What is a Market-Based Corporate Governance System

A market-based corporate governance system relies on the investors in a public company to exert influence over how the corporation is to be managed. It defines the responsibilities of the different participants in the company, including shareholders, the board of directors, management, employees, suppliers and customers. 

BREAKING DOWN Market-Based Corporate Governance System

A market-based corporate governance system is derived from Anglo-American law and is one of several corporate governance systems that have developed differently throughout the world. Since markets are the primary source of capital, investors are given the most power in determining corporate policies. Therefore, the system relies on the capital markets to influence the corporation's management.

Corporate governance covers the practices of how public companies are managed and interact with shareholders. An overriding goal of corporate governance, according to the Organization for Economic Cooperation and Development (OECD), is to create an environment of market and business confidence in individual companies and their ability to put capital to use for long-term productive investments.

Corporate governance addresses issues ranging from concentrated ownership and executive compensation to workplace diversity and independence of a company’s board of directors. One of the key tenets of effective corporate governance is transparency in public disclosure of information pertinent to shareholders and the investing public.

Market-based corporate governance is one of several approaches to ensuring proper protections to shareholders and company adherence to existing regulations. The U.S. and India are examples of market-based corporate governance systems that do not have national governance policies companies must follow, but instead rely on securities laws and regulations. The global trend in governance is toward a “comply or explain” system where companies are required to adhere to state or market exchange-developed governance codes.   

Limitations of a Market-Based Corporate Governance System

One of the biggest challenges to effective corporate governance is short termism, according to governance experts. Public companies are managed to meet quarterly earnings targets set by sell-side analysts on Wall Street. Companies have a repertoire of accounting maneuvers they can utilize to meet or consistently beat Wall Street forecasts, thus boosting their stock price. A quarterly earnings miss, however, can cause a sharp stock decline and send company management scrambling for a short-term solution. Governance experts suggest eliminating earnings guidance as way to promote a more long-term view of a company’s goals and give the companies more time to accomplish them.

While market-based systems have made progress on many governance fronts, a lack of female representation on corporate boards is another drawback of such an approach.