Definition of Corporate Governance
In simple words, corporate governance is a system or structure of rules that govern the way a firm is operated. These rules are there to ensure that the firm’s goals are achieved. Essentially, corporate governance entails meeting the interests of a company's various stakeholders. These stakeholders include owners, the public, government, management, etc.
Investors value corporate governance since it demonstrates a company’s direction and credibility. Corporate governance is essential in the development of trust among the various stakeholders especially between the investors and the other stakeholders of a firm.
All the efforts that are undertaken as part of corporate governance are aimed at enhancing the accountability of management to investors. This is done by encouraging ethical efforts on the part of the board members with controlling authority in the firm and preventing them from resorting to unfair activities for corporate success.
There have been various instances in the past that have further reinforced the need for corporate governance practices in a firm.
In this blog, we’ll first go through a few of these instances and then proceed to the fundamental concepts of corporate governance. Finally, we’ll look at the laws and codes in place to ensure suitable corporate governance.
Examples of Corporate Governance:
Volkswagen AG, a German company, was and still is one of the biggest vehicle manufacturers in the world. It resorted to unfair means to profit off the environment. Volkswagen was involved in an emissions scandal, popularly known as “Dieselgate”.
The United States Environmental protection Agency (EPA) issued a notice of the violation of the Clean Air Act in September 2015 to Volkswagen, which is when the scandal began.
Further investigation revealed that Volkswagen had deliberately rigged engine emission equipment in its cars to manipulate pollution test results in America and Europe. As of 1st June 2020, the Dieselgate scandal has cost Volkswagen $33.3 billion.
Enron's con was that the board of directors waived certain conflict-of-interest laws by allowing Andrew Fastow, the company's chief financial officer (CFO), to form new, private companies and do business with the company.
These private partnerships were actually used to conceal Enron's debts and obligations, which would have diminished the company's income.
Eventually, these manipulations in the accounts of the firm were caught but the investors in Enron lost $74 billion and four years later the company declared bankruptcy in December 2001.
In 2001, WorldCom, one of the world's biggest telecommunications providers and a key dividend-paying stock owned by a lot of passive investors and passive investment funds, tried to falsify almost $4 billion in profits on its profit and loss statement. It did so by using the maneuvers of upper management to manipulate the financial records.
Just like Enron, Worldcom too declared bankruptcy in July 2002 and the chief executive officer (CEO) and the chief financial officer (CFO) at the time were both jailed for five and twenty-five years respectively.
Even though, ultimately all these companies had to answer for their misconducts and had to pay hefty fines, a huge amount of damage to other stakeholders especially the general public either directly or indirectly had already been done.
All the examples taken above are of the world’s biggest companies with multiple regulatory practices to avoid such situations in place. Such instances are even more common in small and mid-sized companies with not as many regulations in place.
However, there are companies with robust corporate governance practices and over the years they have been rewarded for them as well. In India, a few of the well-governed companies are- Infosys, Housing Development Finance Corporation (HDFC), Hindustan Unilever, Cipla, Tata Power, and Dr. Reddy’s Laboratories.
A firm should understand that even though unethical practices might result in short-term profits, they can never ensure long-term success. In the next section, we’ll go through the core concepts that differentiate firms on the basis of their corporate governance.
Principles of Corporate Governance
Accountability: Accountability makes sure that the management of a firm is accountable to the board members of the firm who are accountable to the shareholders.
Fairness: Fairness refers to the way a firm treats its minority stakeholders including minority shareholders, foreign investors, and employees.
Transparency: Transparency is responsible for the accurate timely and high-quality disclosure of all the firm’s substantial announcements including financial statements, annual reports, investor presentations, etc.
Independence: The management should make independent decisions and therefore, independence is meant to avoid conflict of interest situations.
Sustainability: Sustainability refers to the development that meets the needs of the present stakeholders without adversely affecting the ability of future generations to meet their needs.
Openness: Openness ensures that material about current events in the company's affairs must be delivered timely with the exception of commercially confidential information.
Reputation: Reputation is a very important aspect for a firm, especially a firm that is publicly listed. The share price of a company is usually directly and strongly correlated to the reputation of the firm which may be good or bad.
Stakeholder Interface: The stakeholder interface encompasses well-defined shareholder rights. Stakeholder interface includes well-organized shareholder meetings, protection of minority shareholders, well-defined and transparent dividend policies, etc.
Good Board Practices: Good board practices are associated with appropriate board procedures, well-defined stakeholders’ authorities, evaluation and training of board members, etc.
Control Environment: Control environment focuses on internal control procedures including risk management frameworks, disaster management systems, media management techniques, independent internal audit committees, etc.
Board Commitment: Board commitment ensures that the board seriously addresses the corporate governance matters and allocates a sufficient amount of resources for the same.
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In the next section, we will look at laws and codes set up to enforce corporate governance in companies all over the world
Corporate Governances’ Law and Codes
Law and codes serve as the primary source of corporate governance in firms worldwide. Different countries have different laws in place to enforce corporate governance and different firms have different codes in place to enforce corporate governance.
Law: A law establishes the minimum legal requirements that serve as the basis for informal codes of best practices.
Codes: Voluntary Codes set a higher standard for corporate governance standards than legal requirements.
Therefore, firms with good corporate governance tend to have several codes set in place supplementing the pre-existing law in place.
Now, we’ll focus on the Sarbanes-Oxley (SOX) Act of 2002, which is considered to be one of the founding laws of corporate governance and is widely accepted all over the world.
Sarbanes-Oxley (SOX) Act:
The Sarbanes-Oxley Act of 2002 was enacted in response to financial uncertainty surrounding publicly listed firms including Enron and WorldCom in the early 2000s.
The high-profile frauds presented by these firms rattled public interest in the accuracy of corporate financial statements and many market participants demanded certain new rules and regulations to tackle such situations in the future.
For this purpose, the U.S. Congress passed the Sarbanes-Oxley Act on July 30, 2002. A few of the key aspect of the SOX act are:
Chief executive officers (CEOs) and chief financial officers (CFOs) must ensure that reports filed with the Securities and Exchange Commission (SEC) are accurate for publicly traded firms.
CEOs and CFOs must affirm that disclosures provide a complete and accurate presentation of their company’s financial conditions and operations.
CEOs and CFOs are responsible for all the aspects of internal controls in the firm and the employees of the firm are required to disclose any significant deficiencies in internal controls.
The effectiveness of a firm’s reporting procedures and controls must be reviewed annually.
The board members are required to be able to understand the various accounting principles, be able to comprehend financial statements, and have experience with internal audits.
In India, The Companies Act, introduced in 1956 and improvised in 2013 is the primary law on corporate governance. Other regulations including the Securities and Exchange Board of India (SEBI) Guidelines, Standard Listing Agreement of Stock Exchanges, Accounting Standards issued by the Institute of Chartered Accountants of India (ICAI), and Secretarial Standards issued by the Institute of Company Secretaries of India (ICSI) are also incorporated to promote good corporate governance practices in India.
An organization with solid, open corporate governance makes ethical choices that favor all of its stakeholders, helping it to position itself as an appealing investment opportunity if its financials are in good shape.
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Bad corporate governance causes a company's collapse, which also results in scandals and bankruptcy.