What is Corporate Governance?

I have decided to write a three-part blog about corporate governance. I want to describe what corporate governance is, why it is important for a company to have it, what kind of companies should adopt corporate governance policies and what are the hotly debated issues in corporate governance today. This is the first posting.

Corporate governance is a set of internal rules designed to increase transparency in the management of a company and align the interests of its shareholders, directors, managers, employees and creditors. Even though the concept of corporate governance has existed in some form since the time modern corporations began to form, corporate governance has been in spotlight only since the corporate scandals of the 1990s and 2000s, such as Enron, Worldcom, Arthur Andersen, Global Crossing, Tyco International and others. These scandals ultimately led to the adoption in 2002 of the Sarbanes-Oxley Act and that is when the new era of corporate governance has begun.

In general, corporate governance puts checks and balances on the relationship between the senior management of a company and its board. With corporate governance rules in place, managers have to be accountable for the performance of the company and the board, for example, cannot approve bonuses that are unrelated to the performance of the company. All deals among interested parties (such as between the company and its board members or executive officers) have to be disclosed, pre-approved or ratified and be on arms’-length terms. The scandals of Enron, Worldcom and other companies triggered increased shareholder activism and the desire to add transparency and accountability to the internal corporate governing process.

So, which corporate governance policies should a company have? There are mandatory rules that apply to public companies (or companies with registered debt) that are in the Sarbanes-Oxley Act of 2002 and rules written by the Securities and Exchange Commission to implement the Act. The most important ones, in my opinion, are the requirement to have a set of (1) disclosure controls and procedures to assure the accuracy of financial reports, and (2) internal controls over financial reporting, which require a very thorough (and expensive) analysis and evaluation of all internal accounting controls and risk management systems on a company-wide level. There is also the requirement to have a code of ethics for senior financial officers, to have a financial expert on the audit committee, to adopt a procedure for pre-approval of audit-related services, prohibition of personal loans to executive officers, and the requirement to disclose transactions between senior executives and certain shareholders, among others.

There are policies that the companies can adopt to facilitate their compliance with these rules. Such policies include code of ethics, charters for each of the board committees, whistleblower procedures, corporate governance guidelines, insider trading policy, related person transaction policy, audit committee pre-approval policy and disclosure controls and procedures.

It may seem that a private company with no outstanding public debt or equity and a relatively small number of shareholders (less than 500) does not need to worry about corporate governance. After all, implementation and compliance with all these procedures takes time and money, something that many start-ups and smaller companies do not have a lot of (good topic for another blog). However, it is advisable to start implementing some of these policies early on, so that the employees, executive officers and other stakeholders in the company get used to the way the company is run and adjust their expectations accordingly. It is not uncommon for a private company to adopt all these rules right before going public, as part of the pre-IPO process. However, this is a lot to process. It is not only about having these policies in place (although that’s definitely a step in the right direction), but also about fostering a corporate culture that has learned to respect these policies and operate according to them on a daily basis. Also, knowing in advance that compliance with internal controls over financial reporting may be required, financial executives can centralize the accounting and financial reporting systems ahead of time in order to lessen the cost of compliance with this requirement and to avoid the need to re-adjust the systems once the company is public. This takes time… so, just like with life insurance (the earlier in life you get it, the smaller are the premiums), start early in the life-cycle of the company and let the company grow with the policies in place.

In the next blog, I will discuss what kind of corporate governance policies a small company should adopt.