CORPORATE GOVERNANCE MECHANISMS

Corporate governance is based on both internal and external mechanisms.

INTERNAL GOVERNANCE MECHANISMS: CORPORATE ACCOUNTABILITY

The internal mechanisms are centered on three segments – the board of directors, executive
management, and independent control functions – each with its own set of vital, and unique,
responsibilities. In many systems the activities of the three groups are reinforced by codes of
conduct that are intended to promote proper behavior.

If the corporate responsibilities associated with these functions are too vague and diffuse, subject
to too much interpretation, or not diligently followed, the governance process is vulnerable. If
they are too rigid and onerous, enforcement costs mount, shareholder returns decline, and actions
centered primarily on form (rather than substance) may result. Internal mechanisms must
therefore achieve an appropriate balance of flexibility and rigor.

In various national systems the law holds the board of directors and senior executives to certain
standards in order to enforce proper accountability.
These standards revolve around attention to business, fidelity to corporate interests, and exercise
of reasonable business judgment. Theoretically, if these standards are upheld, shareholders and
other stakeholders should be protected.

The figure below summarizes key internal governance mechanisms.

Internal governance mechanisms

Board of directors Internal control groups Code of conduct

Executive
management
 1. The Board of Directors
The board of directors is a body that represents the interest of shareholders, and is accountable
to them for a series of specific duties, including definition of corporate strategy and philosophy,
oversight of executive management, and implementation of internal controls. Directors, as agents
of shareholders, are compelled to carry out their instructions. Under normal circumstances board
directors do not manage the daily activities of executives; such micromanagement would be
impractical. Rather, they hire the best possible senior executives, provide advice and counsel on
a periodic basis, and ensure the system of controls is functioning properly. Only in crisis
situations are directors likely to be more visible, representing the interests of stakeholders more
actively. Although it is not present in daily management matters, effective governance depends
on a board that is capable of dealing with management firmly and decisively.
Essential duties include the following:
 Represent, with a view towards advancing and protecting, the interests of shareholders
and other stakeholders. This means taking an independent view on the actions and
activities of the company and its executives, and dealing firmly with all relevant
executive management issues.
 Create an ethical environment; codify ethical principles and ensure that they are
followed.
 Establish and run specialized committees as needed (e.g. audit, compensation,
nomination) to provide additional support and expertise.
 Ensure adequacy of internal and external controls; monitor specific controls and their
efficacy on an ongoing basis.
 Develop communications dialog/reporting links with internal control groups and serve as
an independent “sounding board” and confidential counselor.
 Oversee the general commercial affairs of the corporation.
 Oversee the strategic and business performance goals of the corporation.
 Define strategy as related to corporate goals, business and financial targets, and financial
and operating risk tolerance.
 Provide for appropriate crisis management planning, including business interruption,
disaster recovery, and liquidity management.
  Develop and implement director and executive management succession plans and
executive compensation plans.
 Consider in detail all corporate control activity (such as potential mergers, acquisitions,
or buyouts) and possible defenses.
 Monitor the performance of management and effect changes when necessary.
 Ensure financial disclosure accurately represents the company’s position.
 Communicate regularly with key shareholders and regulators.

The relationship between board directors and executive management should be strong and
constructive. Even in preferred situations where a majority of directors is independent, there is
no cause for adversarial relationships. However, it is important for directors to be able to
question, critique, and challenge management, and not simply acquiesce blindly, or take strict
instructions from CEOs. Ideally, board directors should meet frequently with executive
management and should be free to meet among themselves, without any representative of the
management team. In practice this occurs to varying degrees.

2. Executive Management

The tone established by executive management has a considerable influence on the culture and
control practices of any firm.
Management must set the ethical/moral standards for the entire organization and lead by
example; executives who are incompetent, secretive, unethical, or dishonest are likely to tolerate
similar traits in others, which will eventually weaken the control framework. Some of this can be
managed through the code of conduct developed by the board and promulgated by executives.
Executives must also demonstrate vision and knowledge in the tactical and strategic operation of
the firm, and display skill in managing the firm’s daily operations in a controlled manner (and
with a view towards maximizing value).

