Corporate governance assumes paramount importance in the 21st Century business landscape.
Often regarded as the backbone of any company, corporate governance dictates a given company's systems, processes, and rules. These frameworks delineate the rights and duties of the stakeholders that make up the company.
Beyond being a mere strategic tool, good corporate governance is pivotal in safeguarding stakeholders' interests.
In this article, we will explore what that means.
How did corporate governance develop?
Corporate governance emerged from the increasing business complexity of the first corporations.
The East India Company, Hudson’s Bay Company, Levant Company, and other major chartered companies of the 16th and 17th centuries created the possibility of conflict between company stakeholders. Adam Smith identified in The Wealth of Nations divergent interest between managers and owners as a confounding factor at the heart of efficient corporate operations.
Fast-forward to the mid-1970s, the Federal Securities and Exchange Commission (SEC) brought corporate governance onto the official reform agenda.
Managers leading with directors and shareholders following characterised the managed corporations of this era. The rapid economic expansion of the United States following World War II meant internal governance of companies was not a high priority, culminating in some of the most infamous business scandals to rock the corporate world.
The malpractices unearthed at Enron and WorldCom highlighted the severe shortcomings in corporate governance and catalysed the introduction of tighter regulations.
These events led to comprehensive legislation like the Sarbanes-Oxley Act in the US. This legislative framework protects investors from fraudulent financial practices by enhancing the accuracy and reliability of corporate disclosures.
Since the 1970s, both the political and business landscape has changed. Though most corporate governance literature and theory still focus on the US, alternative models have become increasingly prevalent.
The recession in the 1980s caused a loss of faith in the US-led governance model, and the economic successes of both Germany and Japan indicated that alternative governance frameworks were often more suitable for ongoing business success. German and Japanese firms did not have to focus solely on the subsequent quarterly earnings, owing to differences in the structure of the markets they operated in.
At the same time, corporate governance also made its way onto the agenda in London.
The London Stock Exchange integrated the code of conduct from the 1992 Cadbury Report into their listing rules. The Cadbury Code soon became a model for developing various corporate governance codes globally, coinciding with the resurgence of the US corporate governance model.
With the US economy rebounding in the 1990s, and Japan and Germany struggling with recession and the continued costs of reunification, respectively, the US corporate governance model became the one to follow.
What are the theories of corporate governance?
Corporate governance, though complex, is not monolithic. Several theories come together under its umbrella, presenting unique perspectives on corporate structures and controls.
What is agency theory in corporate governance?
The Agency Theory is one such perspective that deals with the relationship between principals (owners) and agents (managers).
It underscores the conflicts that might arise from the differing interests of owners and managers.
Aligning stakeholder interests is essential for organisational success, as misalignment reduces efficiency and increases costs.
Agency Theory is also the basis of the Principal-Agent problem, which we have written about here in the context of DAOs.
What is stakeholder theory in corporate governance?
The Stakeholder Theory argues that companies are responsible for shareholders and all corporate ecosystem stakeholders, including employees, customers, regulators, and the wider community.
Stakeholder theory also forms the bedrock of Stakeholder Capitalism - a model that posits all stakeholders in an ecosystem should benefit from corporate growth, not just the shareholders.
What is stewardship theory in corporate governance?
The Stewardship Theory advocates that managers, when left to their devices, will act as responsible stewards, looking after the owners' best interests.
This framework argues that people are “intrinsically motivated to work for others or for organisations to accomplish the task and responsibilities with which they have been entrusted.”
What are the key components of corporate governance?
Successful corporate governance frameworks combine key elements of each theory relevant to the specific business case and operating industry, yet they are only one aspect of the broader purpose.
The purpose of corporate governance is to enable not only efficient business operations but also checks and balances on executive function.
Collegial bodies exist for this purpose, enabling collegial governance whereby colleagues participate in decision-making.
Collegial bodies are grouped by business function, effectively overseeing many aspects of a given business. By sharing responsibilities, collegial bodies can more effectively manage risk.
The annual shareholders meeting
The annual shareholders meeting is the highest collegial body, a meeting of company owners. Separation of management and ownership characterises modern corporations, and shareholders are the owners.
The most important decisions concerning a company are made at this meeting, such as acceptance of strategy or financial plans for the year ahead. This body also enacts yearly financial settlements and dividend distribution.
The board of directors
Below the shareholders' meeting sits the Board of Directors - the apex of the corporate hierarchy. While it is typically thought that corporate decision-making is authority-based, this group leverages consensus in deciding the strategic direction of the company, operating as a production team.
