Internal versus External corporate governance

Advantages and disadvantages of internal versus external corporate governance mechanisms

By: Andy Law

Internal corporate governance mechanisms are established to insure the proper actions of management. Because providers of capital do not control the daily operations of the business, so they set up corporate governance mechanisms to insure that management acts in the best interest of the owners. This mechanism is controlled directly by the owners of the firm. It can be applied to monitor corporate risks and assurance corporate controls

Examples for internal corporate governance mechanisms include the following: 1. Set up a board of directors which are normally composed of members of management and outside members who do not participate in daily operations of the firm to represent the interest of owners (typically shareholders). The board hires, controls and fires management and determines management's compensation. 2. It could have voluntary codes of conduct. 3. Internal auditing should be conducted. 4. Voluntarily provide internal information on firm's operations.

Advantages of internal corporate governance mechanism include: 1 allow directors such as Woolworth who can both won major awards for their excellent governance practices, to differentiate themselves from their competitors. 2. The voluntary, internal and additional governance controls can make sure that their stakeholders such as customers, employees and investors are well protected and looked after.

Disadvantage: 1. additional cost could be generated. 2. Some countries tend to be secrecy; they are unwilling to disclose more information such as china. So cultural influence should be noted. Thirdly, "bad" companies will simply not adopt any internal governance requirements on their directors – requiring only the external ones be complied with and nothing more – even if some internal mechanisms are adopted by these companies, remember, given they are voluntary, they can be removed at any time.

External governance mechanisms are not directly controlled by the current owners of the firm. Example can include 1. independent auditors. 2. Legal system which highlights directors duties and obligation and ensure the company comply with the accounting standards. 3. To comply with stock exchange list rules. 4. External taker-over market.

Advantages: they are imposed on all listed companies and a not subject to control by directors in terms of whether they will comply or not.

Disadvantage: although these mandatory rules do not allow companies to differentiate themselves in the market – i.e. all listed companies must comply with CG rules, thus no one company can claim to their shareholders/ the market that they are better at governance than any other company- not in terms of strictly external mechanisms.

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