Corporate Governance Explained

Corporate Governance Explained

With corporations subject to increased scrutiny from investors, consumers, and regulators, the importance of corporate governance law has never been greater. Among its many benefits, strong corporate governance helps businesses operate more efficiently, manage risk, and safeguard against legal and reputational harm.

What Is Corporate Governance Law?

The term “corporate governance” broadly refers to the system of rules, practices, and processes by which a company is directed and controlled. It also covers the relationships among a company’s board of directors, management, and shareholders, along with the company’s relationships with various stakeholders, including employees, customers, suppliers, and the community at large.

The Basic Principles of Corporate Governance Law

The four basic principles of corporate governance are accountability, transparency, fairness, and responsibility. Below is a summary of each principle:

• Accountability: Accountability refers to a company’s ability to explain its actions, document its decision-making process, and recognize the risks involved. In practice, corporate accountability involves robust corporate reporting, risk management, and internal control systems.

• Transparency: Transparency is essential to building trust with stakeholders and centers on disclosing accurate and timely information regarding key issues, such as the corporation’s finances, material risks, and social position. Tools to promote transparency include comprehensive annual reports, regular third-party audits, and adherence to established accounting standards.

• Fairness: Fairness refers to the obligation to treat all stakeholders (shareholders, corporate officers, employees, etc.) fairly and with equal consideration. In practice, unfair treatment of stakeholders can result in instability, low morale, corruption, and shareholder litigation.

• Responsibility: Responsibility refers to the expectation that the board will act in the best interests of the company and its stakeholders. Establishing the “tone at the top” concerning ethical conduct fosters strong corporate responsibility throughout the organization.

Adhering to these principles is particularly important for the board of directors, which plays an essential role in corporate governance. A board’s responsibilities include overseeing the company’s operations, establishing strategic objectives, managing risk, hiring and supervising senior corporate officers, and protecting shareholder interests. A well-functioning board is comprised of diverse members who work together, communicate effectively with other stakeholders, and prioritize transparency and accountability.

Why Does Corporate Governance Law Matter?

Given the many challenges that today’s businesses face, it can be easy to let corporate governance fall to the back burner. Its importance, however, cannot be overstated. Below are several benefits of proper corporate governance:

• Improving decision-making: A strong corporate governance framework fosters informed decision-making by establishing a structured process, valuing diverse perspectives, and incorporating long-term strategies as well as short-term goals.

• Establishing accountability and transparency: Having clear and consistent rules and procedures in place creates trust among all stakeholders. It can also lead to greater investor commitment, boost employee morale, and build customer loyalty.

• Increasing shareholder confidence: Robust governance practices, including regular shareholder engagement and communication, can serve to strengthen confidence, establish solid working relationships, and avoid costly shareholder disputes.

• Lowering liability risk: Corporate compliance and governance go hand and hand. Strong board oversight, regular financial disclosures/audits, and clear decision-making procedures help companies identify and mitigate potential compliance issues before they become legal headaches. 

• Mitigating reputational harm: Companies with strong corporate governance frameworks in place, including procedures for reconciling conflicts of interest and addressing internal complaints, are less likely to face public scandals.

• Boosting financial performance: Implementation of good corporate governance may also result in improved financial performance by reducing the risk of costly legal disputes and making companies more attractive to investors.

If the principles and laws of corporate governance are not observed, corporations can and do experience significant strife. Recently, Tesla, Inc.’s corporate governance, or as the Court found, lack thereof, was recently spotlighted in Tornetta v Musk, 2018-0408-KSJM, 2024 WL 343699 (Del Ch Jan. 30, 2024), which addressed the approval by the board and Tesla’s shareholders of Elon Musk’s compensation plan in 2018.  In her ruling on this case, Chancellor Kathaleen S. McCormick found that Elon Musk had an outsized influence on the board (Id. at *48-50), the board lacked independence from Musk (Id. *51-53), the shareholder vote was insufficiently informed (Id. at *63-68), approval of the compensation plan resulted from unfair dealing (Id. at *68-72), and the amount of the compensation was unfair (Id. at *72-81).  After making these findings, Chancellor McCormick found that rescission of Elon Musk’s compensation plan was reasonable, appropriate, and practicable Id. at *84).

Is Corporate Governance Only for Large Corporations?

Corporate governance isn’t just important for large public companies. No matter the entity size, strong corporate governance signals to the market that a company is a better-run, positive-performing, and sustainable business by signaling that the interests of directors, management, and shareholders are aligned. These improved efficiencies can unlock new opportunities, reduce risk, and propel faster and safer growth.  The same disputes that engulfed Tesla and Elon Musk can be used by shareholders against management and other shareholders in closely held businesses as well.   

By prioritizing strong governance practices at the outset, companies can often prevent larger and more expensive legal problems from developing down the road. Challenges that can arise as a business matures and scales include ill-defined profit-sharing and decision-making processes, the lack of an independent board, and inadequate financial disclosures.

Scarinci Hollenbeck Helps Clients Establish Strong Corporate Governance

A strong corporate governance framework can position your company for success. Scarinci Hollenbeck’s Corporate Governance and Regulatory Compliance Group has extensive experience advising public companies regarding corporate governance matters ranging from codes of conduct to board training to internal investigations. Our attorneys rely on best practices and practical strategies that are proven to help corporations establish effective corporate governance practices and maintain compliance in response to regulatory changes.