Just as democratic governments should serve the best interests of the electorate, a corporation should serve the best interests of its own constituencies, primarily its shareholders. Naturally, the interests of a company’s other stakeholders—employees, communities, or other groups or individuals—must always be considered, and sometimes may even take primacy. In general, however, capitalism functions on the premise that putting the interests of investors first results in optimal capital allocation and productivity.
In the modern corporation, the parallels of “governance” to “government” are obvious. The executive branch of government corresponds to corporate executive management, and the congressional branch to the board of directors. The primary rights of shareholders and the obligations and responsibilities of both directors and management are well understood and clearly defined by law and by individual corporate guidelines. Though different organizations use slightly different language, the Organization for Economic Cooperation and Development, the National Association of Corporate Director’s Blue Ribbon Commission on Director Professionalism, the Business Roundtable, and others differentiate the roles and responsibilities of directors and executive management in much the same way.
What Boards of Directors Do
Boards of directors set corporate policy and establish and monitor “governance mechanisms” to assure that company systems and critical individual policies are consistent with overall corporate policy. They also have oversight responsibility for strategy and performance, including control of risks, both business and financial.
Setting policy includes establishing and maintaining the philosophy and mission of the company and ensuring ethical behavior and compliance with laws and regulations. Boards of directors have ultimate responsibility for the success or failure of the corporation because of their power and authority to
- hire and fire the CEO
- set executive compensation
- approve strategy and validate that the approved strategy is followed
- oversee risk and its control, both business and financial
- maintain a corporate culture of ethical behavior that limits risk and provides an environment conducive to success
Boards of directors fulfill these responsibilities through “governance mechanisms” that include all systems, policies, procedures, and processes used to collect and analyze performance information, and standards of behavior and values for the company and its employees. These governance mechanisms allow the board to perform its oversight duties and to monitor risk, the level and detail of the company’s financial reporting and transparency, corporate social responsibility, environmental issues, and how key employees are compensated. These board responsibilities typically fall on the shoulders of six to twelve individuals working part-time for limited compensation in an environment dominated by the individuals they supposedly oversee— the managers.
What Management Does
Management, under the direction of the CEO, has direct responsibility for executing strategy and running the business day to day. This includes business and operational planning, strategy and business plan implementation, and all the daily decisions required to perform these tasks.
With regard to governance mechanisms, management is primarily responsible for internal controls, including the systematic identification and management of risks of all kinds. The output of this internal control function feeds into the governance mechanisms. These tasks and responsibilities fall to the CEO and executive management team, supported by extensive staffs, considerable resources, and outside advisers hired by management.
What Shareholders Do
Shareholders risk their hard-earned money by supplying capital to companies based on some level of understanding of the risks and opportunities of the enterprise. As shareholders have become numerous and dispersed, they have increasingly relied on boards to act as their fiduciaries. Shareholders, however, retain the power to sell their stock if they do not like the company’s strategy or its execution. In addition, they theoretically elect directors and have the power to change the composition of the board if they feel the directors are not serving the interests of shareholders well. They can exercise this power in annual elections or through a proxy contest. To hold directors accountable, shareholders need a mechanism to assess the board’s performance as a group and as individuals. That, in turn, requires that shareholders have accurate and timely information about what the board does and why.
For a company and its shareholders to prosper, all parties must work together. Because capitalism is based on self-interest, they must also look over each other’s shoulders. They should not try to do each other’s job, of course, but they should carefully scrutinize each other’s performance.
Just as the executive branch of the federal government manages the ongoing affairs of a country, corporate executives must be empowered to manage a company day to day. They must also have the power to make critical decisions, sometimes very quickly, to ensure the company’s viability and success. For example, corporate executives must certainly use their best judgment to make decisions that will protect the company from unforeseen economic adversity, respond to an aggressive or potentially harmful move by a competitor, or take advantage of opportunities as they arise. No company could long survive if every decision had to be submitted to the board, much less all of the company’s shareholders, for a yea or nay vote.
This does not imply, however, that the power and responsibilities of the board (nor the will of the shareholders) can be subordinated routinely to executive management’s whims or personal motives. While shareholders delegate enormous power to executive management, they expect that management will exercise its broad powers wisely and in the shareholders’ best interest. They should trust management to do so, but management should recognize that such trust will be tenuous, at best, if shareholders cannot verify the quality and results of management’s work.
If only because of their vast numbers and geographic dispersion, shareholders cannot supervise every move that management makes. Instead, they rely on the board of directors, which they elect—at least ostensibly—to do that for them. In theory and by law, the board is directly responsible and accountable to the electorate, and must ensure that the capital the investors have provided is safeguarded and used wisely.
Directors should question management thoroughly about strategy execution and report information on each individual director’s record of performance.
In many cases that simply does not happen because the system of checks and balances supposedly inherent in corporate structure has failed. It has failed not because boards of directors have actually lost their power. In reality, checks and balances have failed because boards have never—or very rarely—actually held power, much less exercised it. Both corporate executives and directors have behaved as if the board’s responsibility to monitor, scrutinize, and scrupulously question management’s decisions and actions never existed, even though these responsibilities rank among the board’s most important tasks.
Constructive Tension
The distinct duties and responsibilities of shareholders, directors, and management require different but specific authority, knowledge, information, and resources. Not only must all parties understand and accept their distinctive roles, they must all have profound respect for the value of sustaining healthy, productive governance relationships. Central to this is an understanding that some amount of tension and conflict are implicit in a checks and balances system.
For example, in fulfilling their strategy approval and verification roles, directors should question management thoroughly about strategy execution. In turn, so that shareholders can hold directors accountable, the board should report information on each individual director’s record of performance. Real-life examples of such tensions are discussed throughout this article.
In the U.S. government, Congress and the executive branch benefit from tension and conflict. It differentiates the political parties and their individual members. Some might conclude that so much tension in government can at times impede progress. The opposite is the case in corporate governance. Recent revelations and events have clearly demonstrated that investors have been severely penalized by a complete lack of tension. Because directors are not really elected by shareholders, and their interests tend to align more closely with management, executives and directors avoid tension and by doing so destroy the checks and balances system. Investors as well often fail in their checks and balances role because of conflicts that can arise, for example, when professional money managers serve individual investors and also manage the pension plans of large corporations.
To a greater or lesser extent, many CEOs and their management staffs have shifted the balance of power away from shareholders and directors and toward management. Management has implicitly changed policy, which boards of directors are explicitly empowered to set. They have changed corporate culture, redefined their mission as one of managing share price instead of their companies’ businesses, redefined acceptable ethical standards, and subjected their companies to risks neither well understood by the board nor disclosed to its shareholders. In the process they have disenfranchised both shareholders and directors. When shareholders were enjoying artificially inflated stock prices and when directors were enjoying lucrative options and jetting around on corporate expense accounts, neither group seemed to notice or care that the balance of power had shifted to management. Today, they care.