In this article, Ankit Suri pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, discusses Corporate governance and its role in Risk Management.
An insight into Corporate Governance
There are various definitions of corporate governance framed by various experts over the course of time. On analyzing the various definitions of corporate governance, a generally accepted definition can be coined as follows,
‘Corporate governance refers to the way in which companies are governed, and to what purpose it is concerned with practices and procedures for trying to ensure that a company is run in such a way that it achieves its objectives this could be to maximize the wealth of its owners, its shareholders, subject to various guidelines and constraints and with regard to other groups, with an interest in what the company does. Sound “corporate governance” may therefore be said to exist where the conflicting interest of all stakeholders in a company are ethically balanced.
The essentiality of corporate governance cannot be over-emphasized as it is the “one key element in improving economic efficiency and growth as well as enhancing investor confidence”, as a result, the cost of capital is lower and firms are encouraged to use resources more efficiently, thereby sustaining growth. Corporate governance also helps to ensure that assets of the firm are secure and not subject to expropriation by individual groups within a firm who could wield excessive power. Corporate governance may, therefore be an instrument of checks and balances in the administration of a company.
Basics of Corporate Governance
Corporations
Corporations are a group of consensual, contractual relations among several constituencies.[1]
Corporate charter (or Articles of incorporation):
This is an agreement between the “corporation” and “state” in which it is incorporated as to how the corporation will be run; this includes:
- Authorized shares of the corporation.
- Corporation’s name.
- Corporation’s purpose.
- In return, the corporation pays franchise tax to state based on authorized capital of the company.
- A corporate charter may be amended after they are originally filed by incorporators by the majority or super-majority vote of shareholders.
- For public companies, vote requires:
- Proxy filing with Securities and Exchange Commission (SEC)
- Hiring of proxy solicitor to encourage shareholders to vote their shares
By-laws
- The main purpose of by-laws is to “Fill the gaps” left by the charter.
- They address board elections and composition, the appointment of officers, timing and conduct of corporate annual meetings, etc.
- By-laws may be amended by the board if permitted by the state of incorporation and charter; otherwise, it is amendable by shareholders.
Board of directors
- The board of directors are elected by shareholders at the annual stockholders’ meeting.
- Each share is generally entitled to one vote per director unless there is cumulative voting or multiple classes of stock.
- The winner of the voting is decided based on simple majority and hence the director who obtains the most votes wins.
- Directors are expected to maximize the value per share.
Directors’ Fiduciary Duties
- Directors have two duties to shareholders under the law:
Duty of care
- Director must act in good faith and strive to exercise ordinary prudential care in making business decisions through processes
- “Business judgment rule”: the presumption is in the favor of the director’s decision-making even if the expected results of the decision are not realized.
- “Total fairness standard”: if the director has a conflict of interest, he/she must prove that his/her decision was fair to all parties.
Duty of loyalty
- A Director must act in the best interests of the corporation and not do things that harm the corporation.
- The Director cannot compete directly with the corporation unless the other directors have expressly permitted the competing enterprise.
- Failure to adhere to these two duties may lead to personal liability one part of the director.
Daily Governance of Corporation
Chief executive officer (CEO)
- The board recruits and hires the CEO to run the day-to-day operations.
- The CEO serves as the management’s representative to the board and is frequently the same person as chair of the board.
- The CEO hires a management team (chief financial officer, chief marketing officer, and other “C-level” executives)
- The board holds the CEO accountable for the corporation’s operating performance and the stock price performance.
Managers have fiduciary duties of care and loyalty that prohibit them from:
- Competing with their employer
- Appropriating business opportunities
- Misappropriating corporate trade secrets and confidential information
Consequences for breaching duties to corporation:
- Managers may be sued personally.
- Manager’s employment may be terminated.
Sarbanes-Oxley Act
- The management of public companies is responsible for structuring corporation with adequate “internal controls” so that the company has integrity in its financial reporting and other processes.
- The corporation must report any deficiencies in and status of its internal controls in its public filings with the SEC.
- This process provides current/prospective shareholders with a view on the perilousness of corporation’s internal management systems.
A brief overview of the development of Corporate Governance in the U.K and U.S
One of the main reasons corporate governance has made is mark is because of the separation of the ownership from management. The agency theory suggests that there could be a divergence in the interests of owners and managers. Corporate governance is an internal mechanism to minimize this divergence.[2]
This section of the report reviews the disclosure requirements in four countries, “the United Kingdom, the United States, Australia and Germany” with regards to the board of directors, audit committee, internal control and risk aspects of corporate governance. A brief review of corporate governance development and regulations in each of the four countries is given below before the evaluation of their practices.
United Kingdom
The Cadbury Committee has played an essential role in the establishment of corporate governance practices in the United Kingdom, and many other countries. In addition to this, a number of committees, such as “Turnbull Report” , “Myners report” and Higgs Report , have refined the corporate governance practices in the UK since the Cadbury Committee report in the early 1990s (Tricker, 2012). The “Financial Reporting Council” is the UK’s independent regulator, responsible for promoting corporate governance.
