What is Corporate Governance?

Corporate governance is the system of rules, practices, and processes by which a firm is directed and controlled. Corporate governance essentially involves balancing the interests of a company's many stakeholders, such as shareholders, senior management executives, customers, suppliers, financiers, the government, and the community. Since corporate governance also provides the framework for attaining a company's objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.

The Basics of Corporate Governance

Governance refers specifically to the set of rules, controls, policies, and resolutions put in place to dictate corporate behavior. Proxy advisors and shareholders are important stakeholders who indirectly affect governance, but these are not examples of governance itself. The board of directors is pivotal in governance, and it can have major ramifications for equity valuation.

Communicating a firm's corporate governance is a key component of community and investor relations. On Apple Inc.'s investor relations site, for example, the firm outlines its corporate leadership—its executive team, its board of directors—and its corporate governance, including its committee charters and governance documents, such as bylaws, stock ownership guidelines and articles of incorporation.

Most companies strive to have a high level of corporate governance. For many shareholders, it is not enough for a company to merely be profitable; it also needs to demonstrate good corporate citizenship through environmental awareness, ethical behavior, and sound corporate governance practices. Good corporate governance creates a transparent set of rules and controls in which shareholders, directors, and officers have aligned incentives.

Key Takeaways

  • Corporate governance is the structure of rules, practices, and processes used to direct and manage a company.
  • A company's board of directors is the primary force influencing corporate governance.
  • Bad corporate governance can cast doubt on a company's reliability, integrity, and transparency—all of which can have implications on its financial health.

Corporate Governance and the Board of Directors

The board of directors is the primary direct stakeholder influencing corporate governance. Directors are elected by shareholders or appointed by other board members, and they represent shareholders of the company. The board is tasked with making important decisions, such as corporate officer appointments, executive compensation, and dividend policy. In some instances, board obligations stretch beyond financial optimization, as when shareholder resolutions call for certain social or environmental concerns to be prioritized.

Boards are often made up of inside and independent members. Insiders are major shareholders, founders and executives. Independent directors do not share the ties of the insiders, but they are chosen because of their experience managing or directing other large companies. Independents are considered helpful for governance because they dilute the concentration of power and help align shareholder interest with those of the insiders.

Bad Corporate Governance

Bad corporate governance can cast doubt on a company's reliability, integrity or obligation to shareholders—all of which can have implications on the firm's financial health. Tolerance or support of illegal activities can create scandals like the one that rocked Volkswagen AG starting in September 2015. The development of the details of "Dieselgate" (as the affair came to be known) revealed that for years, the automaker had deliberately and systematically rigged engine emission equipment in its cars in order to manipulate pollution test results, in America and Europe. Volkswagen saw its stock shed nearly half its value in the days following the start of the scandal, and its global sales in the first full month following the news fell 4.5%.

Public and government concern about corporate governance tends to wax and wane. Often, however, highly publicized revelations of corporate malfeasance revive interest in the subject. For example, corporate governance became a pressing issue in the United States at the turn of the 21st century, after fraudulent practices bankrupted high-profile companies such as Enron and WorldCom. It resulted in the 2002 passage of the Sarbanes-Oxley Act, which imposed more stringent recordkeeping requirements on companies, along with stiff criminal penalties for violating them and other securities laws. The aim was to restore public confidence in public companies and how they operate.

Other types of bad governance practices include:

  • Companies do not cooperate sufficiently with auditors or do not select auditors with the appropriate scale, resulting in the publication of spurious or noncompliant financial documents.
  • Bad executive compensation packages fail to create an optimal incentive for corporate officers.
  • Poorly structured boards make it too difficult for shareholders to oust ineffective incumbents.