Corporate Governance

Corporate governance is no rocket science. In simple words, corporate governance is a system that helps to direct and control companies (Fraser, 2018). The definition of corporate governance could change according to the nature of the organization. In other words, it could be described as a framework that encourages the efficient use of resources (Hafiz and Ladan, 2015). For instant let us assume we have an organization named X and it has several subsidiaries. Organization X is the corporate unit that takes all the strategical decisions of the business such as which path the business should take, whether or whether not to invest in subsidiaries.

Corporate governance is about ruling the organizational affairs effectively by the organization’s management and the board (Reuters, 2009). The board of directors who are well experienced in the industry, knowledgeable, independent, and better at making strategical decisions. The board should regularly oversee, review, approve the actions that need to be taken to manage risk or any possible challengers that businesses could face (Fraser, 2018).

Why Corporate governance is important?

Corporate governance is important as it provides a structure that determines the organization to drive towards the organization’s objectives (Basel, 1999). However, the concept of corporate governance born with the idea of having a need to protect the investments of the stakeholders. Poor corporate governance could lead the organization to financial difficulties (Hafiz and Ladan, 2015). On the other hand, good governance drives the organization to perform well (Gupta, Sharma, and Guptha, 2020). Corporate governance is important because it makes the organization transparent to investors. And also, it makes the organization accountable.

A good real-world example of why we should care about corporate governance is, in 2019, ex-chairman of the Nissan; Carlos Ghosn was accused of financial misconduct. He was charged for breach of trust and stating his income as a lower value than the actual value. Therefore the organizations should care about corporate governance as it helps the organizations to avoid such misconduct (Fraser, 2018).

What is good corporate governance?

As corporate governance is a critical factor that investors consider before investing in the business, good corporate governance can be introduced as an asset for growth. Mckinsey survey, which is conducted in 2002, showed that the investors tend to invest more in well-governed companies (Teitey, 2020).

A business required to have corporate governance to address the separation between ownership and control. The business consists of shareholders. Shareholders are those who own the business and also, they have their own objectives. Shareholders are expecting the directors of the business to fulfill their objectives. On the other hand, directors also have objectives. At some point, those objectives of both parties may contradict. At this exact point where corporate governance comes to play to ensure that the directors behave to make sure that the shareholders’ objectives are met.

Corporate governance has two approaches as mentioned below.

· Rules-based

· Principle-based

Rules-Based

Rules based approach is where there are legal requirements for organizations to follow. If any organization fails to follow those rules as mentioned there will be legal consequences.

Principle-Based

It is a more flexible approach and one of the best practices.

However, the principle-based approach is better than the rules-based approach as judgments are made by the owners whereas in a rules-based approach judgment is made by the court.

What are the best practices of corporate governance?

One of the key elements of corporate governance is the structure of the board. As a best practice is at least half of the board should consist of non-executive members also known as NEDS. Non-executive members have nothing to do with the operations of the organization. Non-executive members are often part-time employees with higher industrial experience. The main focus of NEDS being on the board is to represent what shareholders need. Why is it important to have at least 50% of the board filled with non-executive members is that any of the decisions that are made by the board won’t be dominated by the members who have the operational responsibilities inside the organization. For an instance let us assume that the board consists of the head of financial, so when taking the decisions there is a possibility of considering what is happening within the financial department rather than considering the business as a whole. Having at least 50% of the board filled with NEDS could avoid such things happening as the majority is being outsiders from the organizational operations. Now the question comes if the NEDS are outsiders what exactly they would bring to the table. The answer is NEDS brings strategy, scrutiny, risk, and people. NEDS brings the business strategies and inspects the executive directors to ensure that the decisions that are taken by the executive directors drive the business towards the shareholder’s objectives. Also, the NEDS makes sure risk management has been in place properly. Furthermore, the NEDS ensures the number of members on the board is correct and the members are who are on the board are the right type and right role.

The other key factor of corporate governance best practice is to ensure that the chairman who leads the board and the Chief Executive Officer is also known as CEO who manages the executives in the organization are two separate roles that are owned by two separate individuals. Now the question is why we cannot have one person who is both the chairperson and the CEO. One reason is that it is too much work for one person to handle. Also giving such power to a one-person could be problematic for the shareholders of the business.

The best practice code of corporate governance recommends having three board subcommittees. Those subcommittees are mentioned below.

· Audit committee

· Nominating committee

· Remuneration Committee

Audit Committee

This committee’s main objective is to review the financial statements of the business. This committee consists of three non-executive directors. Also, it is required at least one member has a handful of experience in finance. The advantage of having non-executive directors in the audit committee is that they can get the honest opinion on the external audit as they are more comfortable talking to non-executive directors on what they see wrong in the financial department rather discussing with the finance department itself. Also, the audit committee ensures that risk management is taken place.

Nomination Committee

The nomination committee by definition decides who is named as directors. On the other hand, they have the power of deciding the board’s structure such as what is the maximum number of members so and so. Most importantly the nomination committee decides whether the board is going to have internal members or whether the board is going to hire outsiders.

Remuneration Committee

The remuneration committee is formed to decide on how the business is going to pay the directors. Basically, they will investigate things like fixed salary to bonus ratio or pay the directors based on their performance. When considering the performance-based payments, the committee ensures that it motivates the directors to drive the business through the break-even point of the business also they ensure that the directors won’t be taking any unnecessary risks on the way. Also, this method is used to encourage the directors to drive towards the long-term goals that are defined by the shareholders.

Even though above mentioned three subcommittees are mainly introduced as best practices, there is a fourth subcommittee that came to play recently named the risk committee. Usually, risk management is handled by the audit committee. With the idea of having a risk committee, it takes the burden of managing risks out from the audit committee. Also, by having a risk committee, it gives more weight to risk management. Another advantage of having a risk committee is to have an executive director investigates the risk management directly. On the other hand, it ensures that risk management is given the necessary attention within the organization.

What are Corporate Governance codes?

1. Leadership

2. Effectiveness

3. Accountability

4. Remuneration

5. Relations with Shareholders

Leadership: Investigate the roles of chairman and CEO separately and ensure those two roles are handled by two different people.

Effectiveness: Effectiveness of the board. For instance, whether the directors are having enough time for their job within the organization, whether they are given enough information before participating in the meetings so that they can come up with strategical decisions.

Accountability: Liabilities of the board and refine the liabilities of each member of the board. But most importantly to ensure that the performance and all the operations of an organization are responsible for the board.

Remuneration: To ensure that the directors are behaving in the same way that the shareholders want them to.

Relations with Shareholders: Having a strong relationship with shareholders.

Corporate governance is not only for large organizations. This could be implemented in small businesses as well. Why it is important to be aware of corporate governance is that having better corporate governance drags the attention of the investors. If the organization is looking towards the growth of the organization then the assets the organization should possess is a good corporate governance system.

References

Fraser, A. (2019). Corporate Governance. In: . Ram & McRae Corporate Governance Seminar

Reuters (2009) 2007/2008 financial crisis is considered by many economists to have been the worst financial crisissince great depression of the 1930.

‌Basel, (1999) Enhancing Corporate Governance for Banking Organisations.

Gupta, R., Sharma, S.C. and Gupta, P. (2020). “Corporate Governance” Importance, Pillars and Principle (Road to Corporate Transparency). Journal of Critical Reviews, 7(12).