Chap 5 Governance Flashcards

1
Q

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.

A

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.

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2
Q

The types of issues that investors will address when considering a company’s governance include, but are not limited to:

A

▶ 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.

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3
Q

WHAT IS GOVERNANCE? WHY DOES IT MATTER?

Laws, Culture, Performance.

A

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.

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4
Q

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.

A

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.

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5
Q

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.

A

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.

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6
Q

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.

A

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.

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7
Q

Accountability

People need to be:

A

▶ Given authority and responsibility for decision-making;

and

▶ Held accountable for the consequences of their decisions and the effectiveness of the work they deliver.

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8
Q

**Accountability and the board

A

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.

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9
Q

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.

A

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.

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10
Q

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:

A

▶exercise their oversight responsibilities;

▶challenge and debate performance and strategic plans;

▶set the agenda;

▶influence succession planning;
and

▶debate executive remuneration.

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11
Q

Accountability and accounts

A

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.

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12
Q

Alignment and the agency problem

A

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.

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13
Q

Alignment and executive pay

A

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.

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14
Q

The three key committees of the board,

usually required by corporate governance codes,

are established to respond to each of these key challenges.

A
  1. 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.

  1. The **Audit Committee oversees financial reporting and the audit, delivering accountability in the accounts.
  2. The Remuneration Committee (in some markets, this is called the Compensation Committee)

**seeks to deliver a proper alignment through executive pay.

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15
Q

2

THE DEVELOPMENT OF A FORMALISED GOVERNANCE APPROACH

A

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.

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16
Q

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.

A

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.

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17
Q

Corporate Governance Codes

A

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.

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18
Q

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.

A

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.

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19
Q

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

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).

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20
Q

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.

A

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.

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21
Q

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:

A

▶ 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.

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22
Q

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)

A

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.

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23
Q

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.

A

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).

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24
Q

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’.

A

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.

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25
Q

A final area in which minority shareholders can feel exploited is through the mechanism of dual class shares.

Typically, one of the classes is restricted to the founders of a company (or a limited group chosen early in a company’s life) who receive multiple votes when compared to the class of shares that subsequent shareholders can invest in, the ones that are typically more freely traded on the stock market.

It is also the case that, management, which typically directly benefits from multiple voting rights and often voting control, will feel less accountable to the broader shareholder base, with whose interests they are less aligned.

A

Dual class shares are often frowned upon by many investors, and are rare outside the USA.

They are, however, becoming more visible and more common because of the current success of technology businesses, the founders of which have been keen to retain voting control.

The Council for Institutional Investors, the main organisation for US institutions, has taken a subtle stance on dual class stock, recognising that it can be useful to have some stability in the early life of companies, but urging it to be subject to sunset clauses so that the dual classes are unified after at most seven years (which is the time horizon after which academic evidence suggests that dual class stock will usually have a negative performance impact).

Controversially, Snap Inc. (the parent company of Snapchat) took the dual class stock route further and issued shares without any voting rights at all; indeed, given that the company indicated that there was little likelihood of a dividend, the instruments sold were actually more like warrants than shares.

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26
Q

4

KEY CHARACTERISTICS

A

Assess key characteristics of effective corporate governance,

and the main reasons why they may
not be implemented or upheld:

board structure,
diversity,
effectiveness and
independence;

executive remuneration,
performance metrics and KPIs;

reporting and transparency;

financial integrity and capital allocation;

business ethics.

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27
Q

The current iteration of the

Corporate Governance Code

in the UK was published in 2018.

It includes 18 principles under five themes:

A

▶ board leadership and company purpose;

▶ division of responsibilities;

▶ composition, succession and evaluation;

▶ audit, risk and internal control; and

▶ remuneration.

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28
Q

The Code sets out the expectations and duties

of the three principal board committees that almost all major companies have in place:

A

▶ the audit committee;

▶ nominations committee; and

▶ remuneration committee.

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29
Q

The expectation is that the audit and remuneration committees will be populated solely by independent non-executive directors

while such directors should form a majority of the nominations committee (the chair should not lead this committee while it is seeking to appoint their successor).

Some companies will establish further board committees, either to address ad hoc issues or on an ongoing basis, but should use appropriate judgment in how those committees should best be populated.

A

For example, most financial services businesses now have a separate risk committee, which is usually made up of independent non-executive directors.

Where there is no separate risk committee, the oversight of risk issues falls under the audit committee’s* scope.

The Code also determines appropriate disclosures to make the workings of the board transparent and to demonstrate their effectiveness to shareholders.

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30
Q

Guide to Board Effectiveness.

A

Published alongside the new Code was a

*Guide to Board Effectiveness.

This applies the same structure as the Code, under the same five themes.

It not only provides guidance, but also questions to assist board members when considering whether they are being fully effective in their roles.

The guide also provides questions that board members might choose to ask management to gain additional clarity on corporate culture.

Almost half of the main body of this guide is taken up with the first theme, board leadership and company purpose – essentially, this focuses on culture, strategy and maintaining appropriate relationships with key stakeholders.

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31
Q

Board structure, diversity, effectiveness and independence

A

As governance at its core is about people, the key to exercising effective governance is having the right people with relevant skills and experience around the boardroom table,

as well as having the right board culture to enable each of them to contribute effectively to boardroom debate.

This is easily summarised but difficult to deliver.

As can be seen from the case study sample of BHP’s annual report disclosure on its board skills and diversity, there are multiple skills that boards try to address, often many more than the number of individual directors.

If an issue is of high importance to the business, the usual expectation is that more than one person should have knowledge of the issue.

This is because a board will rarely feel comfortable relying on a single perspective, particularly as that single individual may not always be available.

Compromises need to be made, and plans need to be considered for the future to prepare for expected departures from the board – and to respond to unexpected changes (such as death or conflicts of interest).

As well as training for directors, boards must always consider the need for refreshment as skills
have a half-life and will decrease over time.

The needs of the board will also change over time as its strategy evolves, and it is important to keep the skills matrix updated.

The issue of director tenure and independence is discussed below.

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32
Q

There are many types of diversity needed for a board to be successful, though the most important is
diversity of thought.

The other types include diversity of ***gender, race, age, culture, nationality and experience, which can also often help to deliver diversity of thought.

The aim is to avoid groupthink in the boardroom, which may lead to a lack of questioning and challenge.

A

It is important for the chair to be effective in bringing out the contributions of each board member.

This is less visible to investors but is a **vital part of delivering board effectiveness.

Investors can understand how the chair operates within the boardroom from direct dialogue with the individual and with other board members, but often the clearest indicator is the quality of the individuals on the board overall.

