Corporate governance

When the people who own a company are not the people who run it, something must keep the runners honest and accountable. That system is corporate governance.

Corporate governance is the system of rules, practices, and processes by which a company is directed and controlled, and through which it is held accountable to its owners and other stakeholders. It addresses the fundamental problem that arises when ownership is separated from control, ensuring that those who run a company act in the interests of those who own it.

The separation of ownership and control

The need for corporate governance springs from a feature of the modern company: that its owners, the shareholders, are usually distinct from its managers, who actually run it. This separation creates the principal-agent problem, since managers may pursue their own interests, perks, empire, security, rather than the owners'. Corporate governance is the machinery that aligns the two, holding management accountable and constraining the abuse of the power that controlling a company confers.

The mechanisms

Corporate governance works through a range of mechanisms. The board of directors, elected by shareholders, oversees management on the owners' behalf, hiring and firing executives and approving major decisions. Auditors verify the accounts. Shareholder rights allow owners to vote and hold management to account. Executive pay is structured, in principle, to align managers' interests with shareholders'. Regulation, disclosure requirements, and the market for corporate control, the threat of takeover, add further discipline. Together these are meant to keep management honest and accountable.

When it fails

The importance of corporate governance is most visible when it fails. Corporate scandals and collapses, from accounting frauds to reckless risk-taking, are typically governance failures: boards that did not oversee, auditors that did not catch problems, incentives that rewarded the wrong behaviour, and accountability that broke down. Each such failure prompts reform, and corporate governance has evolved largely through the lessons of disaster. Good governance does not guarantee success, but its absence reliably invites abuse, mismanagement, and the betrayal of those the company is meant to serve.

Corporate governance is the system that holds the powerful managers of a company accountable to its owners and beyond, the answer to the problem created when ownership and control are separated. Its mechanisms, boards, audits, shareholder rights, and incentives, aim to align the interests of those who run companies with those who own them, and its failures, written across the history of corporate scandal, are a standing reminder of why directing and controlling companies well matters so much.