A Practical Guide for Internal Compliance and Potential Investors


Increasingly, both public and private companies face heightened demands from diverse stakeholders for corporate transparency and accountability. Operating under greater public scrutiny than ever before, many companies are protecting themselves by proactively adopting and implementing corporate governance policies according to what are considered to be best practices.

In exploring this trend, this paper has two principal objectives. First, on a very practical level, it aims to assist those companies seeking to enhance their corporate governance practices, whether, in order to improve internal controls through increased transparency and accountability, or in preparation for an initial public offering. Second, this paper is intended to serve as a tool for investors (American and foreign alike) looking to conduct their own governance reviews of target companies. This guide may prove particularly useful to foreign investors, with limited resources, hoping to invest in emerging markets, for whom hiring external consultants to perform diligence may not be feasible. This paper is thus written with a dual audience in mind: companies and the investors who finance them.

Further to the above stated goals, this paper provides its readers with a comprehensive due diligence checklist of criteria for evaluating a specific company's corporate governance practices. Companies and investors conducting a due diligence investigation can utilize this tool to: (i) assess the strength of the existing set of corporate governance policies and practices; (ii) identify any weaknesses; and (iii) consider whether there has been a history of substantial compliance with the policies and procedures that have been put into place. The checklist tool is preceded by an explanation of the many benefits of maintaining and enforcing an effective corporate governance system and conducting diligence regularly to ensure its conformity with best practices. The final section of this paper briefly outlines what are widely considered to be best practices in several topical areas of corporate governance.

Although corporate governance reforms in developing markets often foster new relationships, rules and values within the economy, questions linger with respect to: (i) the effectiveness of such reform; and more specifically, (ii) what it entails. Potential investors should consider these criteria when deciding whether to invest in such markets.

Why is Corporate Governance Due Diligence Important?

Corporate Governance and Due Diligence

Although an amorphous concept for most, corporate governance is generally associated with the direction and control of companies. Indeed, it typically comprises policies, procedures, and relationships within the corporate context that are always subject to change. It further encompasses a wide array of economic phenomena. According to Sir Adrian Cadbury, corporate governance is largely about balancing social and economic interests.1 The concept of corporate governance is elucidated by its purpose. In general terms, it serves to: (i) encourage long-term planning; (ii) establish an effective management structure; (iii) promote integrity within the company; (iv) provide a framework for establishing and carrying out corporate objectives; and (v) ensure that the interests of all relevant constituencies, including investors, employees and the general public, are not overlooked.2

Even having loosely defined the term, it is worth noting that there is no set recipe for a model corporate governance regime that can be applied universally. Corporate governance systems must be tailored to the specific conditions prevailing in each jurisdiction (as well as each individual company), and must respond to a set of economic, legal, cultural and institutional developments that undermine the confidence of the public and investors in company management. Unfortunately, no plan is foolproof. The Sarbanes-Oxley Act of 2002 introduced sweeping legal and regulatory reforms in the United States, but nonetheless failed to prevent option grant backdating practices or to curb excessive executive compensation schemes.

The recent sub-prime mortgage and credit market crises serve to further underscore the widespread failure of company boards and executives to manage potential risk exposure. In certain ways, the current financial crisis has its roots in corporate governance fragility. As one leading corporate governance expert observed, "the boards weren't paying enough attention. They weren't asking the right questions."3 For this reason, the Dey Report recommended a number of significant guidelines for ensuring effective corporate governance. Of the fourteen guidelines proposed, guideline 2, recommending that the board of directors of every corporation be constituted with a majority of individuals who qualify as independent outside directors, and guideline 12, recommending that the positions of board chair and chief executive officer be held by separate individuals, are perhaps the cornerstone of the report.4 The purpose of this greater independence was to enhance the quality of monitoring which would aid in managing the exposure to risk.

Internal Monitoring Device

A well-designed corporate governance regime ensures that boards and officers take responsibility for implementing a system of checks and balances and internal controls that maximizes their risk management capabilities. It is imperative that the company establish a governance structure that provides its management with the proper tools and knowledge to satisfy its duties to the company and its shareholders.

A regular internal due diligence review supplies a mechanism for establishing transparency and thereby encouraging management accountability. It calls for the collection of detailed information on the company's business, legal, financial, and accounting operations and typically consists of three basic parts: (i) review of the company's compliance with laws and regulations, (ii) review of its labour and environmental practices and procedures, and (iii) review of its internal controls, polices, and actual practices.

Periodic evaluation of this sort can prove useful not only for purposes of keeping management informed about the state of company affairs, it also provides a means for holding the company's directors and officers accountable for their actions and decisions.

Outsider Perception

From both a company and investor perspective, the profitability of almost any transaction involving a company valuation hinges heavily on the results of the preliminary due diligence inquiry. Whether it is looking to be sold, entering into a merger, or hoping to arrange a favorable financing arrangement, a company should seek to ensure that its corporate governance standards withstand scrutiny and lead to optimal terms. Similarly, any savvy investor should know to conduct stringent diligence reviews of all target companies before any money is transferred. After all, good corporate governance serves as the bedrock of all trustworthy investment landscapes.

Corporate governance systems should be tailored to the specific conditions of each country and must respond to a set of economic, legal, cultural and institutional developments that underline the confidence of the public and investors in company management. These policies are particularly required in places where corporate, legal, cultural, and political interests often try to influence and/or control one another. Corporate governance rules are most needed in places where current corporate governance, monitoring and enforcement rules are weak making due diligence even more essential. There is no one-size fits all approach as corporate governance must adhere to local principles and customs.

Due Diligence Inquiry Checklist

This paper offers a corporate governance spectrum that sets out areas for due diligence inquiry in order of applicability and importance. The critical due diligence areas canvassed below are integral to all corporate governance models, regardless of the particular company or jurisdiction at issue.

While it is difficult to envision a scenario where these criteria would prove irrelevant, they will have varying degrees of importance depending on the nature and specifics of the transaction. For instance, some of the diligence issues highlighted will apply with more or less vigor depending on whether the transaction takes the form of an asset or share sale, and involves a private or publicly-traded company. The criteria below are likely to be particularly applicable to public companies.

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.