Fundamental Concept of

Corporate Governance
Defining Corporate Governance
• Most definitions are based on implicit or explicit assumptions about
the main objective of the firm
• However, there is no universal agreement as to what this objective
should be
• For example, Andrei Shleifer and Robert Vishny define corporate
governance as “the ways in which suppliers of finance assure
themselves of getting a return on their investment”
• This definition assumes that the main objective of the firm is to
maximize shareholder value
Defining Corporate Governance
• They justify this focus by the argument that investments in the firm by
the shareholders (as well as the debtholders) are sunk funds
• In contrast, the other stakeholders can easily walk away from the firm
without losing their investments
• E.g., an employee should be able to find a job in another firm which
values her human capital
• Another perspective does not focus on the firm being in financial
distress
Defining Corporate Governance
• It focuses on who has the strongest incentive for the firm to be run
efficiently
• That is the most junior claimant in the firm
• The claims of employees, customers and suppliers, etc. have to be
met first before any monies can be paid to the providers of finance
• Put differently, the providers of finance can only eat until the other
stakeholders have eaten
• Hence, the shareholders are the residual risk bearers or the residual
claimants to the firm’s assets
Defining Corporate Governance
• In contrast, Marc Goergen and Luc Renneboog’s definition allows for
differences across countries in terms of the main objective of the
firm:
“A corporate governance system is the combination of mechanisms
which ensure that the management … runs the firm for the benefit of
one or several stakeholders... Such stakeholders may cover
shareholders, creditors, suppliers, clients, employees and other
parties with whom the firm conducts its business.”
Defining Corporate Governance
• For example, German corporate law explicitly includes other
stakeholder interests in the firm’s objective function
• The German Co-determination Law of 1976 requires firms with more
than 2,000 employees to have half of the supervisory board seats
held by employee representatives
Defining Corporate Governance
• In a questionnaire survey sent to managers of German, Japanese, UK
and US companies in the 1990s, Masaru Yoshimori asks the question
as to whose company it is
• 89% of UK and US managers state that the company’s objective is the
shareholders
• Only a minority of French, German and Japanese managers do so
• 97% of Japanese managers believe the company belongs to the stakeholders
rather than the shareholders
Defining Corporate Governance
• Still, if this survey were to be repeated today the views of French and
German managers would likely to be closer to those of their UK and
US counterparts
Defining Corporate Governance
• A more neutral and less politically charged definition of
corporate governance is that the latter deals with conflicts
of interests between
• the shareholders and the managers;
• the shareholders and the debtholders;
• the shareholders and the non-financial stakeholders;
• different types of shareholders (mainly the large shareholder and
the minority shareholders);
and the prevention or mitigation of these conflicts of
interests
• This is the definition adopted by this course
Definition of Governance from IIA

Combination of people, policies, and procedures, and processes

that help ensure that an entity effectively and efficiently directs its
activities toward meeting the objectives of its stakeholders

Responsibility 
of the Board
Governance - Dual Reporting

Audit
Board
Committee

President/CEO

Internal Audit External Audit

COO CFO CIO

Corporate Governance Framework

ACCOUNTABLE TO

REPORT TO/
ACCOUNTABLE TO APPOINT &
MONITOR

Manages Operates

Monitor

PROVIDE REASONABLE
ASSURANCE
Two Major Components of Governance

1. Strategic direction

Determines
- Business model
- Overall objectives
- Approach to risk taking
- Limits of organizational conduct
Two Major Components of Governance

2. Oversight

Elements
- Risk management activities
- Internal and external assurance activities
Principles in Governance
1. Independent and objective board with sufficient expertise, experience, authority
and resources to conduct independent inquiries;
2. Understanding by senior management and board of the operating structure,
including structures that impede transparency;
3. Organizational strategy used to measure organizational and individual
performance;
4. People, policies, procedures and processes (including internal control);
5. Effectively and efficiently directs its activities toward meeting the objectives of its
stakeholders;
6. External or internal.
7. Organizational structure that supports accomplishing strategic objectives;
8. Governing policy for the operation of key activities;
9. Clear, enforced lines of responsibility and accountability;
10.Effective interaction among the board, management and assurance providers;
Principles in Governance
11. Appropriate oversight by management, including strong controls;
12. Compensation policies – especially for senior management – that encourage
appropriate behavior consistent with the organization’s values, objectives,
strategy and internal control;
13. Reinforcement of an ethical culture, including employee feedback without fear of
retaliation;
14. Effective use of internal and external auditors, ensuring their independence, the
adequacy of their resources and scope of activities and the effectiveness of
operations;
15. Clear definition and implementation of risk management policies and processes;
16. Transparent disclosure of key information to stakeholders;
17. Comparison of governance processes with national codes or best practices;
18. Oversight of related party transactions and conflict of interests.
Practices in Governance
Reflects unique culture and largely depend on it for
effectiveness

Organizational Culture
- Sets values, objectives, and strategies
- Defines roles and behaviors
- Measures performance
- Specifies accountability
Practices in Governance
Ensure that organization
- Complies with society’s legal and regulatory rules
- Satisfies the generally accepted business norms and
enhances the interests of stakeholders
- Reports fully and truthfully to its stakeholders
Thank you