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Understanding corporate governance

Understanding corporate governance

01 May, 2019

Sound corporate governance is directly related to business success

With sound corporate governance directly related to business success, and as many African countries tussle with converting potential into genuine returns, Ocorian Director for the Africa region, John Félicité presents a series of articles examining corporate governance as a vehicle for reducing the risk of investing in Africa and catalysing growth on the continent.

In this first part, John will dissect what corporate governance is, whose responsibility it is to implement and the benefits associated with best practice. 

In part two John will look at how boards ensure good corporate governance and in part three he looks at how corporate governance can catalyse growth in Africa.

Successful and sustainable businesses are a necessary spine of modern society from which the socio-economic and political landscape is largely determined. They create jobs, stimulate economic growth and generate tax revenue. Nevertheless, they must evolve and adapt under the pressure of their own success, fostering effective governance processes in order to maintain their priority of increasing value.

But before we examine the role corporate governance can play in Africa specifically, we first need to understand the intricacies of corporate governance and how there is no 'one-size fits all'.

What is corporate governance?

Corporate governance is the system by which organisations are directed and controlled. The responsibility of this falls to the board of directors, who must also ensure that internal controls have been set to protect company assets.

It is important to note that there is no worldwide standard for corporate governance, it is understood from different perspectives and each country has developed its own rules, such as Sarbanes-Oxley in the USA, the King Report in South Africa and the Wates Principles in the UK. The interpretation of good corporate governance may also change according to the cultural context of the country. However, if we take a step back, when a person thinks of governance, do they think of the law or do they think of how ethically someone is running a company?

Understanding corporate governance

Before we can consider what is or is not ethical, it is good practice to have a sound understanding of what is legal or illegal, giving us a guide to understanding what is unlawful or unethical. From this, we can understand that ethics are a set of moral principles that guide behaviour. In the corporate world, an extension of this is the application of ethical values to business behaviour. This should be the norm at all levels of society and company structure, remaining uncompromised by personal gain.

When we look at good corporate governance across the world we need to consider the metrics that are common to all, those that require morality and ethics above all else to ensure clear transparency in how affairs are carried out and managed in a sustainable way. Although corporate governance is interpreted and implemented differently around the world, its success relies on the alignment of society's value chain; the state, the private sector and the public.

When working in the public sector, it is clear how someone should conduct and govern their actions. The UK's seven principles of public life state that those employed in the public sector should follow: Selflessness, Integrity, Objectivity, Accountability, Openness, Honesty and Leadership.

But what are the principles of the private sector? Should they be the same, or should they be completely different?

If we look at the UK's Wates Principles that were introduced on 1 January 2019, they require large private companies of a specific threshold to disclose their corporate governance arrangements in their directors' report and on their website, including whether they follow a formal code. They centre on six key principles:

  • Purpose and leadership
  • Board composition,
  • Director responsibilities,
  • Opportunity and risk
  • Remuneration
  • Stakeholder relationships and engagement

However, the Wates Principles are merely a tool, not a binding framework. Similarly, The UK Corporate Governance Code for listed companies has the following principles at its heart: Leadership, Effectiveness, Accountability, Remuneration and Relations with Shareholders. However, in the current mix of globalisation and international trade, governance focussed on the above ideas and managed through the activities of Audit Committees, Appointment Committees and Remuneration Committees is not sufficient when corporates are tackling how to grow safely and securely in emerging markets.

Both are rare instances of an attempt to provide governance principles for the private sector. Yet, why should this only be relevant to large and listed companies? Most emerging and developed economies see contribution to the economy from both small and large companies, with small and medium sized businesses (SMEs) often the biggest contributor in terms of tax.

There is also the question of whether good governance includes corporate social responsibility and if so, is this at the public or the private sector level? The movement stating that the sole role of companies is to maximise shareholder value is today being challenged, and there is pressure for businesses to provide and prove how they add value to society. However, there is a lack of clarity if it is the role of governments to provide this or the responsibility of corporates. Should society be grateful or should they expect it as a minimum level of business practice?

And what about the effect culture has in determining how a company is governed? Corporate culture can be defined as a combination of the values, attitudes and behaviours displayed by a company in its operation and relationships with its stakeholders. Conversely, it can also be based on local traditions and specific ethnic cultural norms. In many emerging market countries, this can have a substantial effect on how a business is run.

The key to corporate governance success: board structure

With corporate governance at the mercy of the board of directors, how that board is structured and operates is crucial to how successfully a company is governed. According to The UK Corporate Governance Code, "The board and its committees should consist of directors with the appropriate balance of skills, experience, independence and knowledge of the company to enable it to discharge its duties and responsibilities effectively". Yet how is effectiveness measured? Is it judged on profits, employee satisfaction or something else? It is difficult to gauge in one statistic and it is the board's responsibility to engender best practice at the top level of the company in order for good governance to percolate down.

Typically, in the UK board structures tend to be designed as single boards made up of all executive directors, majority executive directors, or majority non-executive directors. This decision is company dependent and is normally subject to annual re-election.

In contrast, in the rest of Europe the concept of multi-tier boards incorporating supervisory and management functions tends to be the norm.

Both have advantages and disadvantages. These range from the considerable levels of life experience being available to the board, through to the separation or dilution of power or in unfortunate situations, confusion over roles and responsibilities for decision making.

For example, in North America, CEO's strongly prefer the dual mandate of being Chairman and CEO, which puts them completely in charge and avoids the likelihood of conflicts or power struggles within the boardroom. The downside of this model is that it may encourage complacency by boards and discourage them from getting deeply involved in issues until it is too late.

In recent times, the rise of the role of lead director, elected by the independent directors, is contributing to a better separation of governance from management. This role should be clearly defined with a job description that is publically available and respected by the Chairman and CEO. The lead director can coordinate the opinions of all directors and facilitate open discussion among them, lowering the chances of poor governance. (We will explore board structure in more detail in part two.)

Corporate governance as a risk indicator

Sound corporate governance can significantly impact the success of a business, but poor corporate governance can cast doubt on the reliability of a company and prove detrimental to its value.

When evaluating risks within a company, it is standard practice to focus on the quantitative aspects (IRR, ROE and CAGR) more than the qualitative aspects. However, quantitative elements do not accurately represent governance. By focussing on qualitative aspects, such as the use of governance to protect the interests of all stakeholders, shareholders, employees and society at large, we can build a clearer picture of the associated investment risk.

On a state level, economic and political governance are both central qualitative aspects that can be used to evaluate risk. Both of these pillars support effective corporate governance and contribute to enabling economic freedom.

Political governance: A measure of both political stability and instability, it is judged by electoral competitiveness, constraint on the government executive and the polity.

Economic governance: The system of institutions and procedures established to achieve the coordination of economic policies to promote economic and social progress.

Economic freedom: Ability of people in society to take economic actions. It is broadly defined by size of government, legal structure, security of property rights, access to sound money, freedom to exchange with foreigners, regulation of credit and ability to control an individual's own labour and business.

Corporate governance as a driver for growth

If economic freedom is engendered, this ensures the liberalisation of markets which, in turn, translates into governments being able to raise revenues to finance spending domestically and allow for increased foreign direct investment to enter the market, as long as the legal structure and property rights are well respected. 

Following suit from foreign direct investment and liberalised markets comes economic and income growth, critical elements for development. This type of growth has been the main engine for the reduction of global poverty. However, economic and income growth is often correlated to effective corporate governance on both a state and private sector level.

When focussing on the developing world generally, academic papers such as Augustin Kwasi Fosu's Governance and development in Africa: A concise review, have shown that sound corporate governance is the most prominent basis for the achievement of economic successes in the developing world, engendering a number of benefits.

Benefits of good corporate governance

The eight benefits of good corporate governance are:

  • Risk mitigation - Managing risk is in itself good governance, and similarly, governance should be seen as a form of risk mitigation. This builds trust and predictability, generating comfort to investors. An example would be providing comfort to shareholders in non-listed companies that their interests will be safeguarded by the board and management.
  • Improved capital flow - Deciding on an appropriate capital structure is a key element of good corporate governance. An improvement in the robustness of financial management reporting will lead to greater access to capital.
  • Enhanced reputation - Improved governance and transparency in a company's internal policies, control mechanisms and how it handles its relationships translates into an improved reputation and the associated benefits.
  • Better decision making - Clearer separation of roles between owners, management and non-executive directors versus executive directors ensures that proper processes are followed which in itself, will lead to better decision making.
  • Improved reporting - More informed, fact based decisions lead to improved sales margins and a reduction in costs.
  • Compliance - Good corporate governance also relies on effective policies that require company activities adhere to local laws and regulations, synchronising with risk management to ensure the company avoids penalty.
  • Staff retention - The final advantage and possibly the most important is the retention of staff who will feel part of a well governed company.
  • Limitation of disruptive behaviour and conflicting interests - Establishing rules to reduce potential fraud and malpractices amongst employees; and avoiding conflicts of interest namely through minority shareholders being given their share of voice by being represented by independent directors.

Part two of the series will examine in detail how the composition of the board is critical to how corporate governance is adopted and interpreted within a company.

Through the use of International Financial Centres, we provide governance and board services to companies wishing to build enterprise and shareholder value. You can learn more about those services here.