To prevent the pursuit of “self-interest” – which might lead ultimately to abusive practices –
executive management must remain under the general supervision of directors and be
constrained by certain structural parameters, including those related to internal controls,
dissemination of information, and certification of financial statements. In order to be effective in
working toward the best interests of the company (and, by extension, shareholders), the
economic interests of executives must be aligned with those of shareholders. This is most often
done through a proper compensation package that allows executives to benefit as they create
shareholder value. Indeed, alignment through compensation is an important governance tool
(although one that has to be structured correctly in order to avoid abuses).

Executive management, led by the CEO or equivalent has daily responsibility for guiding the
corporation and its activities, with the basic intent of maximizing enterprise value. Executive
management is the key link between the company and the board, and must convey critical
information to directors. The more effective it is in performing the role, the lower the associated
agency costs.
Executive management must be able to produce accurate information for board of directors and
the marketplace, and be held accountable for any disclosure errors, such as willful misstatement,
negligent misstatement, or failure to disclose a material fact.

In certain cases, the leader of executive management is also the leader of the board of directors.
While this can enhance information flows and cooperation and ensure cohesion between
management and directors, it has the potential of breeding significant conflicts of interest. A
combined CEO and chairperson controls the executive management team and the board of
directors, and must therefore strike a balance between two very important, distinct, and
sometimes conflicting, roles.

To protect against any pressures of self-interest that might arise, their actions must be monitored
on an ongoing basis by both internal forces (such as directors and internal controllers) and
external forces (activist investors and corporate control mechanisms).

Governance-related duties assigned to executive management generally include the following:

 Manage the firm’s operating, financing, and corporate activities on a daily basis,
remaining accountable to the board of directors for progress and performance.
  Create tactical business plans and operating strategy in conjunction with the board of
directors. Manage the results and adjust them as necessary.
 Define the firm’s short and long-term financial operating goals (for example, revenues,
income, liquidity, leverage, financing plans, and acquisitions) and manage to these goals.
 Define and monitor financial and operating risk exposures in conjunction with the board.
 Ensure internal controls (audit, financial control, compliance, risk management, treasury)
are in place and functioning properly. Ensure all such controls are independent of
business units.
 Provide the board of directors with timely and useful financial data and any other
information directors deem necessary. Communicate regularly with internal and external
parties on items of corporate importance.
 Ensure transparency in the financial and operating frameworks of the firm.
 Create a proper human resources management function and framework.
 Delegate authority internally to hire and fire workers.
 Promulgate a code of conduct and other board directives/policies and enforce vigorously.

3. Internal Control Groups

In order for internal governance mechanisms to work effectively the board of directors and
executive management must rely on a cadre of technical experts that can independently review,
assess, and control a company’s operations. These groups are the essential link between high-
level policies passed by the board and the daily business that forms the core of every company’s
activities.

Control groups that might be regarded as essential to the effective monitoring of corporate
operations include the following:

i. Financial control/accounting
This unit is typically responsible for independently tracking and monitoring all activities that
impact the firm’s financial operations and statements, and reporting on these activities internally
and externally on a continuous basis. It is common in many companies for the unit to report
directly to the CFO who, in turn, reports to the CEO/president.
ii. Risk management
This unit is generally responsible for monitoring and managing the firm’s financial and operating
risks. Though risks can vary by company and industry, financial risks generally include credit
risk, market risk, and liquidity risk, while operating risks include business interruption risk,
property and casualty destruction, worker safety, and technological and operational risk. The risk
management function may report through the CFO, or directly into the CEO/president.
iii. Legal and compliance
This unit is responsible for all aspects of legal and documentation risk, ensuring that the firm’s
legal interests are properly protected and its relationships with external parties (such as suppliers,
customers, and creditors) are properly considered and documented.
Legal units often act as an interface to regulatory authorities and in some cases may also be
responsible for specific corporate governance activities. The department, headed by chief
counsel, may report directly into the CEO/president.
iv. Internal audit
This unit is typically responsible for conducting internal reviews and audits of the firm’s
business and control processes to ensure they are robust enough to prevent, or at least detect,
problems. It also performs random inspections of financial accounts, and works closely with
external auditors in verifying different aspects of the control framework.
In many companies the chief internal auditor reports directly to the CEO/president and the audit
committee of the board.
v. Operations and technology
This unit is generally responsible for creating and managing processes that permit the firm’s
customer and supplier businesses to function in an efficient, automated, and controlled fashion.
This can include development of appropriate infrastructure (technology, networking,
communications data), and establishment and management of trade/transaction flows. The group
is often charged with implementing disaster recovery and business interruption plans, and
managing dimensions of operational risk. Heads of operations and technology may report
directly into the CEO/president, with matrix lines (but no compensation ties) into the specific
business and control functions they support.
 Others might include
vi. Treasury
Responsible for the asset and liability management of the firm’s balance sheet, although this
function is sometimes accorded line/revenue-generating responsibilities and may not thus be a
true control function
vii. Investor relations
Responsible for managing relationships and communications with external parties, including
shareholders, regulators, credit rating agencies, bankers, the media, and so forth.
viii. Human resources
Responsible for managing issues related to a company’s personnel and staffing, including
compensation, reviews, benefits, and counseling.

Duties of internal control groups can include the following:

 Create policies and procedures to support independent control of finance, audit, risk
management, operations, and compliance.
 Install proper technological infrastructure for accurate measuring and reporting of
financial statements, risk profile, legal issues, documentary status, and so forth.
 Update regularly the board of directors/board committees on the status of, and
substantive changes in, all control issues.
 Review and audit all aspects of the company’s business and control process and
infrastructure on a continuous basis, with a special focus on potential weaknesses that can
create losses or problems. Ensure substantive audit findings are elevated and resolved.
 Prepare and disseminate all relevant corporate information (such as financial statements
and risk profile) to internal and external parties.
 Prepare, test, and implement crisis management plans related to business
interruption/disaster recovery.
 Ensure compliance with applicable regulatory requirements and reporting.
 Work with external auditors on continually reviewing and strengthening controls.
 4. Code of Conduct
Many companies feature codes of conduct/codes of ethics often drafted by the board of directors
and promulgated by directors and executive management, is intended to establish the ethical and
moral norms of the company; in essence, to set the standards for behavior and action when
dealing with those inside and outside the firm. Although the nature and detail of such codes vary
by firm, industry, and country, they generally aim to ensure a clear understanding of basic ethical
principles, including proper treatment of stakeholders.

In addition to specifically declaring ethical parameters, the effective code must provide for
penalties or sanctions for those who violate specific provisions. There is little point in creating
rules if they can be flouted or overlooked without fear of reprisal. In order to be truly effective, a
code of ethics cannot simply be seen as a set of statements of good behavior. It must form part of
a company’s culture and belief system, and become a factor in everyday business dealings.
Importantly, it must be driven from the top of the organization; if a firm’s top management is
seen violating basic ethical principles, there is very little incentive for others to behave properly.
Thus a code of ethics must be believed and followed, in the first instance, by executives and
directors.

A basic code of conduct is likely to include certain fundamental principles, including the
following:
 Create an environment, policies, and procedures where internal or external conflicts of
interest are avoided or eliminated.
 Make certain that employees do not engage in corrupt practices or other activities that
might prejudice or jeopardize the firm’s reputation.
 Treat all stakeholders, including suppliers, clients, employees, and others, fairly and
honestly.
 Develop mechanisms where violations of company policy can be reported without fear of
retribution.
 EXTERNAL GOVERNANCE MECHANISMS: SYSTEMIC ACCOUNTABILITY

These are governance forces operating outside a corporation. National governments are typically
responsible for establishing, enforcing, and enhancing mechanisms that support external
governance. From a financial markets perspective, a proper system permits efficient mobilization
of capital, management of risks, identification of investment opportunities, and exchange of
assets.
All of these functions support and benefit governance. From a structural perspective, a proper
system creates authorities that enforce rules and regulations, including a judicial process to
handle legal and bankruptcy issues, and supervisory bodies to oversee local capital markets,
external auditors, and credit rating agencies.

Here we consider various financial and structural governance mechanisms;

1. Regulatory oversight
2. Legal/bankruptcy regimes
3. Capital markets access
4. Corporate control activity
5. Block holder monitoring
6. Activist institutional investor monitoring
7. External audits
8. Credit rating agency review

1. Regulatory Oversight
Regulations are necessary because individual firms might not design proper checks and balances,
or might choose not to honor them in the future.
Supervisory and regulatory agencies attempt to create frameworks that protect all stakeholders:
not just investors, but also suppliers, creditors, customers, and others. Regulations might be
developed by legislators and then promulgated and enforced by financial supervisors or listing
exchanges (for instance, securities market regulations enforced by exchanges in their capacity as
self-regulatory marketplaces).
Regulators also attempt to protect broader macro-economic mechanisms (such as the stability of
the banking and insurance sectors, without which economic growth might be stifled or
jeopardized). In addition, they are often concerned with protecting social welfare, and limiting or
minimizing adverse externalities (such as excess public costs and environmental hazards and
risks).
2. Legal/Bankruptcy Regimes
Corporations require a legal framework to define their activities and conduct business. Investors,
in turn, need a legal foundation to protect their rights and promote good conduct.
Effective legal system must:
 Create and support mechanisms for the incorporation of public and private firms
 Enforce key corporate tenets, including limited liability, control rights,
 Property rights, shareholder rights, and fiduciary duties
 Define and support contracts and other legal mechanisms for conducting business
 Establish an unbiased insolvency process and provide legal mechanisms for
reorganization and liquidation; support the role and status of debtors and creditors.

The control rights of investors must be protected properly from a legal perspective. Shareholders
that believe directors or executives have breached their fiduciary duties have the right to take
legal action. Some have argued that even the existence of such legal mechanisms helps ensure
directors and executives adhere to their duties of care and loyalty.

Structurally, a company is organized through legal mechanisms that define and convey property
rights, private ownership of assets, extent of liability, and so forth. Under common law
frameworks the legal creation of a company is relatively standardized and can often be
accomplished “off the shelf.”

Once created, a company’s daily pursuit of business is based on legal principles embodied in
enforceable contracts. For instance, entering into supplier or client relationships is often done
through legal purchase/sales contracts; borrowing from a bank is arranged through loan and
collateral agreements; floating stock or bonds to raise capital is done through bond indentures,
offering circulars, subscription agreements, and prospectuses; entering into long-term plant and
equipment investment is done through legal purchase and sale contracts and sub-contracting
agreements; creating an offshore financing entity is done through legal special purpose entity
contracts, and so on. These are all essential to the business of the corporate world.

A bankruptcy system is equally important to the governance process; companies and their
stakeholders must understand their rights in the event of financial distress and/or bankruptcy.
This is particularly true for the large group of creditors supplying debt risk capital.
Creditors emerge as key stakeholders, outranking even shareholders, when a company enters a
phase of financial distress. The security provided for creditors depends on a country’s default
system and the strength of its creditor rights. For instance, if the national bankruptcy system
indicates that senior secured creditors receive first priority in the event of forced or voluntary
corporate liquidation, and the rights are upheld through bankruptcy proceedings, creditors gain
comfort in the legitimacy of the system. If the senior secured creditor is prejudiced or abused
(perhaps the security interest or charge over the assets is discarded or disallowed, assets held as
security are stripped away, and proceeds from the asset sale are granted to more junior creditors
or shareholders), the bankruptcy system is not functioning as it should. Stakeholders cannot then
predict ex ante how they will fare in bankruptcy, and cannot necessarily assume equitable
treatment through the courts. Ultimately they may be unwilling to supply capital and will not be
present as monitors.

3. Capital Markets Access

Capital markets – the marketplace for the public and private issuance and trading of debt and
equity capital – are an integral part of the global financial system and individual national
economies. They allow companies to raise, on a primary basis, the debt and equity funding.
Without primary capital, companies would be unable to finance their operations and would cease
to exist (indeed, corporate governance would be irrelevant as there would be no suppliers of
capital requiring protection).

The capital markets are thus the essential conduit between the company, as issuer and user of
funds, and investors, as providers of different forms of risk capital. The secondary trading
marketplace is obviously of considerable importance to investors, as it provides a mechanism by
which to crystallize the value of a security. An investor holding a share of stock and wanting to
reallocate capital to some other venture needs some way to transfer that share (directly or
through a dealer/market maker); a capital market with enough liquidity ensures that the share can
be transferred efficiently and transparently. Intermediaries, primarily large financial institutions,
support the primary and secondary markets by providing services such as due diligence,
arranging, syndication, pricing, distribution, and trading.

A transparent and regulated capital market serves as an important external governance

mechanism in a number of ways. First, it supplies capital to companies that deserve funds.
Second, it differentiates between the strength of various companies, allocating cheaper funds to
those that are “better” and more expensive funds to those that are “worse.”
Third, it makes possible corporate control transactions that provide another layer of corporate
scrutiny and discipline. In advanced systems the capital markets are typically supported by
specific securities market regulations, set by financial regulators and enforced by listing
exchanges, that require all public securities issuers to register their issues (generally by filing
detailed disclosure statements), submit regular financial reports, prohibit insider trading/trading
abuses, adhere to various governance practices and financial standards, and so on. Those
unwilling to comply are generally denied access. This, again, serves as an important check and
balance.

4. Corporate Control Activity

The market for corporate control is the sum total of all corporate merger, acquisition, and
restructuring activity occurring within an economic system.
It includes:
Open market purchases: the purchase of a block of shares in the open market that gives the
acquirer effective control of a target company.
Tender offers: a purchase offer made by an acquirer directly to a company’s shareholders.
Negotiated swaps: an exchange of assets (for example, subsidiaries, companies, or blocks of
shares) between two parties.
Proxy contests: an acquisition offer that is contested through proxy voting.
Friendly takeovers: an acquisition that is agreed on amicable terms between two parties.
Hostile takeovers (contested transactions): an unsolicited acquisition offer that the target
company’s directors/executives do not favor and attempt to thwart.
Leveraged buyouts/management buyouts (LBOs/MBOs): the acquisition of a public company
by a specialist or management group that results in retirement of the public equity through the
assumption of a large amount of debt (in other words, the company is taken private).
Recapitalizations: a process of converting the nature and voting characteristics of a company’s
equity (for example, by assigning more or less voting power to an individual share).
Spin-offs: a process of selling off an asset (for example, a company or subsidiary) to a third
party or through an IPO.

An active market is often regarded as an important external governance check.

The premise is that external forces – including other companies, institutional investors, buyout
funds, or “corporate raiders” – can monitor the performance of management and directors to
ensure they are operating efficiently and attempting to maximize shareholder value. If an
external group feels a company is not operating as it should – reflected, perhaps, through
continuous mismanagement of corporate resources or long periods of inefficiency or losses
leading to a weakened share price – it might bid for the company. If the bid is successful, the
corporate action can result in a spin-off, restructuring, or consolidation, thereby returning to
shareholders incremental value that might otherwise be tied up in unproductive endeavors. In
fact, if the transaction works as intended, shareholders might gain some incremental value on
their risk capital. Thus, the corporate control market can force companies to do what directors
and executives may be reluctant, unwilling, or unable to do.

