Corporate governance in business
‘Good corporate governance is about maximizing shareholders value on a sustainable basis while ensuring fairness to all the stakeholders: customers, vendors-partners, investors, employees, government and society’ – Narayana Moorthy.
The corporate governance framework
The corporate governance framework of practices and rules helps the directors of an organisation to ensure fairness, accountability and transparency in its relationships with its stakeholders. Here, stakeholders refer to the respective government, community, financers, management, employees, and customers.
The framework consists of:
- Both implicit and explicit contracts between the stakeholders and the organisation for the distribution of rights, responsibilities, and rewards
- The ways to reconcile with the conflicting interests of stakeholders in keeping with their responsibilities, rights, and roles
- The techniques for appropriate control, supervision, and information-flow while serving as a checks-and-balances structure
The UK’s Cadbury Committee, in its report submitted in December 1992, stated that their objective was to raise the corporate governance standards along with the confidence level in auditing and financial reporting. The report clearly stated the individual responsibilities of those involved and the expectations from each one of them. The Cadbury Committee described corporate governance as ‘a system by which companies are directed and controlled’.
Nineteen recommendations were presented for the non-executive directors, executive directors, and all persons responsible for reporting and control. Although such recommendations were not made obligatory, all Public Corporations based in the UK were expected to follow them. For example, the London Stock Exchange (LSE) requires all the listed companies to declare compliance or state reasons for non-compliance.
The UK primary corporate governance code, published by the Financial Reporting Council (FRC), applies to all organisations with premium listing of equity shares on the LSE, irrespective of its incorporation within or outside the UK.
The importance of separating ownership from management control
Separating ownership from management has been widely discussed for several years. However, the concept has gained firm grounds in the past two decades after the major business scandals came into prominence. Enron, Polly Peck, Satyam, Maxwell, BCCI are some of the notorious cases that impacted the UK and resulted in various reports and committees such as the Hampel, Higgs, Cadbury, etc., to lessen the possibilities of such happenings again. However, the 2008 banking crisis brought into question the corporate governance mechanisms employed in the UK.
An organisation is made up of its directors and shareholders. The idea of shareholders imposing their instructions on directors have long evaporated. The board today can work independently and is capable of exercising their powers without any direction from the shareholders. Again, with the rise in publicly listed companies on the stock exchange, and the publicly available shares, it has become next to impossible to expect shareholders to control an organisation. However, shareholders can still control business structures like sole-traders, small private businesses and partnerships.
Nevertheless, in such cases where the directors are in charge, the risk remains that shareholder’s interests may take a back seat and their own become priority. Interestingly, Section 172 Companies Act 2006 (CA 2006) is a UK law that holds shareholder’s interests as primary, and which directors must follow.
The most common problems, even today is that the founder(s) are unwilling to accept the eventual separation of the ownership and the management. The separation of the management from the board, and shareholders from the regular functioning of the business, is only a matter of time and growth. Not all owners are capable of seeing their organisation through various stages or taking the business to a new level. It is only a probability that an owner or the shareholders will have the necessary skills, or the experience to build the business systematically. It is only logical therefore to expect a team of expert and qualified managers to run the business.
However, trying to retain control could prove to be detrimental to the growth of a business. Founders, also employees to the business may want to continue their role, but face demotivation if their experience or skills do not allow them to be a part of the management control. The founders must realise, or be made to realise soon, that shareholders alone are the real owners and have the ultimate control over the business. A management team cannot take that right away. The reality is a business requires different experiences and skills to grow, hence it needs more and more people to carry it forward.
Therefore, it is imperative that owners and founders must understand the clear separation of the roles of shareholders/owners and board/management in the organisation.
An interesting take
The separation of management control and ownership in listed companies may create issues because the shareholders tend to be uninterested and diverse when it comes to the day-to-day management. This leaves ample scope for the management to abuse and act in their own interest. The UK law has employed three impressive mechanisms that attempt to handle such situations. All the three mechanisms keep a tab on the power given to executives. What are the mechanisms employed and have they proven beneficial?
1. Shareholder democracy
Shareholders are authorised to exercise some powers. They can approve certain kinds of contracts between the directors and the business, and have the right to decide upon any change being brought to the constitution of the business. They must review the performance of the board when the accounts and annual reports are presented to them. They are also expected to decide whether the performance has been adequate. However, a consensus indicates that the shareholders are usually unable to exercise their rights by assessing the performance of the management or hold the management to account. Shareholders are seemingly disinterested in seeking change in management, and normally fail to attend the annual general meetings as representatives. The ones who attend are mostly campaigners and have separate agenda of publicity.
2. The Combined Code
The Combined Code offers “main principles” that affect the separation of management control and ownership. It states that every organisation must be headed by an effective, and responsible board, who in turn “Should be supplied in a timely manner with information in a form and quality appropriate to enable it to discharge its duties”.
