Corporate governance practices differ from country to country, and even within a country several governance systems may be practiced. There is no single universally accepted definition of corporate governance.
The curriculum defines corporate governance as the arrangement of checks, balances, and incentives that exists to manage conflicting interests among a company’s management, board, shareholders, creditors, and other stakeholders.
Stakeholder management involves identifying, prioritizing, and understanding the interests of stakeholder groups and managing the company’s relationships with stakeholders.
Mechanisms to mitigate shareholder risks include company reporting and transparency, general meetings, investor activism, derivative lawsuits, and corporate takeovers.
Corporate Reporting and Transparency
Shareholders have access to financial and non-financial information about the company from annual reports, proxy statements, disclosures on the company’s website, the investor relations department, and other channels. Such information helps shareholders to:
General meetings provide an opportunity to shareholders to exercise their vote on major corporate issues. There are typically two types of general meetings:
Number of votes required may be one of the following two types based on the type of resolution to be passed:
Proxy voting allows shareholders to authorize another individual to vote on their behalf at the AGM. In cumulative voting, shareholders may accumulate their votes to vote for one candidate in an election that involves more than one director.
Shareholder activism refers to strategies used by shareholders to attempt to compel a company to act in a desired manner. The primary motivation of activist shareholders is to increase shareholder value. Hedge funds are amongst the most predominant shareholder activists.
Shareholder Derivative Lawsuits
Shareholder derivative lawsuits are legal proceedings initiated by one or more shareholders against board directors, management, and/or controlling shareholders of the company. However, in many countries, the law prohibits shareholders from taking legal action through the court system.
Shareholders prefer corporate takeover if the management of a company underperforms. The commonly used methods for corporate takeovers are as follows:
Mechanisms to mitigate creditor risks include bond indenture(s), company reporting and transparency, and committee participation.
Corporate Reporting and Transparency
Creditors require the company to provide periodic financial information to monitor the risk exposure and to ensure covenants are not violated.
In some countries, official creditor committees are formed once a company files for bankruptcy. Such committees are expected to represent bondholders throughout the bankruptcy proceedings and protect bondholder interests in any restructuring or liquidation.
The board of directors delegates specific functions to individual committees that, in turn, report to the board on a regular basis. The most commonly established board committees are:
The key functions of the audit committee include:
The key functions of the governance committee include:
Remuneration or Compensation Committee
The key functions of the remuneration committee include:
The key functions of the nomination committee include:
The key functions of the risk committee include:
Standard rights of employees in any country such as hours of work, pension and retirement plans, vacation and leave, are defined in labor laws. Employees can form unions in many countries to collectively influence the management on issues they may face.
Individual employee contracts define an employee’s rights and responsibilities, remunerations, and other benefits such as ESOPs.
Companies enter into contracts with both customers and suppliers that define the products, services, any guarantee, after-sales support, payment terms, etc. It also defines the course of action in case one party violates the contract.
Governments and regulatory agencies pass laws to protect the interests of consumers or specific stakeholders. Sensitive industries such as banks, health care, and food manufacturing companies have to comply with a rigorous regulatory framework.
Corporate Governance Codes
Many regulatory authorities have also adopted corporate governance codes, which are guiding principles for publicly traded companies. These codes require companies to disclose whether they have implemented recommended corporate governance practices or explain why they have not done so.
The rights of stakeholders depend on the law of the country the company operates in. There are primarily two law systems.
Creditors are more successful in winning legal battles when the terms of indenture are violated. In contrast, shareholders find it difficult to prove in court that a manager/director has not acted in their best interests.
In this section, we analyze the risks a company faces due to a poor governance structure.
Weak Control Systems
Weak control systems and poor monitoring can affect a company’s performance and value. One example is that of Enron where auditors failed to uncover fraudulent reporting that ultimately affected many stakeholders.
Poor decisions include managers avoiding good investment opportunities to maintain a low-risk profile or taking on excessive risk without properly evaluating potential investments. Both decisions are not in the interests of shareholders. Such decisions may result from information asymmetry, when managers have access to more information than the board/shareholders.
Legal, Regulatory, and Reputational Risks
Improper implementation and monitoring of corporate governance procedures may result in the following risks:
Default and Bankruptcy Risks
Poor corporate governance may affect the company’s performance, which in turn may affect the company’s ability to service its debt. If creditors’ rights are violated and they choose to take legal action on defaulting debt, the company may be forced to file for bankruptcy.
The benefits of good corporate governance and stakeholder management are as follows: