down in the company's code of conduct. Large companies often keep corporate governance web pages that indicate specific things the company is doing to meet the expectations of each stakeholder group.

Inclusion or corporate citizenship: The principle of inclusion and corporate citizenship maintains, enhances or generally improves the well-being of all the stakeholder groups. This element of corporate governance typically includes an aspect of social and environmental responsibility, such as using the company's human, technological and natural resources responsibly and acting for the benefit of the community as a whole. Corporate citizenship provides a compelling message regarding the company's value to society.

The rule of law: The company shall operate within the legal frameworks that are enforced by regulatory bodies, for the full protection of stakeholders.

Who Is Responsible for Corporate Governance?

The board of directors is pivotal for the governance of its company. The board's role is to set the company's strategic direction, provide the leadership to put those strategies into effect and supervise the management of the company. Consequently, corporate governance is about the way the board behaves and how it sets the values of the business. This is different from the daily operational management of the company by executives.

Shareholders play a role, too, and must actively participate in corporate governance for it to have any bite. Their role is to appoint the right directors and approve major decisions such as mergers and buyouts. Shareholders have the collective power to take legal action against a company that does not exercise good governance.

From a legal perspective, corporate governance is regulated by state corporate laws, federal securities laws such as the Sarbanes-Oxley Act of 2002 and the listing rules of the New York Stock Exchange and Nasdaq. Together, these codes and laws regulate board size and composition, stock issues, shareholder voting rights, financial reporting and the audit obligations of companies that are listed on a national securities exchange. Failure to follow the regulations could expose the company to lawsuits and fines.

What Are the Issues in Corporate Governance?

Good governance is an ideal which is difficult to achieve in its totality. For the implementation of a rigorous corporate governance code, companies and institutions must come together regionally and internationally to draft corresponding guidelines. One of the main issues, at least in the U.S., is that plenty of well-intentioned people have brought their ideas and experiences to the policy-making table but it hasn't resulted in any clear-cut framework.

To give this context, countries such as the U.K. have had powerful codes of conduct since the 1990s – the position in the U.K. is that every company listed on the London Stock Exchange must comply with the national corporate governance code or explain why it would not. Noncompliance serves as a massive red flag to investors. Generally, this code is considered as the benchmark for sound corporate governance in operations of all sizes.

In the U.S., stock exchanges compete for listings and imposing rigorous corporate governance responsibilities might lose them business. The Securities and Exchange Commission, the primary regulator of listed companies, is hot on the issue of transparency and comes down hard on companies that don't prepare their financial reports properly or disclose information to stakeholders in the appropriate way. However, it doesn't look beyond the issue of disclosure.

So, for example, a company might defy shareholders' wishes and offer a large cash bonus to an unpopular and under-performing director. On the face of it, the decision is an example of poor governance as there's no consensus, inclusion or stakeholder accountability in the decision-making. But the SEC would allow it as long as the company made full disclosure in its reports. This type of regulation has been likened to a stop sign – useful to prevent serious accidents, but in no way a substitute for skillful and judicious driving.

What Are the Challenges of Corporate Governance?

The main problem with corporate governance is that it doesn't stand alone; it has to work in conjunction with a company's mission and values statement to give directors and stakeholders a clear guide about how they should behave. There are several problems that a business might struggle with as follows:

Conflicts of interest: A conflict of interest occurs when a controlling member of the company has other financial interests that could influence his decision-making or conflict with the objectives of the company. For example, a board member of a wind turbine company who owns a significant amount of stock in an oil company is likely to be conflicted, because she has a financial interest in not representing the advancement of green energy. Conflicts of interest erode the trust of stakeholders and the public and potentially open the business up to litigation.

Governance standards: A board can have all the equitable rules and policies it likes but if it can't propagate those standards throughout the business, what chance does the company have? Resistant managers can subvert good corporate governance at the operational level, leaving the business exposed to state or federal law violations and reputational damage with stakeholders. A policy of corporate governance needs a clear enforcement mechanism, applied consistently, as a check and balance against the actions of executive staff.

Short-termism: Good corporate governance requires that boards should have the right to manage the company for the long-term, to create sustainable value. This is problematic for a couple of reasons. First, the rules governing a listed company's performance tend to prioritize short-term performance for the benefit of shareholders. Managers face an unrelenting pressure to meet quarterly earnings targets, since dropping the earnings per share by even a cent or two could hit the company's stock price. Sometimes a company has to go private to achieve the kind of sustainable innovation that cannot be achieved in the glare of the public markets.

The second problem is that directors only sit on boards for a brief period and many face re-election every three years. While this has some benefits – there's an argument that directors cannot be considered independent after 10 years of service – short tenures could rob the board of long-term oversight and critical expertise.

Diversity: It's common sense that boards should have an obligation to ensure the proper mix of skills and perspectives in the boardroom, but few boards take a hard look at their composition and ask whether it reflects the age, gender, race and stakeholder composition of the company. For example, should workers be given a place on the board? This is the norm across most of Europe and evidence suggests that worker participation leads to companies having lower pay inequalities and a greater regard for their workforce. It's a balancing act, however, as companies may focus on protecting jobs instead of making tough decisions.

Accountability issues: Under the current model of corporate governance, the board is positioned squarely between shareholders and management. Authority flows from the shareholders at the top and accountability flows back the other way. In other words, it's shareholders – not stakeholders generally – who are most protected by corporate governance and shareholders – not stakeholders – who get to withhold critical votes unless certain reforms are implemented.

While it's certainly not undesirable to have the actions of the board checked by shareholders in this way, the future of corporate governance is perhaps more holistic. Companies can and do have ethical obligations to their communities, customers, suppliers, creditors and employees, and must take care to protect the interests of non-owner stakeholders in the company code of conduct.