Conceptual Framework of Corporate Governance

Overview

The purpose of corporate governance is to help build an environment of trust, transparency and accountability necessary for fostering long-term investment, financial stability and business integrity, thereby supporting stronger growth and more inclusive societies.

There is no single authority regulating corporate governance. Its principles evolve overtime addressing the needs of the industry which may vary among jurisdictions. Globalization, the treatment of investors and major corporate scandals have been major driving forces behind corporate governance developments.

The accepted principles of corporate governance are scattered among various sources such as

Law; Revised Corporation Code, Sarbanes-Oxley Act 2002
Codes or Standards; SEC Code of Corporate Governance, UK Corporate Governance Code, The King Report, Organization for Economic Co-operation and Development (OECD), International Standards for the Professional Practice of Internal Auditing
Corporate governance theories; Transaction costs theory, Stewardship Theory, Stakeholder theory, Stockholder Theory, Agency Theory
Other Publications; The Essential Books of Corporate Governance (G.N Bajpai), Corporate Governance Matters (David Larcker)

Course Objectives

After studying this module, you should be able to

Define and explain the meaning of corporate governance;
Discuss the implications of the separation of ownership and control;
Analyze the purposes and objectives of corporate governance;
Describe the decision authority and incentives of shareholders, boards of directors, and top management;
Recognize the impact of organizational culture on the overall control environment and individual engagement risks and controls;
Describe and compare the essentials of rules and principles-based approaches to corporate governance, including the comply or explain principle; and
Explore the objectives, content, and limitation of various codes of corporate governance intended to apply to multiple national jurisdictions.

Course Materials

Definition

Corporate governance means to steer an organization. Governance comes from the Latin word “gubanare” which means “to steer.”

Today, corporate governance is given various meanings as follows:

Corporate governance is the system by which businesses are directed and controlled.

Corporate governance is the system of stewardship and control to guide organizations in fulfilling their long-term economic, moral, legal and social obligations towards their stakeholders.

Corporate governance is a system of direction, feedback and control using regulations, performance standards and ethical guidelines to hold the Board and senior management accountable for ensuring ethical behavior – reconciling long-term customer satisfaction with shareholder value – to the benefit of all stakeholders and society.

Corporate Governance is a set of relationships between a company's directors, its shareholders and other stakeholders. It also provides the structure through which the objectives of the company are set, and the means of achieving those objectives and monitoring performance, are determined.

The combination of processes and structures implemented by the board to inform, direct, manage, and monitor the activities of the organization toward the achievement of its objectives.

Corporate Governance is about promoting corporate fairness, transparency and accountability.

Corporate governance deals with laws, procedures, practices and implicit rules that determine a company’s ability to take informed managerial decisions vis-à-vis its claimants - in particular, its shareholders, creditors, customers, the State and employees.

Corporate governance is a system of organizational control that defines and establishes the responsibility and accountability of the major participants in an organization.

Simply put, corporate governance is the road map of an organization in order to maximize shareholders’ wealth and protect stakeholders’ interests.

Based on the above definitions, corporate governance best fits in an organization where the following are present:

Separation of ownership and control
Stakeholders who have legitimate interests in the organization
Underlying principles of corporate governance

Separation of Ownership and Control

Corporate governance has partly developed in response to the issues arising from the corporate structure which separates ownership and control. But what determines structure?

“Structure follows the strategy,” former president of a big water firm espoused. For example, under transaction costs theory, the way the company is organized or governed determines its control over transactions.

The strategy also sets the legal structure of an organization. Such legal structure, in turn, sets the framework and governing rules under which it operates.

Lascano, et. al., in his book Fundamentals of Financial Markets, discussed the forms of organization in this wise:

Sole proprietorship is a type of business organization which an individual personally owns a business. The Sole proprietorship has no distinct personality from the owner; thus, the owner is responsible for all debts and obligations. The owner has full control regarding decision making of the business.
Partnership is formed when two or more persons bind themselves to contribute money, property, or industry to a common fund with the intention of dividing the profits and ownership among themselves. Though the partnership is a separate legal entity from the partners, the partners are still personally obliged to pay for the debts of the partnership. In case of bankruptcy, creditors can compel the partners to pay up to the extent of their personal assets.
Corporation is a legal entity with a personality separate and distinct from the owners/shareholders. Limited liability exists. This means that even if the corporation goes bankrupt, shareholders will only lose his investments equivalent to the amount of his shareholdings.

This separation of ownership and control has led to agency problem since corporation is managed by agents who may not operate it in the best interest of the shareholders.

In finance theory, the basic assumption is that the primary objective for companies is shareholders wealth maximization. Agency theory takes the stance that management is likely to pursue their own personal interests, rather than act as stewards. Transactions cost theory considers that managers’ decisions are limited by the understanding of alternatives that they have, that managers are opportunistic, that they will organize their transactions to pursue their own convenience.

Corporate governance counters this conflict by providing a system that aligns the interest of the owners and managers and putting in place a system of oversight.