Good directors do not tend to join boards which do not allow them to contribute effectively, or if they do, they are quick to leave them.

The unfortunate consequence of this for those who invest broadly is that poor boards remain weak and it is difficult to improve them without broad changes.

Board appraisals*, which are required under many corporate governance codes, help boards to become more effective by bringing problems to the surface.

These are valuable, though investors are often cynical about them as weaker boards and weaker chairs can relatively easily limit their impact,

***without this being apparent to investors.

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33
Q

CASE STUDY

BHP annual report disclosures on board skills and diversity.

A

Total Directors: 11

Mining
3 Senior Executive who have:

▶ deep operating or technical mining experience with a large company operating in
multiple countries;
▶ successfully optimised and led a suite of large, global, complex operating assets that
have delivered consistent and sustaining levels of high performance (related to cost,
returns and throughput);
▶ successfully led exploration projects with proven results and performance;
▶ delivered large capital projects that have been successful in terms of performance
and returns; and
▶ a proven record in terms of health, safety and environmental performance and results.

Oil and gas
2 Senior Executive who have:
▶ deep technical and operational oil and gas experience with a large company
operating in multiple countries;
▶ successfully led production operations that have delivered consistent and
sustaining levels of high performance (related to cost, returns and throughput);
▶ successfully led exploration projects with proven results and performance;
▶ delivered large capital projects that have been successful in terms of performance
and returns; and
▶ a proven record in terms of health, safety and environmental performance and
results.

Global experience
7 have Global experience working in multiple geographies over an extended period of time, including a deep understanding of and experience with global markets, and the macro-political and economic environment.

Strategy
9 have Experience in enterprise-wide strategy development and implementation in industries with long cycles, and developing and leading business transformation strategies.

Risk
11 have Experience and deep understanding of systemic risk and monitoring risk management frameworks and controls, and the ability to identify key emerging and existing risks to the organisation.

Commodity value chain expertise
6 have End-to-end value or commodity chain experience – understanding of consumers, marketing demand drivers (including specific geographic markets) and other aspects of commodity chain development.

Financial expertise
11 have Extensive relevant experience in financial regulation and the capability to evaluate financial statements and understand key financial drivers of the business, bringing a deep understanding of corporate finance, internal financial controls and experience probing the adequacy of financial and risk controls.

Health, safety, environmental and community
7 have Extensive experience with complex workplace health, safety, environmental and community risks and frameworks.

Technology
2 have Recent experience and expertise with the development, selection and implementation of leading and business transforming technology and innovation, and responding to digital disruption.

Capital allocation and cost efficiency
7 have Extensive direct experience gained through a senior executive role in capital allocation discipline, cost efficiency and cash flow, with proven long-term performance.

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34
Q

Board independence is also a key concern.

A

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).

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35
Q

ICGN’s Global Governance Principles

A

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.

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36
Q

ICGN

A

International Corporate Governance Network

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37
Q

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.

A

The issue of the length of tenure on the board and independence is one generally recognised around the world, 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.

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38
Q

Executive remuneration

A

Pay is where the clearest conflict of interest between management and the shareholders occurs.

As (in public companies at least) it is not possible for investors to negotiate pay directly with management…

… shareholders need to rely on remuneration committees to do so effectively on their behalf,

… and need to have confidence that the non-executive directors on those committees…

…will do this well and with shareholder interests in mind.

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39
Q

There is a broader challenge with this, though:

The directors’ obligation is to the success of the individual company, while shareholders in most cases have an eye to the broader market.

A

Therefore, while shareholders may be more concerned about a ratcheting effect of increased pay across the market as a whole …

… (often driven by companies seeking to respond to pay benchmarks and remain competitive in terms of remuneration)…

… directors will have the need to ensure the best possible candidate is appointed to their company in mind…

…which may tempt them to pay up for the benefit. Often, many of the arguments about executive pay arise directly from this difference between the mindsets of the board and the shareholders.

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40
Q

While pay levels differ in different markets, the structure of the pay for top executives is broadly similar.

In brief, executive pay structures in the UK and much of the world come in four categories:

A

▶ fixed salary, usually increased annually;

▶ benefits, including pension (typically calculated as a percentage of the salary, often at a more generous rate
than is enjoyed by the wider employee base);

▶ annual bonus; and

▶ share-linked incentive (usually in the form of a long-term incentive plan (LTIP)).

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41
Q

While the scale of fixed salaries, and the way in which they increase (often ahead of inflation in general
wages), can be controversial, most attention focuses on the variable incentives, the bonus and equity-linked portions.

Bonuses are typically calculated based on annual performance, against metrics set at the start of a year, and paid in cash at the end of the year – though increasingly some of this is deferred for a further two or three years, often into shares that are only released at the end of the deferral period.

A

The metrics for bonuses will predominantly be financial metrics (usually profit-related) but will often include around 20% that is attributable to personal performance or non-financial measures including ESG factors.

The longer-term equity rewards usually measure performance over at least three years and are typically paid out in shares which must be held for a further period (currently the minimum overall period, including the performance period and lock-up thereafter, is five or more years).

Performance for these schemes is usually measured by broad brush financial measures, usually a combination of total shareholder return (TSR) and earnings per share (EPS).

While this may sound complex, it is a significant simplification, as can be seen by the multiple pages of an annual report that a remuneration report now tends to represent.

42
Q

Trust, or a lack of it, has driven much of the problem with executive reward.

This has developed because of failures of understanding between investors who see ongoing payments for failure and corporations that find shareholders voting against schemes that they have supported for some years or have previously given indications that they will support.

A

Companies are faced with various views from investors, many of which are incompatible and so strongly held that they allow little flexibility.

The fear of significant votes against a board’s remuneration proposals leads many companies to produce a form of compromised structure, rather than something which the directors fully believe will drive value in the business.

This can lead to a further escalation of quantum (meaning the amount paid to executives, aggregated across all forms of remuneration)

because the compromise structures mean executives doubt that they can have full confidence that they can deliver what is needed to unlock the full reward –

the higher quantum leads to media and investor attention, and tension will escalate.

43
Q

Investors tend to see whether the pay outcomes match the corporate performance that they enjoy as shareholders…

…and are unlikely to oppose even the most generous packages when share price performance is strong.

A

Companies tend to consider performance within the business itself (seeing the share price as a function of market sentiment as much as business performance)

and directors believe that they need to respond to contractual obligations, paying out according to the terms of the agreed incentives.

….This can sometimes lead to a disconnect in expectations because the reward that is due under the contracted incentives may feel undue to shareholders because it does not reflect the market performance of the shares.

