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Explaining Corporate Governance

written by: Alice Rovney•edited by: Michele McDonough•updated: 10/13/2009

Corporate governance is based on certain ethical policies, framed in conformity with laws, affecting the way a corporation is to be administered to protect the rights and privileges of all stakeholders.

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    What is Corporate Governance?

    Corporate governance, simplistically stated, refers to the principles by which a company is governed. A company has several participants – shareholders, lenders, suppliers, employees, customers – amongst others. A company also interacts with the government and society at large. What duties and responsibilities, rights and privileges are provided to each of the participants will depend on the exact structure of the corporate governance.

    Corporate governance, in a narrow sense, implies the company should be managed to enhance shareholders’ wealth. In a broader sense, it implies the company should be governed on principles that protect the interests of all the participants including the shareholders.

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    Why Corporate Governance is Important for Business Corporations?

    The concept of a corporation is distinct from a proprietorship or partnership business. Firstly, the owners or shareholders of the company run limited risk. When a corporation fails, a shareholder loses nothing beyond the face value of his shares. A partner or a proprietor, instead, is required to make good the business losses with personal funds. Secondly, in a corporation the ownership and the management are separate. Corporate Law and Corporate Governance 

    The shareholders are the owners who provide the capital but the management rests with the directors who are the agents of the shareholders. Shareholder risk should not be confused with business risk. Restricting the shareholder risk merely means passing on the excess risk to lenders, suppliers, managers, employees, government and society.

    Thus, every participant – be it shareholder, lender, supplier – has stakes in the company. The principles of equity demand that a risk-taker should be rewarded. Hence, a corporation needs to be governed by practices that are ethical and rewarding to all its participants. Hence, sound corporate governance assumes relevance and validity.

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    Founding Documents in Corporate Governance

    Companies obviously cannot function without a corporate structure as enjoined by company law. There should be a set of founding documents of the company created in conformity with these laws as a prerequisite for incorporation. These documents are supposed to contain details of what approach has been (has to be) followed for structuring the company and how the segmentation of power has been (has to be) done to create an effective balance of power within the company.

    Much of the strength corporate governance derives will be found in these documents that must be approved before incorporation can take place. These documents lay down the basis for the balance of power amongst shareholders, stakeholders, management, and the board of directors. And, to determine the authority of the participants involved in the decision making process of the company, corporate bylaws, articles of incorporation and other such documents are created and these documents have all the details related to power and authority.

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    Final Words - Corporate Governance is Extremely Important

    Lack of ethical corporate governance can spell disaster as shareholder wealth can be augmented by compromising quality, squeezing suppliers, defaulting lenders/investors, overworking employees, cutting back research budget and defrauding the government. Lack of corporate governance will mean the company will lose credibility, talented and skilled employees, professional expertise, innovation – all of which will seriously affect profitability and shareholder wealth.

    Corporate governance covers specific issues like the role and legal rights of investors – particularly large investors, the powers of the board of directors to maintain surveillance, the checks and balances created for over management functioning, duties and obligations of employees, and standards of reporting and accountability at all levels.

    Image Credit: Wikimedia Commons