Corporate governance refers to the mechanisms, processes, practices, and relations by which corporations are controlled and operated by their boards of directors, managers, shareholders, and stakeholders. It defines how power and responsibilities are distributed within a company, how decisions are made and how performance is monitored. Effective corporate governance is essential for ensuring accountability, transparency and long-term sustainability of organizations which is seen especially in publicly traded companies.
Definitions "Corporate governance" may be defined, described or delineated in diverse ways, depending on the writer's purpose. Writers focused on a disciplinary interest or context (such as accounting, finance, corporate law, or management) often adopt narrow definitions that appear purpose specific. Writers concerned with regulatory policy in relation to corporate governance practices often use broader structural descriptions. A broad (meta) definition that encompasses many adopted definitions is "Corporate governance describes the processes, structures, and mechanisms that influence the control and direction of corporations."Shailer, Greg. Corporate Governance, in D. C. Poff, A. C. Michalos (eds.), Encyclopedia of Business and Professional Ethics, Springer International Publishing AG, 2018. https://doi.org/10.1007/978-3-319-23514-1_155-1
This meta definition accommodates both the narrow definitions used in specific contexts and the broader descriptions that are often presented as authoritative. The latter include the structural definition from the Cadbury Report, which identifies corporate governance as "the system by which companies are directed and controlled" (Cadbury 1992, p. 15); and the relational-structural view adopted by the Organization for Economic Cooperation and Development (OECD) of "Corporate governance involves a set of relationships between a company's management, board, shareholders and stakeholders. Corporate governance also provides the structure and systems through which the company is directed, and its objectives are set, and the means of attaining those objectives and monitoring performance are determined" (OECD 2023, p. 6).
Examples of narrower definitions in particular contexts include: "a system of law and sound approaches by which corporations are directed and controlled focusing on the internal and external corporate structures with the intention of monitoring the actions of management and directors and thereby, mitigating agency risks which may stem from the misdeeds of corporate officers." "the set of conditions that shapes the ex post bargaining over the quasi-rents generated by a firm."Luigi Zingales, 2008. "Corporate governance", The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
The firm itself is modelled as a governance structure acting through the mechanisms of contract.Williamson, Oliver E. (1996). The Mechanisms of Governance. Oxford University Press. Here corporate governance may include its relation to corporate finance.Tirole, Jean (1999).The Theory of Corporate Finance, Princeton. Description and scrollable preview.
Principles Contemporary discussions of corporate governance tend to refer to principles raised in three documents released since 1990: The Cadbury Report (UK, 1992), the Principles of Corporate Governance (OECD, 1999, 2004, 2015 and 2023), and the Sarbanes–Oxley Act of 2002 (US, 2002). The Cadbury and Organisation for Economic Co-operation and Development (OECD) reports present general principles around which businesses are expected to operate to assure proper governance. The Sarbanes–Oxley Act, informally referred to as Sarbox or Sox, is an attempt by the federal government in the United States to legislate several of the principles recommended in the Cadbury and OECD reports. Rights and equitable treatment of shareholders:Cadbury, Adrian, Report of the Committee on the Financial service Aspects of Corporate Governance, Gee, London, December 1992, Sections 3.4Sarbanes-Oxley Act of 2002, US Congress, Title VIII Organizations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by openly and effectively communicating information and by encouraging shareholders to participate in general meetings. Interests of other stakeholders: Organizations should recognize that they have legal, contractual, social, and market driven obligations to non-shareholder stakeholders, including employees, investors, creditors, suppliers, local communities, customers, and policymakers. Role and responsibilities of the board:Cadbury, Adrian, Report of the Committee on the Financial Aspects of Corporate Governance, Gee, London, December 1992, Section 3.4 The board needs sufficient relevant skills and understanding to review and challenge management performance. It also needs adequate size and appropriate levels of independence and commitment. Integrity and ethical behavior:Cadbury, Adrian, Report of the Committee on the Financial Aspects of Corporate Governance, Gee, London, December 1992, Sections 3.2, 3.3, 4.33, 4.51 and 7.4Sarbanes-Oxley Act of 2002, US Congress, Title I, 101(c)(1), Title VIII, and Title IX, 406 Integrity should be a fundamental requirement in choosing corporate officers and board members. Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making. Disclosure and transparency:Cadbury, Adrian, Report of the Committee on the Financial Aspects of Corporate Governance, Gee, London, December 1992, Section 3.2 Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide stakeholders with a level of accountability. They should also implement procedures to independently verify and safeguard the integrity of the company's financial reporting. Disclosure of material matters concerning the organization should be timely and balanced to ensure that all investors have access to clear, factual information.
