The Best Paper of the Institute’s latest Corporate Governance Paper Competition explores the rewards and challenges of embedding good corporate governance practices in organisations, and suggests that innovative strategies will be required to secure long-term sustainable growth.
The Institute’s annual Corporate Governance Paper Competition and Presentation Awards has been held since 2006 to promote awareness of corporate governance among local undergraduates. This article is extracted from the Best Paper of 2022. Here, in part one, the authors examine the background and evolution of corporate governance, and outline the factors that affect an organisation’s future, including its ability to gain shareholder trust, understand potential areas of risk and effectively allocate resources.
Major crises are often the catalyst accelerating corporate governance reform. The 1997 Asian financial crisis and the global financial crisis of 2007–2008 spawned an awareness of the importance of corporate governance to manage the risk of corporate failure. An increased recognition of the need for a longer-term risk horizon to transform challenges into opportunities is beneficial to organisations when operating in a dynamic and turbulent business environment.
Despite emerging beneficial trends in corporate governance, concerns over how corporations should be governed have been accentuated with the rapid internationalisation of corporate activities. The massive increase in the scale and activities of corporations has had a considerable impact not only on directors and shareholders, but also on the wider society. Given the rapidly changing funding world and increased stakeholder demands, organisations have been continually reprioritising their resource allocation in pursuit of sustainability to safeguard and enhance reputation.
In light of the imminent challenges related to climate change and Covid-19 in the 21st century, rethinking the purpose of corporate governance is vital. Embedding environmental and social perspectives into corporate governance practices is imperative to achieve sustainability. Long-term organisational sustainability is an enabler of long-term growth and value creation, which is the key for future organisational success. To enhance the investment climate, corporations are compelled to rebuild investor trust through comprehensive governance practices. A better future for organisations will be built on sustainable inclusive growth in the long run, as well as through trust based on a proactive approach to governance.
A generic definition of corporate governance is ‘the system by which companies are directed and controlled’. Corporate governance focuses on processes and organisational structures that determine an organisation’s direction, control, accountability and management of human relationships. Traditionally, the purpose of corporate governance had been conceptualised by agency theory as maximising shareholder value. Nevertheless, an overemphasis on profit maximisation was later found to be one of the underlying causes of governance crises and corporate failure in the 2000s. Perceiving corporations as having a single purpose of orientating governance practices towards profit-maximisation has in fact narrowed the understanding of the objective of corporate governance.
An adequate understanding of the complexities of corporate governance will require consideration of multiple theoretical perspectives developed after agency theory. Transaction cost, stewardship, stakeholder and managerial theories are all notable perspectives that provide a better conception of the dilemmas involved in corporate governance. A wide diversity of corporate governance systems has been derived from different perceptions of business objectives and is based on ‘historical, cultural and institutional dilemmas’. Convergence theorists, however, assert that no one system should be considered superior. Multiple effective configurations of governance practices are possible in a multifaceted world of business.
Governance best practices
Sufficient flexibility in governance frameworks has been suggested in the G20/OECD Principles of Corporate Governance. OECD illuminates that organisations are operating under widely different circumstances, which requires varying means for achieving identified objectives. Innovative and adaptive practices that take evolving operational conditions into account will create competitive advantage for organisations. Multiple governance guidelines for listed companies, as well as for non-profit organisations, have been published by governments internationally.
The essence of good governance and recommended best practices is that ‘stronger growth and inclusive societies’ in the long-term can be supported through high-standard governance practices in organisational structures, internal controls, risk management, disclosure and transparency. Corporate governance paradigms have been evolving over time in response to the dynamic economic and social contexts. Corporate responsibility for environmental and social sustainability has preoccupied the purpose of corporate governance in the 21st century.
ESG and corporate governance
Corporate governance mechanisms are deemed to have shaped organisational contributions to social and environmental matters. Corporate governance structures determining the role and responsibility of stakeholders, such as the risk committee and the board of directors, help to monitor and control company involvement in environmental, social and governance (ESG) matters. Organisations engaging in ESG-related practices and ESG disclosure contribute to sustainable development goals, committing themselves to a more sustainable future. A more sustainable future reduces risks and uncertainties, and balances the needs of the wider society. This aligns with the goal of corporate governance, which is to ‘support stronger growth and inclusive societies’ in the long-term. A company’s approach to ESG is thus also a bellwether for future governance capability.
Corporate governance and the long-term future
Good corporate governance is often associated with future organisational success. In order to succeed in the future, it is widely accepted today that organisations should strengthen their corporate sustainability capacity. Sustainability entails three interdependent dimensions, namely economic, social and environmental sustainability. While a step-up in resources is required to achieve sustainability, good governance that fosters ‘economic efficiency, sustainable growth and financial stability’ underpins long-term growth and value creation for shareholders and the wider society. Long-term value creation for all key stakeholders helps instil trust and confidence into key stakeholders, incentivising them to partner, invest or fund an organisation on an ongoing basis.
Factors affecting the future of an organisation
Trust is a subjective probability in which a person or a group assesses that a particular action will be performed. It boosts customers’ confidence and loyalty, thus increasing the revenue of companies. Data reveals that companies with trust are 2.5 times more likely to show better financial performance and this benefit is termed ‘high-trust dividend’. Building trust also attracts and secures funding. It is observed that willingness to invest has a positive relationship with investors’ level of trust in the organisation. In terms of non-profit organisations, their operation relies heavily on grants and donations. Trust increases the willingness and confidence of donors and funders to donate and award grants, as well as attracts volunteers to serve in fund-raising events. With stable, or perhaps expanding, profits and funds, an organisation can achieve financial sustainability. From the perspective of employees, trust enhances their engagement and commitment to the organisation, thus retaining talent for the organisation. Talent retention is beneficial to the long-term operation of an organisation since it guarantees quality of work and thus customers’ and shareholders’ satisfaction, maintains positive organisational culture and allows the efficacious nurturing of talents for the succession of roles.
With the rapid social, political, economic and environmental changes, organisations are constantly facing different risks.
Governance risks. The roles and responsibilities of directors and senior managers are dynamic due to the ever-changing legal duties and expectations from stakeholders. Role ambiguity and conflicts are common under these circumstances, resulting in ineffective and inefficient management of the organisation, since time-consuming and redundant communication processes can be required for clarification of tasks.
Financial risks. Weak management leads to poor cash flow management, which is the greatest factor disrupting profitability and sustainability of organisations, especially small- to medium-sized enterprises. Poor management, such as ineffective checks and balances, creates opportunities for administrative employees to misuse or even embezzle the financial resources. This not only results in a deficit of cash flow in the short term, but also leads to loss of funding in the long run when the image of the organisation is tarnished. For non-profit organisations, donors’ and funders’ confidence in the organisation would be lowered in the event of scandals related to the misuse of funds.
Operational risks. Following the Covid-19 pandemic, the practice of ‘work from home’ and online shopping has become more popular. These trends are likely to continue and become mainstream in the future. Thus, personal and business data, as well as the operational systems of organisations, are at a higher risk of being exposed and attacked, resulting in data leakage and operational system failure. This poses a threat of long-term business losses to organisations. After suffering from a data breach or cyberattack, the reputation of an organisation would be severely tainted, followed by the loss of customers and investors to its competitors. Studies reveal that 31% of people have terminated a relationship with an organisation that had a data breach. The most severe blow to the future of an organisation is not a short-term revenue loss, but a long-term loss of business opportunities due to an increase in market share of its competitors. Worse still, when the long-term outlook of a company is grim, its stock price will drop for a significantly long period of time. A massive cyberattack can also cause a downgrade of a company’s credit ratings, raising its cost of capital.
Resource allocation is the process of assigning and utilising available resources to support value creation in an organisation. An organisation’s directions for allocating its financial, technological and human resources greatly affect its future business performance.
Resource allocation for innovation. Product and technological innovation is an important strategy for an organisation to survive in the market by creating a competitive advantage over its competitors. Innovation also helps to enhance profitability of the organisation, thus meeting shareholders’ expectations of corporate value maximisation. Studies indicate that the research and development (R&D) expenditure of a firm has a positive relationship with its earnings growth.
Resource allocation for environmental protection. Overexploiting natural resources and polluting the environment would increase cost of production in the future. Worse still, the exhaustion of natural resources in the supply chain and adverse business conditions brought by climate change can lead to the unviability of the company and the whole industry. Therefore, resource allocation for environmental management is proved to be associated with the higher competitiveness of an organisation, thus attracting business partners when higher and more sustainable profitability is expected, as well as enticing customers when the corporate image is polished.
Winona Lau and Yvonne Lau
The Chinese University of Hong Kong and The University of Hong Kong
This two-part article is a summary of the winning paper of the Institute’s annual Corporate Governance Paper Competition for 2022, entitled ‘Corporate governance – an indispensable element for organisational future triumph’, under the theme ‘Do you think better governance leads to a better future for organisations?’ More information on the competition and the full version of the Best Paper, including case studies cited, along with those from the First Runner-up and Second Runner-up, are available under the Studentship section of the Institute’s website: www.hkcgi.org.hk.