Corporate governance and corporate responsibility
Corporate governance is the process by which organisations are directed and controlled. It is through good corporate governance that the interests of investors and other stakeholders are safeguarded and in so far as possible, aligned
Displaying sound governance is good for companies as it helps with their smooth running, attracts inward investment and helps raise finance
Corporate governance encompasses the following areas:
effective risk management systems and internal controls
timely financial reporting and annual audit confirming that the financial statements give a true and fair view of the state of affairs and performance of the company
good communication, disseminating accurate and relevant information and dealing with shareholders in an open and honest manner to enable them to make informed decisions
transparency and disclosure, particularly in respect of directors' remuneration and the appointment of the remuneration committee
accountability
integrity
ethical behaviour and a culture that delivers the right outcomes
balance on the board (including between executive and non-executive directors) with a diverse mix of individuals possessing the relevant skills, knowledge and experience and who have clear lines of responsibility and who can exercise independence of judgement
fitness and property of directors
effective oversight by senior management and the board of directors
compliance with regulatory standards and legislation
Non-executive directors: Member of a company's board of directors who are not part of the executive team. A NED typically does not engage in the day-to-day management of the entity but focuses on policy and strategy and holds the executive to account
Ownership versus controlling
A problem arises when directors, who manage and control the company, make decisions which are not consistent with the objective of maximising owner wealth. For example, directors may aim to please the market and influence the company's share price in the short term in order to boost their own bonuses where these are rebased on short term company profits and/or share price
Shareholders, the owners, will welcome an increase in value of their company, but only if this is not achieved through aggressive accounting and unwanted risk and is therefore viable in the longer terms. Imbalances in this respect can have catastrophic consequences as was seen in the financial crisis and the role of incentives given to those in control remains a hugely controversial and potentially worrying aspect of corporate governance
Goal congruence
Aligning the goals of owners and managers is an important means of helping overcome the agency problem and ensuring managers act in the best interests of the shareholder
It a hugely controversial area as to whether incentives such as performance related pay, further this aim or not
Performance related benefits need to be carefully structured to ensure managers do not put their own personal gain ahead of the objective of maximising shareholder wealth
Good corporate governance seeks to address conflicts between managers and owners by the achievement of goal congruence. In other words, the company directors and other members of senior management need to be motivated to align their goals with the objectives of the company so that their behaviours and actions result in mutually beneficial outcomes
Describes the alignment and harmonisation of goals and objectives. In the context of agency theory, this means matching the interests of the directors with the interests of shareholders so that directors are incentivised to act in the best interest of the company
Asymmetry of information
Owners are not in a position to fully monitory the managers of the company a they do not have full knowledge of the business and access to all information. For example, shareholders will see the annual report but may often not have access to the management accounts and underlying information unless they are themselves involved in the company's management
This asymmetry of information puts managers in a position where they can, if they lack integrity and high moral standards, focus on their own wealth maximisation to the detriment of shareholder wealth maximisation without always being challenged
Managers may pursue their own goals of increasing their own rewards and bonuses and following their own agenda, including retaining their job there as long as possible
Shareholders who may lack knowledge of the running of the business may remain passive and engaged in the business in which they invest
After a number of corporate failures and financial scandals, there has been a move in recent years to encourage greater shareholder engagement with company management
Institutional shareholders, such a large pension funds, which typically hold large volumes of shares, can have a significant influence on how companies are run by challenging the board's decisions and ensuring the alignment of the objectives of the directors with their own objective of wealth maximisation for the longer term
Targets can be set to reward managers for increasing shareholder returns, for example through improving the company's profitability or share price. Managers will lose motivation however, if for example the required increase in share price looks unachievable. They may also lack drive to maximise the share price if they have already been rewarded for achieving a satisfactory return. Such behaviour is known as satisficing
Profit related incentives and share option schemes therefore need to be properly structured and regularly reviewed to ensure ongoing goal congruence of the interests of managers and shareholders
Satisfying: Describes the behaviour of managers to do just enough to satisfy shareholders and achieve an adequate return on their investment rather than maximising the return for shareholders
High standards of reporting and corporate governance provide comfort that managers are acting appropriately and with integrity and helps reduce the agency problem.
In respect of the annual report and financial statements, the audit function acts as a safeguard for shareholders who may be concerned managers are achieving their goals with the help of aggressive accounting practice
As well as challenging corporate governance standards and how well a company is run, institutional shareholders are well placed to challenge investment decisions and financing decisions, especially where it is believed that directors may not be motivated to align their goals with the interests of the shareholders. This can be seen in the area of mergers and acquisitions where investors have become much more robust in examining take over activity due to the fact that they often destroy rather than create shareholder value
The tendency of chief executives of companies to 'empire build' through acquisition is more under the microscope than it has been in the past and companies are now usually more careful to ensure their majority shareholders are supportive before making an offer. The Financial Reporting Council's Stewardship Code encourages investor engagement with companies
RBS and ABN AMRO