Principal–agent conflict Some concerns regarding governance follows from the potential for conflicts of interests that are a consequence of the non-alignment of preferences between: shareholders and upper management (principal–agent problems); and among shareholders (principal–principal problems), although other stakeholder relations are affected and coordinated through corporate governance.
In large firms where there is a separation of ownership and management, the principal–agent problem can arise between upper-management (the "agent") and the shareholder(s) (the "principals"). The shareholders and upper management may have different interests. The shareholders typically desire returns on their investments through profits and dividends, while upper management may also be influenced by other motives, such as management remuneration or wealth interests, working conditions and perquisites, or relationships with other parties within (e.g., management-worker relations) or outside the corporation, to the extent that these are not necessary for profits. Those pertaining to self-interest are usually emphasized in relation to principal-agent problems. The effectiveness of corporate governance practices from a shareholder perspective might be judged by how well those practices align and coordinate the interests of the upper management with those of the shareholders. However, corporations sometimes undertake initiatives, such as climate activism and voluntary emission reduction, that seems to contradict the idea that rational self-interest drives shareholders' governance goals.
An example of a possible conflict between shareholders and upper management materializes through stock repurchases (treasury stock). Executives may have incentive to divert cash surpluses to buying treasury stock to support or increase the share price. However, that reduces the financial resources available to maintain or enhance profitable operations. As a result, executives can sacrifice long-term profits for short-term personal gain. Shareholders may have different perspectives in this regard, depending on their own time preferences, but it can also be viewed as a conflict with broader corporate interests (including preferences of other stakeholders and the long-term health of the corporation).
Principal–principal conflict (the multiple principal problem) The principal–agent problem can be intensified when upper management acts on behalf of multiple shareholders—which is often the case in large firms (see Multiple principal problem). Specifically, when upper management acts on behalf of multiple shareholders, the multiple shareholders face a collective action problem in corporate governance, as individual shareholders may lobby upper management or otherwise have incentives to act in their individual interests rather than in the collective interest of all shareholders. As a result, there may be free-riding in steering and monitoring of upper management, or conversely, high costs may arise from duplicate steering and monitoring of upper management. Conflict may break out between principals, and this all leads to increased autonomy for upper management.
Ways of mitigating or preventing these conflicts of interests include the processes, customs, policies, laws, and institutions which affect the way a company is controlled—and this is the challenge of corporate governance.Cadbury, Adrian, Report of the Committee on the Financial Aspects of Corporate Governance, Gee, London, December 1992, p. 15 To solve the problem of governing upper management under multiple shareholders, corporate governance scholars have figured out that the straightforward solution of appointing one or more shareholders for governance is likely to lead to problems because of the information asymmetry it creates. Shareholders' meetings are necessary to arrange governance under multiple shareholders, and it has been proposed that this is the solution to the problem of multiple principals due to median voter theorem: shareholders' meetings lead power to be devolved to an actor that approximately holds the median interest of all shareholders, thus causing governance to best represent the aggregated interest of all shareholders.
Other themes An important theme of governance is the nature and extent of corporate accountability. A related discussion at the macro level focuses on the effect of a corporate governance system on economic efficiency, with a strong emphasis on shareholders' welfare.Daines, Robert, and Michael Klausner, 2008 "Corporate law, economic analysis of", The New Palgrave Dictionary of Economics, 2nd Edition. Abstract. This has resulted in a literature focused on economic analysis.Shleifer, Andrei, and Robert W. Vishny (1997). "A Survey of Corporate Governance", Journal of Finance, 52(2), pp. 737–783.Oliver Hart (1989). "An Economist's Perspective on the Theory of the firm", Columbia Law Review, 89(7), pp. 1757–1774.Valentin Zelenyuk, and Vitaliy Zheka (2006). "Corporate Governance and Firm's Efficiency: The Case of a Transitional Country, Ukraine", Journal of Productivity Analysis, 25(1), pp. 143–157, A comparative assessment of corporate governance principles and practices across countries was published by Aguilera and Jackson in 2011.
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