What is corporate governance?

Expansion and diversification of today''s businesses make good corporate governance essential. PriceWaterhouseCoopers'' Frank Lyn and Angel Dou explain.

Freedom and control always create tension. At its heart, governance is managing the tension between achieving the objectives of a corporation and the fulfilment of personal objectives. This governance can be extended to corporate governance, which is a process of reconciling the ambitions and behaviour of individuals in a corporation with the achievement of the objectives of the corporation, such as maximizing the interests of shareholders.

The success of this process is measured by the transparency in information disclosures, openness in operations and accountability of management.

Why corporate governance matters?

Worldwide, corporate governance is increasingly recognized as a key to establishing a healthy corporation able to cope with rapidly changing markets, technology and expansion of operations. The interest in corporate governance grew in the United States after World War II with a huge demand for capital by corporations. In Asia, corporate governance gained prominence when the Asian financial crisis in 1997 exposed the lack of openness and accountability of Asian companies and governmental organizations. There are several factors bringing governance to the forefront of corporate concern today.

First, separation of ownership and management as a result of diversification and expansion has hastened the need for good corporate governance. Unlike corporations in the early 1900's, most of which were family-owned businesses with limited diversification and therefore vulnerable to competition, expansion and diversification are vital to the survival of corporations in today's business environment. No single family can continue to manage competently a business or corporation with diversified activities. Therefore, professionals are brought onto the management board. Diversification and expansion also require outside capital, hence, the introduction of outside investors to family-controlled corporations. Outside investors are demanding more openness and transparency of corporations' operations.

More importantly, massive changes, especially in technology and modernity have spurred the need for outside capital and the use of professionals as management. The more capital intensive the operations, the more need for outside capital. This is especially true for such industries as telecommunication and chemical and oil production. Almost all blue chip companies in the US have a diversified investor base and are managed by professional experts.

Finally, the development of capital markets has provided a means for obtaining outside capital and has created a number of public minority shareholders. The increased involvement of investors in the ownership of corporations requires more openness and accountability by management and therefore the need to set up good corporate governance.

What can good corporate governance bring to a corporation?

Good corporate governance should secure an effective and efficient operation in the interest of all stakeholders. It provides assurance that management is acting in the best interest of the corporation; thereby contributing to business prosperity through openness in disclosures and accountability. While there is no hard evidence to link business success to good corporate governance, good governance enhances the prospect for profitability. The key contributions of good corporate governance to a corporation include:

  1. Creation and enhancement of a corporation's competitive advantageá

    Competitive advantage grows naturally when a corporation or its services have advantage in creating value for its buyers. Creating competitive advantage requires both the vision to innovate and the strategy to manage the process of delivering value. An effective board should be one that is able to craft strategies that fit the business environment of the corporation and are flexible to accommodate opportunities and threats, and to compete for the future. Corporations, which develop their strategies by involving all levels of employees, create widespread commitment to make the strategies succeed. Practical examples of strategies that create value to corporations are sales and marketing strategies, customer base and branding strategies. Coca Cola projects American values to its customers worldwide. Sony is reputable for the invention of new products. P&G and Johnson & Johnson are world renowned as the largest manufacturers of quality personal hygiene products.

  2. Enabling a corporation to perform efficiently and preventing fraud and malpracticeá

    The code of best practice - policies and procedures governing the behaviour of individuals of a corporation - form part of corporate governance. This enables a corporation to compete more efficiently in the business environment and prevents fraud and malpractice that can destroy business from the inside. Failure in management of best practice within a corporation has led to crises in many instances. The Japanese banks that made loans to property developers that created the bubble economy in the early 1990s, the foreign banks who granted loans to State-owned enterprises in the PRC that became insolvent after the Asian financial crisis in 1997, and the demise of Barings are examples of management not governing the behaviour of individuals in the corporation.


  3. Providing protection to shareholders' interestá

    Corporate governance is a set of rules that focus on transparency of information and management accountability. It imposes fiduciary duty on management to act in the best interests of all shareholders and properly disclose operations of the corporation. This is particularly important when ownership and management of an enterprise are in different hands.

  4. Affecting the valuation of an enterpriseá

    Improved management accountability and operational transparency fulfil investors' expectations and confidence on management and corporations, and in return, increase the value of corporations.

  5. Ensuring compliance with laws and regulations

    With the development of capital markets and the increasing investment by institutional shareholders and individuals in corporations that are not controlled by particular shareholders, jurisdictions around the world have been developing comprehensive regulatory frameworks to protect investors. More rules and regulations addressing corporate governance and compliance have been and will be released. Compliance has become a key agenda in establishing good corporate governance. After all, corporate governance ensures the long-term survival of a corporation.

How to achieve good corporate governance?

Corporate governance starts with a corporate management structureá- the lines of authority and responsibilities that direct a corporation and its employees to operate towards its objectives. Boards of directors drive effective corporate governance by determining appropriate directions and strategies. When the ownership and management are different, strategic direction should address and protect the interests of all shareholders. The key elements of good corporate governance are:

  1. Effective board of directorsá

    The board of directors leads and controls a corporation. The primary role of the board is to set the strategic direction and planning of a corporation, and to make decisions on major transactions. An effective board would require:

    1) The creation and maintenance of a dynamic and innovative board of directors who possess the competencies needed to govern the corporation. Directors may be internal or external. Competencies include strategic perception and decision making; analytical skills; communication and interaction with others; ability to plan, delegate, appraise and develop others; focus on achievement and through risk taking; integrity and commitment to fiduciary duty; and independence (non-executive directors)

    2) The board should have a balance of executive and non-executive directors (including independent directors) such that no individual or small group of individuals can dominate the board's decision making. Non-executive directors are normally those with industry expertise who can bring experience and new ideas to the board. US, UK and Hong Kong legislation require non-executive directors to include independent members who then form the majority of the audit committee. (See Independent supervisioná- audit committee.)á

    3) The roles and responsibilities of board members should be clearly defined:


    The key role of Chairman is the running of the board as he/she is the leader of a corporation.

    Executive directors

    Executive directors are the executors of the board. Executive directors are mainly responsible for shareholders and the corporation; approve and make decisions for major transactions of business; approve top level budgets, more detailed budgets are prepared by management; and monitor the implementation of business strategies, performance of operations and financial performance of the corporation on an on-going basis.

    Non-executive directors

    Apart from determining the strategic direction and operating policies of a corporation, non-executive directors are responsible for monitoring and challenging the performance of executive directors and management, and ensuring that adequate controls on operations are in place.á

    4) The nomination and appointment process should be a formal and transparent procedure. In addition, all directors should be subject to re-election at regular intervals. This helps promote the effectiveness of the board and recognizes the shareholders' inherent rights.á

    5) To have an effective board, the board shall be supplied in a timely fashion with information in a form, and of a quality appropriate for it to make decisions.

    6) Shareholders delegate the direction of the corporation to the board. Shareholders should only intervene if it is not functioning well.á

  2. Management structure and policies and proceduresá

    The board of directors delegates the daily operations to management through a management structure and policies and procedures. The day-to-day operations are led by the Chief Executive Officer. Normally, the board sets the strategic directions of a corporation and the management of each operating unit produces plans to achieve targets.á

    The operations of a corporation are managed by senior management who are responsible for the major operating cycles of a corporation. The roles and responsibilities of the key management under a normal corporate structure are described below:

    Chief Executive Officer (CEO)

    The CEO is responsible for the overall operations of a corporation, in particular: reporting to the board of directors; preparing procedures for the implementation of business development strategies determined by directors; and monitoring the business operations with the assistance of other senior management.

    Chief Operations Officer (COO)

    The COO is responsible for operational aspects of a corporation, in particular: monitoring daily operations including marketing and sales, production operations and personnel; establishing policies and procedures that control the smooth running of operations; and providing assistance to the CEO.

    Chief Finance Officer (CFO)

    The CFO is responsible for the financial activities of a corporation, in particular: reviewing financial data and reporting to the board of directors the financial performance; preparing budgets and monitoring actual expenditure according to the budget; coordinating fund raising and external finance to the corporation and monitoring the liquidity of a corporation; and providing assistance to the CEO.

    Hierarchy of a management structure depends on the scale and nature of the business. Maintaining the optimal management hierarchy is an on-going exercise in the development of a corporation and of corporate governance. A good management structure has to be supplemented by a set of policies and procedures to control and monitor the implementation of strategies at the operational level. Nonetheless, it is difficult to maintain a balance of control and empowerment.á

  3. Independent supervision  audit committees

Procedures on the management of control should be established to ensure the effective application of policies and procedures. This includes the set up of independent supervisory bodies including an internal audit department and an audit committee.

Audit committees have been well-established features of corporate governance in many countries including the United States (the earliest since 1970), United Kingdom, Canada, Australia, and recently in Singapore and Malaysia. They were introduced to Hong Kong in 1998 when the listing rules issued by the Stock Exchange of Hong Kong Limited recommended setting up audit committees by listed companies.

Structure of audit committees

The structure and responsibilities of audit committees in Hong Kong as outlined in "A Guide for the Formation of Audit Committee" issued by the Hong Kong Society of Accountants in December 1997 are broadly similar to those of many other jurisdictions. The key features of audit committees are set out below:

  • An audit committee should be established as a committee of the board of directors with written terms of reference that deal clearly with its authority and duties.áááá
  • A typical audit committee shall comprise between three to five members, with a quorum of two, depending on the size of the company and the complexity of issues arising. An audit committee shall comprise a majority of independent directors.áááá
  • Committee members should be remunerated adequately to reflect the time, commitment and responsibilities involved in serving on the committee.áááá
  • A typical audit committee will meet three or four times a year, normally prior to the finalization of the interim and year-end accounts to review the accounts and discuss issues arising. It is also recommended that at least one meeting shall be held with the auditors with no executive directors present to ensure a free and frank exchange of views.

Responsibilities of audit committees

The responsibilities of audit committees vary depending on the circumstances of a company. They should be clearly documented in their terms of reference. The principal duties of an audit committee should include the review and supervision of the company's financial reporting process and internal controls. The responsibilities of an audit committee also include:

  • Financial and other reporting

The committee should review the financial statements focusing primarily on completeness, accuracy and fairness. The review process should include reviews of significant accounting policies for compliance with accounting standards and practices in Hong Kong, judgmental issues and estimates made by management for reasonableness, disclosures for fairness, consistencies within the financial statements, usual items and significant audit adjustments or adjustment in discussions with management.

  • Internal control

Business risk is a major concern for management. The audit committee's role is to monitor management's strategy to ensure that appropriate controls are in place and are effectively functioning. Focus should be on the effectiveness and efficiency of operations, the reliability of internal and external reporting and compliance with laws and regulations and internal policies and procedures.

  • Audit

The audit committee should monitor the internal and external audit coverage to ensure that all key risk areas are considered. This includes the assessment of the quality of auditors' services and fees charged.

  • Responding to management needs

According to the experience of committee members, the audit committees may consider additional issues as specifically delegated by the board of directors. These include the review of compliance with regulations including listing rules and other industry or legal requirements.

Recent developments in corporate governance will lead to an expanding role for the audit committee as directors seek help in discharging their corporate governance responsibilities and in meeting today's business challenges. There is also an increasing trend to have the audit committees reviewing the legal and ethical conduct of management and employees.

  1. Directors and senior management's remunerationá

    The remuneration of directors and senior management should be included in the corporate governance process. The amount and method in which senior management are remunerated has an impact on the public reputation and morale of the corporation. The level of remuneration should be sufficient to attract and retain talented directors and senior management and to encourage them to work in the best interests of the corporation. As an incentive, remuneration should be structured so as to link reward to performance. A well-established practice of transparency is to disclose the remuneration paid to directors and senior management in the annual report.á

  2. The shareholders and annual general meeting (AGM)á

    Constant communication should be encouraged between the corporation and investors to ensure transparency of corporate operations. Corporations should make good use of the AGM to communicate with private shareholders and encourage their participation.

  3. Accountability, audit and transparency

The board should present a fair assessment of the corporation's financial position and prospects to ensure accountability of their performance. The auditors should report to shareholders independently in accordance with professional requirements.

Limitations to Asian companies

Corporate governance has gained importance in Asian business circles since the Asian financial crisis in 1997 exposed the lack of openness and accountability of Asian companies and governmental organizations. Corporate governance is regarded as a key to the establishing healthy Asian corporations. Imposing the entire Western model of corporate governance on Asian companies, however, without modification, is unlikely to create value to Asian companies.

The fundamental difference is culture. The United States and Europe are known to be open societies with written constitutions that protect freedom, strong frameworks of laws and regulations, established capital markets and democratic environments. The concept of fiduciary duty, the basis of effective corporate governance, has been well recognized and is expected in these environments. Asian societies, however, tend to have a more closed nature, where obedience and familial relationships are important. People in Asia are better acquainted with an environment that does not emphasize reward based on merit and are therefore indifferent to fault. Trust, linked by blood, is paramount rather than fiduciary duty and accountability.

The management in Asian companies is more reluctant to accept the concept of openness and transparency in information disclosure, and to admit fault. Problems are always hidden until they are beyond a cure. This was an additional cause leading to the Asian bubble economy of the 1990s'.

Most Asian companies are owned and managed by family members. They are closely involved in the operations of the business and do not see the need to have written policies and procedures. The coherence of family members are resistant to outside parties and are reluctant to let external managers enter. Another element of family run businesses is that both the family and the business are normally led by the eldest who is respected and seldom challenged. In most cases, the non-executive directors are often held accountable to the Chairman or managing director and place trust in their decisions without questioning. Abusive management is seldom challenged and accountability is always a silent subject. Collusion in expropriation is common.

