Corporate governance is the combination of rules, processes and laws by which businesses are operated, regulated and controlled. The term encompasses the internal and external factors that affect the interests of a company’s stakeholders, including shareholders, employees, customers, suppliers, government regulators and management.
The board of directors or corporate executive board is responsible for creating a framework for corporate governance that best aligns business conduct with corporate objectives, prevailing regulation and legislation and industry best practices. Good corporate governance involves establishing principles of security, transparency, equity, compliance, reliance and accountability.
How corporate governance works
Corporate governance is about making sound, ethical decisions to sustain and grow the business long-term. It assures that a business fosters the processes and controls needed to balance all its stakeholders’ interests fairly.
Consequently, corporate governance is a collection of interwoven practices and procedures implemented to address high-level management issues. Every business can consider similar practices and procedures but also approach each consideration in unique ways — as long as the overall business goals are met.
Practices and procedures that are part of good corporate governance can include the following:
- Strategic planning. This determines the purpose, direction and goals for the business.
- Strategic risk planning. This involves understanding the varied risks foreseen by the business and implementing plans to mitigate and respond to those risks as they occur.
- Product planning. This involves deciding on the products and services to be developed and offered by the business. There is often a strong emphasis on competitive, legal and regulatory matters.
- Technology planning. This determines how the company should use technology such as IT, networks and the public cloud to conduct operations and develop products such as new software.
- Sales planning. This includes deciding where and how to generate revenue and profit through the products and services the business develops. This often involves product planning as well as marketing and media planning.
- Financial planning. This process decides how financial resources, including cash, capital and equity, are managed and reported.
- Security planning. This determines how to use and protect business infrastructure and sensitive business data. It can also include acceptable use policies and incident reporting guidelines.
- Media planning. This procedure decides how the business should communicate with internal and external stakeholders on a routine level and in response to emergencies.
Each of these elements can vary in scope and complexity depending on the organization’s needs and can be developed with input from numerous senior managers across the company. Senior leadership typically reviews and approves each plan before it is adopted and implemented. Plans are reviewed and revised frequently as changes arise in business needs, competitive and threat landscapes, regulatory and political shifts and technological evolutions. Reviews enable the business to refine its strategic goals, ensure it will continue forward, and inspire stakeholder trust.
Importance of corporate governance
Corporate governance is critical for the proper functioning of an organization. Demonstrating good corporate governance is vital for maintaining a company’s reputation.
Corporate governance is based on rules, bylaws, policies and procedures to ensure company accountability. When done correctly, it establishes a framework for attaining a company’s objectives in all management spheres. It also recognizes the importance of shareholders. Shareholders elect the company’s board members, fund company operations and have a direct say in the operation of the business.
Good governance ensures a company’s integrity, overall direction, risk management and success planning. This, in turn, helps companies stay financially viable and build strong community, shareholder and investor relations and trust. Demonstrating good corporate governance is often considered as important as profitability for businesses.
Bad corporate governance can lead to a host of adverse outcomes, such as the following:
- Failure to reach company goals.
- Loss of support from stakeholders and community.
- Financial losses.
- Regulatory violations.
- Security breaches and sensitive data misuse.
- Complex and lengthy litigation.
- Collapse of the company.
The role of the board of directors
Ownership is a matter of equity, and modern business organizations are owned by shareholders who possess a financial investment in the business, either through stock or other equity, such as venture capital. However, routine shareholders rarely play a role in the management or operation of a modern corporation.
It is common practice to separate a business’s ownership from its control, so shareholders vote to engage the services of a governing board called a board of directors (BoD). All publicly held companies have a BoD. Privately held companies frequently have a BoD, though fewer rules require one.
Members of the BoD are typically elected or extended through an annual shareholder vote. The size and composition of a BoD can vary depending on the size and needs of the business. The governing BoD hires a senior manager, such as a president or chief operating officer (CEO), to run the business. The senior manager reports to the BoD, which represents the shareholders or business owners.
Where a senior manager is responsible for the day-to-day operation and outcomes of the business, the BoD typically meets several times a year to discuss high-level strategy and outcomes over the last period. A BoD is generally tasked with ensuring that the business and its outcomes serve the best interests of the shareholders and other stakeholders. If not, the BoD can direct the senior manager to make changes or replace them outright — often leading to a broader change in the organization’s senior management team.
A BoD can comprise individuals, including major or majority shareholders, inside executives, such as the CEO, or outside parties, such as venture capital representatives or other nonexecutives. Such professionals with comprehensive industry expertise can help provide objective insight into business and its goals. Beyond the acts of hiring, firing, setting salaries and monitoring the performance of senior managers, a BoD can shoulder other high-level responsibilities, such as these:
- Issuing new shares or classes of stock.
- Authorizing other investments such as loans or venture capital.
- Paying dividends on issued stock.
- Overseeing corporate governance activities and other policies or practices.
Principles of corporate governance
While corporate governance structures can vary, most organizations incorporate the following key elements:
- Fair and equitable treatment. All shareholders, customers, employees and other stakeholders should be treated equally and fairly. Part of this is ensuring shareholders know their rights and how to exercise them.
- Accountability. Legal, contractual and social obligations to shareholders and non-shareholders must be upheld. Organizations should define a code of conduct for board members, committees such as the audit and compensation committees, and senior executives. New individuals joining those ranks must meet those established standards.
- Diversity. The board of directors must ensure diversity, equity and inclusion within corporate governance and the company.
- Oversight and management. Board members must also possess the necessary skills to review and understand management practices.
- Transparency. All corporate governance policies and procedures should be disclosed to relevant stakeholders. This includes regularly and consistently communicating pertinent information to employees, customers, investors, vendors and community members.
Conflict management in corporate governance
One purpose of corporate governance is to implement a checks-and-balances system that minimizes conflicts of interest between various stakeholders and any individual party.
Conflicts arise when two parties have opposing opinions or goals about how business should be conducted. Conflicts of interest can also occur when individual stakeholders might gain personally from a corporate action or decision in which they are in a position to influence. The board of directors should provide a nonbiased way to handle these conflicts.
Conflicts can occur when executives disagree with shareholders. For example, the shareholders might want to pursue goals that generate greater profits, while the CEO might want to invest in better employee engagement efforts. Another type of conflict could arise if multiple shareholders disagree with each other.
Personal conflicts of interest or conflicts among directors, audit plan administrators and company executives are typically disclosed in proxy statements. A proxy statement is a document that shareholders use to evaluate the qualifications and compensation of the board of directors and key senior management staff.
The U.S. Securities and Exchange Commission (SEC) requires public companies to release proxy statements. These statements are shared during annual meetings when a company solicits shareholder votes on a given matter, such as nominating a new member to the corporate board.
Corporate governance models
There is no single means, approach or standard for implementing corporate governance. However, several major governance models have evolved to offer prominent frameworks across different regions, including the Anglo-American, Continental European and Japanese models.
- Anglo-American model. This corporate governance model uses a market-driven approach that emphasizes shareholder value and maximizing investor returns. In short, it seeks to meet the best interests of business owners, focusing on an independent BoD and relying on external oversight to ensure transparency and corporate accountability. This model is common in the U.S., U.K., Canada, Australia and other countries.
- Continental European model. This model offers a broader focus that considers the interests of different stakeholders — not just shareholders — including customers, employees, elements of the supply chain and social responsibility. Employees play a more significant role in governance and are often represented by BoD. This model is common across continental Europe, including Germany and France.
- Japanese model. The Japanese model follows the continental European emphasis on fostering broad stakeholder interests but expands the pursuit of those interests into stable, long-term relationships such as ensuring stable, long-term employment. This model also fosters collaboration and seeks to build stronger ties across all economic interactions, such as government, banking and inter-company relationships. This is the primary corporate governance model in Japan.
Examples of corporate governance
Specific processes that can be outlined in corporate governance can include the following:
- Action plans.
- Performance measurement.
- Environmental, social and governance (ESG) principles.
- Disclosure practices.
- Executive compensation decisions.
- Dividend policies.
- Decision-making practices.
- Procedures for reconciling conflicts of interest.
- Explicit or implicit contracts between the company and stakeholders.
An example of good corporate governance practices is a well-defined and enforced structure that benefits everyone by ensuring that the enterprise adheres to accepted ethical standards, best practices and formal laws.
Alternatively, inadequate corporate governance involves poorly structured, ambiguous and noncompliant approaches to running a business. All of these approaches can damage a business’s image or financial health.
The Enron scandal is an example of poor corporate governance. Enron Corp. declared bankruptcy in 2001 — just months before it was one of the largest companies in the U.S. Enron falsely reported its revenue by a wide margin and used fraudulent methods to hide debts and toxic assets from investors and regulators to avoid accountability. This scandal had a lasting effect on Wall Street and led the government to pass new corporate accountability and governance regulations.
Good corporate governance often goes unnoticed in the public sphere. One example of a company with a reputation for good corporate governance is PepsiCo. In its 2020 proxy statement, the company outlined its leadership structure and changes to the compensation program, as well as input from investors in the following areas:
Regulation of corporate governance
Corporate governance has received increased attention because of high-profile scandals involving abuse of corporate power or alleged criminal activity by corporate officers. To counteract those activities, various laws and regulations have been passed to address the components of corporate governance guidelines, including the following:
- Basel II. This business standard minimizes the financial effect of risky operational decisions. Basel II includes the rights of shareholders, thus affecting corporate governance.
- Gramm-Leach-Bliley Act. GLBA regulates how financial institutions handle private information. Companies must include how they oversee financial organizations and stakeholders in their corporate governance strategy.
- Sarbanes-Oxley Act. SOX was passed after it was found that high-profile companies and their executives were committing fraud — specifically, Enron and WorldCom. As a result, emphasis was placed on corporate governance as a way to restore faith in public companies.
- Dodd-Frank Act. The lesser-known Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires additional proxy disclosures and shareholder votes related to executive compensation. The act also enables more access for shareholder-sponsored director nominees.
In addition, there are specific regulations related to establishing businesses and trading their securities or stock. For example, most U.S. states have specific laws that address the formation, operation and ESG posture of corporations incorporated in a given state. Similarly, the SEC implements an array of rules that corporations must follow to be listed and traded on an exchange to maintain a fair and transparent securities market, such as insider trading rules.
Good corporate governance depends on complying with various regulations, both general and industry-specific. Learn the top cloud compliance standards and how cloud companies can use them.
