Chap 5 Governance Flashcards
Corporate governance is the process and structure for overseeing the business and management of a company.
From the Latin word for the steersman of a boat, gubernare, governance has that sense of guiding and controlling.
Corporate governance has become more complex as the scale and complexity of companies has grown and as ownership has become more dispersed.
As a result, the role of the board of directors has become more important.
The board is responsible for representing the owners of the company and for holding management teams accountable for running the business in the interest of its owners.
The effectiveness of the board depends on whether good corporate governance practices are applied.
These principles have been developed over the years and codified into corporate governance codes.
Increasingly, investors are expecting companies to disclose their corporate governance processes and approach so that external investors can understand where the company stands on the spectrum of good governance.
The types of issues that investors will address when considering a company’s governance include, but are not limited to:
▶ shareholder rights;
▶ the likely success of the intended company strategy, and the effectiveness of the leadership in place to deliver it;
▶ executive pay;
▶ audit practices;
▶ board independence and expertise;
▶ transparency or accountability;
▶ related-party transactions; and
▶ dual-class share structures.
WHAT IS GOVERNANCE? WHY DOES IT MATTER?
Laws, Culture, Performance.
Corporate governance is the process by which a company is managed and overseen.
There are different rules worldwide – **governance grows out of the legal system of the country in which the company is incorporated – but at its heart, governance is about people and processes.
Good governance also involves developing an appropriate culture that will underpin the delivery of strong business performance without excessive risk- taking and through appropriate conduct of business operations.
Good corporate governance should lead to strong business performance and long-term prosperity to the benefit of shareholders and the company’s other stakeholders.
The corporate culture needs to be supportive of that long-term business success in the interests of all stakeholders.
While at its heart, corporate governance is about people (the individuals in the boardroom), in order to exercise their responsibilities effectively, those board members are supported by processes.
These processes bear an increased burden in large and complex companies; at smaller companies there is greater scope for individuals at the top to have direct knowledge across a business, but at larger companies this is impossible.
Companies will have policies and codes of conduct in place, but they will need to lean on processes to be confident that those policies are indeed delivered in practice.
Investors will judge a company’s governance based on the quality of its policies and processes and on the diligence and care with which the board oversees their implementation.
Assessing the effectiveness of corporate governance systems within a firm gives investors insight into the accountability mechanisms and decision-making processes that support
ALL critical decisions impacting the allocation of investors’ capital and the likely delivery of long-term value.
A company with sound governance is more likely to address key risks, including environmental and social issues, effectively.
Conversely, a company that is failing to manage a key long-term risk (again including environmental and social issues) may have a governance failure that is blocking its ability to address the issue.
In practice, corporate governance comes down to two ‘A’s:
accountability and alignment.
These concepts are reflected in many of the core elements of corporate governance standards and investor expectations.
Accountability
People need to be:
▶ Given authority and responsibility for decision-making;
and
▶ Held accountable for the consequences of their decisions and the effectiveness of the work they deliver.
**Accountability and the board
Just as people are most effective when they are conscious of being accountable to someone – typically their manager – in the same way, senior executives need to feel accountable to the non-executives on their board.
In turn, that board will be most effective when its non-executive members feel accountable to shareholders for effective delivery.
Therefore, corporate governance has a strong focus on::
board structure and
the independence of directors.
The mixed skillsets of directors are also important, so that discussions and debate are appropriately informed from a range of perspectives and the risk of “group-think” is avoided.
Increasing diversity and the range of perspectives in the boardroom, through gender diversity, but also diversity in terms of professional backgrounds and experiences, has been demonstrated to deliver a more challenging culture that is more likely to enhance
*** long-term value.
The role of the chair of the board is vital in facilitating a balanced debate in the boardroom.
Consequently, many investors prefer that the chair is an independent non-executive director.
*** If the chair is not independent, and especially if that individual combines the role of chair with the role of CEO, this can lead to an excessive concentration of powers and hamper the board’s ability to:
▶exercise their oversight responsibilities;
▶challenge and debate performance and strategic plans;
▶set the agenda;
▶influence succession planning;
and
▶debate executive remuneration.
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.
This is 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.
Alignment and the agency problem
Alignment comes down to the challenge of the agency problem.
Since the seminal publication of The Modern Corporation and Private Property by Adolf Berle and Gardiner Means in 1932
(seen by many as the starting point for the modern understanding of corporate governance),
the agency problem has been identified as an inevitable consequence of the separation of ownership and control.
The agency problem arises in that the interests of these professional managers – the agents – may not always be wholly aligned with the interests of the owners of the business and so, the company may not be run in the way the owners wish.
This challenge is magnified at larger corporations, not least public companies, where ownership is fragmented between many investors owning a small fraction of the company.
Corporate governance attempts to ensure that
there is greater alignment in the interests of the agents with the owners through incentives,
but also through appropriate chains of accountability, to mitigate the potential negative consequences of the agency problem.
Alignment and executive pay
With regard to alignment,
the major focus in terms of executive pay is always on addressing the agency problem and helping to ensure that executives are not subject to incentives to perform in their own interests and contrary to the interests of the owners.
Thus, executive pay structures aim to align the interests of management with those of the owners, usually by creating a balanced compensation package that includes performance-related remuneration based on long-term goals and that vests over a long-term period.
The goals ideally include a mix of key performance indicators (KPIs) related to business and share price performance.
The three key committees of the board,
usually required by corporate governance codes,
are established to respond to each of these key challenges.
- The **Nominations Committee (in some markets, this is called the
**Corporate Governance Committee, or some combination of these terms)
aims to ensure that the board overall is **balanced and effective, ensuring that management is accountable.
- The **Audit Committee oversees financial reporting and the audit, delivering accountability in the accounts.
- The Remuneration Committee (in some markets, this is called the Compensation Committee)
**seeks to deliver a proper alignment through executive pay.
2
THE DEVELOPMENT OF A FORMALISED GOVERNANCE APPROACH
Explain the evolution of corporate governance frameworks and key motivators for step change:
Development of corporate governance;
roles and responsibilities;
systems and processes;
shareholder engagement;
minority shareholder alignment.
Corporate failures and scandals have been a powerful driver for the formalisation of corporate governance and the development of codes.
When companies fail and investors lose money, there is often pressure for an improved approach.
The Walker Review, following the financial crisis, and the recent Kingman1 and Brydon reviews in the wake of Carillion’s failure, are examples of this.
Corporate Governance Codes
The first formal Corporate Governance Code emerged in the UK in 1992.
The Cadbury Committee had been brought together in May 1991 by the Financial Reporting Council,
the London Stock Exchange
and the accounting profession
to consider what were called ‘the financial aspects of corporate governance’.
Its creation followed the Caparo and Polly Peck scandals.
Caparo had mounted a successful takeover bid for Fidelity, only to subsequently discover that Fidelity’s profits were significantly overstated.
The market had pumped up the share price of Polly Peck for years on the basis of financial reporting that later turned out to be misleading.
The Cadbury committee was created because of the perceived problems in accounting and governance.
Once the committee was founded and began its work (but before its planned publication),
the Maxwell/Mirror Group scandal was beginning to emerge,
and the Bank of Credit and Commerce International (BCCI) collapsed spectacularly
in the wake of money laundering and other regulatory breaches.
It was clear that much needed to change.
Much of what the Cadbury Commission recommended is still considered best practice today and has been incorporated in codes and guidelines globally.
For example, the committee proposed that every public company should have an audit committee meeting at least ***twice a year.
Notably, at the time it was released, only two-thirds of the largest 250 companies had such committees at all (although nowadays they are commonplace).
The committee’s core theme is that no individual should have ‘unfettered powers of decision’;
so, for example, the roles of chair and CEO should not be combined, as they frequently were at the time.
A codified set of guidelines for good governance has grown from the basic concepts of accountability and alignment.
Governance differs from country to country based on cultures and historical developments, as well as local corporate law.
At the most basic level, some countries, including Germany and the Netherlands, have two-tier boards with wholly non-executive supervisory boards overseeing management boards; whereas others have single-tier boards, with some dominated by executive directors (in Japan), some having a combined CEO and chair (most commonly seen in the USA and France),
and some lying in between these models (the UK being an example).
The UK model of a code of recommendations with which companies should comply or explain any non- compliance has been followed throughout much of the world.
It is now highly unusual for any market to be without an official corporate governance code.
Since Japan adopted one in 2015, the USA is the only major world market that does not have a code, which is largely a consequence of corporate law being set at the state level.
Most markets adopt the language of ‘comply or explain’, although the Netherlands favour ‘apply or explain’, and the Australians use the blunt ‘if not, why not?’.
The thought process, however, is the same:
Adherence to the relevant standard or a thoughtful and intelligent discussion of how the board delivers on the underlying principle.
Companies’ willingness to provide thoughtful discussions of differences from guidance varies.
Some companies may look negatively on corporate governance as they consider it to be **inflexible.
This arises because the proxy advisory firms (a highly-concentrated group led by ISS and Glass Lewis) tend to adhere to the details of **corporate governance codes in **giving recommendations on how their clients might vote.
Some argue that it is the role of the proxy advisers to interpret the standards strictly,
and it is for the actual shareholder to apply the flexibility that arises from a closer understanding of the specific circumstances of the individual company.
On this analysis, the problem of inflexibility arises more from the investor clients’ tendency to follow the proxy advisers’ recommendations with too little independent judgment about whether that voting decision is the right one.
Just as the Caparo and Polly Peck scandals sparked the establishment of the Cadbury Committee,
and Mirror Group and BCCI set a firm context for publication and acceptance of its report,
later scandals have continued to fuel the development of governance standards around the world:
▶ 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).
▶ The Enron, Tyco and WorldCom scandals in the USA led to the Sarbanes-Oxley Act in 2002. This lifted expectations for greater integrity in financial reporting and created the Public Company Accounting Oversight Board (PCAOB) as the country’s audit standard setter and inspector, establishing a standard for auditor independence and challenge.
▶ The 2003 failures at Ahold and Parmalat, in the Netherlands and Italy respectively, led to pressure for heightened standards of corporate governance and both board and auditor independence across Europe. No longer could Europe pretend that Enron represented a problem isolated to the USA.
▶ The financial crisis of 2008 led to various changes around the world and a renewed focus on corporate culture and executive pay, as well as questions around audit, and the advent of stewardship codes,
in the UK initially and then around the world.
Most notable of the legislative changes was the 2010 Dodd-Frank Act in the USA (formally the Dodd-Frank Wall Street Reform and Consumer Protection Act),
which among its multiple clauses tightened standards for, and oversight of, banks.
▶ In Japan, the Olympus scandal of 2011–12 revealed long-running market deceit,
apparently not for personal gain but to maintain the apparent health of the company and jobs for its workforce, whereby more than US$1.5 billion (£1.15bn) in losses were hidden.
When the much larger Toshiba revealed its own scandal of overstated profits in 2015, some felt that there might be something culturally wrong in Japanese companies that sought to hide the truth and failures of governance.
The combination of these shocks has helped fuel the rapid advance of Japanese governance standards and also expectations for ESG disclosures across the market.
Scandals in brief
Caparo (1984) – Caparo was a steel and engineering business that mounted a takeover of a UK public company, Fidelity, an electrical equipment manufacturer. The takeover followed a series of profit warnings and associated share price decline of more than half. Unfortunately for Caparo, Fidelity’s position was much worse than it believed and its accounts indicated. Caparo sued the auditor for breach of a duty of care.
Polly Peck (1990/1) – Polly Peck was a textile and trading business that grew so rapidly in the 1980s that it joined the FTSE 100 in 1989. A prolific dealmaker, it later emerged that much of its apparent profit arose from the high inflation and associated high interest rates in Turkish Cyprus, where many of its operations were. CEO Asil Nadir fled to North Cyprus in 1993, returning to face trial in 2010. In 2012, he was found guilty of ten charges of theft.
Maxwell/Mirror Group (1991) – Shortly after media businessman Robert Maxwell drowned in the Atlantic off his yacht, the Lady Ghislaine, it was discovered just how weak the finances of several of his businesses were. In particular, the fraudulent misappropriation of the UK’s Mirror Group Newspapers pension scheme was revealed. The Maxwell businesses entered bankruptcy in 1992.
BCCI (1991) – Briefly one of the largest private banks in the world, BCCI was seemingly designed to fall through regulatory cracks, with its main holding companies in Luxembourg and the Cayman Islands, and a web of other business operations run out of Geneva, Kuwait and Cayman. There were long-running concerns about the business – BCCI was barred from buying a US bank, but it did so in 1982 through middlemen. Eventually the regulators moved in and closed the bank down in 1991, thereby revealing the extent to which it had been used to launder money for drug smugglers and terrorists, as well as lending recklessly to legal businesses.
Enron (2001) – A US electricity utility turned energy trading business, Enron used a range of off- balance sheet vehicles and other aggressive accounting techniques to appear hugely profitable, even on projects that had barely begun.
The CFO was given permission to sidestep the company’s code of conduct in order to create and run some of the related party organisations used to take losses off Enron’s balance sheet. Its collapse also led to the dismantling of its auditor Arthur Andersen, which split apart rapidly after some of its staff in Houston were discovered to have shredded documents linked to Enron and the US Securities and Exchange Commission’s (SEC) investigation.
HIH (2001) – This Australian insurer collapsed before ever revealing the scale of its multi-million dollar losses for the six months to the end of 2000. Having grown rapidly, insured aggressively and under-reserved, the business had insufficient assets to cover its liabilities – the deficit was estimated to be up to AU$5.3bn (£2.7bn)
Tyco International (2002) – When losses mounted from unsuccessful deals by this aggressive Bermuda-incorporated acquisition vehicle, questions were raised about the behaviour of CEO Dennis Kozlowski.
Allegations centred on inflated profits, but also about ill-gotten earnings by senior management. In the end, the trial of Kozlowski and of CFO Mark Swartz centred on payments of US$150 million (£115m), which they claimed the board had authorised as their remuneration. They were convicted, but the suggested level of actual theft is believed to have exceeded US$500m (£384m).
WorldCom (2002) – The internal audit function of this US telecoms business uncovered its use of one of the simplest accounting deceits – booking current expenses as capital investment, boosting profits by some US$3.8bn (£2.9bn).
A subsequent investigation concluded that, in total, assets were exaggerated by US$11bn (£8.5bn). The fraud was undertaken to hide falling growth in a more challenging market.
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 (£3.1bn) in cash and equivalents on the company’s reported balance sheet turned out to be imaginary.
Satyam (2009) – The founder and chair admitted to falsifying the accounts of this India-based IT services company. For around five years, the company had inflated revenues using thousands of false invoices; the auditor had apparently failed to check the bank statements that might
have uncovered the fraud.
The entire board was removed by regulators, the chair was jailed and following a lengthy regulatory procedure, the company’s auditor, PwC, was banned in 2018 from auditing any Indian public company for two years.
Olympus (2011/12) – Following his appointment, new CEO Michael Woodford rapidly became concerned about the profitability of Olympus.
He was ousted but acted as a whistle-blower and slowly it emerged that the camera maker had hidden losses for many years, principally through the medium of over-priced acquisitions where some of the excess fees paid were returned to the company to shore up its finances.
Volkswagen (2015) – Volkswagen was revealed to have cheated US emissions tests on its diesel engines through software, so-called ‘defeat devices’. Though, on the face of it, this was not a governance scandal, many investors had long been concerned at the lack of accountability at the company, where the voting shares were predominantly held by the founding families, the local government and the government of Qatar. These groups similarly dominated the board, leading to an insular and unaccountable culture.
SHAREHOLDER ENGAGEMENT
AND
MINORITY SHAREHOLDER ALIGNMENT
Sharehoder engagement is the active dialogue between companies and their investors, with the latter expressing clear views about areas of concern (which often include ESG matters).
Engagement helps ensure that the board directors remember that they are accountable for their actions.
For minority shareholders – which institutional investors will almost always be – a crucial issue is that they are not exploited by the dominant or controlling shareholders.
In many cases, protections for minorities are built into company law, and they often exist in listing rules and other formal protections.
These are often bolstered in corporate governance codes, but the issues are so fundamental (because they relate to avoiding exploitation of minorities and protection of their ownership rights) that in most countries they benefit from underlying legal protections.
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 of 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.
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 countries’ company laws (excluding though, for example, USA) 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’.
As rights issues are cumbersome, particularly
if a company is issuing a relatively small number of shares, companies often seek authority at AGMs to issue
a relatively small proportion of shares (up to 5% or 10%) non-pre-emptively, i.e. without having to offer
them fairly to existing shareholders.
Investors are usually prepared to grant such authority but with certain protections in place.
Larger issuances are more controversial, as are issues possibly at a price less than the prevailing share price.
An example of a particularly unpopular model with defenders of minority shareholder rights are the ‘general mandate’ resolutions in Hong Kong, which seek to enable issuance of up to
20% of the share capital, potentially at a discount.
