Corporate governance is the system of rules, practices, and processes by which a firm is directed and controlled. Corporate governance essentially involves balancing the interests of a company’s many stakeholders, such as shareholders, senior management executives, customers, suppliers, financiers, the government, and the community.
Since corporate governance also provides the framework for attaining a company’s objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.
Understanding Corporate Governance
Governance refers specifically to the set of rules, controls, policies, and resolutions put in place to dictate corporate behavior. Proxy advisors and shareholders are important stakeholders who indirectly affect governance, but these are not examples of governance itself. The board of directors is pivotal in governance, and it can have major ramifications for equity valuation.
A company’s corporate governance is important to investors since it shows a company’s direction and business integrity. Good corporate governance helps companies build trust with investors and the community. As a result, corporate governance helps promote financial viability by creating a long-term investment opportunity for market participants.
Communicating a firm’s corporate governance is a key component of community and investor relations. On Apple Inc.’s investor relations site, for example, the firm outlines its corporate leadership—its executive team, its board of directors—and its corporate governance, including its committee charters and governance documents, such as bylaws, stock ownership guidelines, and articles of incorporation.
Corporate Governance and the Board of Directors
The board of directors is the primary direct stakeholder influencing corporate governance. Directors are elected by shareholders or appointed by other board members, and they represent shareholders of the company.
The board is tasked with making important decisions, such as corporate officer appointments, executive compensation, and dividend policy. In some instances, board obligations stretch beyond financial optimization, as when shareholder resolutions call for certain social or environmental concerns to be prioritized.
Boards are often made up of inside and independent members. Insiders are major shareholders, founders, and executives. Independent directors do not share the ties of the insiders, but they are chosen because of their experience managing or directing other large companies. Independents are considered helpful for governance because they dilute the concentration of power and help align shareholder interests with those of the insiders.
The board of directors must ensure that the company’s corporate governance policies incorporate the corporate strategy, risk management, accountability, transparency, and ethical business practices.
As an investor, you want to ensure that the company you are looking to buy shares of practices good corporate governance, in the hope of avoiding losses in cases such as Enron and Worldcom. There are certain areas that an investor can focus on to determine whether a company is practicing good corporate governance or not.
These areas include disclosure practices, executive compensation structure (is it tied only to performance or other metrics?), risk management (what are the checks and balances of making decisions in the company?), policies and procedures on reconciling conflicts of interest (how does a company approach business decisions that might conflict with its mission statement?), the members of the board of the directors (do they have a stake in profits?), contractual and social obligations (how do they approach areas such as climate change?), relationships with vendors, complaints received from shareholders and how they were addressed, and audits (how often are internal and external audits conducted and how have issues been handled?).
Types of bad governance practices include:
- Companies that do not cooperate sufficiently with auditors or do not select auditors with the appropriate scale, resulting in the publication of spurious or noncompliant financial documents
- Bad executive compensation packages that fail to create an optimal incentive for corporate officers
- Poorly structured boards that make it too difficult for shareholders to oust ineffective incumbents
These are all areas an investor can research before making an investment decision