Stakeholders

Stakeholders are persons or groups that have a legitimate interest in a business's conduct and whose concerns should be addressed as a matter of principle. A stakeholder can be anyone who has any type of stake in a business.

There are several ways to classify stakeholders such as by Proximity, Legitimacy, Claims, Voice, How much affected, How much affects, Degree of Participation, Engagement, and Public Knowledge.

Each stakeholder has different claims from the organization. For example, customers demand low price but high quality goods and services; employees seek higher compensation and good working conditions and environment; trade unions protect the interest of the employees; Investors require high financial return, government enforces taxes, imposes laws, and protects public interest; and the society in general is conscious on the effect of the business to health of inhabitants, peace and security of the community, jobs creation, economic development, and preservation of environment.

Which of these conflicting interests are legitimate?

Stockholder theory (shareholder theory) argues that shareholders (as principals) own the company. As owners, they alone have a legitimate claim to influence over the company. It is the directors’ sole duty to maximize the wealth of the shareholders.

Under stakeholder theory, management has a duty of care, not just to the owners of the company in terms of maximizing shareholder value, but also to the wider community of interest, or stakeholders. Stakeholder theory proposes corporate accountability to a broad range of stakeholders. In case of conflict of interest, the managers are responsible to mediate between these different stakeholders’ interest.

Fernando Zobel De Ayala, President & COO of Ayala Corporation said, “We do not work in isolation. [It is] important to support the very ecosystem that makes us successful.”

Mendelow classifies stakeholders on a matrix whose axes are power held and likelihood of showing an interest in the organization’s activities.

Key players are found in Segment D. The organization’s strategy must be acceptable to them, at least. An example would be a major customer. These stakeholders may participate in decision-making.

Stakeholders in Segment C must be treated with care. They are capable of moving to Segment D. They should therefore be kept satisfied. Large institutional shareholders might fall into Segment C.

Stakeholders in Segment B do not have great ability to influence strategy, but their views can be important in influencing more powerful stakeholders, perhaps by lobbying. They should therefore be kept informed. Community representatives and charities might fall into Segment B.

Minimal effort is expended on Segment A. An example might be a contractor's employees.

Underlying Principles of Corporate Governance

Good corporate governance allows company to reap the full benefits of international and local capital markets, improve investors’ confidence, reduce cost of capital, and induce stable sources of financing.

However, there is no one size fits all framework of corporate governance. Rather, it must be principles-based to allow a company certain degree of flexibility in shaping its own best practices based on the company’s age, size, complexity, extent of internal operations, and other factors. Smaller companies may consider the cost and benefit of implementing certain policies and procedures or decide that those are less relevant in their case.

According to Teresita J. Herbosa, Chairperson of Securities and Exchange Commission, “strong corporate governance is founded on the principles of fairness, accountability, and transparency.”

Fairness means equal treatment. This principle requires that everyone who has legitimate interest in the company must be taken into account and their rights and views be respected. For example, the Revised Corporation Code protects minority shareholders by precluding shareholders to remove directors elected by minority shareholders without cause.

Corporate accountability means acceptance of full responsibility for the powers and authority granted to those charged with governance and of obligation to explain one’s action in carrying out its responsibilities. It requires the board to present assessment of the company’s position and how the company is achieving its objectives.

Transparency means open and clear, timely and accurate disclosure of relevant information, financial or non-financial, to shareholders and other stakeholders, as well as not concealing material information. Transparency reduces the information gap between directors and stakeholders. It ensures that stakeholders can have confidence in the decision-making and management processes of a company. It can come in the form of annual report or well-documented policies that reader can understand.

Guided by these principles, the SEC adopted the Code of Corporate Governance for Public Companies and Registered Issuers (the Code) to promote the developments of a strong corporate governance culture and keep abreast with recent developments in corporate governance best practices. The Code is consistent with the G20/OECD Principles of Corporate Governance and other internationally recognized corporate governance principles.

The G20/OECD Principles of Corporate Governance laid down the six building blocks for a sound corporate governance framework.

Ensuring the basis for an effective corporate governance framework
The rights and equitable treatment of shareholders and key ownership functions
Institutional investors, stock markets, and other intermediaries
The role of stakeholders
Disclosure and transparency
The responsibilities of the board

The author submits the principle of shared responsibility and accountability among shareholders, board directors, and other stakeholders. Corporate governance is primarily about how the board steers the company. However, the shareholders have the power to elect directors and remove them when directors contravene their duties or act contrary to the principles, values, and ethics of the company. The shareholders must exert effort and be held accountable in the long-term value creation for all shareholders. The shareholders’ role cannot be undermined.

In addition, the interests of the stakeholders create the ecosystem within which the company operates. Hence, their role is to raise their voices to the company, and their voices should be heard.

And while corporate governance is a flexible concept, it must always adhere to principles consistent with the wide interests of stakeholders. In this manner, each stakeholder’s action is guided by common principles, which action balances shareholders’ interests.

Finally, it is the view of the author that corporate governance should address the issues arising from separation of ownership and control, balancing stakeholders’ interest, and the adoption itself of corporate governance principles.

References

Reading materials you may use in this course are the following: