Corporate governance: meaning, concepts of good governance and stakeholders

A company with 40,000 small shareholders is run by nine directors. The shareholders own it. The directors run it. If the directors pay themselves too much, hide bad news or take a deal that helps a friend, the owners may not know, and may not be able to stop it. Corporate governance is the set of rules, habits and checks that keep those in control working for those who own.

This topic covers the meaning of corporate governance and how it differs from management, the separation of ownership from control, the laws and codes that support good governance, the main governance issues, the Enron case, governance in public sector bodies and charities, the concepts of good governance (fairness, openness, independence, honesty, responsibility and accountability, reputation and judgment), Nolan’s seven principles, and stakeholders, including Mendelow’s framework and institutional investors.

The previous area covered risk management. The next topic covers agency theory and other theories of governance. Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on this topic.

Key terms in plain English

Syllabus check

This topic is in syllabus area D (corporate governance, 5% of the marks). It covers:

• the meaning of corporate governance and the separation of ownership from control;
• the principles of good governance and governance in other types of organisation;
• stakeholder groups and their influence on governance.

CAMA 2020 and governance

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.

The meaning of corporate governance

The Cadbury Report (1992) defined corporate governance as the system by which companies are directed and controlled. It is not the same as management. Management makes business decisions and runs operations. Governance gives leadership and direction and monitors and controls management’s decisions so that the company meets its purpose.

As Professor Bob Tricker put it, if management is about running the business, governance is about seeing that it is run properly. Governance is not about management skills and techniques, or about forming strategy, although the board’s responsibility for deciding strategy is a governance matter.

Governance asks: in whose interests is the company governed? Who has the power to decide? For what purposes and in what manner are those powers used? Who else influences governance? Are the governors held to account? How are risks managed? The same issues arise in state bodies, state-owned entities and charities.

Separation of ownership from control

A company is a legal person, separate from its shareholders. Its constitution delegates management to the board, which delegates to executives. Directors act as agents of the company, and their duties are to the company. It is widely accepted that a company should be run in its shareholders’ interests, though employees and others may also influence directors.

The problem: directors may run the company against shareholders’ interests, and shareholders may be unable to stop them. Problems are unlikely where shareholders are also directors, or where a majority shareholder can remove any director. They are most severe in large companies with many shareholders and no majority holder, where shareholders keep buying and selling and are not long-term owners.

That is why reform has focused on listed companies and, to a lesser extent, on smaller public and large private companies. The same gap between owners and controllers can exist in non-corporate entities such as charities and public bodies.

Laws and codes

Bad governance means running the entity in the interests of the directors personally. Good governance rests on key concepts. The law supports it: in Nigeria directors owe duties to the company under CAMA 2020, and must present the annual report and accounts to shareholders. The Sarbanes-Oxley Act 2002 in the USA followed the collapse of Enron and WorldCom.

Where law is weaker, voluntary codes backed by investors and exchanges have been issued, for example the UK Corporate Governance Code (comply or explain), a Singapore code and the OECD guidelines.

ICAN refers to the Nigerian Code of Corporate Governance (2018) prepared by the Financial Reporting Council of Nigeria, which it says applies to all public companies (listed or not), private holding companies of public companies, concessioned and privatised companies and regulated private companies.

The 2009 Walker Report on UK banks found serious governance failures that contributed to excessive risk-taking and the depth of the crisis. It said that following procedures is not enough if the chairman is weak, the board’s make-up and dynamics are poor or there is little engagement with major owners.

Key governance issues

• The role and responsibilities of the board and the leadership it gives.
• Composition and balance: integrity and independence of judgment, and no domination by a powerful chief executive or chairman.
• Financial reporting, narrative reporting and auditing: scandals such as Maxwell, Polly Peck, Enron, WorldCom and Parmalat involved misleading accounts.
• Directors’ remuneration: pay should be linked to performance, but this is hard to do well and is often criticised.
• Risk management and internal control.
• Shareholders’ rights and their involvement through dialogue and voting.
• Corporate social responsibility and business ethics.

Enron (2001). ICAN lists the failings:

• false accounting
• an audit committee that approved seriously misleading statements
• executives and advisers profiting secretly from deals
• a board that failed to supervise senior executives
• a board that ignored whistleblowers

Governance in other organisations

Governance also matters in public sector bodies (hospitals, schools, local authorities, nationalised companies and other non-governmental bodies) and in charities. The shared point is that stakeholders want the entity run to fulfil its purpose.

• Public sector: the public is a key stakeholder, interested in value for money and worried about bureaucracy and cost. The UK Good Governance Standard sets six principles: focus on purpose and outcomes for citizens and service users; perform effectively in clear functions and roles; promote values and show them in behaviour; take informed, transparent decisions and manage risk; build the capacity and capability of the governing body; and engage stakeholders and make accountability real.
• Charities: in Nigeria they are usually called non-governmental or civil society organisations and are registered with the Corporate Affairs Commission. Stakeholders include donors and beneficiaries. A donor’s main concern is that money is used as promised. For example, a donor who gave ₦100 to famine relief would not be pleased to find that ₦90 went on administration.

Concepts of good governance

• Fairness: all shareholders are treated fairly: one vote per share and the same dividend per share. Law protects minority shareholders in some countries more than in others. A takeover law may allow a higher price for large holders than small ones.
• Openness or transparency: “not hiding anything”. Intentions are clear and information is not withheld from those entitled to it. It covers what the company has done, will do and what risks it faces. For listed companies it includes disclosure of major shareholdings and announcements of major developments.
• Independence: freedom from the influence of someone else. A substantial number of directors should be independent. Executive directors cannot be, a retired executive may still share the management culture, and a director representing a major shareholder is not independent. Auditors must be independent too. Over-reliance on one client’s fees, and long familiarity with a client, threaten independence. ICAN suggests this happened in the Houston office of Andersen, the audit firm that collapsed after Enron.
• Honesty and integrity (probity): honesty is essential for directors and advisers. Integrity also means keeping to a strict ethical code. If shareholders doubt directors’ honesty, there is no trust and good governance is impossible.
• Responsibility and accountability: directors hold the powers and remain responsible even when they delegate. The board should keep key decisions such as strategy and major investment. Accountability means answering to shareholders through the annual report and the annual general meeting, and being removable or subject to re-election. ICAN says Nigerian directors commonly retire by rotation every three years. In the UK Code, directors have an annual performance review.
• Reputation: built on competence, honesty, fair dealing and being a good employer and environment-friendly. Investors, employees and customers prefer firms they trust. Ethical funds invest only in ethical firms. Badly governed companies lose goodwill.
• Judgment: directors must be objective and avoid bias and conflicts. The OECD says the board should exercise objective judgment independent of management.

Nolan’s seven principles of public life

The UK Nolan Committee (1995) set out: selflessness, integrity, objectivity, accountability, openness, honesty and leadership. They apply to public bodies and not-for-profit organisations as well as companies.

Stakeholders

Freeman (1984) defined a stakeholder as any group or individual who can affect, or is affected by, the achievement of the organisation’s objectives. Stakeholders in a company include shareholders, employees, directors and management, customers, suppliers, trade unions, communities, government and pressure groups. Their expectations differ and often conflict. Governance should give each enough satisfaction to keep them involved.

Claims

Each group makes claims on the company: dividends and share price for shareholders; pay and security for employees; quality and price for customers. Direct claims are made by the stakeholders themselves. Indirect claims are made on their behalf, for example for a powerless small customer or future generations. With indirect claims we cannot be sure that the stakeholders are properly represented.

Mendelow’s framework

Influence = power × interest.

Key players influence strategy, and difficulties arise when there are two or more with differing aims. High-interest, low-power groups may form coalitions to gain power. High-power, low-interest groups (such as government for a large company) should be kept satisfied. The framework ignores ethics, so a group with low power may still deserve consideration.

Categories of stakeholder

Shareholders and directors

Shareholders’ influence varies: in a small company they may be the directors. A majority shareholder can remove directors. In a listed company they care about share value and dividends but may have little influence. Directors are a major stakeholder because they hold power, both as a board and as individuals. Executive directors are employees. Non-executive directors are part time and, in Nigeria, the UK and US, not employees. The chairman and chief executive are usually the most influential.

Other stakeholders

• Employees: senior managers with share options or bonuses care more about profit and share price than other employees. Some staff have power because of rare skills. Trade unions may decide whether working practices can change.
• Lenders: expect repayment and monitor performance. They become key in financial difficulty.
• Suppliers, government (tax, and sometimes a major customer), regulators and stock exchanges, auditors (who should make sure the accounts give a true and fair view) and investors who set the share price.

Institutional investors

Institutional investors are pension funds, insurance companies and mutual funds (unit trusts and similar). Each may hold a small share of a large company. But acting together through trade associations they can influence the board, for example by voting against a director or pay report.

In the UK their influence helped persuade listed companies to adopt the UK Corporate Governance Code, and a Stewardship Code encourages them to engage with companies. Their views also reflect investor confidence. Arthur Levitt, former chairman of the US SEC, warned at the time of Enron that capital flows to countries and companies with strong governance and disclosure.

The rules in more depth

Why large listed companies need the most governance

Dispersed owners have little power and little information, so the checks must be built into the system.

Why independence matters

An independent person can challenge management without fear or favour. Without it, a board becomes a rubber stamp.

Why stakeholder analysis does not replace the shareholder duty

The law says directors act in the interests of the company, and shareholders are the owners. Stakeholder analysis helps the board see who can help or harm the company and how to respond.

Why indirect claims are hard

Someone speaks for a group that cannot speak for itself. The company must judge whether the speaker is genuine.

Effect on analysis

In a question, name the failing concept, link it to the people affected and propose the check that would have prevented it.

Worked examples

1. Influence = power × interest: investors 20, regulator 10, union 10, community group 2.
2. Investors: key players. Regulator: keep satisfied. Union: keep informed. Community group: minimal effort.
3. The bank should still treat the community fairly on ethical grounds.

1. The union’s claim is direct.
2. The environmental group’s claim is indirect, made for future generations who cannot speak.
3. The company should check whether the group truly represents them.

1. The retired chief executive may share the management culture, so is not independent.
2. The shareholder’s nominee represents one interest and is not independent.
3. An executive director can never be independent.
4. The retired judge is the best candidate for an independent non-executive role.

1. The reliance on fees is a threat: the auditor may avoid challenging management.
2. Long service creates familiarity: the auditor may accept what management says.
3. Safeguards: rotate the audit partner, limit non-audit work and have the audit committee review independence.

How to score full marks

• Define governance and separate it from management.
• Link each concept to a fact in the scenario.
• Place stakeholders on the matrix with reasons.
• Distinguish direct from indirect claims.
• Use a case (such as Enron) to show the failing.
• Recommend a check for each weakness.

Common mistakes in the exam

• Treating governance and management as the same thing.
• Saying directors owe their duty to shareholders alone, when the law says to the company.
• Calling an executive or a major shareholder’s nominee independent.
• Placing stakeholders on the matrix without reasons.
• Ignoring ethics when using Mendelow.
• Listing concepts without examples.

Quick revision

• Governance: direct and control. Management: run.
• Problem: separation of ownership and control, worst in large listed companies.
• Concepts: fairness, openness, independence, integrity, accountability, reputation, judgment.
• Stakeholders: claims, Mendelow, categories.
• Institutional investors act collectively.
• CAMA 2020: ss. 303, 305, 306, 309, 385, 404(7).

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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