44
Q

Overcoming these differing perspectives is necessary, but as yet no proposed alternative structures have gained sufficient traction among both investors and companies to become the solution to the problem.

A

OK!

45
Q

Discussions about executive pay are also complicated by concerns about fairness, and the extent to which executive pay outcomes far exceed the experience of ordinary people.

This is exemplified by the pay ratio disclosures now mandated by some markets (notably the UK and USA).

A

These compare the remuneration of the CEO with the firm’s average worker, and reveal very sizeable differences, often hundreds to one.

While investors will often have sympathy for companies that are keen to have the best leadership, the growing tensions about income and wealth disparity make the question of fairness exemplified by pay ratios make this an issue that is increasingly hard to ignore.

46
Q

Reporting and transparency

A

Principle N of the 2018 Corporate Governance Code states:

“The board should present a fair, balanced and understandable assessment of the company’s position and prospects”.

47
Q

The starting responsibility for the oversight of company reporting sits with the audit committee, but as the principle indicates this is a whole board responsibility.

A

The phrase ‘fair, balanced and understandable’ was delivered after considerable debate and has led many companies to undertake a rigorous restructuring of their processes and reporting.

Reporting and transparency is led first by the management team, and then overseen by the audit committee and the board as a whole.

Independent challenge then comes from the auditor.

48
Q

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).

A

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 actually 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 from the annual report do not entirely tally with the numbers revealed in the financial accounts in the back half of the report.

49
Q

Audit Committee and Auditor

A

A strong audit committee should strictly oversee the reporting process and ensure that these sorts of discrepancies do not occur. A strong and challenging auditor, assisted by regulations, should also intervene to limit any misleading of investors.

50
Q

The European Securities and Markets Authority (ESMA) published a set of guidelines on the use of APMs in 2015.

A

These require consistency, with the APMs not to be disclosed more prominently than the official measures and a full reconciliation between the two, though enforcement of these standards is variable.

51
Q

IASB
IFRS

Exposure Draft on Primary Financial Statements

A

In a similar way, in December 2019 the International Accounting Standards Board (IASB), via its IFRS Foundation, published an Exposure Draft on Primary Financial Statements, which would allow the disclosure of a management-preferred measure of performance on the face of the income statement but alongside the permitted standard measures and with full reconciliation between them.

It remains to be seen what the final outcome of this consultation will be, and how effectively companies will respond to any new standard.

52
Q

Financial integrity and Capital Allocation

A

The key concern active shareholders usually have about a company’s strategy is **capital allocation.

Generally, this is a function of history: a company retains a legacy business operation, even a sizeable operating business, when the opportunity for the company as a whole has in fact moved on.

Shareholders can be more open- minded about disposing of older businesses or operations than management – often because they do not understand the full complexities that would be involved in fully moving on from the legacy activity.

53
Q

Even where the issue is not a historic legacy, most companies have opportunities where a number of businesses may diverge.

Conglomerates are now firmly out of favour and most investors prefer to invest in focused businesses – with the ability to diversify across their portfolios.

A

The crucial decision for the boards of such companies is how they allocate capital between the different businesses and make the most of those opportunities.

Even where there is not an active investor pressing for a different approach to capital allocation, the board may need to have active dialogue with the shareholder base because decisions about which business opportunity to pursue will appeal to different investors.

54
Q

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.

A

Companies without debt on their balance sheets are often thought to be inefficient and failing to drive the full extent of possible returns;

however, the financial crisis 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.

55
Q

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.

A

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.

56
Q

Decisions regarding share buybacks and the issuance of shares are key elements of these…

overall capital structure decisions and should be considered as these by both boards and shareholders.

Similarly, considerations with regard to the payment dividends to shareholders need to encompass decisions about what is a sustainable level of capital to support ongoing business success.

A

Paying dividends beyond the cash flow from the business is clearly not sustainable on an ongoing basis and is likely to raise significant questions among shareholders even while they may welcome the immediate cash payments.

But the opposite circumstance, of a low dividend pay-out ratio, is also likely to cause concerns, especially if the company already has significant cash on its balance sheet.

This latter circumstance has proved central to disagreements between several Japanese companies and their shareholders over recent years.

57
Q

Business ethics

A

A company needs to abide by the laws of its home country (formally known as its country of incorporation),

and a group must act within the laws of any country in which it operates.

In some respects, such as bribery and corruption, many jurisdictions impose extraterritorial laws, meaning that a company can be guilty of an offence wherever in the world it may be involved in corruption.

For example, both the US’s Foreign Corrupt Practices Act and the UK’s Bribery Act have extraterritorial effect; the UK Act also explicitly requires companies to maintain procedures to ensure that no bribery is carried out by agents or others on its behalf.

58
Q

Many companies, particularly those based in legalistic environments, tend to believe that obedience to the law is sufficient.

However, many investors expect more than this, and companies aspiring to be responsible world citizens and enjoy ownership on the public markets are likely to need to go further.

The companies need to operate whilst being conscious of business ethics and broader responsibilities to stakeholders and communities.

A

By doing so, they are more likely to prosper in the long-term, not least as a failure to deliver on these ethical aims may lead to a breakdown in relations with one or more key stakeholders.

At its extreme, an ethical failure might lead to a loss of licence to operate in a market or as a business as a whole.

59
Q

An ethical approach to business will encompass such issues as:

A

▶ corporate culture and having a set of expected behavioural standards for all staff, not tolerating inappropriate behaviours;

▶ treating employees fairly, by holding high standards in health and safety, human rights and avoiding modern slavery;

▶ offering value to customers and avoiding discriminatory or other exploitative behaviour, including avoiding collusion with rivals or other anti-competitive activity;

▶ avoiding bribery and corruption, and fraudulent behaviour;

▶ paying suppliers appropriately and promptly, and not seeking unfair benefit from any dominant negotiating
position;

▶ developing appropriate relationships with local communities close to relevant business operations, and being ready to enter into dialogue on any key concerns they may have;

▶ approaching any regulatory or political lobbying activity honestly (including ensuring that the lobbying is not inconsistent with the company’s publicly stated approach to particular issues) and without seeking unfair advantage;

▶ seeking to pay a fair and appropriate level of tax by approaching tax compliantly and recognising that tax avoidance, not just evasion, can be inappropriate; and

▶ acknowledging that a company’s reputation is a valuable asset which can be harmed by unethical or inappropriate behaviour by the business or its staff.

60
Q

A company with a robust ethical approach and culture will have well-publicised whistle-blowing procedures in place to which all employees (and perhaps others, such as suppliers) have access.

