Ch 5 Governance Factors Flashcards
What are Accountability and accounts?
Accurate accounts are needed for accountability.
The annual accounts of the company represent the formal process of the directors making themselves properly accountable to the shareholders for financial and broader business performance. This explains why
the first item at many annual general meetings (AGMs)
is an acceptance of the report and accounts,
often through a formal vote. Hence the central importance of transparent and honest accounting by companies, and of the independence of the audit of those accounts by the auditor. Again, it is not by chance that the auditor reports formally to shareholders each year and is reappointed annually in most countries at the AGM. The integrity of the numbers that investors look at when assessing the business performance is central to their ability to hold management and boards to account. The votes to ‘discharge’ board directors in some countries (such as Germany) effectively absolve them of liability for any actions over the year, and are usually dependent on the annual report providing a full, true disclosure of
activity in the year and the position at year-end.
why there are typically higher disclosure requirements around related party transactions and rights for non-conflicted shareholders to approve them.
in the UK listing regime, class tests
What is a ‘rights issue’?
Exploitation of minorities could involve money being siphoned out of the business in ways that benefit the controlling shareholders but not the wider shareholder base, which explains why there are typically higher disclosure requirements around related party transactions and rights for non-conflicted shareholders to approve
them. Minority shareholders will also be unwilling to see the company they invested in change dramatically without their having the chance to vote on the issue.
For example, in the UK listing regime, class tests are applied if:
▶ a transaction affects more than 5% of any of a company’s assets, profits, value or capital, there must be additional disclosures (Class 2 transactions); or
▶ it affects more than 25% of any of them then there must be a shareholder vote to approve the deal, based on detailed justifications (Class 1 transactions).
Another key area for shareholder protection is pre-emption rights. These rights ensure that an investor has the ability to maintain its position in the company. Fundamental in many markets’ company laws (excluding USA, for example) is that a company should not issue shares without giving existing shareholders the right to
buy a sufficient amount in order to maintain their existing shareholding. Because these rights come before potential external investors, they are called pre-emptive, and the existence of these rights is why a large equity fundraising by companies is often called a ‘rights issue’.
Will independence of serving directors erode over time?
In most corporate governance codes, independence of serving directors is viewed as eroding over time. This is why most codes have a defined maximum tenure for serving directors, which varies from
5–7 years in China and Russia to
12–15 years in Belgium and France.
The issue of the length of tenure on the board and independence is one generally recognized around the world (though it is not acknowledged even as an issue in some major markets, most notably the US), but where different standards are applied. As can be seen from Figure 5.2, from the 2019 OECD Corporate Governance
Factbook, different markets have varying expectations as to how long it takes for independence to erode. Investors may often seek to apply a single global standard, while companies may expect that their local
standard will be respected.
Zaibatsu
Stichting
Which method is designed to keep shareholders at arm’s length in the event of a hostile takeover bid?
Zaibatsu
is a Japanese term (meaning ‘financial clique’) and refers to industrial and financial business
conglomerates in Japan, usually family controlled, whose influence and size allowed control over significant parts of the Japanese economy up until the end of World War II.
Stichting (foundation)
is a legal structure that can be used for any purpose, though in the context of corporate governance and control it usually refers to an organization that itself owns the shares in the underlying company and issues depositary receipts to the market. Investors would buy these instead which would mean that they did not enjoy all the rights of legal shareholders.
Stichting structures are designed to keep shareholders at arm’s length in the event of a hostile takeover bid. They involve setting up a separate organization that owns the shares in the underlying company. Investors buy shares in this separate company that restricted legal rights compared to the underlying shares.
female directors 30%, Norway, France
UK’s 2017 Parker Review
non-white director on every public company board by 2021.
While this broad understanding of the concept of diversity – diversity of thought – is understood, most of its initiatives focus on the visible issues of gender and race.
A number of markets now have quotas for female directors (notably Norway, which pioneered the approach, and France), and most are moving towards an expectation that
at least 30% of public company directors should be women.
The issue of racial diversity has been an active debate in the USA for some years, and
the UK’s 2017 Parker Review called for at least one
non-white director on every public company board by 2021.
This target seems very unlikely to be met as the 2020 assessment found 60% of companies had not met the target. These initiatives have gained fresh impetus through the momentum of the Black Lives Matter campaign in 2020, which could mean that more change is likely.
Corporate governance in France
While there is scope for two-tier boards in France,
the vast majority of French boards are single-tier and led by a combined chair/CEO, sometimes still referred to as the President Directeur General (PDG).
Standards require that 40% of the directors be female, and around a third of the board should be employee representatives, ensuring that the stakeholder voice is clearly heard in the boardroom. French law takes conflicts of interest particularly seriously and shareholders are invited to vote on related party transactions (often multiple resolutions in a single year), even those of relatively small value.
Beyond this, two aspects of French governance are particularly unusual and worthy of discussion:
the requirement for joint auditors; and the existence of double voting rights for some shareholders.
With regard to the audit, France is the only major market to require two audit firms to look at financial statements, rather than the usual one, and these are usually one of the Big Four firms (Deloitte, EY, KPMG and PricewaterhouseCoopers or PwC) and one from the next tier of firms.
Under 2014’s so-called Florange Act (named after a steelworks in Northern France that closed and became a symbol of the risk of further industrial decline), unless there was a two-thirds shareholder vote to the contrary, French companies would award double voting rights to long-standing shareholders, defined as those who have held shareholdings in a particular way for at least two years.
questions about the independence of an individual who:
The intent is NOT TO suggest that boards should NEVER include directors whose independence is questioned.
such individuals may provide useful skills and perspectives.
The ICGN’s Global Governance Principles set out an unusually complete investor perspective on independence criteria; these extend and elucidate some of the criteria embedded in standards in various Codes around the world. These suggest that there will be questions about the independence of an individual who:
▶ had been an executive at the company, a subsidiary or an adviser to the company, and there was not an appropriate gap between their employment and joining the board;
▶ receives, or has received, incentive pay from the company, or receives fees additional to directors’ fees;
▶ has close family ties with any of the company’s advisers, directors or senior management;
▶ holds cross-directorships or has significant links with other directors through involvement in other companies or bodies;
▶ is a significant shareholder in the company, or is an officer of, or otherwise associated with a significant shareholder, or is a nominee or formal representative of a shareholder or the state; and
▶ has been a director of the company for a long enough period that independence may have become
compromised.
The intent is NOT TO suggest that boards should NEVER include directors whose independence is questioned. Indeed, such individuals may provide useful skills and perspectives. However, every board needs a sufficient weight of clearly independent individuals such that it is able to operate independently and is not subject to bias or inappropriate influence. Investors recognise that independence is a state of mind, and that some individuals can be fully independent notwithstanding some of the issues raised while others, whatever their appearance of independence, will only ever support a CEO or dominant shareholder. One of the challenges for investors is being able to identify both these sorts of individual.
should Board members be independent of the management team?
Board members should be independent of the management team to challenge management decisions and ensure independence of thought.
Board independence is also a key concern. The aim must be to have a board that is independent of the
management team and operates with independence of thought such that it can challenge both management and previous decision-making at the company (including prior board decisions).
Corporate governance in Germany
co-determination
the German code on corporate governance, the Kodex
The two-tier board structure in Germany distances shareholders from the operations and from holding
management accountable. Shareholders appoint half the members of the supervisory board, and the other half are appointed from among the workforce. All supervisory board members are charged with acting in the best interests of the corporation. This inclusion of workers in the boardroom is called co-determination and in theory, it enables boards to take longer-term decisions and to gain staff support even for difficult decisions. Certainly, German business has been highly successful over the last 70 years and many world-leading companies have been built. Anecdotal reports tend to suggest though that there are usually meetings of the supervisory board without the workforce in attendance, where many of the crucial discussions happen, and that the full supervisory board meetings are more formalised.
As shareholders vote on the appointment of half of the supervisory board, which in turn is responsible for the appointment of the management board, the supervisory board are accountable to them, rather than the management board. This sense of distance between the management board and shareholders is increased by the co-determination structure, which allows management to feel at least as accountable to stakeholders as it does to shareholders. A symbol of the distancing of shareholders from decision-making is the position on remuneration: the German code on corporate governance, the Kodex, insists that shareholders vote on management remuneration structures through advisory votes only, with the actual decision-making resting with the supervisory board.
should The board take on some debt to optimize the capital structure of a company?
The board should take on some debt to optimize the capital structure of a company. Companies without any debt may be viewed as inefficient, whilst companies with excessive levels of debt could lead to insolvency especially in an economic downturn or crisis. A key risk of high levels of floating rate debt is of interest rates rising.
In a similar way, the capital structure of a company is a crucial area of debate within the boardroom and
between the board and its shareholders. Companies without debt on their balance sheets are often thought to be inefficient and failing to deliver the full extent of possible returns, maximising return on equity. However, the 2008 financial crisis – and the more recent challenges to business resilience arising from the COVID-19 pandemic – reminded all investors that there is a danger in seeking to load companies with excess debt in order to generate greater returns on the remaining equity capital. That danger is the risk of insolvency if interest rates rise and/or if there is a downturn in the business. Having a sustainable capital structure means there must be some compromise between the extremes of maximising returns on equity in the short term and making the company entirely robust from a downturn. Unless the company is operating in a highly volatile business (where the gearing comes from operational gearing rather than financial), the board should seek to optimise the capital structure by taking on some debt.
Why use APMs?
Their use sometimes indicates a management that is keen to flatter performance rather than to admitting a failure to generate better performance
Alternative Performance Metrics (APMs) are adjusted forms of standard measures of performance aimed to conceal or improve weak underlying performance. Firms that change calculation methodologies year-on-year may indicate an underlying weakness they are attempting to conceal.
Investors often learn much about the management team from their reporting. That is especially true where a company may appear to be masking weakening performance. One way in which this is sometimes done is through alternative performance metrics (APMs). These are measures that are adjusted forms of the accounting standard-approved measures of performance, often referred to as ‘adjusted’ or ‘underlying’. Their use sometimes indicates a management that is keen to flatter performance rather than to admitting a failure to generate better performance, as the elements omitted through these adjustments may be difficult to justify objectively.
Investors are particularly wary when the APM calculations vary from one reporting period to another. A further indicator of where an attempt may have been made to obscure an issue is where numbers
in the narrative disclosures of the annual report do not entirely tally with the numbers revealed in the financial accounts in the back half of the report.
Which country’s corporate governance requirements has both independent auditors and statutory auditors both with different obligations?
Italy’s corporate governance requirements have both statutory auditors and independent auditors. The statutory auditors have a legal role to affirm the legality of certain actions by the board. The independent auditors assess the accuracy of the financial statements.
The other unusual feature of the Italian governance structure is that there are elections for statutory auditors,
these are not the independent auditors, charged with assessing the accuracy of the financial statements.
Rather, the statutory auditors have a legal role to affirm the legality of certain actions by the board. Usually
one of the three to five proposed candidates is a lawyer and another is a former (financial statements)
auditor. These are again appointed by a voto di lista slate process and form a further protection for minority
shareholders.
a way minority to prevent shareholders being potentially exploited?
Pre-emption rights ensure that an investor has the ability to maintain their proportionate ownership of the company. The company must give existing shareholders the right to buy sufficient new shares to maintain their proportionate ownership. These rights come before potential external investors (i.e., pre-empt external investors).
Dual class shares give certain classes of share multiple voting rights (e.g., founder shares to enable the company to be controlled).
Soft pre-emption rights are a less formal arrangement usually offered only to larger institutional investors rather than rights applying to all shareholders.
General mandate resolutions are unpopular with minority shareholders as they enable the issuance of up to 20% of share capital at a discount, negatively affecting existing shareholders.
which corporate governance failures in Europe, led to pressure for heightened European of governance and calls for
both board and auditor independence?
In 2003, European failures at Ahold and Parmalat led to pressure for heightened corporate governance in Europe. This followed closely on from the United States Enron case in 2001, which led to the Sarbanes-Oxley Act of 2002 in the United States.
Ahold (2002/3) – Ahold was a Dutch grocery chain that went international through acquisitions
principally in the USA, in part because management had a 15% earnings growth target.
Deteriorating performance was hidden through fraud – dubious joint venture accounting, hidden
costs and vendor rebates.
Parmalat (2002/3) – False accounting spiralled from an initial decision by this Italian milk
business to hide losses in its South American operations, mainly through inflating apparent
revenues by double billing. In the end, more than €4bn (£3.4bn) in cash and equivalents on the
company’s reported balance sheet turned out to be imaginary.
Which event led to which report that revised the UK Corporate Governance code in 1995?
The Greenbury report revised the corporate governance code following shocks around pay levels at newly privatized utilities at that time. This report required greater transparency and visibility of remuneration structures and key performance indicators used for bonuses and performance pay.
In the UK, shocks around pay levels at newly-privatised utilities led to the Greenbury report, which revised the corporate governance code in 1995. It increased the visibility of remuneration structures and pressed towards transparency over the KPIs that drive performance pay and the time horizons over which pay is released (for long-term schemes, this is a minimum of three years).
