Understanding Corporate Governance

While performing the fundamental analysis of the company, one may look at its financials, past returns, current operations, etc. However, one factor that investors, especially long-term investors, should not miss out on is corporate governance. Public companies’ annual reports usually have a detailed section on corporate governance.

This article covers the meaning of corporate governance, the benefits of corporate governance, shareholder primacy vs stakeholder primacy, principles of corporate governance, how to assess it and real-world examples of corporate governance.

What Is Corporate Governance?

Corporate governance is a discipline involving a set of rules, policies and processes that direct the overall corporate behaviour. It is essentially an interaction between the company’s management, board of directors, shareholders, and other stakeholders like employees, suppliers, creditors, customers, etc.

Understanding Corporate Governance

The key purpose of corporate governance is to create value for shareholders and safeguard the interest of all stakeholders. The board of directors, i.e. the group of people chosen by shareholders to manage the company, plays the most important role in practising corporate governance. 

The importance of the board of directors in corporate governance is that it decides the company’s vision and mission and sets policies and processes to achieve them. The company’s management team also plays a vital role by performing tasks like planning, reporting, risk management, etc.

The salient features of corporate governance are clear strategy, efficient risk management policies, discipline, commitment, regular evaluation, fairness, transparency, etc.

Benefits Of Corporate Governance

Some of the key significance of corporate governance are as below.

• Companies with good corporate governance practices may enjoy higher investment inflow. Not just retail or institutional investors but foreign institutional investors may also see such companies as good investment options. 
• Adopting good corporate governance may also help the companies to gain a sense of trust and confidence from shareholders, which is necessary for long-term survival.
• Adherence to corporate governance will likely lower the chances of bankruptcy, malpractices like corruption, legal issues, etc.
• Strong corporate governance plays a vital role in the long-term success of companies. At the same time, it may also result in value creation for investors.
• The importance of corporate governance to shareholders is that they can assess it to check whether the company has good potential to sustain itself for long and create value for them.

Shareholder Primacy Vs Stakeholder Primacy

The shareholder primacy theory of corporate governance suggests that the corporate’s responsibility is to keep shareholders’ interest over other parties. The company must make efforts to increase shareholders’ returns. However, such efforts may negatively impact the environment and society. 

Another theory, known as stakeholder primacy, suggests that the company should consider the interest of all stakeholders, including shareholders, employees, suppliers, creditors, customers, etc.

The Principles Of Corporate Governance

Fairness

The fairness principle of corporate governance suggests that the corporation should equally and impartially treat all stakeholders, including shareholders, employees, and vendors. They must be given an opportunity to speak out about their grievances and issues regarding the violation of their rights.

Transparency

The management should keep shareholders and other stakeholders informed about major decisions, financial performance, practices, and all material information of the company that may affect shareholders and other stakeholders. Transparency may create a feeling of togetherness between the management and stakeholders.

Risk management

The management should decide and inform all stakeholders about the uncertainties that can arise. Plus, it must have a solid mechanism to deal with these risks.

Responsibility

The board of directors is responsible for looking into corporate matters and managing the company in a way that is in the best interest of the company and shareholders.

Accountability

Accountability means accepting responsibility for your actions. The company’s management must be accountable to the board, and the board of directors should take responsibility for each action and be answerable to shareholders, which may boost shareholders’ confidence in the company.

How To Assess Corporate Governance?

Investors may look for companies with good corporate governance practices, as they are likely to have more chances to sustain longer. Here are some parameters which may help you evaluate a company’s corporate governance.

• Whether the company’s related party transactions, i.e. transactions with the person (promoters, key management personnel, etc.) or entities related to the company (subsidiaries, associate companies, etc.), are done just like with unrelated parties or not.

• Remuneration structure – one may check whether it is in line with its financials, whether the compensation is performance-linked, whether it is in line with those of competitors in the industry, etc.

• Fairness, i.e., whether the company treats all its stakeholders fairly and whether their complaints are addressed or not, etc.

• Whether the company disclose accurate information on time or not

Examples Of Corporate Governance

Here are examples of good corporate governance and bad corporate governance in India.

Good Corporate Governance

HDFC sets a good example of corporate governance. It has introduced a corporate governance scheme that aims to manage and regulate the bank according to corporate governance policies. HDFC even received Corporate Governance and Value Creation rating by CRISIL.

Bad Corporate Governance

Satyam Computer Services, which once won the Golden Peacock Global Award for corporate governance in 2008, also became a case of bad corporate governance. The company’s former chairman Ramalinga Raju misled investors and the public by portraying a positive image of financials. 

The management overstated revenue, profits and assets and understated debts. Consequently, the World Bank prohibited the company from conducting any business for eight years.

Final Thoughts

Corporate governance is not an additional factor to incorporate. Instead, it is an essential one. Companies following the fundamentals of good corporate governance may prove to have a competitive advantage in the long run. 

After all, corporate governance facilitates the alignment and protection of the interests of all stakeholders. Investors should assess it before investing in any company to avoid negative investment outcomes later.

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