5. Block Holder Monitoring

Shareholder diffusion is characteristic of many modern corporate systems.
There are, however, some exceptions to this rule. Companies in some systems feature blocks of
shareholdings that are concentrated with institutional parties, either banks, family groups, other
companies or activist investors.
Though concentrations may not be sufficient to exercise effective control following the schema,
they can be large enough to allow an active monitoring role.
A key corporate governance problem – problems associated with agency costs – declines with
active monitoring. Block holders generally have much greater access to management and
information than diffuse shareholders. Where this is not true, they are able to bear the cost of
acquiring information and/or monitoring management. (They are, after all, significant
shareholders, and typically have enough resources to pay for monitoring activities, particularly if
they view the shareholding as a long-term investment commitment.) Block holder monitoring
can thus serve as an additional external governance check by allowing large investors to:
 Monitor the activities of management and directors in light of corporate goals and
stakeholder interests, and take actions when results are unsatisfactory
 Evaluate the decisions being taken by management more directly
 Nominate or appoint board director(s)
 Exert influence through financing or voting pressures
 Promote long-term value creation by de-emphasizing short-term metrics.

6. Activist Institutional Investor Monitoring

Activist shareholders take a stake in a company based on a view that directors and management
are not doing a proper job of protecting or advancing the interests of shareholders. The size of
the actual stake can vary: in some cases it might be a token amount, just large enough to endow
relevant shareholder rights, but often it is large enough to permit the investor to be taken
seriously when communicating with the company. Most activist investors are institutions,
including investment funds (such as pension funds and mutual funds) and financial institutions
(such as insurance companies and trust units of commercial banks). In some cases dedicated
activist shareholder groups or very wealthy individuals also participate.
Activist investors can be an effective external check by engaging in the following processes:
 Monitor the activities of management and directors in order to help advance corporate
goals and shareholder interests.
 Evaluate the decisions being taken by management more directly.
 Exert influence through direct communication with directors, AGM/ proxy actions, and
lawsuits.
 7. External Audits
Many stakeholders rely on the independent advice and expertise auditors bring to the review of a
company’s financial position; when performed properly, the function adds an extra level of
scrutiny and control.

Basic duties:
 Verify the strength and integrity of internal financial controls.
 Test a sample of transactions impacting the income statement, statement of cash flows
and balance sheet.
 Review off-balance-sheet structures and transactions (for example, special purpose
entities, derivatives, commitments, contingencies).
 Test a sample of asset and liability valuations (for example, historical valuations, mark-
to-market or mark-to-model valuations).
 Review reserving and expensing policies and test transactions.
 Ensure compliance with relevant accounting standards and principles (for example,
Generally Accepted Accounting Principles, International, Accounting Standards).
 Make certain financials meet regulatory reporting requirements/ standards.
 Review interim and/or annual statements.
 Prepare management letter with audit opinion.

The external auditor works very closely with a company’s internal auditors to investigate the
nature and source of potential control weaknesses.
Indeed, if internal auditors are discharging their duties properly, they should be highlighting
potential areas of concern for independent review by external auditors. The external audit team is
also likely to review issues and findings with executive management and the board. Depending
on the nature of potential issues or problems, it could also engage in additional forensic
accounting work to discover the nature and impact of different errors.

8. Credit Rating Agency Review

Credit rating agencies can play an important role in the external governance process by adding
another layer of scrutiny to companies seeking to access the public debt capital markets. Rating
agencies rate the creditworthiness, or financial strength, of individual companies to determine
their capacity to repay obligations (such as the debt risk capital, along with other balance sheet,
and off-balance-sheet, liabilities).

Since credit ratings are an assessment of a company’s ability to repay obligations, they relate to
debt and hybrid securities, rather than equity securities. Agencies thus focus primarily on the
repayment ability and financial condition of companies: liquidity, leverage, cash flows, earnings,
market shares and competition, litigation and contingencies, and so forth.
Although the exercise is largely quantitative, an essential part of diligent credit analysis involves
a qualitative review, including an examination of the nature and quality of the firm’s
management and internal controls. All other things being equal, a company that has sufficient
financial capacity to pay its obligations, and features strong management and controls, will
receive a higher rating that one that has sufficient financial capacity but weak management and
controls. Rating analysis techniques vary by agency, and may be based solely on analysis of
publicly available information, or supplemented by management discussion and the review of
non-public information.