Good governance refers to effective and ethical ways of directing and controlling organizations. Effective governance ensures that the organization benefits its intended beneficiaries. Ethical governance ensures that the enterprise at least does no harm.
Good governance ensures constructive engagement with interest groups. This means having them help provide the benefit to the Intended Beneficiaries.
External stakeholder groups include investors, suppliers, customers, and others affected by the organization's activities. Internal interest groups include executives, and other employees.
The situation of the board of directors is an interesting one. The board should represent the principals or intended beneficiaries. They act as agents of the beneficiaries. The executives are agents of the board, and so on.
A vital aspect of good governance is the accountability of those in the enterprise.
Let me explain.
Good governance involves addressing the Principal-Agent problem.
This is the issue of motivating someone to act on behalf of another.
The principal pays someone, the 'agent', to perform actions useful to the principal. Also, the performance is difficult or expensive to observe. This is the case to some extent for all contracts. There is unequal access to information. Sharing of uncertainty and risk is usually unbalanced. Often, a principal does not know whether the contract execution is satisfactory.
How do we address this? Provide incentives for agents to act in the interests of the principal. This involves aligning the self-interested rational choices of the agent with the principal's desires. This is difficult. Hence, we have many compensation mechanisms, or 'carrots'. We also need accountability arrangements with sanctions for non-performance, 'sticks'.
Recent decades have seen some spectacular and large business failures. This has lead to tougher commercial laws.
In the U.S., these failures include Enron Corporation and MCI Inc. After their demise, the Sarbanes-Oxley Act (SOX) came in 2002. This aimed at rebuilding shattered public confidence.
Failures in Australia, such as HIH, and One.Tel, spurred the move to good governance. This included amendments to the Corporations Act 2001. This is the Corporate Law Economic Reform Program Act 2004, or CLERP. See - Directors and company officers play an essential role in good corporate governance.
Similar corporate failures in other countries stimulated increased regulatory interest (e.g., Parmalat in Italy). Other countries made similar changes to corporate law. Among others, examples include -
These efforts try to balance information available to governors and executives of the organization. Improved disclosure of accounting information is the main way.
These changes give non-executive directors guidance for their board roles. Such detailed road maps may curb some of the previous problems.
However, they do not get at the essence of good corporate governance. Governing directors may become overwhelmed with information. They can bury themselves in detailed compliance tasks. They may not pay enough attention to the main game. The most vital information they need may still be difficult to uncover.
Improved accounting for an organization's activities is a step in the right direction. There is still work to do in coming up with good governance practices. This work needs to address the defects in previous practice in these crucial aspects:
They do not protect the interests of the intended beneficiaries. They continue to occupy a less than prime position in the minds of many managers. They can pervert the resources of organizations for their own benefit.
There is no clear link between form of governance and organizational performance.
Interest groups do not seem better protected under one rather than some other scheme. Not even direct representation on a governing body seems to be the answer. The relevance of any specialist representative erodes as times change. They are seldom replaced. There is no clear link between the forms of governance and organizational social responsibility.
The governors face a temptation to usurp the role of the managers. This adds a layer of bureaucracy. The managers can usurp the role of governors. This may lead to the perversion of the organizational aims.
Governors will be more effective once they shed any pretence to manage.
Managers will be more effective once they stop trying to govern.
There needs to be a genuine separation of powers.
The job of governing directors is ensuring that the organization serves the intended beneficiaries. This is essential to good governance.
At its essence, corporate governance has to do with trust. It is about fiduciary obligation.
This comes from Latin fiduciarius, meaning "(holding) in trust". A fiduciary duty is a legal relationship of trust between two or more parties. A fiduciary is someone who has undertaken to act for and on behalf of another. This requires a relationship of trust and confidence. This happens when directors of a business are in effect trustees for the shareholders. The shareholders entrust funds to the governing directors for investment. In a fiduciary relationship, one person invests confidence in another. The first needs the aid, advice, or protection of the second in some matter. The fiduciary must act for the benefit of the one who trusts.
Good governance is about the care of other people's money.
Blunt and I hope clear!
Following the failures mentioned above, there has been some rethinking of corporate governance. There has been a growing consensus on some of the key elements of good governance.
There have been many studies. Laws have changed. Though the details differ, a small number of common elements have emerged.
Let us now look at each of these.
Recent reports are unanimous in their support for director independence. A majority of directors should not be employees of the organization. Conflict of interest or independence standards should be in place. Everyone should be aware of them to ensure a commitment to independence. Most of the other elements that follow reinforce this concept of director independence.
Focus on governance improvement
Many reports recommend explicit attention to governance as a function in the organization. This may take the form of a governance committee. Communicate written policies throughout the organization. Have a formal process of evaluation of the performance of the governing body. Use a set of good governance criteria for this.
Separation of Positions of Chair and CEO
There is growing agreement that there should be separate positions for chair and CEO. The intention is to enable independence of thought. Also, avoid any conflict of interest between the governing and managing roles. I am not talking about a simple re-labelling of board functions. It is also necessary to safeguard against too much power concentrated in one individual. One-person rule is often a precursor to corporate distress or even failure.
Separate independent audit committee
This means a body that meets meet, without management. They must have access to the information to review enterprise performance.
Appropriate director payment
Most studies seem to agree on the need for 'adequate' compensation to directors. How do we set 'adequate' and not 'excessive'. This line will vary with territory. Organizational type and the competition for governing talent will also have an influence. The payment must attract capable directors. It must reward according to the results required in the job. The director should feel they cannot 'rock the boat' that brings in the payment.
This is difficult in some non-profit sector organizations. In the past, the ethos was about voluntary service to the organization.
For businesses, should directors own shares in the company? Some argue that such directors will more understand the other shareholders. Opponents believe that the motivation will be short-term gains. This may work against the longer-term interest of the majority of shareholders. Not all shareholders have the same risk-reward profiles.
Knowledgeable and informed Directors
This may seem like a blinding flash of the obvious. In some enterprises, directors are not always called upon for their knowledge and capabilities. They are appointed because they are 'cooperative' with the current managers.
It is also important that directors have the tools to do their job. These include at least -
In my view, it is important not to confuse compliance with effectiveness. The above individual components of good governance are helpful. By themselves, they do not guarantee effectiveness and good conduct of the organization.
The above elements, backed by legislation may have positive influence on organizational ethos. There may always be those who know the law, and still use their wits to get around the rules. Some will achieve their own ends at the expense of the intended beneficiaries. Sometimes this can be even while within the letter of the law.
Good governance depends on a few commitments that are more fundamental. You can find these in the Beneficiary Doctrine.
John Argenti developed the beneficiary Doctrine. It is a view on sound organizational governance. It has these essential aspects. Beneficiary Doctrine -
The sum total of corporate governance has become quite complex. Good governance does not need to be so complex. We must not let the complexities obscure the essentials.
Governance is about taking care of other people's valuables. Who are these other people? They are the intended beneficiaries.
In addition, it is about how we behave while delivering on promises to the beneficiaries. Good corporate governance is also about ethics. It is about protecting beneficiaries' benefits and managing risk. It also means complying with relevant rules and laws.
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You will find more information on the effects of poor governance, and impacts on the wider financial system in the following titles.