Latest Debates and Questions in the Sphere of Corporate Governance
As institutional investors' power has grown and corporations' impact on society has grown, corporate governance has become a topic of widespread public interest. However, opinions on how corporations should be governed differ greatly. People disagree on fundamental issues such as the purpose of the corporation, the role of corporate boards of directors, shareholder rights, and the proper way to measure corporate performance.The question of whose interests should be considered in corporate decision making is particularly contentious, with some authorities emphasising shareholders' interest in maximising their financial returns while others argue that shareholders' other interests — in corporate strategy, executive compensation, and environmental policies, for example — as well as the interests of other parties must be respected.
The debate rages on today, with a new sense of urgency. While some academics and many members of the financial community continue to believe that the corporation's purpose is to maximise the wealth of its shareholders and that it should be governed accordingly, others advocate for a more robust definition of corporate purpose. This debate may appear to be theoretical and best left to academics, but it has far-reaching practical implications. With investors, regulators, and the general public calling for greater clarity of corporate purpose, boards and executives will want to give this issue serious thought and take steps to ensure that they have a shared understanding of their purpose in governing and leading.
Let us now examine some of the most important discussions and debates that have occurred in the field of corporate governance in recent years.
1) What is the role of the shareholders?
Shareholders provide equity capital to companies and have ownership rights to the shares they hold. While shareholders are frequently referred to as company owners, this description exaggerates shareholders' rights. In most jurisdictions, shareholders have the legal right to own and sell their shares, as well as vote on certain corporate matters as defined by law and the corporate charter. The definition and exercise of ownership rights varies greatly between companies and, more importantly, between countries.
The rise of ownership concentration, increased shareholder engagement, and hedge-fund activism all point to a period of greater shareholder influence over corporations. These developments call into question the accountability of shareholders, particularly those seeking to influence corporate decisions, as well as the prevalent model of shareholder value maximisation as the goal of good corporate governance.
These developments also raise concerns about institutional investors' responsibilities to retail, or individual, investors, who are the ultimate owners or beneficiaries of the institutions' holdings. Although institutional investors describe themselves as both stewards of the corporations in which they invest and fiduciaries for their own customers and clients, some commentators question whether they can effectively play both or, indeed, either role given the inherent conflicting interests involved and the nature of the low-cost business model of passive investors.The proxy voting system and the process by which shareholders are permitted to submit proposals for shareholder vote have also become contentious issues, with some arguing that the criteria for permissible proposals should be relaxed while others argue that they should be tightened.
In this context, boards and executives would be wise to have a thorough understanding of their companies' shareholder base as well as a deliberate approach to shareholder engagement. They must be prepared to face activist investors, and their overall governance arrangements must strike an appropriate balance of power among shareholders, the board, and management.
2) What is the composition of role of the Board?
The corporation's governing body is the board of directors. The board of directors is empowered by law to manage the corporation's business and affairs, and its members have a fiduciary responsibility to act in the best interests of the corporation and its shareholders. Boards are thus collegial bodies in the traditional sense that their members share authority and responsibility and are held individually and collectively accountable.
Boards typically delegate much of their authority to an executive team that oversees the corporation's day-to-day operations. Some board duties, however, cannot be delegated, and the extent to which boards are involved in the business varies greatly. The board's core functions typically include selecting, monitoring, advising, and compensating the CEO; overseeing the company's strategy, performance, risk management, and compliance with relevant legal and ethical standards; monitoring the company's financial structure and declaring dividends; deciding on major transactions and changes in control; monitoring the company's financial reporting and internal controls; and overseeing the company's strategy, performance, risk management, and compliance with relevant legal and ethical standards.
Several trends in board composition have emerged over the last few decades, spanning jurisdictions. One example is the growing presence of female directors, who were once uncommon but are now required in some countries to make up at least 40% of the board's total. The overall percentage of female directors remains low in comparison to their workforce numbers, but the rate at which female directors are being added appears to be accelerating, and surveys indicate that adding women to boards has benefited those boards.
Another trend is an increase in the percentage of directors who are "independent," meaning they have no commercial or family ties to the company or its management and are thus assumed to have a higher or more reliable capacity for objective judgement. Boards have become more independent over the last decade, and independent directors are more likely to meet in "executive" sessions separate from the board's management members. High-performing boards around the world are looking to improve their effectiveness through more systematic self-evaluation and succession planning, as well as by adding members with a more diverse set of skills, perspectives, and backgrounds.
