Why is Corporate Governance Important?
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Published: Tue, 02 Jan 2018
What is Corporate Governance? Why is it important for Business?
Corporate Governance can be defined as the organizational structure of a company. It encompasses the overall processes, operations and policies by which a company is controlled and functions. According to James McRitchie corporate governance is ¹’most often viewed as both the structure and the relationships which determine corporate direction and performance`. Within the governing body of a corporation there are various stakeholders. Stakeholders are individuals which are of great importance to the company because they contribute directly or indirectly to its economic activity. Stakeholders retain different degrees of importance within an organization depending on their title or function which are some of the following: shareholders, the board of directors, employees, customers, creditors and suppliers. All together this group of individuals defines a corporate community in which day to day business is conducted and must be sustained in order for the company to survive. Similar to any other community, where there are conflicts of interests, miscommunication, or other organizational problems it affects the entire community and others around it. However is this applicable to the business world? Is corporate governance important for business?
Firstly corporate governance implies the notion of hierarchy. As mentioned above the rights and importance of any stakeholders involved in the economic life of the company varies in function of the roles the individual holds. Following this logic we can identify the key actors within the governing structure of a company: shareholders who own shares of stock and have a right of ownership over the dividends which they receive from their stock and the right to vote on company matters such as electing the board of directors. In return the members on the board of directors oversee the management of the company and are paid in cash or stock for the responsibilities they are obliged to fulfill by contract to the company. In terms of internal management the employees of the company supply their skill and expertise in exchange for financial compensation (salary and bonuses). Another important stakeholder is the customer, who pays for the company’s product or services because he/she believes in the value it retains for them. Amongst other stakeholders such as suppliers and creditors the customer is essential to a company’s activity because a satisfied customer base represents 80% of a company’s profits.
In order for us to understand corporate governance it is important for us to comprehend that it is a multi-lateral issue, and thus it influences the choices of stakeholders and the outcome of company transactions and relations with the rest of the world.
It is important for companies to take into account external factors such as: competition. In order to stay solvent and relevant, companies must engage respective strategies and face other corporate adversaries on the free market. Equally debt management is important as companies need to make sure that their assets outweigh any short-term and long-term debts on a regular basis. Also government regulations should be taken into account as they differ from country to country. For example in the United States corporate governance is known to be very free-market orientated but in North Korea legislation has a tough hold on corporate decisions. Finally the media and other instances are actors of external pressure as they force companies to uphold a certain social standard in their day to day operations, public relations and more and more today their ecological impact on the environment. In today’s economic climate no company can afford to be scrutinized in the mass media as this decreases their popularity and trust with clients. The trust of clients is an immeasurable asset that can almost never be reacquired once it is lost. Take for example the American International Group that was under a severe media backlash back in 2009 after it was discovered that it was paying huge bonuses to employees of its financial services department during the financial crisis. President Obama expressed his discontentment during a press conference: ‘²it’s hard to understand how derivative traders at A.I.G. warranted any bonuses, much less $165 million in extra pay. How do they justify this outrage to the taxpayers who are keeping the company afloat?’ Existing customers and potential customers need to be reassured by a company’s, performance history, social responsibility initiatives but overall its integrity. And this is why corporate governance is critical for business; the atmosphere which it creates has to be one of congruence where it can be held accountable for doing what it says and what it stands for.
Another one of the facets of this is issue the internal domain of corporate governance, where the management structure (CEO, middle management) is concerned with maximizing company profits in order to increase shareholders profits. This is motivated by a prospect of self-interest and higher gain (promotion, bonus etc…) which generates a need to perform in order to reach that goal. Likewise employees are motivated in a similar way to do their job. However their needs are not directly correlated with that of the members of the upper management structure who have larger responsibilities and more information within the same organization. This situation is called information asymmetry when one corporate body has more information than another. This can create conflict within the workplace if this type of imbalance is not managed. Furthermore employees working in high profile positions such as CEOs may be prone to act out of character and make bad decisions because of the immunity they may enjoy through their status. For example the Jerome Kerviel former French trader of Societe Generale abused of the company’s confidence to commit fraudulent transactions during his late professional career. As a result, the company lost: ³’near €5 billion (£3.7 billion) in a rogue trading fraud’ according to the London Times. This example of bad behavior known as a moral hazard, when an individual protected from risk within an organization behaves differently than he or she would have behaved if they were fully exposed to the risks they took. In order for companies to protect their clients and themselves from similar fates they must implement effective rules and regulations that enable internal and external auditing bodies to monitor they’re day to day activities. Therefore rules that corporate governance create must be strong, as the Italian philosopher Niccolo Machiavelli said: ‘Where there are sound laws there is a strong army, for there cannot be a strong army where there are not sound laws’. Corporate law ensures that natural rules and regulations are in place in order to encourage correct business practices in the corporate world.
Overall good corporate governance should input regular auditing processes. Interiorly, within the company itself an internal auditing body should monitor the company’s financial health. In addition to this, the same should be implemented exteriorly through an external auditing company in order to get an objective perspective on company statements and verify their integrity. Also a sound board and management system must be put in place, separating every main executive function throughout the organization. Historically this minimizes the moral hazard factor in the workspace and encourages transparency and a clear flow of information within the institution. The Toyota Motor Company is a fine example of this; the company management structure allows the free flow of information and enables each employee to contribute to operational activities at every scale of the production process. This has had positive effects for Toyota mainly in terms of productivity and logistics efficiency. Finally all stakeholders should be aware of their rights and duties; this minimizes confusion in long-term strategy and goals of the company. Furthermore a clear ownership structure is critical to a corporation’s legal validity; it has to be a registered and recognized institution according to the appropriate corporate law regulation of the country in which in conducts its business.
In conclusion corporate governance is an important component of business. As we have demonstrated affects every facet of business organizations and the various stakeholders involved. Furthermore because of the hierarchal nature of corporate governance it becomes evident that good leadership is equally essential. Members within executive, managerial, technical and administrative positions have to work within their respective roles to create an atmosphere of seamless affinity in terms of corporate governance. Leadership is important but in the context of corporate governance the whole body of the organization is vital, hence the root of the word ‘corp’ in corporate. Nevertheless corporate governance must retain a standard of order; this is where the term governance gains more weight. Historical facts show that sustained order is the key to the long-term effectiveness of an organization; General Electric is prime case of this. Within the 200 year life span of the company, good choices and exceptional leadership have made General Electric today the most valuable company in the United States with a market cap of 300 billion US dollars. From this we can draw the conclusion that corporate governance is indeed important and will surely continue to gain more and more value in the world of business in the future.
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