Corporate Governance (Encyclopedia of Management)
Corporate governance is the responsibility of a firm's board of directors. While management runs the company and oversees day-to-day operations, it is the board of directors that "governs" the corporations by overseeing management and representing the interests of the firm's shareholders.
By law, a corporation of any size must have a board of directors elected by its shareholders. The directors have a fiduciary duty to the shareholders, who are the corporation's owners, and directors as well as corporate officers can be held liable for failing to meet their fiduciary duties to stockholders. A passive board can get into trouble by relying on an influential CEO.
Investors and the public are particularly interested in the financial reports that publicly-traded companies release, and boards of directors of these companies have a legal obligation to ensure that these reports are fair and accurate. Recent business failures, auditor malfeasance, and material deficiencies in financial disclosures, however, have caused a serious erosion of public confidence in the financial reporting of these companies.
Consequently, Congress enacted the Sarbanes-Oxley Act of 2002. Common law has traditionally held that corporate directors have a primary fiduciary duty to the corporation and a secondary duty the shareholders. Sarbanes-Oxley has essentially made directors primarily responsible to the shareholders. The mandates of Sarbanes-Oxley are both complex and extensive. Stated simply, however, they basically require that members of corporate boards must avoid any financial, family, employee, or business relationships with the companies on whose boards they serve.
Further, Sarbanes-Oxley limits the ability of employees of the independent auditing firm from going to work for companies the auditor performs audit services for, and it requires five-year rotation period for audit partners on a given company's assignments. In other words, Sarbanes-Oxley clearly emphasizes independences and avoidance of conflict of interest.
KEY GOVERNANCE ISSUES
Historically, corporate boards of directors have had a myriad of duties, most of them set by common law and the corporation's own by-laws. These duties often include: hiring, supervising, and sometimes firing the Chief Executive Officer; approving major strategic decisions; meeting with shareholders; establishing executive compensation; making decisions about mergers and acquisitions; assessing the viability of potential takeover bids; taking action if the corporation fails; overseeing financial reporting and audits; nominating board candidates; and refining board rules and policies.
One of the most difficult governance duties of the board of directors is the removal of the firm's CEO. This can occur when the board, representing the interests of the shareholders, disagrees with the strategic direction being pursued by the CEO, or if they merely want to show they are "doing their duty" as board members. For example, when Carly Fiorino was ousted as CEO of Hewlett-Packard (HP) in 2005, she was viewed by many to be hard-driving and fearless. The HP board of directors, however, had grown increasingly uncomfortable with her inability to deliver the profits that she promised she was going to deliver. Her refusal to relinquish some operating control, or to make any changes that the board requested, led to her downfall during a period of low profits and falling stock prices.
One measure of good governance is whether the company has a CEO who can maximize the company's performance. Whereas part of the governance function of the board of directors is to select the firm's CEO, another is to endorse the CEO's strategyf it is the right one. For example, boards can support the CEO's strategic direction by endorsing proposed acquisitions. It can push the CEO to accomplish even more by encouraging him or her to think more broadly or by setting higher sales targets. The board can also support the CEO's leadership by making sure that the CEO is able to put together a strong management team to achieve those goals. In some cases the following CEO will be recruited from the management team built by the present CEO.
Another difficult time for boards occurs when the firm is the target of a takeover attempt. It is vitally important at such a time that the board have a clear sense of the value of the firm and that it is enabled to fully evaluate takeover offers. During a takeover it is the board's responsibility to accept or reject offers, and in so doing it must represent the shareholders' interests when negotiating the sale of the firm.
Boards often administer their governance responsibilities by establishing committees to oversee different areas of concern. Typical committees include audit, nominating, and compensation committees. This is largely in line with U.S. regulatory guidance. On August 16, 2002, the Securities and Exchange Commission (SEC) updated earlier proposals related to corporate governance that would recommend, but not mandate, that boards establish three oversight committees: a nominating committee, a compensation committee, and an audit committee. The SEC recommended that these oversight committees be composed entirely of independent directors.
Each committee oversees a specific area of corporate governance and reports to the full board. The nominating committee's area of oversight consists of issues related to management succession, including the CEO, and to the composition of the board of directors. The compensation committee oversees compensation of the firm's CEO and its officers, as well as director compensation. The audit committee is concerned with the company's financial condition, internal accounting controls, and issues relating to the firm's audit by an independent auditor.