A

These procedures will allow any concerned party to raise issues with people of appropriate seniority and independence, so that any apparent failure to live up to the asserted ethical standards can be identified and addressed promptly if need be.

Typically, these whistle-blowing processes will be overseen by the audit committee (and sometimes by the risk committee or other appropriate board-level group)

so that non-executive directors can assure themselves of the independence of the process and that the company is living up to the standards that the board expects.

61
Q

5 STRUCTURAL DIFFERENCES

A

Assess and contrast the main models of corporate governance in major markets and the main variables influencing best practice: markets: Germany, Japan, the Netherlands, Scandinavia, the UK and the USA; extent of variation of best practice; differences in legislation, culture and interpretation.

62
Q

The division between the supervisory board and the management board marks one of the fundamental structural differences in governance globally, between these so-called two-tier board structures seen, for example, in Germany, the Netherlands, Scandinavia and (at least formally) China, and the single-tier (also called unitary) boards that are more typical of the UK, the USA, Japan, France and most of the rest of the world.

A

But this structural difference covers other differences, as for example, there are multiple forms of the single-tier board:

▶ In the USA and France, a single executive sits on the board and often bears the responsibility of both chair and CEO.

▶ In Japan, there is usually a single-tier board dominated by executive directors with only one, or a small handful of, non-executive directors (not necessarily independent).

▶ In most other countries, single-tier boards have a few executive directors and a majority of non-executives (most of whom are independent), one of whom acts as chair.

63
Q

By contrast, supervisory boards are largely consistent, with all members being non-executives; although in some cases, they are not independent, as there may be direct representatives of major shareholders, and in some cases the chair of the supervisory board is the former CEO of the company.

A

No one model of corporate governance is better than the others.

They are creatures of the legal histories and cultures of the countries in question.

Best practices have been identified and incorporated in global initiatives such as the ICGN Principles and the Organisation for Economic Co-operation and Development (OECD) Principles.

64
Q

In the same vein, investors will often expect companies to adopt international best practices and go beyond local standards contained in country-specific codes.

A

The OECD’s Corporate Governance Factbook is a good source for detail on the governance structures and approaches in jurisdictions. Inevitably, the following brief survey covers a much smaller set of geographies.

65
Q

Corporate governance in Germany

A

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 from the workforce.

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 held more for formality’s sake.

66
Q

It is intended for the strategy to be developed by the supervisory board and management board working together, though the management board is usually expected to initiate the thought process.

A

Principally, the role of the supervisory board is to hold the management board to account, though all major transactions (according to the German code, the ***Kodex, these “include decisions or measures that fundamentally change the company’s net assets, financial status or results of operations”) need the supervisory board’s approval.

The supervisory board structure thus keeps shareholders one step further from holding management to account.

67
Q

The most controversial term of the Kodex is in Principle 7:

“The Supervisory Board Chair should be available – within reasonable limits – to discuss Supervisory Board-related issues with investors”.

A

This phrase was opposed by a number of leading supervisory board chairs, and in contrast to many countries it can, in practice, be difficult for shareholders to meet with the chair (and all but impossible to meet with any other members of the supervisory board).

This challenge of access is slowly improving, but investors do rely on the goodwill of the individual chair.

68
Q

Corporate governance in Japan

A

Many companies in Japan (and also in Taiwan and South Korea) enjoy the structure of having statutory auditors, which are in addition to the independent audit firm that assures the accounts.

There is typically a small odd number of statutory auditors (usually three or five), each of whom is appointed individually by shareholders, typically on a three-year rotation.

In theory, these are independent individuals, but in many cases, this independence may be questionable as many come from family companies or the lending banks, which can have a close relationship with large companies.

Increasing numbers of companies in Japan have decided to have a ‘board with committees’, which is more similar to a board with non-executive directors and committees, and removes the need for statutory auditors.

Although the Zaibatsuii conglomerates that dominated the Japanese economy for decades were officially dismantled after 1945, the culture of family groups of companies held together by cross-shareholdings persisted.

There was a perception that these cross-shareholdings acted as dead weights on fresh strategic thinking and innovation.

It is for this reason that the Japanese Corporate Governance Code, introduced for the first time in 2015 and revised in mid-2018, includes provisions that discourage the maintenance of cross- shareholdings (there is a specific principle, 1.4, discussing cross-shareholdings and in effect, requiring the disclosure of a policy to reduce them over time).

The other main focus in the code is increasing independence on Japanese boards, requiring at least one independent non-executive to be in place on every board, even where the statutory auditor model is still in use.

69
Q

Corporate governance in the Netherlands

A

The 2017 contested takeover bid for Dutch chemicals firm AkzoNobel from US rival PPG put corporate governance in the Netherlands firmly in the spotlight.

While in most countries the bid – certainly the revised terms offered by PPG after its initial, and second approaches were rebuffed – and the strong support for discussions from significant shareholders would have led to active negotiations, AkzoNobel never came
to the negotiating table. Instead, the Dutch firm successfully argued that the board owed duties as strong
to stakeholders, particularly employees, as it did to shareholders, and argued that the value offered to shareholders was unattractive (though the shareholders themselves largely and often publicly disagreed) and the protections for staff were insufficient.

70
Q

AkzoNobel declined to hold an extraordinary general meeting (EGM) proposed by several shareholders that would have considered ousting the supervisory board chair Antony Burgmans.

A

A May 2017 court decision by the Enterprise Chamber backed the board’s understanding of Dutch corporate governance, including both its basis for not entering into discussions on a deal despite investor support and its decision not to hold the proposed EGM.

Burgmans finally departed from the board ahead of the 2018 AGM. In effect the court decision backed the board’s stance on the bids, and the company also benefited from significant political support – further takeover protections for all Dutch companies have since been proposed.

In the end, the company sold off its speciality chemicals business, focusing on paints and coatings, and returned the bulk of the proceeds to shareholders.

71
Q

As with other countries with supervisory board structures, the shareholders appoint the supervisory board in the Netherlands and are kept at a distance from holding management accountable for performance and strategy. The AkzoNobel case demonstrates that shareholders do not necessarily come first in the Dutch corporate governance model, and that stakeholder interests must be taken into account.

A

That is particularly true in the case of takeovers, which have long been a sensitive issue in the country and remain so long after the dismantling of most of the Stichting structures which were able to keep shareholders at arm’s length if there was a hostile bid, securing the role of management and the supervisory board.

But the AkzoNobel case also shows that other than in the case of a takeover, the influence of shareholders is strong: the outcome of the disputes was board change and a significant streamlining of the company and return of value to shareholders.

72
Q

Corporate governance in Sweden

Governance in Sweden has been shaped by the dominance of major shareholders in the registers of many leading companies.

Most prominent of these is the Wallenberg family vehicle, Investor AB. Investor AB is itself a public company but controlled by the Wallenberg’s through the mechanism of dual classes of shares with differential voting rights – a feature of Swedish governance, which persists at many businesses despite its controversial nature.

Investor AB’s ownership of other Swedish companies includes among others:

A

▶ Atlas Copco (16.9% of the shares, 22.3% of the votes);
▶ ABB (11.5% of the shares and votes);
▶ AstraZeneca (3.9% of the shares and votes);
▶ SEB (20.8% of the shares and votes);
▶ Ericsson (7.2% of the shares, 22.5% of the votes); and
▶ Electrolux (16.4% of the shares, 28.4% of the votes).

73
Q

Investor AB argues that its investments, and its voting influence, enable it to avoid short-term pressures and build these businesses for the long-term.

This dominance of the share capital, and particularly of the votes, could lead to Investor AB being able to appoint the bulk of corporate boards in Sweden and having even more disproportionate influence than it already does.

To mitigate this, Sweden has developed an unusual structure whereby the nomination committee at companies is not in fact a committee of the board, but is instead appointed from among the shareholders –

with the largest shareholders invited to participate in the order of their shareholding until the committee is fully populated.

A

This nominations committee proposes to the AGM a board (which may include no more than a single executive and should be in the majority independent non-executive directors) and a chair
of the board for shareholder approval.

The outcome of this is reasonably positive: skilled and generally well- balanced boards.

The Wallenberg family still appears in many Swedish boardrooms, frequently providing the chair. In contrast to most countries, the proposed board is usually put forward as a single slate, meaning that shareholders have a vote on the board as a whole rather than votes on each individual proposed director.

Similar structures and approaches can be found in other Scandinavian markets.

74
Q

Corporate governance in the USA

The USA stands out in terms of governance.

Now that Japan has introduced its own Corporate Governance Code, the USA is the only major market – and almost the sole country – not to have a code of its own.

The reason is a fundamental issue of US politics, the relationship between the federal government and the individual states.

Corporate law is a matter for the states, and so there is no scope for a federal set of rules to govern corporations.

A

Indeed, the fact that each state has its own corporate law led to a race to the bottom for company standards between the states, competing with each other for the tax revenue from incorporating businesses.

This race was comprehensively won by the small state of Delaware which is now home to more than half of all publicly traded corporations in the USA. The decisions of the Delaware courts are therefore of disproportionate importance to US corporate life.

75
Q

In the absence of countrywide US governance standards, there have been various attempts to establish market- led best practices.

The leading among these are:

A
  1. The Commonsense Corporate Governance Principles, first published in July 2016 and revised in October 2018.

These were created by a coalition of company representatives, including the leadership of Berkshire Hathaway, BlackRock, General Electric, General Motors, JPMorgan Chase and Verizon Communications, along with representatives of the largest US investors.

These principles focus mostly on the inner workings of corporate governance, board effectiveness and accountability, and also alignment through pay.

  1. The Investor Stewardship Group’s (ISG) Corporate Governance Principles for US Listed Companies, which went into effect at the start of 2018.

As the name suggests, these were created by a coalition of investors (a number of them in common with those involved in creating the Commonsense Corporate Governance Principles).

They are also more about the relationship of US companies with their shareholders rather than about their internal governance.

The ISG has also produced a set of Stewardship Principles, in effect the reciprocal responsibilities of investors in response to these corporate responsibilities.

  1. The Corporate Governance Policies of the Council of Institutional Investors (CII).

These set out in detail the approach of the CII – the pre-eminent representative of long-term investors in the USA – on the full range of corporate governance issues.

These are less a set of principles and more an indication of the likely positions of CII members on issues that might go to a shareholder vote or be subject to public policy debate.

In combination, the first two initiatives represent a corporate governance code as it would be understood elsewhere in the world.

76
Q

With reference to governance, what is regulated on a federal level in the USA is securities law: hence, the importance of the US Securities and Exchange Commission (SEC), and the rules it sets.

For example, the SEC sets requirements for the independence and skills of members of the audit committees of companies listed in the USA.

These standards were set by the Sarbanes-Oxley Act.

Typically, the USA creates rules in statute that reflect pre-existing expectations set down as principles in other markets.

A

There are two examples under the Dodd-Frank legislation:

  1. The so-called ‘say on pay’ vote approves executive remuneration, to be put to shareholders at least every third year.
  2. The ‘access to the proxy’ standard permits shareholders that fulfil certain criteria to add a candidate to the company’s formal proxy statement, avoiding the cost and administrative complexity of mounting a full proxy fight over board membership.
77
Q

6

WHY AUDIT MATTERS AND WHAT MATTERS IN THE AUDIT

A

Explain the role of auditors in relation to corporate governance and the challenges in effective delivery of the audit:

independence of audit firms and conflicts of interest;

auditor rotation;

sampling of audit work and technological disruption;

auditor reports;

auditor liability;

internal audit.

78
Q

The modern concept of the auditor evolved from the financial scandals of another era.

The industrial revolution (from circa 1760 to 1840) saw for the first time the creation of multiple large-scale corporations that sought to raise capital from outside parties.

Those providers of finance insisted that management account for their use of this capital at least annually, leading to requirements for both annual reports and accounts and an AGM.

The failures and downright frauds of the UK’s 1840s railway boom (an early investment bubble) saw minority shareholders suffer significant losses.

An audit of the accounts was therefore required, by an independent party, providing the shareholders with assurance that the numbers they were presented with were true and fair.

A

The concept of the audit has not changed: the auditor is there to provide an independent pair of eyes assessing the financial reports prepared by management, and to provide some assurance that those reports fairly represent the performance and position of the business.

There is no absolute assurance that the numbers
are correct, nor is there certainty that there is no fraud within the business.

Auditing is a sampling process trying to identify anomalies that can then be followed up.

According to the 1896 UK Court of Appeal judgment re Kingston Cotton Mill (No 2) – following another corporate failure, this time when the auditor had taken a management assertion on inventory at face value – auditors should be watchdogs, not bloodhounds.

There has been an ongoing debate following every corporate failure since, both as to whether the watchdogs were asleep on the job, and also as to whether we ought to expect a little more bloodhound-like –

or perhaps, to use a more modern metaphor, sniffer dog-like – behaviour.

79
Q

Reviewing financial statements and annual reports

A

The auditor checks and assures the financial statements in detail; their role in relation to the words and numbers in the more discursive front half of the annual report is less stringent.