According to a study carried out by professors of the Chinese University of Hong Kong, Asian conglomerates tend to adopt a pyramid-like corporate structure, with the holding company being a family wholly owned private company. The family can exert control over a chain of companies by holding minority interests that have control over the subsidiary companies. The degree of sharing the economic flow or cash flows by the controlling family is usually low as compared with the control they have. Expropriation to the benefit of the family is always done through intra-group transactions.

There are also a lack of rules and regulations that ensure a fair play. The concept of enforceability by law is weak in many Asian countries. Owners, managers, borrowers and bankers are bound by trust among family members and close associates rather than enforceable contracts. Foreign investors are eager to invest in this huge market and have found it difficult to protect their interests by law. In China, the economy is still dominated by State-owned enterprises that used to operate under a "budgeted economy" which means that fair play is a not an issue. China's move towards a market economy has facilitated the need to have rules and regulations that ensure a fair game.

Additionally, there is lack of social capital and institutional activities to promote corporate governance. The set up of pension funds in the US in the early 1970s catalyzed the concept of fiduciary responsibility of managers required to exercise due care in making investments. The aggressive takeover bids by corporate raiders in the US in the 1980s hastened a growing recognition for the need to focus on shareholder value. This increased the institutional shareholders' involvement in corporate governance. Without the active participation of outside shareholders in the ownership of corporations in Asia, weaknesses in corporate governance associated with family controlled businesses are hard to mitigate.

Going forward

Corporate governance is a set of rules to ensure fair play. Like it or not, Asia has to move in this direction, in an Asian way, recognizing that corporate structure and governance arrangements are products of the local economies and social environments.

We should recognize that Chinese culture adds value to governance. Obedience to authority, royalty and righteousness can be extended to governance behaviour in terms of compliance with rules and regulations, honesty and integrity. Chinese people are more committed than Western investors to invest for longer terms, focusing on value to shareholders. This enhances the long-term survival of corporations especially during times of economic uncertainty or difficulty.

Family businesses will continue to dominate the economy in Asia for the foreseeable future. They will add value to the success of corporations if the family members can place the interests of all shareholders ahead of their own benefits. Family businesses are less vulnerable to takeover bids. Trust, the basis that enables empowerment under a management structure, is inherent rather then established by performance that takes time to prove. On the other hand, the experience of the Asian financial crisis combined with the rapidly changing business environment, has meant that Asian conglomerates have seen the need to diversify. Good governance is a must for ensuring the smooth operation of expanded business. Under this worldwide trend, the management of family businesses will be gradually open to external professionals.

Technology and the need for modernity in Asian countries particularly China, act as catalysts for the need of capital and the participation of outside individuals and institutional shareholders. This helps mitigate the dominance of family business, and more importantly demands openness and management accountability. The Tracker Fund and Mandatory Provident Fund Scheme recently introduced in Hong Kong are examples of the increasing importance of institutional investors.

Technological development increases the flow of information. Investors and business partners demand more transparency in dealing and conducting business with corporations.

Good corporate governance can only be achieved by setting up a comprehensive regulatory, accounting and auditing framework, and with the enhancement of the execution and implementation of these laws and regulations. A reliable regulatory framework is the basis of an environment for fair play. Businessmen will be able to rely on outsiders with enforceable contracts, and will be able to reduce expropriation and fraud resulting from collusion.

Since 1997 in Hong Kong, the listing rules issued by the Stock Exchange of Hong Kong Limited have required listed companies to disclose compliance with corporate governance in their annual reports. Listing companies are recommended to set up audit committees as good practice of corporate governance. This is currently seen as form over substance rather than actually ensuring corporate governance, but it is a good start. The Chinese government is also working hard to establish a comprehensive regulatory framework. A number of accounting and auditing standards and regulations that follow the concept of the International Accounting Standards have been issued since 1997. Recently, the China Securities Regulatory Commission has announced that listed companies in China will be required to follow the soon to be released rules addressing corporate governance.

Transparency, openness and accountability are the key measures of good corporate governance. Integrity, trust and fiduciary responsibility are the fundamental elements to long lasting and effective corporate governance. Good corporate governance should not be seen as just a matter of prescribing particular corporate structures or check lists of the hard and fast rules, it requires a complete change in the mind set of the leaders of Asian companies. The principles of corporate governance should be applied and adopted flexibly and with common sense to the varying circumstances of corporations. Although there is still a long way to go before the Asian companies achieve corporate governance to the satisfaction of Western investors, Asia is moving in the right direction by creating an environment where corporate governance is nurtured.

Note: This article was first published in a book called "Structuring for Success"
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