Almost all publicly held corporate entities in the United States have an audit committee. Since 1978, the New York Stock Exchange (NYSE) has required corporations to have audit committees composed entirely of independent outside directors as a condition for being listed. The audit committees of corporate boards of directors are generally expected to serve as watchdogs for the investors and the creditors. Audit committees are expected to protect the interests of both investors and creditors, as well steward corporate accountability. Moreover, audit committees should make sure that management, the internal auditors, and the external auditors understand that the committee will hold them accountable for their actions (and in some cases, inaction).
The independent audit committee plays a key role in stewardship of the corporation it serves. The audit committee should help ensure that the financial statements are fairly stated, the internal controls are operating effectively, management risk is being reduced, and new processes are minimizing risks. Moreover, the audit committee members should be independent of management and maintain a close working relationship with the independent auditors.
In an article in the Pennsylvania CPA Journal, author John M. Fleming sets forth the primary responsibilities of the corporate audit committee: (1) Evaluating the processes in place to assess company risks and the effectiveness of internal controls, and assisting management in improving these processes where necessary; (2) monitoring the financial reporting process both internally and externally; and (3) monitoring and evaluating the performance of internal and external auditors.
A board will sometimes establish a fourth committee, the governance committee. The governance committee is concerned with overseeing how the company is being run, including evaluation of both management and the board of directors. In some cases the nominating committee will evolve into, or function as, a governance committee.
Historically, corporate boards have been described as either active or passive. Some corporate CEOs relished having what they thought were "rubber stamp" boards of directors who would approve virtually any actions they chose to pursue. Sarbanes-Oxley has dramatically changed that dynamic. Corporate directors must now be much more independent, and their legal liability to shareholders has increased significantly.
One example in which a traditionally "quiet" board stepped up and became more active occurred with the Walt Disney Company. For years, Michael Eisner ruled the Disney empire with an allegedly brutal iron fist. After Roy E. Disney, Walt Disney's nephew, led a shareholder revolt of sorts and complained that investor votes were being ignored or circumvented, the Walt Disney Company board of directors finally decided to step in. In early 2004, the board took the chairmanship away from Eisner after more than 45 percent of votes cast at company's annual meeting opposed his board re-election. It was a resounding vote of no confidence. But the board then chose an Eisner ally, former U.S. Senator George Mitchell, as chairman, over the objections of several larger shareholders. Ironically, a year later, Eisner was easily re-elected to the board, with only 8.6 percent of voters withholding their support for him.
Boards can take simpler steps to ensure they are not passive without voting out the CEO. They can establish a non-executive chairman, a chairperson who is separate from the CEO. The board can also staff all board committees with independent outside directors, except the president and CEO.
THE ROLE OF INVESTOR ACTIVISM
Finding qualified people to serve on corporate boards of directors can be a challenging task. Corporate board members are learning in the current legal environment that serving on such board is can open them to a wide range of legal liability issues. The reforms of Sarbanes-Oxley and the SEC all seem well-intended, but will they make a difference for board members who get in over their heads or choose to look away?
Many critics argue that the proposed and enacted reforms do little to solve the real problems that exist with corporate boards. For example, one issue that has been repeatedly raised is the fact that corporate boards tend to only meet a couple of times a year. Yet it is further argued that more frequent meetings do little to solve the major problem, which is the fact that most corporate board members do not have enough access to information to fulfill their duties of stewardship to the shareholders.
Another issue that has been raised after continuous corporate failures revolves around the financial knowledge and competence of corporate board members. One proposed reform to remedy this problem has been to offer more generous pay for corporate board members, particularly those who serve on audit committees. The theory behind the increased pay is that it would help attract more chief financial officers and former chief executive officers from major accounting firms to serve on audit committees.
Proponents of such a move argue that former CFOs and CEOs are ideal audit committee members. But, there remains a limited pool of these professionals available to serve on audit committees. Furthermore, increased disclosure requirements are likely to raise liability for individual audit committee members, thus having a negative impact on their willingness to serve. Increased compensation may not persuade highly-qualified potential committee members to accept the burdensome legal responsibility of vouching for a multinational company's complex and intricate accounting system.
Finally, it is important to realize that having the best and most qualified corporate board of directors is no guarantee that financial reporting or other problems will not occur. Many of the corporate failures, large and small, that occur every year have arisen as a result of inattention, reckless disregard, or malfeasance. While some of the new and proposed regulations may address specific issues that have occurred in certain situations, they will never fully compensate for flaws in human nature. Many corporate failures would still have occurred under the new rules set by Congress and the SEC if board members found ways to ignore or circumvent them. As long as human judgment and discretion is permitted to operate within the corporate board function, there is room for error and wrongdoing.