The auditor must read this segment and should comment if they discover something that is inconsistent with what they have learned through the process of the audit.

Any such comments are typically not visible to the shareholder because they will usually be addressed and changes made before the annual report is published – as will any significant issues the auditor identifies in the financial statements.

This means that the outcomes of the audit are largely invisible to shareholders – although the new enhanced auditor reports give more insight into the process.

80
Q

The independence of audit firms and conflicts of interest

The independence of the audit firm is critical.

Large audit companies typically offer non-audit services (consulting work and tax advice, principally) to the companies that they audit, despite the obvious risks raised from conflicts of interest.

Auditors can build closer relationships with the management of their audit clients than they can with the non-executive directors for whom they are working.

Audit firm staff also sometimes move to work at companies that they have audited.

Investors should assess potential conflicts of interest by looking at how much an audit firm is being paid for its audit work versus its consultancy work and whether a company has a policy to limit this risk.

A

Regulators have intervened to remove the most obvious conflicts of interest, which has led to a significant decline in recent years of the scope for auditors to provide non-audit services to audit clients.

This can be seen with the EU: for example, providing not only a list of non-audit services that are the only ones an audit firm may provide to audit clients, but also by placing a monetary limit (calculated in relation to the audit fee) on their overall value.

The UK’s Competition and Markets Authority has also proposed much more separation between the audit and non-audit arms of the accountancy firms so that audit is much less likely to be influenced by other concerns.

81
Q

Another important question surrounds behavioural independence.

There is a natural tendency for individuals to seek consensus, and for people to want to avoid disagreement or even confrontation with those with whom they spend time.

A

These natural human behaviours run counter to the very role of the auditor, which must be to question and to challenge the information that the audited entity provides.

Every member of the audit team must work to avoid succumbing to such tendencies, and the audit partner overseeing the whole process needs to ensure that scepticism has been maintained throughout.

In practice, it is not always easy for investors to be confident that this has been done.

82
Q

Auditor rotation

A

The concentration of the audit market makes it more difficult to address the issues of auditor independence and effectiveness.

In the EU, public companies are obliged to change auditors after 20 years at most (and to tender the audit after 10 years).

With the incumbent barred from competing after 20 years, and the other audit firms sometimes being unwilling to give up valuable non-audit services contracts, there is a sub-optimal level of competition.

Even in markets where audit firm rotation is not practised, the international auditors’ ethical standards require a rotation of the audit partner at least every seven years.

Increasing numbers of investors are setting their own time-limits for the length of audit tenure that they are prepared to see continue (the USA is the market with particularly long-serving auditors – for example, Deloitte and its predecessors have been auditing Procter & Gamble since 1890).

Lengthy tenures put further strain on the auditor’s need to maintain behavioural independence – after all, even the most effective and independent audit partner will not want to admit to his or her partners that it is they who have lost an audit contract that the firm has held say for more than 50 years.

Hence regulators, and investors, are likely to need to play roles in constraining auditor tenure.

83
Q

Sampling and audit work

The sampling process that underlies audit work has been mentioned previously, however technological and
AI developments may see this change.

Significant effort should go into assessing what is an appropriate level of sampling to gain a good insight into the accuracy of the underlying numbers, and also into assessing the output of that sampling.

On occasions though, it seems that the budget for the audit does more to determine the work undertaken rather than the activity being driven by the need for clarity of assurance.

The depth of sampling is highly dependent on the auditor’s assessment of the quality of the company’s own systems and financial controls (see below the discussion of disclosures of performance materiality).

In this, the external auditor leans on the work of internal audit (the company’s own assessment process of risks and the quality of reporting, discussed below),

and well-run audit committees sensibly coordinate the work of internal and external audit so that they get an appropriate level of assurance across the company.

Sir Donald Brydon’s recent independent review into the quality and effectiveness of audit proposes that audit committees produce an annual audit and assurance plan which discloses the committee’s expectations for overall assurance of company reporting, including both internal and external audit, which should make this coordination more apparent and perhaps more effective.

Under Sir Donald’s proposals, shareholders would be invited to provide input into the development of this plan.

A

In theory at least, the world of big data is changing the sampling approach and the leading audit firms are exploring methods of using technology to consider every single transaction, rather than sampling a proportion of them.

A number of independent software firms have developed packages that deliver this, though these currently seem to be more focused on the small and mid-sized end of the corporate market rather than on larger businesses.

The challenge with any approach to assessing every transaction is then spotting anomalies among this barrage of data, and not just checking that the numbers add up.

The technology potentially removes the need to sample, not the need to intelligently consider the information that is delivered. This remains a work in progress.

84
Q

Enhanced auditor reports

Shareholders today have more insight than before into the work of auditors because of the new enhanced auditor reports.

Originated in the UK, these have now been adopted globally. These reports include three crucial elements:

A

▶ Scope of the audit – how many parts of the company the audit has covered and in what depth.

Typically, an audit will only apply full audit to the largest segments (usually geographies, but sometimes business segments), it will apply tailored audit procedures to others, and some may be ignored altogether.

▶ Materiality – the level of transaction or valuation below which the auditor spends little time.

For the biggest companies this can be a large number (US$500m (£384m) is not unusual).

Of more interest to investors are the levels of materiality applied to the different segments, and – where it is disclosed – the performance materiality number (the level below the materiality threshold that the auditor uses in practice in its audit procedures, to avoid problems arising when the numbers analysed are aggregated), as this indicates the extent to which the auditor trusts the company’s financial systems: 75% of the overall materiality threshold is typical, whereas anything around 50% to 60% suggests a low level of confidence in the financial controls.

Such lower levels of performance materiality might indicate a highly devolved organisation or one whose controls should perhaps be enhanced.

▶ Key audit matters – the handful of key areas of judgment in the accounts.

While the areas covered will rarely come as a surprise to investors, the way in which these issues are discussed and what the auditor chooses to highlight in their open discussion can reveal interesting and important insights.

The best auditor reports not only highlight the key areas of judgment, but indicate whether the company’s reporting on them is conservative, neutral or aggressive.

This so-called ‘graduated audit’ adds real value to investors’ understanding of the company’s reported performance.

85
Q

These enhanced auditor reports upgrade prior practice where the sole piece of insight was the auditor’s opinion on whether or not the financial statements represented a true and fair view of the company’s performance and position at the end of the financial year.

When an annual report was published, it would be quick work to find out if an auditor had given a negative opinion.

Auditors’ past unwillingness to provide much insight was driven by their fear of litigation in the case of a corporate failure.

