What is corporate governance?

Posted on January 6th, 2023

The concept of governance

Corporate governance refers to a set of decisions, rules and practices designed to ensure the optimal functioning of an organization, as well as the structural bodies responsible for formulating, implementing and monitoring these decisions, rules and practices[1].
The term “corporate governance” has its origins in the English expression ” corporate governance “, and refers to publicly traded companies.
Originating in Anglo-Saxon countries, the concept made its appearance in Europe in the 1970s, following a number of British and North American financial scandals such as the collapse of BCCI bank and Enron.
Good corporate governance comprises the procedures and instruments that enable an optimum balance to be struck between entrepreneurship and the pursuit of performance, on the one hand, and risk control and prevention, on the other[2].
More narrowly, the term corporate governance is used to designate the relationship between shareholders and management, and primarily the functioning of the company’s board of directors [3].

  • Shareholders provide the capital, define the company’s vision and bear the business risk.
    They appoint the Board of Directors and oversee its management.
  • The Board of Directors sets the company’s strategic direction, supervises management performance, monitors risks and controls accounting and financial information.
    It reports to the shareholders.
    Specialized committees are sometimes set up within the Board of Directors, such as the committee dealing with executive compensation and appointments, or the audit committee.
  • The Executive Board, appointed by the Board of Directors, is responsible for the day-to-day management of the company in line with the defined strategy.
    It reports on its performance to the Board of Directors.

Two governance models exist in Europe:

  • the monistic model, in which the Board of Directors has a dual role: on the one hand, approving strategy and certain decisions, and on the other, overseeing risks, controlling management and approving financial information.
  • the dual model, as used in Germany and the Netherlands, with a dual board structure: a Supervisory Board and a Management Board, with Supervisory Board members overseeing the decisions of the Management Board.

The concept of governance has evolved to encompass the interests of stakeholders, giving rise to the notion of corporate citizenship.
In the 21st century, companies are called upon to take responsibility for the impact of their decisions and activities on their stakeholders – and to integrate their expectations as far as possible into their strategy and decision-making processes.
In a way, this is a 3rd type of “pluralist” governance model, alongside the two mentioned above (monistic and dual).
Numerous research studies have shown that companies with strong governance, supported by effective supervision and management mechanisms and adapted to economic and environmental change, achieve significantly better long-term financial results, and grow faster and more sustainably.
High-quality corporate governance is therefore not an objective in itself, but a means of achieving corporate strategy and creating long-term value.

Governance at (inter)national level

A credible governance framework is seen by supranational bodies as one of the key factors in improving efficiency and economic growth.
As far back as 1999, the “OECD Principles of Corporate Governance” approved by member countries set out non-binding recommendations and standards of good governance practice.
In Europe, the G20 leaders approved the G20/OECD Principles of Corporate Governance in 2015.
These principles are aimed primarily at policymakers and regulators, helping them to shape a legal and regulatory framework that supports investment, corporate sector dynamics and financial stability.
The principles focus on listed companies, both financial and non-financial.
In Luxembourg, many of the principles of corporate governance are included in the provisions of the law on commercial companies.
Under the impetus of European initiatives, a special company law, specific to listed companies, has gradually been enacted in Luxembourg.
In terms of corporate governance, the main ones are
The “transparency” law of January 11, 2008 provided an important framework for the disclosure of regulated information by issuers of securities admitted to trading on a regulated market.
This also includes privileged information such as insider trading and market manipulation.
The law of May 24, 2011 on shareholder rights and the principle of shareholder equality is another example of how corporate governance is being taken into account in national legislation[4].
The law of December 10, 2010 introduces international accounting standards.
Regulators such as the Commission de Surveillance du Secteur Financier and the Commissariat Aux Assurances have published an arsenal of laws, regulations and governance principles aimed at insurance and reinsurance companies, SICAVs, investment funds, financial sector professionals and credit institutions subject to their supervision.
In 2007, the Luxembourg Stock Exchange issued its x Principles of Corporate Governance for listed companies (with the exception of SICAVs and UCIs). The principles state that
(…) “Good corporate governance aims to
– achieve an appropriate balance between entrepreneurship and control, and between performance and compliance with corporate governance rules;
– facilitate performance-based management and provide management and leadership mechanisms, while ensuring the integrity and transparency of the decision-making process;
– set the company’s objectives, the means of achieving them, and how performance is to be assessed.

In this sense, corporate governance essentially has an incentive value that contributes to the ability of the board of directors and management to pursue objectives in line with the interests of the company, its shareholders and other stakeholders, such as customers or the company’s staff” (…).
At present, there are no specific governance arrangements for unlisted companies in Luxembourg.

What are the principles of good governance?

  1. A Board of Directors responsible for the company’s strategy, management and supervision.
    Board members must be competent, available
    competent, available and of good repute. A sufficient number
    of independent directors, with no business or family ties to management, and with a wide range of skills, are selected to enable a debate of ideas, bring in different perspectives and safeguard the various interests involved.
  2. The roles and responsibilities of the Chairman of the Board, Board members and management, the decision-making processes and the rules of communication between these bodies are formalized in order to guarantee a division of powers and manage any potential conflicts of interest as effectively as possible[5].
  3. Key policies and processes are documented.
    Companies establish codes of ethics and good conduct to guide employees and maintain good ethical practices.
  4. The risks facing the company are identified, managed and controlled. Internal controls help companies to promote accountability, secure assets and strengthen their resistance to mismanagement.
  5. Executive remuneration policy is approved by the General Meeting of Shareholders and aims to ensure a balance between performance and risk management.
  6. The precise designation of roles and responsibilities between governance players and operational departments is formalized in an organization chart, distinguishing between hierarchical and functional links.
  7. Succession plans are in place to ensure business continuity and workforce stability.
  8. Corporate Social Responsibility (CSR) is integrated into the company’s overall strategy and decision-making principles.
    The subject is systematically placed on the agenda of the Board of Directors and discussed by the Executive Committee.
  9. The Board (self-)evaluates the performance and adequacy of governance mechanisms at regular intervals, with a view to adapting them to the company’s needs and challenges.

The pillars of quality governance are as follows:

  1. Transparency and quality of information
  2. Body responsibility
  3. The obligation of these bodies to account for their actions
  4. Directors’ duties of care and loyalty
  5. Directors’ independence and integrity

Governance in SMEs
[6]

Governance is generally attributed with positive spin-offs in terms of performance, innovation, internationalization, growth and competitiveness.
Are these benefits within the reach of SMEs?
The characteristics of SMEs are specific, and their needs and challenges are different from those of a listed or regulated company.
Although the principles are similar, these characteristics would justify a different approach to governance as it is generally known and applied within large structures.
Events in the life of a company, such as a change in management or the board of directors, can provide interesting opportunities to review its governance model.
But more often than not, it’s the pressures that drive the need to rethink governance.
For example, when governing bodies are faced with conflict and deadlock, or at the request of shareholders.
The company’s size, shareholder structure and sector of activity, as well as the maturity of its lifecycle, are essential to understanding the risks at each stage, and the governance requirements.
The end result for the manager will be to clearly identify his challenges and select the appropriate governance tools to enable his company’s development.
Let’s take a look at some of the particularities of SMEs and see what solutions might apply in terms of good governance.
We deliberately exclude regulated SMEs, whose rules are specified by the regulator, subject to the application of a principle of proportionality that needs to be justified.

Specificity 1 – Rapid growth and increasing complexity of the organizational structure

In a small company (5-10 people) or in a start-up, the owner is also a director and/or manager.
He or she is involved in day-to-day decision-making, and controls management and results.
The organization is simple, communication is informal, staff wear many hats and remain close to the decision-maker.
At this stage, governance needs are limited to setting up a cash management system and calling in external consultants on an ad hoc basis.
As the SME progresses through the various stages of its growth, the organizational structure grows in size and complexity.
The number of employees increases.
The owner’s role evolves, as operational decision-making is gradually decentralized and entrusted to managers.
From the entrepreneur-expert immersed in day-to-day action, he or she must evolve into a leader, setting the framework and ensuring that delegated activities are carried out and results achieved.
The following issues may then arise.

  • Lack of cross-functional communication across silos can undermine team autonomy and initiative.
    Decisions can lack clarity and objectivity for staff, and create frustration on both sides of the chain of command.
  • The founder-manager may be tempted to retain power and not give his managers the autonomy they need to grow and stay committed.
    As they are not always trained to delegate or manage teams, management errors are frequent, and the internal climate can deteriorate, leading to the first resignations.
  • Over-dependence on key personnel, and a lack of succession plans to deal with the departure of key staff, can lead to market losses and significant dysfunction for a small structure.
  • In the war for talent, SMEs are competing alongside major players, yet do not have the same resources to manage their selection processes effectively.
    SMEs devote little time to developing, formalizing and communicating their strategy; this can lead to a lack of attractiveness on the market and make it difficult to hire the skilled personnel needed for growth.
  • Another risk is the possible mismatch between the skills and know-how of staff originally hired in a certain context and the new expectations of the market and the company’s new operating methods.

Solutions

The company must rapidly change its decision-making processes and respond to the need for cross-functional information.
The“coach” is a professional who holds up a mirror, so that the manager (the coachee) can see himself from new angles and acquire a new vision of himself.
The coach helps to unlock the knowledge and skills that the coachee already possesses but is not always aware of, and helps him/her to progress in his/her development for the benefit of his/her company.
Setting up a steering committee of managers can improve cross-functional communication, involvement and collegial decision-making.
In order to steer and mobilize all men and women, and to measure their contribution to the overall objective, it is essential to describe :

  • The exercise of decision-making power, establishing roles and responsibilities, their limits and clear lines of authority
  • Strategic objectives translated into operational objectives that can lead to the evaluation of teams and the monitoring of a few key indicators.
  • Key policies (procurement, finance, succession management, etc.) and the processes that put these policies into action
  • Staff training initiatives to increase skills in line with market requirements and reduce the need for external recruitment, including an internal mentoring plan to pass on knowledge.
  • Succession planning to ensure that staff adapt to the growing complexity of the business, and that solutions are in place in the event of the departure of a key position.

These challenges give rise to the need for a competent human resources management function that goes beyond simple personnel administration.

Specificity 2 – The loneliness of the manager

The boss is faced with a daily rhythm that leaves little time to step back and think strategically, or to analyze growth opportunities.
This can create an imbalance between the need for long-term strategic thinking and the day-to-day running of the organization.
Occasional recourse to external consultants is useful, but does not always enable the company’s long-term challenges to be taken into account.

Solutions

An experienced outside eye is invaluable in validating your business model and helping you develop your vision.
There are a number of ways to shed light on and constructively challenge a company’s actions or strategies.
The mentor is a neutral, experienced interlocutor who has more experience than his or her mentee, and is willing to share his or her knowledge, experience and insight with the manager.
The mentor supports the mentee in meeting the company’s growth requirements and in drawing up or implementing action plans, and encourages him or her to see the situation from new angles, and to take a step back.
Particularly during periods of change, the mentor can provide a secure framework for exploring and managing the new demands of change.
The Advisory Board can be a first step in improving governance.
It enables an entrepreneur to surround himself with an informal, benevolent group of independent men and women, chosen for their individual and collective ability to challenge him effectively on his company’s issues, to advise and enlighten him in difficult situations, and to help him gain perspective.
With no hierarchical link or legal responsibility, this concept is still relatively recent, and is the subject of warnings from certain professionals.
Incorrect advice can lead to decisions contrary to the company’s interests, without the members of these informal structures being held responsible.
An Advisory Board may precede or co-exist with a Board of Directors.
The formation of an independent Board of Directors, with a wide range of specialist skills, can bring the following benefits:

  • Protection of interests through management oversight mechanisms (which may mean that the executive feels challenged)
  • Access to ongoing support and enhanced expertise, so you can approach the market with greater confidence and innovative capabilities.
  • Openness to other points of view and constructive questioning of the company’s strategy and means of action.
  • Developing a risk culture within the organization
  • Help with succession planning and, if necessary, convince the various stakeholders (including the family) of the need for succession planning.
  • Increased confidence on the part of investors and lenders, enabling access to less costly external financing
  • Increased stakeholder confidence and enhanced attractiveness of the company

For the board to be a true ally and strategic advisor, it is essential for the executive to play an active role in shaping his board and setting the tone for his relationship with it.
Not having a full-time role, board members don’t always feel sufficiently informed or more qualified than the executive himself to give their opinion on strategy.
That’s why establishing an open, transparent dialogue and ensuring that you understand board members’ expectations, even outside board meetings, helps to build trust, respect and support.
Communication becomes more reciprocal and less focused on power dynamics.
Setting up a board generates costs, the extent of which needs to be analyzed in relation to its added value in the pursuit of the SME’s objectives.

Specificity 3 – Risk management is informal

The culture of risk is very much present in the entrepreneur’s mind, as he knows that he may lose the income from his capital, or even all or part of it.
However, their knowledge of business risks is limited to financial risks and external risks such as competition and regulation.
Operational and strategic risks are not always identified, and the implementation of internal controls[7] is limited to the most commonly used controls, which are modified as and when risks arise.
Lack of risk identification and management is akin to navigating in fog, without sonar in a heavy storm, and is bound to lead to obstacles or accidents that can severely damage a company’s profitability and longevity.

Solutions

In an increasingly complex, highly regulated environment, or in the presence of foreign investors, it becomes important to identify and formalize the major risks facing the company.
Based on a proposal from management, the Board approves the level of risk the company is willing to take to achieve its strategic objectives.
A risk management function is tasked with quantifying the probability and impact of risks, and encouraging the implementation of corrective measures and internal controls, within the risk tolerance approved by the Board of Directors.
An internal audit function (which may be outsourced under certain conditions) is tasked with providing management (and later the Board of Directors) with reasonable assurance that internal controls are adequate and effective.

Specificity 4 – The need for financing to ensure growth

Access to finance is a major constraint to SME growth.
SMEs are less likely than larger companies to obtain bank loans, and rely on “family” funds to get up and running.
As external investors are reluctant to invest due to the lack of accountability structures and policies, the SME may face a financing gap that can slow its growth or, more severely, initiate its decline.
The exit of one of the initial investors due to disagreement over vision or strategy can occur, and in the absence of a pre-agreed settlement, financial losses and external or internal tensions can have serious consequences for the structure.

Solutions

Investors demand rigor and formalism.
Banking institutions need guarantees, and their risk assessment involves analyzing the company’s governance structure.
The arrival of venture capital funds inevitably requires the implementation of a board of directors.
Crowdfunding is a form of alternative financing that enables young entrepreneurs and small and medium-sized enterprises (SMEs) to finance specific projects for small amounts. [8]
Crowdfunding allows funds to be raised from a large public (Internet users) via participatory financing platforms.
It can take the form of donations, interest-bearing loans or equity stakes in the company.

[9]
It generally involves 3 types of players:

  • the project owner (individual or legal entity), who proposes the project to be financed;
  • investors, who finance the project;
  • the operator of a platform that brings together project promoters and investors via a publicly accessible Internet-based information system.

Financing by
business angels
can leverage other financing (bank financing, for example).
Business angels provide a private solution to startups’ financing needs, as well as expertise and connections.
Generally speaking, they remain a minority shareholder in the company (with an average share of less than 20%), but sometimes play an active role in the company’s life and decision-making.
The main difference between business angels and venture capitalists is the amount of money involved (usually less than 100,000 euros in the case of business angels).
Venture capitalists provide capital to companies with high growth potential in exchange for an equity stake.
This may involve financing start-ups or supporting small businesses that want to grow but have no access to the stock market.
Entrepreneurs have a range of solutions to choose from, depending on their growth objectives, their own values and their desire to retain control of their business.

Specificity 5 – The specific issue of managing family businesses

Family-run SMEs have a long-term vision of their assets, and wish to pass on a healthy business to their children.
The risks most often encountered in this context are confusion between the interests of the family and those of the company.
The result is a heightened emotional component that tends to lead to a lack of clarity or transparency in decision-making, particularly in financial matters.
Tensions can arise when excessive apprehension about potential indebtedness and the desire to preserve the family patrimony contribute to holding the executive back from taking the risks necessary for growth, or when the different generations clash over the strategy to be pursued.

Solutions

Drawing up a family charter defines internal relationships and control structures, and sets the ground rules for the future from an intergenerational perspective.
The creation of a family council helps to develop a solid, professional basis for governance.
Having an outside viewpoint (in the case of the Advisory Board) and protection, notably through the creation of a Board of Directors, ensures a virtuous sharing of power and the assurance that finances and major decisions are examined and approved by an independent and competent Board of Directors.
It should be noted that in family businesses which have set up a Board of Directors or Advisory Board, it is often the case that the members of the Board are personally linked to the manager; this does not allow for in-depth debate on situations or the questioning of certain decisions.
These family-run businesses might therefore question the added value of a Board of Directors or Advisory Board that is independent of any influence from management or shareholders.
The Luxembourg Institute of Directors (ILA) issued a publication in 2018 entitled “L’entreprise familiale et la gouvernance d’entreprise”.

Specificity 6 – Transmission

A crucial element of a family or owner-managed business is the handover of the stewardship of the business.
The task of deciding who will take over is psychologically and emotionally onerous for those managers who are not inclined to jump ship, or who regard the family business as their baby and would like to retain control or hand it over to a family member.
Handover therefore requires meticulous planning to secure the company’s long-term future and resilience in times of crisis, and thus preserve the accumulated wealth.

Solutions

The active use of family governance practices such as a family charter, family council and informal family meetings serves as a framework for decision-making on succession-related matters, and helps the family business to approach succession planning in a way that respects family values.
This framework can then be communicated to the Board of Directors, whose duty it is to address succession planning.
The Board can then participate in succession planning and flag up any issues concerning the succession process.
Where appropriate, family charters may stipulate that family members must gain relevant experience outside the company for x years before joining the board or management of the company.

If the buyer is from outside the family, the company’s succession plans can be used to assess the true potential of internal candidates for key management positions, if they have been identified early and coached to maximize their potential.

Useful tools to take you further

Together with the
Corporate Governance Guidance and Principles for Unlisted Companies in Europe
– March 2021 [10] a number of principles to take account of the size, complexity and level of maturity of companies and their own development objectives.
ecoDa has also developed a self-assessment questionnaire that companies can use to evaluate the extent to which they are already applying these principles, and to determine whether there are areas in which they could strengthen their governance framework.
The questionnaire is available in English on the organization’s website.
IFC’s SME governance handbook, written in collaboration with the Luxembourg government, specifically addresses the challenges and opportunities facing SMEs at different stages of their life cycle, offering corporate governance recommendations tailored to these small units.
The advice provided is designed to help SME owners, investors and managers adopt a pragmatic approach to governance, as a means of strengthening their businesses over the long term.

[11]

Tools such as the B-Corp label and the GRI can provide structuring alternatives.
The B-Corp label is an international label supported by over 5,000 companies in 77 countries (mostly SMEs).
The B Corp approach is based on a free online self-assessment questionnaire, the “Business Impact Assessment” or “BIA”, which is open to all companies, whatever their size or sector of activity.
It measures the impact of both operations and the business model.

[12] In this case, the company has a “roadmap” for planning the structural changes it needs to make towards more sustainable management.
Mature” companies that meet a specific rating can apply for certification.
GRI – Global Reporting Initiative

[13] Launched by an American NGO in 1997, its aim is to develop and disseminate guidelines to help companies report on the economic, social and environmental dimensions of their activities, products and services.[14].
La préparation d’un rapport en conformité avec les normes GRI permet d’obtenir un panorama complet des enjeux pertinents d’une organisation, des impacts qui y sont liés et des modalités de gestion de ces impacts.
Une organisation peut également utiliser l’ensemble ou une partie des normes GRI sélectionnées pour établir un rapport sur des informations spécifiques.
Aujourd’hui, les lignes directrices de la GRI sont largement utilisées par les entreprises et diverses organisations pour mesurer les actions concrètes mises en place en matière de développement durable et améliorer la transparence de leurs résultats extra-financiers.
Au Luxembourg

[15]There are various labels and charters that enable companies to demonstrate their commitment to different areas of CSR, such as :

The last word

Governance is not a panacea for everything, and cannot prevent fraud, mismanagement or bad decisions.
There are many examples to remind us of this.
While governance alone cannot explain success, many examples demonstrate that neglecting governance can affect a company’s performance, reputation and longevity.
To survive and grow, all businesses need to be well governed.
SMEs, many of which are family businesses, differ from large organizations, and although they are not subject to the obligation to adopt strict good governance practices, applying sound practices commensurate with their objectives can help them avoid many pitfalls on the road to development and prepare them to tackle growth and innovation (ACCA, 2015; ecoDa, 2010).
As mentioned in this article :

  • Companies with good governance have better access to financing because they appear more attractive and less risky to investors and banks;
  • Prudent governance reduces risk and improves conflict management between different shareholders and stakeholders;
  • Well-structured management bodies (and later, boards of directors) provide the stewardship, strategic direction and business relationships essential for sustainable growth;
  • Family businesses increase their chances of long-term survival through proactive succession planning and management of the family-business relationship;
  • Effective policies, structures and processes help reduce over-reliance on a few “key people”;
  • Well-managed companies attract and retain better quality staff on whom the founders can rely;
  • Prudent internal controls help companies improve risk management and strengthen their resistance to fraud, theft and mismanagement;
  • Good governance is a prerequisite for an IPO;
  • Good governance practices help founders to regain a certain freedom in their lives.
    They can control and direct the company without having to be directly involved in all operational decisions.

Spurred on by financial scandals and the growing mobilization of citizens and investors, fueled by the transparency offered by the digital age, debates around corporate social responsibility (CSR) are undergoing major development.
While CSR is still a voluntary approach on the part of the company, it demonstrates a desire to legitimize the company in the eyes of a public increasingly concerned by social and environmental phenomena.
Governance, by definition evolving and contextual, is a journey.
As no two companies are identical, each will have to “find its own way” when it comes to implementing a governance framework, using solutions and tools adapted to their company’s stage of development.

Annick Lebrun-Nelissen

[1] Youmatter.world
[2] The x principles of the Luxembourg Stock Exchange
[3] The x principles of the Luxembourg Stock Exchange
[4] Corporate governance in the Grand Duchy of Luxembourg: current situation and outlook – anthémis – Marcier 1395
[5] A conflict of interest is a situation that arises when the independent, impartial and objective exercise of a person’s duties is likely to be influenced by another public or private interest distinct from that which he or she must defend in these duties.
https://transparency-france.org/wp-content/uploads/2018/06/GUIDE-CONFLITS-DINTC389RC38ATS-WEB.pdf
[6] SMALL AND MEDIUM-SIZED ENTERPRISES (SMES)
Companies including :

  • fewer than 250 employees;
  • and either annual sales not exceeding 50 million euros, or annual balance sheet total not exceeding 43 million euros.

[7] Internal controls can be defined as policies and practices designed to detect and prevent errors, identify fraud and ensure the reliability of financial statements.
These controls set preventive “locks” and enable action to be taken when “alarms” sound.
[8] https://guichet.public.lu/fr/entreprises/financement-aides/financement/apercu-general/crowdfunding.html
[9] https://www.economie.gouv.fr/entreprises/crowdfunding-financement-participatif#

[10] https://ecoda.eu/corporate-governance-guidance-and-principles-for-unlisted-companies-in-europe/

[11] https://www.ifc.org/wps/wcm/connect/c3ec6ade-10c6-4aaf-b10f-637cec0402ed/IFC+SME+Guide+FRENCH+LOWRES.pdf?MOD=AJPERES&CVID=n7bB42W

[12] https://www.bcorporation.fr/certification/

[13] https://www.globalreporting.org/how-to-use-the-gri-standards/gri-standards-french-translations/

[14] https://www.novethic.fr/lexique/detail/gri.html

[15] https://guichet.public.lu/fr/entreprises/urbanisme-environnement/entreprise-responsable/responsabilite-sociale/entreprise-socialement-responsable.html