Byron, Ellen. "Corporate Governance (A Special Report): Managers: Keep Out: Independent Directors Have a Lot More Power These Days, and a Lot More Responsibility." Wall Street Journal, 21 June 2004.
Fleming, John M. "Audit Committee: Roles, Responsibilities, and Performance." Pennsylvania CPA Journal 73 (Summer 2002): 292.
Hymowitz, Carol. "Corporate Governance (A Special Report); Experiments in Corporate Governance: Finding the Right Way to Improve Board Oversight Isn't Easy; But Plenty of Companies are Trying." Wall Street Journal, 21 June 2004.
Karmel, Roberta S. "Should a Duty to the Corporation Be Imposed on Institutional Shareholders?" The Business Lawyer 60 (November 2004): 1.
Raber, Roger. "What Has Really Changed in the American Boardroom." Community Banker 13 (October 2004): 60.
Saporito, Bill. "Why Carly's Out." Time, 21 February 2005, 34.
Sherman, Jay. "Eisner Still in Charge." Television Week, 14 February 2005, 3.
U.S. Securities and Exchange Commission. "NASD and NYSE Rulemaking: Relating to Corporate Governance." Available from <<a href="http://www.sec.gov/rules/sro/348745.htm" target="_blank">http://www.sec.gov/rules/sro/348745.htm>.
Corporate Governance (Encyclopedia of Business)
Corporate governance involves the relationship among the various participants involved in determining the strategy and performance of corporations. The major participants include the firm's shareholders (including large institutions), the management team, and the board of directors. Corporate governance encompasses: corporate performance, succession/nomination, relations between the board and the chief executive officer (CEO), and relations with shareholders and stakeholders.
THE ROLE OF THE BOARD OF DIRECTORS
The ultimate control of the corporation rests with the shareholders. The shareholders elect the members of the board of directors, who set overall policy for the corporation, and appoint the officers. The directors elect a chairperson. The board also appoints the CEO, who manages the day-to-day affairs of the corporation. Being a director is a part-time position that provides compensation in the form of an annual stipend plus a fee for meetings attended.
Most large corporations have boards that are composed of notable corporate executives of other major firms. The directors are typically not aware of the company's daily workings and rely on management to provide this information. They provide, however, an overall direction to the corporation and approve major decisions and proposed structural changes to the firm. Increasingly, boards are expected to be proactive, and are becoming more involved in replacing executives of underperforming corporations.
A board of directors generally consists of both inside members and outside members. Insiders include some of the corporation's senior management, whereas outside directors do not have direct managerial responsibilities over the firm's day-to-day activities. Boards of publicly held companies consist of approximately 9 to 15 members, most of whom are outside directors. The Securities and Exchange Commission (SEC) and several major institutions would like to see a greater proportion of outside directors on the boards of public companies.
Many issues, such as attempts at takeovers, are usually required to be brought up before the board of directors. The board determines requirements and may recommend that the issue be taken to a shareholder vote. The compensation of the senior executive officers of the corporation is also set by the board of directors. The directors usually appoint a compensation committee that is charged with recommending executive compensation to the board as a whole.
INCREASED PRESENCE OF INSTITUTIONAL INVESTORS
In 1950 institutional investors held less than 3 percent of the publicly traded stock of U.S. corporations. By 1991, however, they controlled 53 percent. As a result, institutional investors, particularly large pension and mutual funds, now have the power to directly influence managerial decisions in many corporations.
The collapse of the takeover market in the early 1990s led institutional investors to seek other means of protecting their investment interests. They began introducing shareholder resolutions at annual meetings. Critics of this trend express concern that institutional investors will pressure management to support or increase stock prices, preventing management from undertaking long-term strategic initiatives that will make U.S. corporations competitive in the global marketplace.
In October 1992 the SEC adopted rules that reformed the proxy solicitation process. The new amendments made it easier for institutional stockholders to communicate with each other. Previously, shareholders who desired to communicate with more than ten other shareholders were required to have their comments approved by the SEC before the comments could be circulated. Under the new rules, the SEC no longer serves as editor/sponsor of the material; the only requirement is that the materials be filed with the SEC.