The products include monitoring and disciplining top management, which is difficult due to information asymmetries, and engaging in corporate policy-making. An important distinction is that while the board is responsible for company management, they have few managerial responsibilities. The policies the board creates, however, are an integral aspect of management, as they are important in cost-effective agency constraints.
Executive management
Executive management makes authority-based decisions in implementing board-created policies.
The executives delegate monitoring responsibility to hierarchical sub-levels all the way down to employees, with bounded rationality constraining the number of reportees.
Reportee performance for each monitor is then rated against the governance frameworks developed by the board.
These functional managers are responsible for ensuring adherence, thusly constraining agency costs.
Alongside these, transparency and disclosure form another crucial element. Providing timely, accurate, and comprehensive information is not just about compliance with regulations; it's about winning stakeholder trust and fostering an environment of openness.
How do corporate governance models vary around the world?
Globally, corporate governance models display considerable diversity.
Fundamental cultural, ideological, and historical differences in the business environment drive this variation.
What is the Anglo-Saxon model of corporate governance?
The Anglo-Saxon Model, prevalent in countries like the U.S. and the U.K., places high emphasis on shareholder rights, with the board having a fiduciary duty to the owners. The board in this model is often paid in shares, aligning board interests with those of shareholders.
What is the European model of corporate governance?
The European Model tends to consider a wider stakeholder ecosystem, often including employee representatives on the board.
A major challenge in effective board oversite is information asymmetry between the executive and non-executive management. Employee board representation reduces that asymmetry, giving the board direct insight into company policy and performance.
What is the Asian model of corporate governance?
The Asian Model, particularly in family-dominated businesses, tends to centralise control. As discussed in this article, family-run organisations are fundamentally tribal because blood relations are more important than bonds. This raises distinct challenges for effective oversight owing to the insider model that can sometimes form.
What is the impact of corporate governance?
Good corporate governance reaches beyond the boardroom, influencing company performance, investor confidence, and corporate sustainability.
As previously mentioned, governance frameworks are essential in constraining agency costs, ultimately reducing business costs. Robust corporate governance can boost a company's effectiveness by driving strategic decisions and fostering operational efficiency.
Equally, clearly defining business processes through corporate governance frameworks enhances transparency and accountability.
This plays an instrumental role in cementing investor confidence, allowing investors to understand company operations.
With awareness and concern over social and environmental issues also increasing, good governance is emerging as a vital player in Corporate Social Responsibility (CSR) and sustainability.
What are the recent trends in corporate governance?
Several emerging trends are shaping the future of corporate governance. The COVID-19 pandemic, the war in Ukraine, and macroeconomic headwinds have underscored the need for resilient and adaptable corporate governance.
A confluence of macroeconomic uncertainty in rising interest rates, inflation, growth challenges, and geopolitical tension is challenging for boards to manage.
Resultant human capital issues and talent shortages in crucial business areas due to generational shifts in the workforce may leave boards exposed to greater risk.
Environmental, Social, and Governance (ESG) criteria are also gaining prominence, with companies facing increased scrutiny of their environmental footprints and social impacts.
The increasing importance of technology and digital transformation also impacts current governance trends. Adopting artificial intelligence (AI), blockchain, and other advanced technologies offers innovative solutions to age-old governance problems.
However, they also introduce new challenges and risks with the opportunities they present.
What are the challenges of corporate governance?
While a corporate governance framework, theory, or model may be perfect on paper, people are ultimately responsible for its implementation.
This is where the difficulty lies, as humans are not machines constrained by their capabilities and resultant bounded rationality.
Designing and implementing corporate governance models requires a multimodal approach.
Any model is an approximation at best, making diverse stakeholder interests and rapid environmental and social changes complex to balance.
Managing that complexity is necessary to ensure 21st-century business success.
The challenge for boards is designing a model that is fit for purpose, as opposed to one that fits in a box.
Discover the future of corporate governance with Polity Network
Corporate governance is a potent force that propels companies towards sustainable success, and it continues to evolve with the times.
Recent years have seen organisations increase their focus on the business applications of network organisational structures.
This novel organisational form requires a fundamentally different approach to governance in a hierarchy. We will explore this in the following article.
We at Polity Network believe that network organisations such as Decentralised Autonomous Organisations (DAOs) are an important step in the evolution of corporate governance.
This is why we are running Polity Network as a pDAOⓇ.
To learn more about the Polity Network, subscribe to this publication or visit our website at https://polity.li.
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