A

Investors learned that auditor reports were not worth reading – a lesson that now needs to be unlearned.

Investors have much to learn from these enhanced auditor reports, if they can begin to navigate the tone and specialist language used in them (or if auditors could begin to make them more accessible to the general user).

These reports may be further enhanced if some of the proposals in the Brydon Review of audit are adopted –

indeed, Sir Donald Brydon in his independent review proposes that auditors should do a lot more to inform investors and the market as a whole.

He emphasises the importance of this role for auditors by using inform as one of the three words in the title of his final report, “assess, assure and inform”.

86
Q

Auditor liability

One reason that auditors give for not providing more than they are strictly required to in terms of the audit
or auditor reporting is liability. In most markets, the auditor has unlimited liability.

A

Indeed, the US SEC has established a rule that any company subject to its jurisdiction (this includes many foreign companies because they have US listings of either their equity or debt) may not in any way limit the liability of the auditor.

Even where audit firms enjoy the benefit of limited liability partnership status (meaning that all the partners are no longer exposed to risk because of a potential failure by one of their partners), the individuals who are directly responsible for any failure, and especially the audit partner themselves, can face losing everything.

This risk is seen as significant in part because auditors are often one of the few deep-pocketed players if and when there is a corporate failure, and so they are regularly included in lawsuits.

The extent to which the courts would attribute liability to the individuals and their firms though is less clear because most of these cases are settled before they come anywhere near to judgement.

Most of those settlements are private and so, it is unclear whether in practice the liability risk is as large as the profession tends to indicate.

87
Q

Internal audit

A

Internal audit should not be confused with external audit.

It can be outsourced, but most of the time, the internal audit function is part of the company itself, with a formal reporting line to the executive team (though usually with a dotted line to the Audit Committee). Its function is largely a risk management role, seeking to ensure that the company’s procedures and expected behaviours are delivered in practice.

88
Q

Internal audit has highly variable status in different businesses – and indeed, it does not exist at all in some organisations.

Where it is deployed most effectively, it is a tool for both the executive team and the non- executive directors to gain confidence and comfort about the delivery on the ground, helping the company operate more effectively and efficiently.

A

There is a step change taking place in internal audit, involving directing the work towards helping the board and senior managers protect their organisation’s assets, reputation and sustainability.

The Internal Audit Code of Practice recently issued by the Chartered Institute of Internal Auditors is, in effect, a pathfinder for the profession to help it deliver fully on this promised step change.

89
Q

7
IMPACT OF GOVERNANCE ON INVESTMENT OPPORTUNITIES
5.1.5

A

Assess material impacts of governance issues on potential investment opportunities, including the dangers of overlooking them: public finance initiatives; companies; infrastructure/private finance vehicles; societal impact.

90
Q

Of the three ESG factors,

governance is the element most often taken into consideration by traditional investment analysts.

CFA Institute’s 2017 ESG survey10 showed that 67% of global respondents take governance into consideration in their analysis and investment decision-making (up from 64% in 2014); ahead of environment and social factors (both on 54%).

In the EMEA region, the number of analysts indicating that they take governance into account was 74%.

The primacy of governance is logical. Academic research indicates that of the three ESG factors, governance has the clearest link to financial performance. Friede, Busch and Bassen’s 2015 meta study on ESG11 and financial performance notes that:

A

▶ 62% of the studies that they reviewed showed a positive correlation between governance and corporate financial performance; and

▶ 58% of environmental studies and 55% of social studies showed the same correlation.

91
Q

Similarly, in mid-2016, one UK investment manager estimated that companies with good or improving corporate governance had tended to outperform companies with poor or worsening governance by ***30 basis points per month on average in the prior seven years.

Environmental and social factors had also demonstrated their ability to guide investors towards better performing companies and away from poorly performing companies, but the dispersion in performance was about ***half as large. .15%

A

Good governance is fundamental to a company’s performance, both in terms of long-term shareholder value creation and the creation of broader prosperity for society and all stakeholders.

Failures can be devastating to shareholders and other capital providers.

The description of the board’s failings in the case of Enron (where the company’s market value fell from US$60bn (£46bn) in December 2000 to zero in October 2001) is bracing.

92
Q

The special investigation committee’s report reads:

A

“Oversight of the related-party transactions by Enron’s Board of Directors and Management failed for many reasons. As a threshold matter, in our opinion the very concept of related-party transactions of this magnitude with the CFO was flawed.

The Board put many controls in place, but the controls were not adequate, and they were not adequately implemented.

Some senior members of Management did not exercise sufficient oversight and did not respond adequately when issues arose that required
a vigorous response.

The Board assigned the Audit and Compliance Committee an expanded duty to review the transactions, but the Committee carried out the reviews only in a cursory way.

The Board of Directors was denied important information that might have led it to take action, but the Board also did not fully appreciate the significance of some of the specific information that came before it.

Enron’s outside auditors supposedly examined Enron’s internal controls but did not identify or bring to the Audit Committee’s attention the inadequacies in their implementation.

93
Q

Governance matters because the wrong people – or just not enough of the right people – around the boardroom table are less likely to make the best decisions and so may see significant value eroded, and a failure to address key risks, including environmental and social issues.

A

And if the interests of management and shareholders are

**not aligned, there is also a risk of **value erosion for stakeholders generally.

94
Q

Thus, companies with poor governance risk destroying value, or at least adding less value than they might have done.

These issues are as true of private companies as they are of public companies: governance, good or bad, is not the exclusive preserve of the public company and the exclusive concern of the public equity investor.

Governance is just as much an issue in ***private equity investments and infrastructure vehicles (including public finance initiatives), and value can be lost as easily.

A

While some will say that governance is less of an issue in private equity because **investors are directly represented on the board – and the same is typically true in many **infrastructure vehicles – this reduces the risk of misinformation and a lack of responsiveness, but does not in itself remove all governance risks.

Particularly, given the highly indebted nature of many such investments, the margin of error is not always great and so, ***failure can be swift if it does occur, often overwhelming even more responsive governance structures.

95
Q

Theranos Board
In 2014, as it was raising money from private market investors, Theranos, the company that claimed to be reinventing blood testing with exclusive technology, had the following board of directors:
▶ Elizabeth Holmes, 30 — founder, CEO and chair
▶ Sunny Balwani, 48 — president and COO, former software engineer
▶ Riley Bechtel, 62 — chair of the board of construction company Bechtel Group
▶ William Frist, 62 — heart and lung transplant surgeon and former US senator
▶ Henry Kissinger, 90 — former US secretary of state
▶ Richard Kovacevich, 70 — former CEO of Wells Fargo
▶ James Mattis, 63 — retired US Marine Corps general
▶ Sam Nunn, 75 — former US senator, chair of the Senate Armed Services Committee
▶ William Perry, 86 — former US secretary of defense
▶ Gary Roughead, 61 — retired US Navy admiral
▶ George Shultz, 93 — former US secretary of state

Thus, overseeing an innovative blood testing technology company was a board where the non- executive directors were exclusively male, mostly with military or foreign services backgrounds rather than medical or scientific experience, with an average age (less the executives) of 73. There were more former secretaries of state in their 90s on the board than people with medical training.

The degree of oversight offered by this board of the management and operations was always likely to be limited and its influence was further hindered by the operation of a dual share class structure that saw the founder hold 99% of the voting rights. In addition, it appears that the board met infrequently, and several directors had poor attendance rates. This suggests that the board was not operating as effectively as it might have been.

In the end, all of the US$700m (£538m) (and over) invested in the business was lost (together with its largely theoretical estimated US$10bn (£7.7bn) valuation) when it was revealed to have falsified test results and misled investors about the nature and effectiveness of its technology.

A

Case study

In retrospect, the Theranos board incorporates many red flag warning signals that something might have been amiss –

at the very least, the board could have been better designed to deliver effective oversight of an early-stage high-risk technology business with unproven leadership.

The red flags at other boards may be less obvious, but the two key questions that investors will always need to ask are:

  1. Is there the right mix of skills and experience, and enough of the right skills and experience, to properly oversee the next stage of development of this business? If there are obvious gaps, investors need to consider how those gaps might best be filled.
  2. Is there the right dynamic around the board table to enable the views of the appropriately skilled individuals on the board to be heard? This is about behaviours and so is inevitably harder to identify from outside; nonetheless, there are often indicators suggesting that the board dynamic is not as effective as it might be.
96
Q

Theranos is not the only ‘unicorn’ – a private company whose valuation is believed to be greater than US$1bn (£0.77bn) – to experience governance challenges impacting its estimated value.

Uber, the transportation network company, felt obliged to change its governance practices in the wake of a series of damaging scandals that were impacting its growth. The founder CEO’s responsibilities were reallocated, preferential voting rights were adjusted and the board’s independence was strengthened.

In 2019, WeWork was obliged to abandon its planned initial public offering (IPO), and its valuation plummeted from the intended capitalisation at listing when investors baulked at several governance issues, including the dominant decision-making position of the founding CEO and related party deals with the CEO.

While these governance issues were addressed in the latter stages of the process, they were enough to raise broader questions in investors’ minds, including the crucial ones about business model and the absence of a clear path to profitability.

A

Few governance failures are as extreme in their destruction of value as Theranos, and few boards are as lacking in diversity and the relevant skill set as the Theranos board was.

There is good evidence of the beneficial effect of diversity in academic literature.

Carter, Simpkins and Simpson’s 2003 study of Forbes 1,000 firms finds statistically significant positive relationships between the presence of women or minorities on the board and firm value, as measured by Tobin’s Q (a valuation measure based on the ratio between a company’s market value and the replacement cost of its assets).

Bernile, Bhagwat and Yonker’s 2017 study concludes that diversity in the board of directors reduces stock return volatility (consistent with diverse backgrounds working as a governance mechanism) and that firms with diverse boards tend to adopt policies that are more stable and persistent, consistent with the board decisions being less subject to idiosyncrasies.

In addition, while diverse boards take less financial risk, “this behaviour does not carry over onto real risk-taking activities”, with diverse boards investing more in research and development (R&D).

Overall, their study finds that greater heterogeneity among directors leads to higher profitability and firm valuations, on average.

Governance failings lead to fines and additional liabilities, as well as litigation and other costs.

Revenues also fall as trust is eroded and customers boycott the company or buy from competitors, and profits fall as additional cost burdens are placed to mitigate future risks.

All of these effects harm security values. Governance analysis should be a core component of valuation practice.

97
Q

INCORPORATING GOVERNANCE INTO INVESTMENT AND STEWARDSHIP PROCESSES
5.1.6

A

Apply material corporate governance factors to: financial modelling; ratio analysis; risk assessment; quality of management.

98
Q

Different fund managers integrate governance factors into their investment decision-making in different ways.

For many, it is a threshold assessment, a formal minimum criterion before they will consider making an investment at any price; often, it is talked about as quality of management, which despite the name is never simply an assessment of the CEO and CFO, but of the overall team and the governance structure by which they oversee the company and drive the success of the business.

For others, it (governance factors into their investment decision-making)

amounts to a ***risk assessment tool, which may be represented by the level of confidence about future earnings or the multiple on which those earnings are placed in a valuation – or may be reflected less in full financial models and more in a simple level of confidence in the valuation range or investment thesis.

A

If the analysis of corporate governance is specifically built into valuation models, this is most typically done through recognising ***negative governance characteristics by way of adding a risk premium to the cost of capital or raising the discount rate applied.

Others regard weak governance as an engagement and investment opportunity –

the logic being that governance can be improved through active dialogue with management and proxy voting such that past underperformance, on which the company is valued in the market currently, is reversed and the valuation can be enhanced by stronger performance and an expectation for more positive performance in future.

99
Q

Many governance issues lend themselves to stewardship dialogue with companies, not least because many of them will be directly addressed in corporate AGM agenda. Investors will then be obliged to take a view on them

(for many investors this is why governance has a lengthier heritage than environmental and social issues –

particularly as in many markets the obligation to consider voting decisions actively has been long-established).

In almost every market, investors will be faced annually with voting decisions on at least the following:

A

▶ accepting the report and accounts;
▶ board appointments;
▶ the appointment of the auditor and perhaps their fees; and
▶ executive remuneration.

Thus, there is a natural driver at least annually for engagement on these issues – though investors are increasingly keen to avoid the crunch of all such discussions occurring during the AGM season (largely April to June in the Northern hemisphere, July in Japan, and September to November in the Southern hemisphere) and so work to ensure the dialogue happens throughout the year, with the conclusions reached in the dialogue reflected in the voting.

100
Q

However, there is one asset class where the G of ESG will always have a very different meaning.

In the sovereign debt arena, G means the effectiveness of the governance and robustness of the state and its institutions, the approach to the rule of law and the general business environment (including such issues as competition and anti-corruption).

A

In effect, the concern is to gain assurance that the economy can prosper through good governance such that the sovereign debt obligations can continue to be covered.

ESG-minded investors are increasingly integrating the analysis of these issues into their broader financial analysis of sovereign credits.