In this second and final extract from the Best Paper of the Institute’s latest Corporate Governance Paper Competition, the authors consider how better governance can lead to a better future and how tensions within that process can be resolved.
The Institute’s annual Corporate Governance Paper Competition and Presentation Awards has been held since 2006 to promote awarenessof corporate governance among local undergraduates. In 2022, the theme of the paper required students to discuss whether better governance leads to a better future for organisations.
Better corporate governance and a better future
Better risk management and reduced risks
It is generally believed that the risk management of an organisation can ‘create shareholders’ value by mitigating and managing financial and operating imperfections and enhancing its opportunities’.
Reducing governance risks. Role ambiguity and role conflicts can lead to weak management of organisations. To counteract this requires the efforts of directors to keep themselves up to date with their legal duties and to understand shareholders’ expectations through internal discussions. In addition, incentives have to be created for managers, since the separation of ownership and management can easily lead to their pursuit of personal interests, instead of the company’s interests as a whole. Corporate governance mechanisms – including the protection of shareholders’ rights through the legal system and performance-based compensation for managers, such as a share option plan or a share award scheme – can motivate managers to focus on the company’s interests with which their personal interests are aligned.
In addition, the presence of an effective board of directors provides strategic guidance for managers, as well as supervision of management as a whole, minimising their role ambiguity and conflicts to construct and maintain good management practices in the long run.
Reducing financial risks. An effective board of directors oversees management of the organisation, including its cash flow management, minimising its risk of cash flow deficit. In addition to this, the board can prevent financial statement fraud and embezzlement. According to HKEX’s Corporate Governance Guide for Boards and Directors, the core committees of the board should include an audit committee, which is responsible for supervising the integrity of financial reporting and for monitoring internal auditors. Another responsibility of the audit committee is to manage the independent external auditors, who serve as the second line of defence against financial statement fraud, embezzlement, money laundering and other financial crimes in an organisation by reviewing the financial reports. For non-profit organisations, the presence of effective board management, independent audits and an audit committee is proved to be associated with its fund-raising abilities, because donors and grant-makers would have fewer concerns about misuse of the financial resources.
Reducing operational risks. In an era of rapid technological advancement, cyber threat is a major risk faced by organisations, while corporate governance practices are becoming more important in managing cyber risks. The board of directors, ideally with cybersecurity experts incorporated, can put cyber risk management up for discussion during regular board meetings to improve the organisation’s capabilities and employee competencies in handling cyber risks. When cybersecurity is valued and prioritised in the organisational culture, managers and workers would be more aware of it, and related policies can be executed more smoothly.
Better resource allocation and improved sustainability
Innovation. Corporate governance is one of the most important determinants facilitating innovation, including product, service and technological innovation. Innovation requires a large amount of capital and human resources, and is a risky long-term investment since R&D takes a long time but does not guarantee success. Therefore, the firm, and thus directors and managers, have to be incentivised to take risks. The composition of the board of directors can also enhance resource allocation for innovation.
Environmental protection. Innovation creates competitive advantages and enhances profitability in the long run, bringing sustainability to the organisation. However, this argument is only tenable when environmental protection is achieved, which relies on good corporate governance practices. Organisational culture that prioritises environmental protection would lay the foundation for directors and managers to take pollution, climate change, resource overexploitation and other environmental issues into account during resource allocation. More firms are going one step further by adopting ‘environmental management systems’, which require an audit evaluating the firm’s current environmental performance, a plan with objectives and targets, and an action plan for the execution of policies.
Better stakeholder engagement and increased trust
Good corporate governance ensures value creation for key stakeholders in the long run, fostering enduring relationships with them. Corporations should understand the focus of key stakeholders and address their concerns. This is important as mutually valued outcomes create trust and incentivise key stakeholders to continue to partner with the organisation, sustaining value creation in the future and driving organisational success. In order to enhance an organisation’s stakeholder management capacity, defining and analysing key stakeholders is essential. Good governance will acknowledge stakeholder interests and their contribution to the long-term success of organisations.
External stakeholder engagement. Corporate governance provides mechanisms that ensure stakeholder voices are heard and their rights are not overshadowed by powerful organisations, and that corporate accountability is maintained. External stakeholders offer diverse perspectives on a more efficient and sustainable manner of operating, strengthening future organisational sustainability.
A longer-term horizon increases corporate capacity to combat future changes and risks, thereby ensuring the viability of organisations in the long term. Additionally, there are rising expectations of consumers and the local communities for organisations to exercise corporate social responsibility. External pressure has proven to have shaped organisational commitment to sustainable growth and a more inclusive society.
Internal stakeholder engagement. Employees are critical to the fulfilment of productive goals and the development of viable purposes and strategic intentions for organisations. Corporate governance encourages mechanisms that actively involve employees. Employee representation on boards enables inclusion of employee voices in decision-making and promotes board effectiveness by lessening the risk of groupthink. Having a safe-harbour regime for employee complaints also helps reassure employees that they are being treated ethically and that their right to complain is protected, thus gaining employee trust and minimising any detrimental effects of reputational damage due to unethical practices. Internal stakeholder engagement that promotes and prioritises employee well-being, and which safeguards organisational reputation, is shown to be strongly associated with talent retention.
Strategic stakeholder communication. As corporate governance and environmental, social and governance (ESG) matters have become the centre of attention in sustainable businesses, effective stakeholder communication is a vital ingredient in building and securing trust and reputation. Increasing transparency and disclosure of information on good governance practices facilitates ongoing dialogue between organisations and their stakeholders, enabling public understanding and evaluation of organisations. A proactive approach to consistent communication between an organisation and its stakeholders, as well as demonstrating impressive ESG practices, is important for building trust and relationships over time.
Metrics measuring a better future for organisations – long-term value creation for all key stakeholders
Organisations’ long-term success would manifest itself through the following performance and ESG metrics.
Key performance indicators
Key performance indicators (KPIs) provide organisations with criteria that enable the comparison between the actual results and set goals, gauging the organisation’s long-term performance. Linked to organisational strategic objectives, KPIs can be viewed as markers of the overall achievements and success of an organisation in various aspects, such as internal process quality and consumer satisfaction. The choice of KPIs varies between different organisations, depending on their characteristics and strategic direction.
KPIs that quantify effective governance and sustainability efforts will help identify areas for improvement and determine future strategies. Continuously balancing and improving organisational performance in the three dimensions – social, environmental and economic dimensions – are indications of an organisation’s capacity to generate long-term value for all key stakeholders.
Issuance of green, social and sustainability bonds
Sustainable and green finance investment products secure an organisation’s capacity to create value in the long term and reduce market volatility related to corporate performance. The rapid growth in green and ‘labelled’ bonds markets is evident in the recent decade. These bonds enable capital-raising for projects committed to environmental and social benefits. Issuing labelled bonds provides ‘sustainability ambitions’ in corporate strategies, leading to more investment in innovative sustainable practices of the organisation.
Tensions between corporate governance and a better future
Corporate governance confronts organisations with the reallocation of limited resources and prioritisation of strategic options. Fundamentally altering current business patterns, governance practices require organisations to allocate additional human resources and capital investment. When organisations envisage achieving sustainability and long-term growth, they have to shift focus from short-term decision-making to the consideration of the long-term implications of current behaviours. The longer-term horizons will require supporting techniques such as scenario analysis, which will increase operational costs. Additionally, disclosure guidelines and requirements in corporate governance sometimes complicate operational procedures, thereby increasing disclosure costs. Despite the additional resources required to uphold good governance, many corporations still strive to comply with the dominant institutionalised expectations to secure trust and legitimacy. Failing to meet increasing governance expectations due to resource constraints not only exposes organisations to more risks, but also further deteriorates public confidence, which is a vital determinant of sustainable financing. Organisations with a narrow resource base, particularly small-scale corporations and non-profit organisations, therefore face challenges to strengthen corporate governance, adversely affecting their long-term resilience and viability.
