How corporate governance is changing

Corporate governance is one of the most crucial aspects of the modern economy. Good corporate governance allows companies to mobilise domestic and international capital and channel them to productive ends at the lowest possible cost. 

Traditionally, preventing corporate frauds have been one of the primary reasons for establishing corporate governance in a company. But frauds can be effectively mitigated with improved supervision and stringent enforcement of the rules. 

Instead, corporate governance has a much more robust and complicated role in a company. Its aim should be to regulate the transaction between the management and the shareholders.  

In order to accomplish that, corporate boards often have to walk a thin line between fulfilling the interest of the shareholders and providing the management with enough authority to act effectively and decisively. 

But in recent years, the "interest" of the shareholders has shifted significantly. Economist and Nobel laureate Milton Friedman theorised that providing profits to its shareholders is the only objective of a corporate entity; it should be free of other social, political and environmental duties. 

This conception has been proven wrong. For example, the Business Roundtable — an association of the country's top chief executives — released a statement in 2019 that revised the purpose of a corporation as promoting an "economy that serves all Americans," including customers, employees, suppliers, and communities.

Instead of maximising profit for their shareholders, companies should focus more on increasing their welfare, because shareholders may care more about other causes than just  making a profit. 

Even a cursory look at the make-up of modern boards reveals how significantly they have changed. Environmental damage, social and racial injustice, gender inequality, the Covid-19 pandemic, technological disruption, and other pressures are pushing companies to take a broader look at their purpose and mission. 

Companies now want board members with specific expertise in areas such as: impact investing, human resources, auditing and accounting, crisis management, machine learning and artificial intelligence etc. 

Traditional board members, who are primarily focused on managing the financial aspect of businesses, are now becoming increasingly incapable of providing guidance for navigating a tumultuous economic and political environment. 

Firms are moving away from a model in which board members have an almost adversarial relationship with managers, toward one of greater collaboration. They now like to take an active part in solving corporate problems while assisting the management. 

These changes not only help companies navigate rough waters, they also help companies meet the demands of customers and employees.

Infograph: TBS

Shareholders now want companies to be transparent about their environmental and social goals. Plans to reduce carbon footprint, ethical sourcing of raw materials, curbing gender pay-gap, taking stance against social problems - are now at the forefront of a company's corporate identity. 

As a result, the CEOs of today are less like business managers and more like statesmen, who communicate their company's ideology and vision to the public and try to convince them to buy their company's goods and services. The boards are quick to intervene if the CEO speaks out of turn with the company's views.

But corporate governance still has a long transformation ahead to be completely compatible with our ever changing world. One of the most pressing issues is the disparity of compensation between the executives and other employees of the companies. 

Executive pay is skyrocketing based on the "pay-for-performance" principle that does not extend down to rank-and-file employees who also contribute to the company's success.

Research has linked this disparity to harmful outcomes within the company and society at large, including: lower morale, reduced collaboration, underinvestment in public goods, and higher crime rates.

It is important for boards to understand how pay disparity hurts their companies and they have to find alternatives. Firms can incentivise executives to pursue social or environmental goals by using the long-term incentive portion of compensation packages to reward them. 

It is evident that many firms across the world currently attach some measure of executive pay to social and environmental outcomes. Research suggests that it works to help move environmental and social goals (ESG) forward. But if income inequality increases due to this, the company will get hurt in turn. 

Environmental concerns have been strengthened more than anticipated, increasing investors' demand for green stocks and customers' demand for green products. This is also another challenge for corporate governance. 

The rise of ESG investing has made capital cheaper for green companies and more expensive for non-green companies. It is expected all companies will become greener in order to increase their share price, and for capital to be reallocated toward green firms.

But it should be understood that the free market cannot resolve all problems; policymakers must draft better regulations. ESG investors alone are not going to save the world.

Another crucial concern is regarding transparency and accountability in the post Covid-19 market. Despite the enormous challenges the pandemic poses, it arguably should be seen as an opportunity for reform of the corporate governance structure, especially in emerging markets. 

The Anglo-American model of corporate governance may be hard to implement in these economies due to: family ownership and the absence of independent directors, political business operations, corruption and the lack of enforcement, and supranational agencies' continual interventions. 

Although many emerging economies have been adopting the Anglo-American model of corporate governance, for historical reasons, it lacks the capacity and robustness to tackle local challenges. Even though these economies have similar laws to that of Britain, their socio-political institutions and civil societies are also important factors which are not reflected in the Anglo-centric model of corporate governance. 

Many companies' financial statements submissions have been delayed globally. Audit committees should work virtually and evaluate the impact on internal control over financial reporting. They should also consider the impacts of profitability, cash flow, capital preservation and internal reporting structure etc. 

The key disclosure challenge is the IAS 1 Presentation of Financial Statements, which requires management to assess a company's ability to continue operating. Due to the nature of the pandemic and the uncertainty it brings, investors and shareholders need high quality financial information more than ever.

As a result, companies will have to update their forecasts and provide sufficient disclosures to alert investors about underlying financial conditions. They will also have to be able to adopt and plan ahead. Enforcing force majeure clauses, understanding the cybersecurity and concerns of working from home, assisting management in addressing crisis-related issues and others will be crucial challenges in the long term. 

"Corporate governance in the future" might encourage wild speculation of epochal change. Some might see the demise of the corporation; others, the emergence of new organisations with intelligent robots playing the role of boards.

But corporate governance has not changed a lot in the past 12 years, except for in the banking sector. The current changes are also not caused by technological or financial advancements. Rather, they are responses to an ongoing crisis. 

One should therefore expect limited change. But change there will be, and it will be mainly driven by four key drivers: diversity, disclosure, data and Development Financial Institutions (DFIs).

Md Kafi Khan is the Company Secretary at City Bank Ltd.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.