Corporate Governance Part 1: The Rules of the Game for Corporations

August 16, 2013 — Leave a comment

Whenever a large and well-know organization run into troubles, we often hear in the news and read in the investigations reports that there is a “problem” with Corporate Governance, or that more precisely the corporate governance system was somehow “WEAK” in the organization under scrutiny allowing greed and self-interests to go on unrestrained. The suggestion is often that more rules and controls are “needed to prevent this from happening again”. And then a little while later, the same problem is happening again in the same organization or in another one despite the new rules and controls in place. You may wonder why is the problem? I would like in this post to help the readers to make a bit more sense of what this corporate governance stuff is all about. First, it would be appropriate to define clearly what we are talking about i.e what Corporate Governance means? I would like here to refer to a widely used and recognized definition, the OECD definition:

Corporate Governance can be understood as the SYSTEM and STRUCTURE by which organizations are directed and controlled.

To translate into plain language what directing and controlling an organization actually entails, I will use the metaphor of a “game” to characterize Corporate Governance activities. In short, running organizations is very much like “playing” a “game” involving multiple players (called ‘stakeholders’) and to make it simple, we just need to understand that the role of Corporate Governance is to establish the RULES of the GAME that need to be followed to run organizations effectively and fairly taking into account the interests of all the relevant stakeholders. Therefore in practice, it means that corporate governance rules will specify who are the participants (players) in the “corporate game”, such as the management, shareholders, BOD, regulator, customers, suppliers, staff, etc. It will clarify the distribution of rights and responsibilities among the different participants and will spell out the rules and procedures for making decisions on corporate affairs. In this regards, Corporate Governance should provides the structure through which the organization strategic objectives are set, the means of attaining those objectives and finally the system for monitoring management performance in achieving those objectives.

The first question is… Why do we NEED RULES to play a game?

Rules of GWell simply because without rules, there is chaos, everything is uncertain, everything is possible. In essence, this is what we could call “the Law of the Jungle” and quite naturally unrestricted self-interest dominates with stronger players in the game taking advantage of privileged situations and abusing the weaker ones. Hence rules based on sound principles and supported by the right culture are a necessity to protect all the stakeholders involved ensuring 1) a fair game and 2) the achievement of socially acceptable objectives. I will explore soon in more details what are those rules in a future post in this issue.

What if there are rules BUT at least some of the players are CHEATING?

Cheating is about deception, it is acting dishonestly or unfairly (usually be breaking a formal or an informal rule of conduct) in order to gain or give an advantage (it include acts of bribery, cronyism, sleaze, nepotism, corruption, favoritism, etc).

The problem is that cheating gives an unfair advantage for the party committing it because it dramatically increases their odds of winning the game. Hence it is necessary to have a system of controls to PREVENT cheating and if someone still find a way to ‘go around’ the controls anyway then the system must be able to DETECT and stop the cheating behavior before it creates too much damages. Finally there must be strong PENALTIES for cheaters so that all the players in the game know that cheating will NOT be treated lightly and hence it is in their self-interest to respect the rules. To find out more abut why people are cheating i.e. breaking moral and/or legal rules, you refer to my post “Combatting Fraud with the Fraud Triangle“.

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