What is corporate governance? Principles and theories explained

13 May 2021

As investor power grows and the impact of corporations within society increases, opinions and ideas on how corporations should be governed have also spread.

For those unfamiliar with corporate governance, we'll take a closer look at its definition and importance, along with the theories and codes of practice that go into overseeing the operations of large and corporate companies.

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What is corporate governance?

Corporate governance is the system by which companies are directed and controlled, and to what purpose. It identifies who holds power and accountability and who makes decisions. Essentially, it gives both the board and management the tools to run a company more effectively.

Such tools allow businesses to balance the interests of their stakeholders, whether it's shareholders, employees, suppliers, customers or the wider community. It involves, but is not limited to, the following responsibilities:

  • Setting the company's strategic aims,
  • Providing the necessary leadership to put them into effect
  • Supervising the management
  • Reporting to shareholders on their stewardship

At its core, corporate governance differs from the day-to-day operational management of the company since it concerns what the board of a company does and how it sets the values by which the company follows.

team meeting

Why is corporate governance important?

Since it oversees accountability, corporate governance is critical. When shareholders, the board of directors, the management team and the company's employees are responsible for each other, it ensures everyone is accountable.

When it comes to poor corporate governance, there’s no clearer and more high-profile example than Enron. The American energy company became infamous for its less-than-stellar corporate governance; its executives employed covert accounting methods to cover up what essentially amounted to theft from the business.

Incorrect figures were passed along to the board of directors, who failed to relay this information to shareholders. As a result, shareholders were unaware that the company's debts and liabilities totalled more than Enron could repay.

The lack of accounting cost them dearly. Executives were charged with several offences, the company went bankrupt, and employees lost billions in pension benefits. 

Thus, the need for corporate governance is essential. Without it, a company can face the risk of collapse, and shareholders can bear the brunt of sizeable losses as a result.

Is there a code of practice for corporate governance?

Yes. Previously known as the Combined Code, the UK Corporate Governance Code sets out standards of good practice for listed companies on topics such as board composition and development, remuneration, shareholder relations, accountability and auditing. It is published by the Financial Reporting Council (FRC).

signing document

What are the principles of corporate governance?

Fairness

For whatever shareholdings they have, all shareholders should receive equal treatment and consideration. Companies in the UK are protected by the Companies Act 2006 (CA 06), but certain companies may prefer to have a shareholder agreement due to its more robust, effective minority protection.

Along with shareholders, a company should also endeavour to treat all of its stakeholders, including employees, communities and public officials, fairly.

Accountability

Corporate accountability refers to the obligation and responsibility to provide explanation(s) or reason(s) for the company's actions and conduct by doing the following:

  • The board should present a balanced and understandable assessment of the company's position and prospects
  • The board is responsible for determining the nature and extent of the risks it's willing to take
  • The board should maintain proper risk management and internal control systems
  • The board should establish formal and transparent arrangements for corporate reporting and risk management, as well as for maintaining a relationship with the company's auditor
  • The board should regularly communicate with stakeholders, providing a clear and understandable assessment of how the company is achieving its business purpose.

Responsibility

The board of directors have the authority to act on behalf of the company. They should therefore accept full responsibility for the power that it is given and the authority it exercises.

The board of directors are responsible for overseeing the management of the business, company affairs, appointing the chief executive, and monitoring the performance of the company. It must, therefore, act in the best interests of the company.

Responsibility tends to overlap with accountability. The board should be made accountable to the shareholders for how the company has carried out its responsibilities.

businesswoman talking

Transparency

Stakeholders should be informed about the company's activities, plans and any risks that are part of its business strategy.

By following the principle of transparency, a company demonstrates its willingness to provide clear information, such as accurate financial performance figures, to shareholders and other stakeholders.

Such material should be timely and accurate. This ensures that all investors have access to clear, factual information that accurately shows the company's financial, social and environmental position.

Through transparency, stakeholders can be confident in the decision-making and management processes of a company.

What are some theories of corporate governance?

Several theories describe the relationship between various stakeholders of the business as they carry out their duties. Some of the more prominent examples include:

Agency theory

According to agency theory, the principals of the company (such as shareholders) hire the agents (such as directors of the company) to perform work.

The agent represents the principal in a particular business transaction and is expected to represent the best interests of the principal without regard for self-interest. However, the varying interests between principal and agents may become a source of conflict, as some agents may not always act in the principal's best interests.

This can result in miscommunication and disagreements within companies, which could lead to inefficiencies and financial losses.

Stewardship theory

This theory states that a steward (company executives) protects the interests of the owners or shareholders and makes decisions on their behalf. Their objective is to create and maintain a successful organisation so that shareholders can flourish.

Companies that follow this theory place the responsibilities of the CEO and Chairman under one executive, with a board comprised mostly of in-house members. This approach allows for more in-depth knowledge of organisational operations and a deeper commitment to success.

team meeting

Stakeholder theory

Stakeholder theory states that a company owes a responsibility to a wider group of stakeholders rather than just shareholders.

The original proponent of the stakeholder theory, Edward Freeman, recognised it as a key element in Corporate Social Responsibility (CSR) – a concept that some of the world's largest corporations claim to have at the centre of their corporate strategy.

This links to stakeholder theory's central focus: that the interests of all stakeholders have intrinsic value, and that no set of interests holds power over others.


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Shareholder theory

The shareholder theory states that the sole responsibility of a business is to increase profits. Management personnel are hired as the agent of the shareholders to run the company for their benefit. Thus, they are legally and morally obligated to serve their interests.

By concentrating on short-term strategy and greater risk, the shareholder theory is an outdated approach. Companies have largely woken up to the realisation that there are disadvantages to only focusing on shareholder interests.

The limitations of this theory can be seen in the Enron scandal mentioned earlier. Pressure on management to increase returns to their shareholders is what led to the manipulation of company accounts, and ultimately, was the company's undoing.

 

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The views, opinions and positions expressed within this article are those of our third-party content providers alone and do not represent those of Gazprom Energy. The accuracy, completeness and validity of any statements made within this article are not guaranteed. Gazprom Energy accepts no liability for any errors, omissions or representations.

 


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