Corporate Governance
Compiled and Edited by
Muhammad Abubakar Siddique,
Lecturer, Int’l Institute of Islamic Economics (IIIE),
Int’l Islamic University, Islamabad.
Website: http://islamicfina.com/
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Corporate governance
Capitalism is thus called because it is a system organized around the production and allocation of capital. The savings of individuals are the basis of all capital. Yet the ways in which economies accumulate and allocate capital are quite different in different countries, and seem closely related to how each country handles corporate governance issues. Corporate governance—that is, decisions about how capital is allocated, both across and within firms—is entrusted to very different sorts of people and constrained by very different institutions.
Corporate governance involves the interests of shareholders, the responsibility of the board of directors, the rights of other stakeholders, and appropriate ethical standards, notably of disclosure and transparency.
Individuals can save by investing in corporate stocks and bonds. Companies they view as good bets can raise huge amounts of money by issuing securities. If investors know what they are doing, capital is allocated to firms that can use it well and is kept away from firms that are likely to waste it. This process underlies shareholder capitalism, as practiced in the United Kingdom and United States. Firms in those countries that can issue stock and bonds to investors acquire funds to build factories, buy machinery, and develop technologies. For investors to trust a company enough to buy its securities, they need reassurance that the company will be run both honestly and cleverly. This is where corporate governance is critical. The corporate governance of large corporations in these countries is entrusted to CEOs and other professional managers. Investors collectively monitor the quality of governance of each listed firm, and its share price reflects their consensus.
Characteristics of Corporate governance
One view of corporate governance is that it is based on a series of underlying characteristics;
- Fairness
The directors’ deliberations and also the systems and values that underlie the company must be balanced by taking into account everyone who has a legitimate interest in the company, and respecting their rights and views. In many jurisdictions, corporate governance guidelines reinforce legal protection for certain groups, for example minority shareholders. It should mean the company deals even-handedly with others.
- Transparency
Transparency means open and clear disclosure of relevant information to shareholders and other stakeholders, as well as not concealing information when it may affect decisions. It means open discussions and a default position of information provision rather than concealment.
Circumstances where concealment may be justified include discussions about future strategy (knowledge of which would benefit competitors), confidential issues relating to individuals and discussions leading to an agreed position that is then made public.
- Innovation
The concept of innovation in the approach to corporate governance recognizes the fact that the needs of businesses and stakeholders can change over time. It also has an impact on how organisations respond to meeting the ‘comply or explain’ requirement contained in various codes of corporate governance that are currently in effect.
- Skepticism
The UK Corporate Governance Code, under the heading of ‘Leadership’, encourages non-executive directors (NEDs) to adopt an air of skepticism so that they can effectively challenge management decisions in their role of scrutiny. Applying professional skepticism is also an important part of the role of auditors and audit committees.
International Standards on Auditing (ISA) 200 defines professional skepticism as: ‘An attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.’ This does not mean that all management decisions and evidence have to be approached with suspicion or mistrust; but rather that an open and enquiring mind must always be employed. A healthy corporate culture and environment is one that encourages and enables such skepticism to thrive.
- Independence
Independence is the avoidance of being unduly influenced by vested interests and free from any constraints that would prevent a correct course of action being taken. It is an ability to stand apart from inappropriate influences and be free of managerial capture, to be able to make the correct and uncontaminated decision on a given issue. Independence is a quality that can be possessed by individuals and is an essential component of professionalism and professional behavior.
An important distinction generally with independence is independence of mind and independence of appearance.
- Independence of mind means providing an opinion without being affected by influences compromising judgment.
- Independence of appearance means avoiding situations where an informed third party could reasonably conclude that an individual’s judgment would have been compromised.
Independence is an important concept in relation to directors; in particular, freedom from conflicts of interest. Corporate governance reports have increasingly stressed the importance of independent nonexecutive directors, directors who are not primarily employed by the company and who have very strictly controlled other links with it. They should be in a better position to promote the interests of shareholders and other stakeholders. Freed from pressures that could influence their activities, independent nonexecutive directors should be able to carry out effective monitoring of the company and its management in conjunction with equally independent external auditors on behalf of shareholders.
Non-executive directors’ lack of links and limits on the time that they serve as non-executive directors should promote avoidance of managerial capture – accepting executive managers’ views on trust without analyzing and questioning them.
The independence of external auditors from their clients is also important in corporate governance. As the auditor is acting on behalf of the shareholders and not the client, close friendship with the client may influence the external auditor’s judgment, and mean that the external auditor is not effectively representing the shareholders’ interests. Internal auditors also need to be independent of the colleagues whom they are auditing.
A complication when considering independence is that there are varying degrees of independence, lying between total independence(no knowledge/connection with the other party) and zero independence (inability to take a decision without considering the effect on the other party). In real-life situations the two extremes are unlikely, but in most situations independence should be as near to total independence as possible.
- Probity/honesty
Hopefully this should be the most self-evident of the principles. It relates to not only telling the truth but also not misleading shareholders and other stakeholders. Lack of probity includes not only obvious examples of dishonesty, such as taking bribes, but also reporting information in a slanted way that is designed to give an unfair impression.
Guidance in the UK charitable sector has defined probity in terms of receipt of gifts or hospitality by trustees. The Code stresses that all gifts should be clearly recorded, and trustees should not accept gifts with a significant monetary value or lavish hospitality. They should certainly not accept gifts or hospitality which may seem likely to influence their decisions.
- Responsibility
Responsibility means management accepting the credit or blame for governance decisions. It implies clear definition of the roles and responsibilities of the roles of senior management.
- Accountability
Corporate accountability refers to whether an organization (and its directors) is answerable in some way for the consequences of its actions. Directors being answerable to shareholders have always been an important part of company law, well before the development of the corporate governance codes. For example, companies in many regimes have been required to provide financial information to shareholders on an annual basis and hold annual general meetings.
- Reputation
Reputation is determined by how others view a person, organisation or profession. Reputation includes a reputation for competence, supplying good quality goods and services in a timely fashion, and also being managed in an orderly way. However, a poor ethical reputation can be as serious for an organisation as a poor reputation for competence.
The consequences of a poor reputation for an organisation can include:
- Suppliers’ and customers’ unwillingness to deal with the organisation for fear of being victims of sharp practice
- Inability to recruit high-quality staff
- Fall in demand because of consumer boycotts
- Increased public relations costs because of adverse stories in the media
- Increased compliance costs because of close attention from regulatory bodies or external auditors
- Loss of market value because of a fall in investor confidence
- Judgment
Judgement means the board making decisions that enhance the prosperity of the organisation. This means that board members must acquire a broad enough knowledge of the business and its environment to be able to provide meaningful direction to it. This has implications not only for the attention directors have to give to the organization’s affairs, but also on the way the directors are recruited and trained.
- Integrity
‘Integrity means straightforward dealing and completeness. What is required of financial reporting is that it should be honest and that it should present a balanced picture of the state of the company’s affairs. The integrity of reports depends on the integrity of those who prepare and present them.’ (Cadbury report).
Integrity (means that) holders of public office should not place themselves under any financial or other obligation to outside individuals or organisations that might influence them in the performance of their official duties (UK Nolan Committee Standards on Public Life).
Integrity can be taken as meaning someone of high moral character, who sticks to strict moral or ethical principles no matter the pressure to do otherwise. In working life this means adhering to the highest standards of professionalism and probity. Straightforwardness, fair dealing and honesty in relationships with the different people and constituencies whom you meet are particularly important. Trust is vital in relationships and belief in the integrity of those with whom you are dealing underpins this.