Strategy: technological innovation. Moving towards a digitised world, organisations should seek to utilise technology tools as a technical solution to reduce transition costs. With the utilisation of technological innovation, transition costs can be reduced when human capital is employed effectively and business processes become more efficient. Technology tools not only help save costs, but can also improve governance through empowering executives to better communicate with their board and leverage their expertise. An online board portal is one of the communication and collaboration tools supporting internal processes and enhancing the quality of governance. A board portal enables easy access to board papers, agenda creation for board meetings and more, thereby streamlining workflows and fostering board communication. It also provides functionality with integrating ESG considerations into corporate strategy and leadership behaviour, and aligning board culture and leadership with evolving governance expectations and requirements. Effectively improving communication at board level and ushering in paradigm shifts in organisational priorities for sustainability are integral to good corporate governance. The adoption of technology tools provides a cost-effective channel for better governance practices.
Intertemporal choice problems
Being criticised for their short-termism, which can further induce financial instability, corporations are expected to integrate longer-term considerations into their business models. A long-term orientation for environmental protection and social equity in corporate governance creates a tension with short-term financial targets ordinarily set in corporate decision-making. Companies face intertemporal choice problems, which refers to decisions in which ‘the course of action that is best in the short term is not the same course of action that is best over the long run’. Creating a more sustainable business will require investment in social and environmental projects that may not bring immediate short-term benefits. Investors, however, may focus on more immediate short-term returns. To justify their longer planning horizon and investment for sustainable development goals, corporations have to use various qualitative tools to safeguard investor trust in their sustained performance. A longer planning horizon also involves more stakeholders in the decision-making process, requiring more time to materialise the solutions and leading to slower responses. Some corporate governance confusion may even be created. For example, institutional investors are found to desire – simultaneously and contradictorily – instant short-term returns, sustained performance and corporate social responsibility. Managers may be confronted with difficult choices and make decisions that deviate from good corporate governance practices.
Strategy: sustainable bonuses. Organisational practices combining both short- and long-term outcomes can induce managers to consider long-term objectives. An example of such practices is the implementation of financial bonus systems based on short-term and long-term targets, with an emphasis on non-financial objectives. Traditional corporate bonus systems could have encouraged excessive risk-taking and cost-cutting, creating an irresistible force for short-term egotistic practices and governance failure. To avoid short-term egotistic practices that often go against sustainable societal goals, corporations should reconsider corporate incentives. A number of multinational corporations have recently added long-term social and environmental dimensions to their bonus systems. Incentive plans and compensation packages with a stronger focus on non-financial objectives will still consider short-term earnings important, but will add complexity to managerial objectives by highlighting the need to meet demands from stakeholders. Despite the inherent contradictions between short-term financial objectives and long-term sustainability goals, managers are persuaded to acknowledge the need to complement short-term financial outcomes with long-term sustainable goals.
Strategy: alternative corporate governance structures. Organisations can implement corporate governance structures with a greater tolerance for not meeting short-term financial objectives. Corporate governance structures, resulting from company characteristics and identity, play a role in creating an enabling environment to pursue short-term and long-term objectives. For instance, hybrid organisations that blur for-profit and non-profit boundaries can better balance short- and long-term objectives. The distribution of rights among different stakeholders, the formal procedures involved in decision-making and the positions of stakeholders in the governance system will all influence corporate policies, final decisions and, eventually, corporate ability to effect positive environmental and social change. To safeguard their long-term mission, organisations can try to attract stakeholders that support and work for their long-term horizons. For example, corporations can use internal promotions for key managerial positions and hire employees with little work experience so as to ingrain the long-term objectives into them through training. Regular training can help raise the awareness of the leadership to the importance of balancing short- and long-term objectives, and can build their capacity to create governance structures that commit to the long-term objectives of the organisation.
The role of corporate governance in future organisational success has been increasingly emphasised of late. Through prudent risk management, strong trust reinforcement and efficient resource allocation, executives can navigate their way towards success in a sustainable manner. These measures increase the corporation’s organisational resilience, reputation and overall profitability in the long term. Checks and balances are also in place to monitor executive performance and compensation, as well as to ensure that different stakeholder interests are taken into consideration accordingly. It is imperative to do so as stakeholders may have conflicting interests, thus there is a need for prudent management to resolve tensions between different voices. Ultimately, the corporation’s long-term success would manifest itself in KPIs and green bond issuance. As a result, there is empirical evidence that shows that corporate governance affects the entire corporation deeply, from top to bottom, as well as from present to future.
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.hkics.org.hk.