The United States of America
The United States is often seen as being the pragmatic case of the market-based model to corporate governance (Jackson, 2010). However, corporate governance failure in Enron resulted in high criticism of the corporate culture in the US and caused substantial changes through the Sarbanes-Oxley Act of 2002.
Public listed companies are also required to follow additional governance standards stipulated by stock exchanges in the country.
What is the Risk involved here?
Any and every business in today’s world faces risk on a daily basis. Their efficiency in managing those risks is all too apparent when major business failures unfold. Thereby making the first and foremost point clear that “failure” is often the result of poor risk management practices. Risk Management can be defined as a term which is used to describe the processes aiming as assisting organizations to understand, evaluate and take action on their risks with a view to increasing the probability of their success and reducing the likelihood of failure.
It is forgone conclusion that “effective risk management” gives comfort to shareholders, customers, employees and society at large that a business is being effectively managed and helps the company or organization confirm its compliance with corporate governance requirements. Risk management is relevant and an essential aspect in regard to all organizations, large or small. Effective risk management practices support accountability, performance measurement, and reward and can enable efficiency at all levels through the organization. Risk management requires a detailed knowledge and understanding of the organization and the processes involved in the business. The board of directors and management must appropriately select and manage the risks that a corporation takes as it seeks to increase the per share value of its stock.
Role of Corporate Governance in effective Risk Management
Risk, associated with a business, has a very broad ratio. With the intention of understanding the aspect of risk in corporations and businesses, it can be categorized into “three” kinds of risks namely:[3]
- Counterparty risk
- Interest rate risk
- Liquidity risk
Counterparty risk
- This refers to the kind of risk that an organization/person with which a corporation has a business relationship with, fails to perform its obligations.
- Defaulting by borrowers on their loan agreements with banks.
- Prospective buyers “fail to close” on the purchase of a contract with home sellers.
- Domino-like effect (must consider counterparties’ counterparty risk)
To mitigate this risk
- It is essential to avoid concentration of lenders, vendors, customers, etc. (i.e. diversify)
- This is relatively easier for a large company to do than for a small, entrepreneurial firm.
Interest rate risk
- This refers to the kind of risk where a shift in interest rates will adversely affect either the company’s assets or its liabilities.
- In the event of a corporation having $100 million of floating rate debt outstanding, a rise in interest rate will increase company’s interest expense burden.
- If the interest rate increases, the value of the investor’s fixed rate bonds will be reduced, since the bond prices rise when the interest rates fall and vice versa.
- The lower the coupon payment and the longer the bond has until maturity, the greater the interest rate risk.
To mitigate this risk
- The balance duration (weighted average cash flows) and mix of fixed/floating interest rate instruments between assets and liabilities
- Easier for large financial firms to do than for smaller and non-financial firms.
Liquidity risk
The possibility that the firm will not have sufficient cash on hand or immediately available credit to pay its bills as they come due.
Some possible causes
- Accounts receivable go bad (due to counterparty risk).
- Lenders get nervous and call the loan before due date
- The unexpected order which necessitates the emergency purchase of inventory.
To mitigate this risk, keep higher cash balances
- Cash is expensive.
- Without sufficient profitability, raising equity to provide that cash is also expensive.
- Keeping cash rather than investing it again can be costly.
- Nevertheless, a failure to have sufficient cash can cause financial distress or bankruptcy.
Other types of risk
- Product obsolescence risk.
- Exchange rate risk (mainly for companies doing business internationally).
- Succession risk: risk that company cannot adequately replace its current CEO[4]
Before looking into the details of methods to mitigate different kinds of risks that corporations and businesses undergo, it is essential to understand that Corporate boards and audit committees must first identify and confirm the particular risk involved and then move to thinking about way and ways to mitigate/eliminate those risks. In this respect, the “UK Corporate Governance Code Main Principle” states, “The board should establish formal and transparent arrangements for considering how they should apply the corporate reporting and risk management and internal control principles and for maintaining an appropriate relationship with the company’s auditor.”
CONCLUSION
Corporate Governance alone cannot be held responsible for the current Financial Crisis. However, Corporate Governance could have prevented some of the worst aspects of the crisis, only if effective governance operated throughout the period of time during which the problems were developing and before they crystallized. Furthermore, effective Corporate Governance could have helped to reduce the catastrophic impacts that the global and national economies are now suffering.
Corporate Governance has been an integral part of risk management since the dawn of companies, and should be stringently incorporated as its only interest is welfare of shareholders in terms of increase in shareholder wealth, increase in confidence on the investor and reduced cost of capital along with other benefits such as better brand equity, greater employee morale and greater confidence of creditors.
References
[1] http://www.oecd.org/daf/ca/risk-management-corporate-governance.pdf
[2] https://www.oecd.org/corporate/ca/corporategovernanceprinciples/42670210.pdf
[3] http://www.emeraldinsight.com/doi/abs/10.1108/09513570310492335
[4] https://www.icaew.com/en/technical/corporate-governance/risk-management
