Chapter 5 Corporate Governance

Learning Outcomes Explain the term corporate governance Understand the responsibilities of the board of directors and the major governance committees Explain the significance of the “King I” and “King II” reports

Learning Outcomes (continued) Explain the differences between the following two governance methodologies: “comply or explain” and “comply or else” Identify an appropriate corporate governance model for an organization

Corporate Governance System by which business corporations are directed and controlled Good corporate governance - Plays a vital role in underpinning the integrity and efficiency of financial markets Poor corporate governance - Weakens a company’s potential and can lead to financial difficulties and fraud

What Does Corporate Governance Look Like? Owners - Supply equity or risk capital to the company by purchasing shares in the corporation Board of directors: Group of individuals who oversee governance of an organization Elected by vote of the shareholders at the annual general meeting (AGM)

Audit and Compensation Committees Operating committees staffed by members of the board of directors plus independent or outside directors Audit committees are responsible for monitoring the financial policies and procedures of the organization Compensation committees are responsible for setting the compensation for the CEO and other senior executives

Corporate Governance Committee Monitors the ethical performance of the corporation Oversees compliance with the company’s internal code of ethics as well as any federal and state regulations on corporate conduct

Figure 5.1 - Governance of the Modern Corporation Source: Adapted from Fred R. Kaen, A Blueprint for Corporate Governance (New York: AMACOM, 2003).

In Pursuit of Corporate Governance King I report was recognized as advocating the highest standards of corporate governance Took a more integrated approach to the topic of corporate governance By recognizing the involvement of all the corporation’s stakeholders in the efficient and appropriate operation of the organization

King II Report Formally recognized the need to: Move the stakeholder model forward Consider a triple bottom line as opposed to the traditional single bottom line of profitability Triple bottom line recognizes the economic, environmental, and social aspects of a company’s activities Successful governance in the world in the 21st century requires companies to adopt an inclusive and not exclusive approach

King II Report (continued) Company must be open to institutional activism and should emphasize the sustainable or non-financial aspects of its performance Boards must apply the tests of fairness, accountability, responsibility, and transparency to all acts and be accountable to the company and its stakeholders Correct balance between conformance with governance principles and performance in an entrepreneurial market economy must be found

Two Governance Methodologies Comply or explain  Set of guidelines that require companies to abide by a set of operating standards or explain why they choose not to Comply or else Set of guidelines that require companies to abide by a set of operating standards or face stiff financial penalties

The Chairman and the CEO Disregarding the corporate governance model involves merging the roles of chief executive officer (CEO) and chairman of the board into one individual Oversight provided by the board of directors is lost Operational focus changes from long term to short term Merging the two roles may lead to higher efficiency

The Chairman and the CEO (continued) Advantages of merging Disadvantages of merging Potential for conflict is minimized Board is given the benefit of leadership from someone who is in touch with the inner workings of the organization rather than an outsider Governance of the corporation is with one person, which eliminates the checks and balances process that the board was created for in the first place Independence of the board is compromised, and the power of the stockholders is minimized

Effective Corporate Governance European business school INSEAD emphasizes corporate governance as an organizational culture issue through CRAFTED principles Consistency, responsibility, accountability, fairness, transparency, and effectiveness that is deployed throughout the organization

Effective Corporate Governance (continued 1) To serve the purpose in setting the operational tone for the organization, the board should be: Comprised of members who represent professional conduct Granted proper authority to fulfill their responsibilities of oversight, guidance, and approval Willing to work with the executive leadership to provide feedback and guidance in a detailed and timely manner

Effective Corporate Governance (continued 2) Electing to take strategic projects under advisement for extended periods of time may serve to reinforce the power of the board of directors

Dangers of a Corporate Governance Checklist Effective corporate governance is more than just maintaining a checklist of items to be monitored on a regular basis Having mechanisms in place will not guarantee good governance

A Fiduciary Responsibility Corporate governance is about managers fulfilling a fiduciary responsibility to the owners of their companies Based on trust, which is a difficult trait to test when hiring a manager or enforcing it later Enforcement is only an option when trust is broken

Key Safeguards for Corporate Governance Properly constituted boards Separation of the functions of chairperson and CEO Audit committees Vigilant shareholders Financial reporting and auditing systems that provide full and timely disclosure