The Code also states that a business must clearly divide the running of the board from the running of the business. No one must have unregulated powers to make a decision. Again, it also says that the process of appointing a director must be formal and transparent. The Code also delineates the practice rules for accountability, remuneration, and audit.
However, the soft law approach of the Code indicates that any non-compliance is met with an action that is decided upon by the shareholders. This in turn results in the shareholders, who have only limited interest in the management, to make a decision. The breaches, thus, do not result in any legal consequence. However, the listing rules require businesses to include in their accounts and annual reports, the way they have applied the Code and have complied with it. Non-compliance to the Code requires an explanation of the incident as per the listing rules.
3. Non-executive Directors
The Code suggests that a board of an organisation, mainly the bigger ones, must comprise of both non-executive and executive directors to create a balance. This negates the chances of a biased board decision-making. It also adds that a senior non-executive director must be available to shareholders as an alternate contact to the chairperson, finance director or the chief executive, in case they are not available for contact. The objective is to keep a different perspective to the board of directors. A non-executive director may improve the performance of the business or the internal management, and they may also keep a check on the powers of the executive directors.
However, there are issues with this position because there might be chances of conflict. In the case where a non-executive director is a part-timer, they may fail to perform all necessary tasks within their limited time. Again, if they are full-timers, they might not be given an independent position. Furthermore, where the executive directors intend to keep important information from the non-executive directors, there are no legal remedies to the situation. These various issues weaken the potential benefit of the non-executive directors, whose position otherwise, is a vital and powerful mechanism to ensure a balance in the separation of ownership and management control.
It is thus only a hope that despite the issues prevailing within the various mechanisms, the monitoring of the separation of management control from ownership will successfully operate in the presence of both.
Identify whom the organisation should serve
To discuss the reality in the world of business and trade we need to focus on whom an organisation must serve, and who is in fact being served. The various debates and discussions lead to an unequivocal answer that most organisations serve their shareholders.
Here is whom an organisation used to serve. AmerisourceBergen, a $136 billion drug wholesale business in the US once represented their mission as ‘To build shareholder value by delivering pharmaceutical and healthcare products, services and solutions in innovative and cost effective ways. We will realize this mission by setting the highest standards in service, reliability, safety and cost containment in our industry’.
However, progressively, such large organisations demonstrated direct responsibility not only to their shareholders, but also to the community, the environment and their employees.
AmerisourceBergen altered its mission statement to: ‘Our mission is to improve patients’ lives by delivering innovative products and services that drive quality and efficiency in pharmaceutical care’.
From another angle, Walmart Stores announced new vendor requirements in order to steadily lower the sodium content of all the grocery products they put on their shelves. This move influenced the entire retail food industry due to Walmart’s market dominance.
Kimberly-Clark was rated “Best Corporate Citizen” for their emphasis on public accountability. The selection was based on the criteria of human rights and environmental concerns.
In countries such as Canada, USA, and the UK, the shareholder-centric approach was due to their legal obligation to their shareholders (‘primacy of ownership and property rights’). A paper presented at the 9th International Anti-Corruption Conference in South Africa, the lawyers stated: ‘Employees, suppliers and other creditors have contractual claims on the company. As owners with property rights, shareholders have a claim to whatever is left after all contractual claimants have been paid’. Therefore, boards remained obligated to serve shareholders.
Conversely, in countries such as Germany, Netherlands, France and some Asian countries, boards served very differently. They were obligated to satisfy local expectations by serving the interests of the employees and other stakeholders, including the communities in which the organisation operated. The public organisations in these countries reported to broader constituencies. These organisations practiced integrated reporting which consisted of combining reports on financial results and social goals.
Steadily, integrated reporting became a norm. E.g., Southwest Airlines, in 2009 published its first integrated report. Organisations adopted more corporate-citizenship and non-financial goals enabling them to create incentive compensation plans for their executives and employees. This motivated both the shareholders and stakeholders and the community. Although the focus on the shareholders never reduced and they always received their due, social responsibility became an indispensable part of an organisation too.
The government might take longer to implement low-sodium content grocery across USA while costing the taxpayers directly. Organisations such as Walmart implemented the same provision overnight and at no public cost. Such actions not only promise a healthier future for customers, but also displays responsibility and trustworthiness of an organisation while assuring patrons to buy shares. Therefore, the shareholders of such organisations, that extend their definition of corporate governance, and implement the same, can enrich their organisation ethically, socially and financially.
Corporate governance and regulation forms part of the unit on Corporate Strategy, Governance and Ethics in the post-graduate Level 7 Diploma in Business Management which in turn leads to enhanced entry on to MBA programmes.
Other relevant articles: