Understanding corporate governance: Its importance, examples and issues
8 December 2019
Corporate governance, the processes that help a company balance competing interests, has always been an important consideration for businesses large and small. In the last two decades, however, corporate governance has become critical. Following the collapse of many large organisations, the global financial crisis and, more recently, the shocking findings of the Banking Royal Commission, governments and shareholders alike have advocated for better governance. Consequently, understanding corporate governance is now a fundamental skill for those entering leadership or management positions in Australia.
Read on for a thorough explanation of what corporate governance is and why it’s important, as well as a detailed exploration of corporate governance examples and potential corporate governance issues.
What is corporate governance?
In any business, numerous stakeholders have a vested interest in what the company does and how it does it. These stakeholders may include shareholders or investors, customers, the company’s leadership team, employees, the government and different community groups.
Corporate governance provides organisations with a framework to ensure a company’s board of directors is able to manage its stakeholder relationships in a fair and transparent manner. It’s also the most important tool to enhance board and management accountability.
The importance of corporate governance
At its most basic level, corporate governance keeps a company out of trouble. It helps control risks and ensure compliance. When executed correctly, it helps a company prevent fraud, scandals and potential liabilities.
Beyond risk mitigation, some people believe optimal corporate governance can enhance company performance. While academics have extensively tried to ‘prove’ this link, it remains unclear whether it exists. Nevertheless, poor governance opens businesses up to a myriad of risks.
Key elements of corporate governance in Australia
What does corporate governance look like in Australia? It involves these three key elements:
- Extensive regulation and personal liability of directors (board and management accountability to shareholders)
- Principle-based systems of governance (ethical and responsible decision-making)
- Institutional investors, proxy advisors and shareholder associations.
Extensive regulation and personal liability of directors (board and management accountability to shareholders)
Ensuring directors are personally liable for issues that may arise within a company is a key feature of corporate governance. Over the last 20 years, the Australian state and federal governments have adopted a number of new laws that have increasingly tightened the personal liability requirements of directors. Directors are now personally liable for breaches in a number of areas, including tax laws, environmental laws, occupational health and safety laws, trade practices laws and the Corporations Act.
Directors who don’t comply face severe consequences. They may have proceedings brought against them by a number of parties, such as the company itself, creditors, shareholders, and, in cases where the company has gone bankrupt, insolvency administrators and trustees. It’s also possible for proceedings to be brought against them by the Australian Securities and Investments Commission (ASIC) or the Australian Competition and Consumer Commission (ACCC).
While few directors have been prosecuted, strong corporate disclosure requirements have led to a growth in shareholder class actions, especially when a surprise announcement causes a drop in the company’s share price. Personal liability is not the only regulation directors face. They’re also required to report extensively on remuneration to increase their accountability to management and shareholders.
Principle-based systems of governance (ethical and responsible decision-making)
Principle-based systems of governance, which refer to the ASX Principles that recommend corporate governance practices to businesses, are the second essential element of corporate governance in Australia. They aim to ensure that companies make ethical and responsible decisions.
The ASX principles, developed in 2003, outline practices that ‘meet the reasonable expectations of most investors in most situations’. They provide strong guidelines while giving companies the flexibility to use different practices if their boards deem it appropriate to do so.
While companies must benchmark their corporate governance practices against the ASX principles, most businesses also invest significantly in creating their own practices to produce the best outcomes for their shareholders.
Institutional investors, proxy advisors and shareholder associations
The final element of corporate governance in Australia are the reforms made to protect institutional investors, proxy advisors and shareholder associations.
Institutional investors, such as insurance companies, superannuation funds, hedge funds and banks, can exert considerable influence on company boards and business decisions because of their large and sometimes majority shareholding. These types of investors, particularly superannuation funds, seek long-term returns, as they are investing critical retirement savings.
To appease these shareholders, new reforms have been put in place that protect and support the sustainable, long-term growth of shareholder wealth. They increase an organisation’s disclosure requirements, which enhances the communication channels among the board, management and investors.
To help institutional investors vote and to provide an extra layer of protection, a number of proxy advisor groups, including the Australian Shareholders’ Association (ASA), also supply research and best-practice recommendations on important company votes.
What is the corporate governance framework in Australia?
To facilitate companies’ understanding of best-practice corporate governance, the ASX Council has developed Corporate Governance Principles and Recommendations. The following eight principles constitute the corporate governance framework in Australia and help prevent corporate governance issues.
Principle 1: Lay solid foundations for management and oversight
Corporations should create, establish and disclose the various roles of management and the board. They need to separate the responsibilities reserved for those on the board from those delegated to company executives. The processes used to evaluate senior executives should also be disclosed.
Principle 2: Create a board structure that adds value
Boards must be structured in a way that will add value to the company. There must be enough board members, and they must have the appropriate skills and commitment to perform their duties.
Furthermore, the majority of the board should be independent directors, as should the chair, and the roles of the chair and the chief executive officer (CEO) should not be performed by the same person. Finally, companies should disclose the process for evaluating board, committee and individual director performance.
Principle 3: Promote ethical and responsible decision-making
This principle lays down a number of guidelines to ensure that ethical and responsible decision-making takes place within the business. For example, the company should create a code of conduct that covers the practices required to maintain the company’s integrity. This code should also include information for individuals who may want to report on unethical practices.
These guidelines specify that companies should establish a policy on whether it’s appropriate for directors, senior executives or even employees to trade company securities, as this practice may be considered insider trading in certain cases.
Principle 4: Safeguard integrity in financial reporting
Companies must have a structure that ensures the integrity of their financial reporting. This principle recommends that organisations establish an audit committee consisting of only non-executive directors and chaired by an independent individual (not the board chair).
Principle 5: Make timely and balanced disclosures
Organisations must disclose, in a reasonable timeframe, all matters concerning the company. To execute this principle, companies should establish written policies that specifically ensure compliance with the ASX Listing Rule disclosure requirements.
Principle 6: Respect the rights of shareholders
Companies must respect the rights of shareholders. Recommendations to do so include designing a communications policy to promote best-practice communication and encouraging participation at meetings.
Principle 7: Recognise and manage risk
Recognising and managing risk is essential to avoid corporate governance issues. This principle sets out guidelines to help companies establish a robust system of risk management and internal control. For example, companies should establish risk management policies, and the board should design a risk management plan. The board should also disclose how well it has performed according to the plan.
Principle 8: Remunerate fairly and responsibly
Lastly, Australia’s corporate governance framework stipulates that the level and composition of remuneration in organisations (and its relationship to performance) be clear. To that end, boards should establish a remuneration committee.
Examples of corporate governance in action
To fully understand what corporate governance is, it’s important to explore examples of corporate governance in action.
Rights and equitable treatment of shareholders
To ensure all shareholders receive equitable treatment, a company may implement the following measures:
- Allow all shareholders one vote per share
- Enable shareholders to vote in person, by proxy or electronically
- Give at least 21 days’ notice prior to the annual general meeting
- Prohibit insider trading
- Ensure related party transactions are conducted at arm’s length and appropriate disclosure is given.
Responsibilities of the board
In practice, boards hold various responsibilities, which often include the following:
- Providing and monitoring the business’s strategic direction
- Monitoring the organisation’s operations and finances
- Driving performance
- Continually assessing, monitoring and mitigating risks
- Appointing, assessing and, where needed, removing the CEO
- Approving budgets and business plans.
Disclosure and transparency
To avoid corporate governance issues, disclosure and transparency are critical. Best-practice disclosure and transparency involve the following actions:
- Establishing accountability
- Ensuring answerability (making sure justification for the company’s actions align with expectations)
- Guaranteeing enforcement (making sure the company accepts the consequences of failing to comply)
- Enabling all stakeholders to see and understand how the company operates.
What does good corporate governance look like?
Corporate governance is not simply set and forget: it’s a continual process of reviewing, refining, and ensuring necessary checks and balances are in place to mitigate your company’s risk.
Nonetheless, there are foundational elements you can put in place to set you up for success. If you’re looking to achieve best-practice corporate governance, make sure you have completed the following:
Good governance starts with putting basic roles and structures in place.
After you’ve put in place your basic structures and roles, you’ll need to further define what the key functions of the board will be.
As part of the continual cycle of improvement when it comes to risk mitigation and governance, you’ll need to regularly review the administrative and record-keeping processes of your board.
Given the board’s critical role in corporate governance, it’s important to not only check their processes but to assess their overall effectiveness at regular intervals.
How to assess and measure corporate governance
Here’s how corporate governance is assessed and measured in Australia:
Board structure, diversity and experience
A board has appropriate structure, diversity and experience if it meets the following criteria:
- Within the board, there is a mix of personal attributes that enable members to fulfil their roles.
- The tenure of directors is limited.
- All directors are appointed on merit, through a fair and transparent selection process.
- The board assesses and records each member’s skills.
A board is accountable if it meets the following criteria:
- The organisation’s governing documents (especially those relevant to governance) are available.
- Any transactions between related parties are disclosed to the board.
- The director’s remuneration is disclosed.
- Members have the opportunity to ask the board questions at any time about the organisation’s overall performance.
- The board abides by all other meeting and reporting requirements.
Financial disclosure and internal controls
A company has appropriate financial disclosure and internal controls in place if the board:
- Oversees and provides direction on the use of the business’s resources
- Approves the annual budget
- Evaluates the company’s performance against strategy
- Continuously monitors the solvency of the organisation.
A company provides shareholders with their due rights if it meets the following criteria:
- The board understands who the shareholders are and what they need and expect.
- The board meaningfully and appropriately engages with shareholders.
- There is an established policy and process for collecting shareholder feedback and another for protecting vulnerable shareholders.
A company has appropriate controls around executive remuneration if it meets the following criteria:
- The quantum and structure of remuneration have been adequately disclosed.
- There are mechanisms in place to assess performance against the required key performance indicators.
- The company has considered the effect the remuneration structure might have on risk-taking.
- The company has assessed the remuneration structure to ensure it aligns with shareholders’ interests.
Ownership structure and related parties
To avoid corporate governance issues, a company must have appropriate controls around its ownership structure. It has these if it meets the following criteria:
- All related party transactions are appropriately disclosed.
- Majority shareholders do not have a conflict of interest when voting on company issues.
- There are appropriate controls in place to prevent insider trading.
Social and environmental impact
Companies in Australia are not legally required to disclose any sustainability-related information, so there is no benchmark for assessing performance or measuring success. However, the Corporations Act 2001 requires some companies to report information about their environmental performance. Some states and territories mandate additional reporting, depending on the industry.
Benefits of corporate governance
Corporate governance can feel arduous and challenging at times. However, the following benefits make the effort worthwhile.
The importance of corporate governance is perhaps epitomised by the fact that it increases investor confidence. According to research compiled by the Australian Institute of Company Directors, when investors, the very people providing the company with financial capital, are satisfied with its governance, they’re more likely to vote with the board on important decisions.
Good governance and business transparency go hand in hand. When reporting and disclosure requirements are met, all company stakeholders can rest assured they have the information they need to make decisions in the best interest of the company.
According to research undertaken by the Australian Institute of Company Directors, while there is no evidence that good governance directly improves performance, it does engender confidence in shareholders and helps companies source capital.
The future of corporate governance in Australia
Lately, there have been some subpar examples of corporate governance in Australia. No doubt many in the financial sector are keen to avoid a repeat of the Banking Royal Commission.
Yet for every company that might not be doing the right thing, there are many that are – and many who want to do more. As climate change becomes a growing concern, researchers suggest sustainability reporting might form a more important – if not mandatory – part of Australian corporate governance in the future.
Until that time, companies have a thorough framework in place, but they should always seek to iterate and improve corporate governance.