The increased activity of institutional investors has in turn led to a greater emphasis on shareholder value creation. Management now places greater priority on the impact of decisions on its shareholders rather than on other stakeholders such as bondholders, employees, customers, and communities. In addition, companies are actively attempting to communicate important corporate developments to the Wall Street community (and institutional shareholders) through press releases and meetings with Wall Street security analysts and institutional shareholders.
Senior managers are beginning to embrace key equity investors through a process known as relationship investing. Relationship investing consists of an established committed link between a company and one or more shareholders. Under this model, large investors will have greater knowledge about the portfolio companies and play a more significant role in corporate governance and oversight. Accordingly, relationship investing should better align the interests of shareholders and corporations, and increase the probability that the firm will realize the benefits associated with independent oversight of corporate affairs.
In the relationship investing model, representatives of large shareholder groups meet with the company's board of directors on a regular basis to discuss the company's long-term strategy to gain market share and profits and press for change when needed. Armed with greater knowledge, these investors are more likely to work with management and invest for the long term rather than seeking short-term trading profits. Advocates of the relationship investing concept contend that it would bring the corporate governance process in the United States closer to the models employed in Germany and Japan.
Relationship investing comes in two major formsegotiated and nonnegotiated transactions. In nonnegotiated investments, large institutional shareholdersypically pension fundsffer suggestions about corporate policy to the firm's senior managers.
This usually occurs when the investor has held a stock in his or her portfolio that has declined in value, and resolves to take corrective action. In negotiated transactions, the investor makes a large, long-term financial commitment to a company in return for a voice in the way it is managed.
Relationship investing is not without its pitfalls. Investors with sizable stakes may demand constant updates on major corporate decisions, irrespective of their skill levels or ability to effectively manage the corporation. Thus, a CEO could potentially spend all of his or her time communicating with a relationship investor, and not enough time managing the corporation. Moreover, the constant scrutiny of a powerful investor might force a CEO to become more risk averse.
Critics of relationship investing also suggest that nothing fundamentally changes with the firm. In fact, they argue that the extended evaluation period, often stretching from one year to three years, ties up capital longer, and drives up the required rate of return. The strategy of taking small, minority stakes in companies makes the funds more vulnerable to poor managerial decisions than funds that take control of investee companies. In addition, relationship investing may not allow funds the ability to take immediate corrective action if an investment deteriorates, nor determine the timing of the exit strategy for their investments.
CORPORATE GOVERNANCE OVERSEAS
The corporate governance systems in Japan and Germany differ quite markedly from those in practice in the United States. In Japan and Germany, companies benefit from the long-term holdings of banks and other financial institutions, and are less subject to short-term performance pressures.
The boards of Japan's major corporations represent the collective interests of the company and its employees rather than the interests of the firms' shareholders. Almost all directors are senior executives or former employees of the company. Most companies have no outside board members. In large corporations, the outside directors are typically major bank lenders.
Japanese shareholders are passive owners. In Japan, there are overlapping boards of directors, and companies maintain close formal and informal ties with shareholders, customers, suppliers, and employees. These constituent groups overlap in Japan whereas in the United States they are generally independent of one another.
The members of the Japanese kereitsu are usually organized around the leadership of a major financial institution. The shares held by business partners and institutional investors are rarely sold, thus forming blocks of friendly and stable shareholders. This all but prevents the possibility of a hostile takeover attempt being successful in Japan.
Companies in Germany have two boards: a supervisory board and an executive board. The supervisory board typically includes professional advisers to the company, such as lawyers, accountants, and bankers. In turn, the supervisory board appoints the executive board. The most important decisions of the executive board have to be ratified by the supervisory board. In addition, plants with more than five employees are required to have a works council, which must be consulted prior to changes in work practices and dismissals.
In Germany, only a small number of multinational firms have a diversified share ownership. Institutions exert relatively little influence over board policy. As in Japan, corporate cross shareholdings are common. Also, the major universal banks exert substantial control over companies.
[Robert T. Klelman,
updated by Ronald M Horwitz]
Davies, Adrian. A Strategic Approach to Corporate Governance. Gower Pub., 1999.
Keasey, Kevin, and Mike Wright, eds. Corporate Governance: Responsibilities, Risks, and Remuneration. New York: John Wiley & Sons, 1997.
Kleiman, Robert T., Nathan, Kevin, and Joel M. Shulman. "Are There Payoffs for Patient Corporate Investors?" Mergers and Acquisitions, March/April 1994, 34-41.
Monks, Robert A. G., and Nell Minnow. Watching the Watchers: Corporate Governance for the 21st Century. Blackwell, 1996.