Corporate governance

Governance is nothing but action or manner of administering. Hence, when we say corporate governance, it is the manner of governing or administering a corporate organization. It includes a mechanism through which policies are established to regulate the organization and also continuously monitored in order to examine its effectiveness in the organization. We are very much familiar with concept of government, which governs or administers the country. Basically, these government comprises of Prime Minister/President as country head followed by various Ministers and secretaries which makes a governing unit of a government, working for the best interest of the country with certain strategies and policies. Similarly, in a corporate entities we have Board of Directors which along with support of CEO and management team are responsible for governing the organization for the best interest of that corporate organization. Having a sound corporate governance is very much important in an organization as it is what defines how a corporation should be directed and run to meet the desired objective while taking care of all the stakeholders in the process.

There are various perspectives to define corporate governance. From operational perspective, it may be defined as the system through which companies are directed and controlled. From the relational perspective, it may include division of roles among various stakeholders involved such as shareholders, BOD, management, etc. and functioning of the company as per the defined roles. From stakeholders’ perspective, it could be defined as process by which company functions for benefit of shareholders. From financial economics perspective, it could be the process through which company make sure to generate the healthy profit out of investment made. Whereas, from social perspective, corporate governance could be the process that not just take care of stakeholders, internal members or contractual parties who are directly linked with company but also the external parties or people in the community or society. In this perspective, society is also considered in the process of governance. Sir Adrain Cadbury addressing Global Corporate Governance forum of World Bank in 2000 said, “Corporate Governance is concerned with holding the balance between economic and social goals and between individual and communal goals.”

Scope and significance of corporate governance

As we talked about different perspective while defining corporate governance, what we understood is that corporate governance involves around various parties in and around the company. The scope of governance would include Shareholders, Board of Directors, Management, Market Intermediaries, Finance market, contractual shareholders, customers or suppliers, government entities and other regulating authority, media and society. Apart from these, external auditors also play a vital role in corporate governance. Their auditing is one of the core most way to ensure that an organization is financially functioning well within the setup rules and policies. Since so many of the stakeholders are directly and indirectly affected by it, importance of corporate governance becomes even more significant.

In a company, generally shareholders and investors are the one who invest their money into it with all the risk. However, once invested they have little control over how that money is used or mobilized. The money is expensed by management of organization which have no ownership of that money. Hence, good governance is very much essential to protect the shareholders’ money against misuse. Having said that, significance of good governance isn’t limited to that. Good governance can enable better functioning of the firm which in turn can encourage outside investors and attract the capital to further strengthen the firm financially to scale up. Good governance also helps in forming effective management and organizational structure which can lead to better efficiency. It also helps to ensure that everyone including board of directors and top management are acting ethically which helps to enforce the integrity of the company. This also, helps to foster a healthy culture in the organization.

Read more on: Scope of corporate governance

Theory of corporate governance

While it is important to understand the significance of a good corporate governance, it is even more important to actually use that understanding into practice and apply a good corporate governance in companies or organizations. There are various theories of corporate governance which can help us to design the framework. These theories are postulated based on the causes and effects of variables such as: structure of BOD, audit committee, dependency of managers, role of top management and their social relations beyond the legal regulatory framework, etc. Some of the popular theories are agency theory, stewardship theory and transaction cost economies.

Agency theory is a little conservative type of theory which tries to explain the relationship between principals and agent. Here, principals are the shareholders and agents are the top management including board of directors. It assumes that both of them want best for themselves from the organization. And hence, agent who works on behalf of principal agent may try to rip maximum benefit out of the organization for themselves. Agency theory is concerned with resolving problems that can exist in agency relationships due to unaligned goals between these parties. Theory of transaction cost of economics, which is regarded as part of agency theory, suggests that there will occur a cost whenever a transaction takes place whether be it in the form of managers taking charges to run the organization or be it the good & services that the company purchase. It stresses upon corporate governance framework revolving around the organizational structure with focus on internal and external transactions. Another theory is stewardship theory which contradicts agency theory. It believes that directors or the “so called agents” do not inevitably act in a way that maximizes their own personal interests. It argues that they can do and act responsively with independence and integrity. Since people are guided by moral values and principles, reinforced by social forces and ethics; stewardship theory assumes and advocates that directors or managers, left on their own, will act as stewards of assets they control and will demonstrate positive behavior and action in favor of the organization.

Apart from these theories, we have stakeholder theory, resource dependency theory, political theory, ethical theory, etc. which incorporate the idea of corporate governance. However, each of these theories and the ones presented above have some criticism. Hence, effective corporate governance requires applying a combination of these existing corporate governance theories, rather than applying an individual theory.

Governance of corporate entities

Depending on the nature of liability/shareholders/objective of that entity, there are various kinds of entities such as limited liability companies, public companies, government corporations, joint ventures, social or charity organizations, private or family run business, etc. Each of these entities has their own style of governance. Hence, the corporate governance depends a lot on the nature of that company as well.

Generally, private companies are owned and directed by founders. Hence, the governance of company is more or less dependent on the founder itself. Since founder himself is in the charge, there is less fear of investment being misused. Hence, private companies has requires less demanding governance-standards than the public companies. In case of public companies, vast portion of shareholders, who are general public, has little control over how their money is used in the organization or company. Besides, management has more of the inside knowledge than the owners themselves. Hence, a tighter legislation and practices of governance is demanded. However, even in the case of public or listed companies as well, the person or entity with significant amount of share in that company can have some influence in the company. In US history, we have seen cases of hostile takeovers of companies by raiders. Frequency of meetings, formalities in proceedings or decision making can be less in private companies than in public companies. Family owned businesses is a form of private owned company, where governance of company is transferred from one generation to another.

In case of subsidiaries, parent company (aka holding company) setup the governance rules & policies for that subsidiaries and are more or less in line with parent company. Whereas, in case of joint ventures, the governance is decided on mutual agreement between the entities who agreed to enter into the joint venture. This can have more complexity if these parties have some disagreement on any issues that were not clearly defined in the agreement beforehand. In case of employee owned companies, priorities could be given more on rewarding and motivating the employees for retaining their long term interest in the company. For non-profit or social organizations, governance would be based on the community objectives and the constitution of that organization. The hedge funds, sovereign funds and private equity firms are the entities with less transparent governance and is relatively unregulated.