3) How are corporate leaders chosen and compensated?
Corporations are complex organisations that rely on leadership and day-to-day management to function. The most important job of a company's board of directors is to ensure that such leadership and management are in place. This job entails specific tasks such as appointing the company's chief executive, evaluating the executive's performance, deciding on executive pay, planning for executive succession, and, on occasion, removing an executive from office.
The board's job has become more difficult in recent years, in part because the CEO's job has become more difficult. The traditional activities of corporate leadership have become more difficult as companies have grown larger and more complex, and the pace of change has accelerated. In addition to market and competitive pressures, today's corporate leaders must contend with a slew of challenging forces ranging from increased investor activism and volatile capital markets to increased social and cultural diversity, mounting social and environmental challenges, political and regulatory uncertainty, and disruptive technologies that are transforming industries around the world. The increased demands on corporate leaders have emphasised the importance of succession planning and raised concerns about the qualities required of today's executives.
One of the most difficult tasks for the board is determining an appropriate compensation package for the CEO and top management. Typically, this task is delegated to the compensation (or remuneration) committee of the board. Over the last few decades, CEO pay has risen dramatically in relation to corporate performance and average employee pay. Some commentators argue that the increase in executive pay is justified by the increased complexity and difficulty of the CEO job or by the returns generated for shareholders, but others see it as unjustified, excessive, and unfair.
More boards are also establishing goals based on non-financial metrics such as innovation, quality, culture, or other aspects of corporate strategy, such as social and environmental performance. Critics of the current system for selecting, evaluating, and rewarding corporate leaders point to the closed nature of the selection process, the narrowness of standard performance measures, the undue influence of executives whose own forecasts are used to set targets, the excessive complexity of many plans, and the outsized and sometimes perverse rewards bestowed even on those who clearly fail at their jobs. Whether valid or not, these criticisms raise a number of issues that every board should consider in carrying out its responsibility to ensure effective leadership and management.
4) How to strategize and allocate resources?
Corporations serve many functions in society, one of which is the mobilisation and allocation of financial capital to investment opportunities. Senior managers typically collaborate with other members of the organisation to carry out this activity, while the board serves as an oversight body. However, in some cases, decisions about how to use the company's resources are delegated to the board, either by law or by the company's by-laws—for example, whether to approve a major investment, declare a dividend, or authorise a share buyback. Managers and boards, in theory, allocate resources in a way that advances the company's strategy, which is the result of a forward-thinking process of identifying and analysing worthwhile opportunities in light of the company's distinct capabilities and in light of anticipated changes in the market, competitive landscape, and broader economic, political, regulatory, and social environment.
When corporate resource allocation is performed appropriately, businesses can evolve and renew themselves over time, while also producing a continuous flow of products and services that meet the needs of their customers and a continuous flow of profits that can be re-invested in the business or paid out to shareholders. However, in practise, resource allocation is extremely difficult, particularly when comparing businesses with different strategic characteristics, investments with long time horizons, or innovative projects with uncertain pay-offs, to name a few common challenges. The difficulty is exacerbated by shareholder pressures with varying objectives, time horizons, and risk tolerance. As a result, when making resource allocation decisions, many managers overlook strategic and human complexities and instead rely on standard financial tools such as discounted cash flow analysis.
Costs and benefits to third parties, known as "externalities," have traditionally been excluded from this analysis. As a result, factors such as increased carbon emissions or potential risks to customers or employees are not typically taken into account when making these decisions. However, it is becoming increasingly important to consider these factors.
5) How to define and measure corporate performance?
Capital providers, the prototypical users, seek performance data in order to compare across opportunities in order to identify the best use of their capital and ensure effective ongoing stewardship of their investments. Other users may have different goals, such as a lender ensuring timely payment of interest and principal, or a corporate centre allocating resources to different divisions. The board of directors requires this information to assess the success of corporate strategy or to make executive compensation decisions. Others, such as a potential customer or employee, or a local community will almost certainly have additional requirements. Because there are so many different sources of demand for corporate performance information, no single definition of performance or simple measurement system will suffice.
Different time horizons for evaluating performance complicate the task even more. Many stakeholders expect periodic performance evaluation and reporting, but operating and investment cycles do not neatly correspond with calendar quarters or years.
Acknowledging that no single metric (whether based on stock price or summary accounting metrics) or time horizon is sufficient to capture the richness of business outcomes, some companies have adopted a dashboard approach based on ideas such as the balanced score card to measure interim rather than final outcomes. This method looks at shorter-term indicators that will eventually lead to better overall results.
