Corporate Governance

While definitions vary, corporate governance can be explained as the set of rules, policies, laws, measures, and instruments that have an effect on the manner in which a company is ruled. These factors can be external to the company, meaning that they are given by the environment in which the company develops its business activity, or internal to the company, such as its board culture. Good corporate governance is appreciated by the market, as investors are more willing to place their money in those companies with higher governance standards. On the other hand, low-level corporate governance discourages investment, because it is seen as an obstacle to the good performance of the company. Financial scandals involving bad governance practices, such as those at Enron or Parmalat, as well as initiatives in the form of laws or voluntary codes aimed to improve corporate governance, have existed both in the past and in recent times.

The way institutions are governed varies among countries and over time. With the development of large public companies, a separation between ownership and management has occurred. Companies are now owned by a large number of investors who cannot directly rule the company. Therefore shareholders appoint directors and pass on the control of the company to them. These, collectively known as the board of directors, hire the CEO and managers. The main task of the board of directors is to represent the owners and protect their interests in the company. But problems arise because directors and shareholders may have diverging objectives.

In academic literature this is called a principal-agent problem, which finds its theoretical base in the agency theory. According to this theory, a principal, in this case the shareholder, hires an agent, the director, to perform a task on his or her behalf. Once the agent has been appointed to carry out the job, they may not have incentives for seeking the principal's best interest, but their own. In order to avoid this possible situation, measures need to be taken to align the interests of both parties. The instruments used to achieve this target may vary from reward schemes, such as remuneration linked to the company's long-term performance, to enforcement schemes.

The aspiration of any initiative on corporate governance is to have a board made up of directors who make decisions and behave with honesty, diligence, integrity, and commitment to the company and the shareholders. Different measures can be undertaken in order to accomplish this broad and somehow challenging goal. Some countries have passed acts that establish detailed compulsory rules. This has been the path followed by the United States with the Sarbanes-Oxley Act. In other cases, good corporate governance practices are compiled in the form of codes that are of voluntary application. These codes may be issued by professional organizations, international institutions, [Page 403]financial market supervisors, stock exchanges, or other entities. As their application is not compulsory, companies merely explain if they comply or not with the recommendations or principles. Thanks to these disclosures, investors can decide whether to rely on the company's practices.

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