Companies are being asked to measure their social and environmental performance on a variety of dimensions ranging from diversity and inclusion, to customer privacy and supply chain conditions, to human rights and carbon emissions. This demand is being driven in part by investors and others who believe that a company's social and environmental performance is related—causally or otherwise—to its long-term financial performance, and in part by those who believe that social and environmental performance is important in and of itself or is required as a matter of corporate citizenship for the healthy functioning of society and the broader economy.
Corporate performance measurement continues to be an exciting area of innovation and debate, both in terms of appropriate measures and measurement horizons. Companies are experimenting with broader disclosure of strategy and long-term success drivers, while acknowledging that investors and other stakeholders often prefer summary metrics and shorter-term outcomes to identify trouble early.
6) How to undertake corporate oversight?
Although the board's responsibility to oversee corporate risk is widely acknowledged, interpretations of what this responsibility entails vary greatly. Today's boards are expected to oversee a diverse and ever-expanding set of risks. Following the 2008 financial crisis, the boards of banks and financial institutions were chastised for failing to pay adequate attention to excessive financial risk. The recent rash of behavioural complaints lodged against senior corporate executives has raised concerns about board oversight of executive conduct and caught many boards off guard.
Several companies have also experienced serious cybersecurity breaches, exposing a lack of preparedness and resulting in significant reputational damage; others have been caught off guard by data privacy concerns and are facing political and user backlash. Environmental disasters, supply chain labour abuses, and customer mistreatment are just a few examples of the new breed of risk management issues occupying boardrooms.
The growing number of risks has posed a challenge to traditional internal control practises and is putting boards' ability to provide adequate oversight to the test. Internal audit and risk management functions have received significantly increased attention since the financial crisis, particularly in banks and financial institutions.
Overseeing risk thus necessitates boards going far beyond their traditional monitoring activities and developing new ways of gauging the organization's pulse. This task is being aided by advances in data science and computing capabilities, which enable digital compliance tools and predictive analytic capabilities to be used to assist with risk management, particularly in banks and financial institutions.
Most directors today recognise the importance of strong oversight, but it is unclear whether boards, as they currently exist and function, are up to the task. The growing size and complexity of businesses, the expanding range of risk areas, and the difficulty boards have in gathering the information needed to exercise effective oversight all point to a negative answer to this question. Other institutions, both internal and external to the organisation, provide oversight as well. Large investors, proxy advisors, regulators, the media, non-governmental organisations, and the general public all play a role. However, it is doubtful that these institutions can replace boards, and it could be argued that these institutions can be effective only if boards are effective. In the coming years, boards will face increased pressure to strengthen their risk oversight capabilities while also driving the type of entrepreneurial innovation required for long-term growth and profitability.
7) How to improve corporate reporting?
Boards of directors are crucial in ensuring that investors and the general public receive accurate and timely information about corporate activities and performance. In some areas, such as accounting and financial reporting, disclosures are highly regulated and standardised, and the board's role, through its audit committee, is primarily to ensure that the company's reporting adheres to the relevant standards, as well as to make accounting policy decisions as permitted by those standards. Boards and audit committees have faced an increasing number of reporting and disclosure challenges in recent years.
The globalisation of capital flows has created a new set of challenges. Another set of challenges has arisen as mark-to-market or fair value accounting has spread to a growing number of asset classes. The emergence of new business models as a result of rapid technological innovation raises similar concerns. Companies have responded by developing measurements and reporting figures that, while arguably better reflecting their businesses, are incompatible with traditional reporting metrics. While non-traditional measures may have merit, they also undermine the benefits of uniform measurement rules, make it more difficult for users to draw meaningful conclusions, and necessitate increased vigilance on the part of boards and audit committees.
Along with these new challenges, businesses have faced increased pressure to provide various types of non-financial information, particularly about their social and environmental impacts. These demands range from specific disclosures about climate-related risks, political spending, or different pay ratios to comprehensive periodic reports on companies' social and environmental performance. Corporate social responsibility (CSR) reporting, also known as sustainability reporting, has progressed from an ad hoc activity carried out by a few select companies to a routine practise at many of the world's largest corporations.
Although the benefits of transparency are obvious, and the availability of accurate and timely information is critical for the efficient operation of markets and society, gathering and reporting on corporate-wide data can be costly. As the demand for more extensive reporting and disclosure grows, boards and companies will be forced to find more efficient and meaningful ways to respond.