chapter 5 Flashcards
Definition of Corporate Governance
Corporate governance refers to the system by which companies are directed, controlled, and held accountable. It encompasses the rules, practices, and processes that govern corporate behavior, ensuring that the interests of shareholders and other stakeholders are protected.
Key Concepts
Governance involves a range of
elements, including the roles and responsibilities of the board of directors, the rights of shareholders, the duties of management, and the integrity of financial reporting.
Significance in ESG Investing
Effective corporate governance is a cornerstone of sustainable business practices and long-term financial performance. It is critical for maintaining investor confidence, mitigating risks, and ensuring that companies act in the best interests of their stakeholders.
Key Concepts - Accountability
Board of Directors’ Role: The board of directors is responsible for overseeing management and ensuring that company actions align with shareholder interests. They are accountable to shareholders and must act with integrity and transparency.
CEO and Management Oversight: The board holds the CEO and senior management accountable for the execution of corporate strategy, operational performance, and compliance with legal and ethical standards.
Examples of Accountability Mechanisms: Annual general meetings, shareholder voting rights, and performance evaluations of senior executives are key mechanisms that reinforce accountability within the corporate structure.
Key Concepts - Alignment of Interests
Agency Problem: The agency problem arises when there is a conflict of interest between management (agents) and shareholders (principals). Effective governance seeks to align the interests of these parties to ensure that management acts in the best interests of shareholders.
Incentive Structures: Executive remuneration packages, including stock options and performance-based bonuses, are designed to align
management’s incentives with the long-term goals of the company and
its shareholders.
Corporate Examples: Companies like Berkshire Hathaway and Apple have
successfully aligned management interests with shareholder value
through long-term incentive plans and equity ownership by executives.
Development of Governance Frameworks
Historical Context: Corporate failures and scandals, such as Enron and WorldCom, have highlighted the need for robust governance frameworks to prevent mismanagement and protect stakeholders.
Cadbury Code: Established in the UK in 1992, the Cadbury Code was the first formal corporate governance code, setting the standard for practices like board independence, separation of CEO and chair roles, and transparent financial reporting.
Global Adoption and Variations
Comply or Explain (UK): Companies are required to either comply with
governance codes or explain why they have not, providing flexibility while promoting high standards. Apply or Explain (Netherlands): Similar to the UK’s approach, this model emphasizes the application of governance principles, with companies expected to explain any deviations.
If Not, Why Not? (Australia): This approach encourages companies to adopt best practices while allowing them to deviate if they provide a clear rationale.
Key Components of Governance Codes
Board Composition: Ensuring a balance of independent and non executive directors.
Shareholder Rights: Protecting minority shareholders and ensuring equitable treatment.
Transparency and Reporting: Mandating regular and comprehensive disclosure of financial and operational performance. Formalized Governance Frameworks and Codes
Board Structure
Diversity and Independence: A diverse and independent board is better equipped to challenge management and provide a broad perspective on strategic decisions. Independence ensures that directors can act in the best interests of shareholders without undue influence from management.
Board Composition: Effective boards include a mix of executive, non-
executive, and independent directors, with the latter playing a critical role in
oversight and governance.
Board Committees: Specialized committees, such as audit, remuneration, and nomination committees, are essential for addressing specific governance issues and ensuring detailed oversight.
Executive Remuneration
Alignment with Performance: Executive remuneration should be closely tied to the company’s long term performance, with a significant portion of compensation based on achieving specific financial and non financial targets.
Components of Remuneration Packages: Typical executive pay structures include base salary, annual bonuses, long-term incentives (e.g., stock options, performance shares), and benefits. These components should be structured to incentivize sustainable growth and discourage excessive risk-taking.
Case Study: The controversy surrounding executive pay at companies like BP and Tesco highlights the importance of transparency and shareholder approval in remuneration practices. Board Structure and Executive Remuneration
Key Governance Characteristics - Transparency in Reporting
Financial Disclosure: Transparent financial reporting is essential for
building investor trust and ensuring that stakeholders have access to
accurate and timely information about the company’s performance and risks.
ESG Reporting: Increasingly, companies are expected to disclose their ESG performance, including environmental impact, social contributions, and governance practices. This transparency helps investors assess the long-term sustainability of the business.
Integrated Reporting: The trend towards integrated reporting combines financial and ESG data, providing a holistic view of the company’s value creation and risk management strategies.
Key Governance Characteristics - Capital Allocation
Strategic Decision-Making: Effective capital allocation involves making
strategic decisions on how to deploy financial resources to maximize long-
term value for shareholders. This includes investments in innovation,
infrastructure, and sustainability initiatives.
Shareholder Returns: Balancing reinvestment in the business with returns to shareholders through dividends and share buybacks is a critical aspect of governance. Companies must consider the long term implications of their capital allocation decisions on growth and sustainability.
Examples: Companies like Microsoft and Alphabet have been praised for their capital allocation strategies, which balance innovation and shareholder returns.
Key Governance Characteristics - Business Ethics
Ethical Business Practices: Upholding high ethical standards is crucial for maintaining the company’s reputation and
stakeholder trust. This includes anti-corruption measures, fair labor practices, and responsible sourcing.
Corporate Social Responsibility (CSR): Businesses are increasingly expected to demonstrate their commitment to ethical
practices through CSR initiatives that address social and environmental issues.
Case Example: The fall of companies like Wells Fargo due to unethical practices underscores the importance of a
strong ethical foundation in governance.
Governance Structures Across Major Markets - Two-Tier vs Single-Tier Boards
Two-Tier Boards (Germany, Netherlands): In countries like Germany and the Netherlands, the governance structure is divided into two separate boards: the Management Board (responsible for day-to-day operations) and the Supervisory Board (responsible for oversight and strategic direction). This separation is designed to enhance checks and balances.
Single-Tier Boards (UK, USA, Japan): In single-tier systems, the board of directors includes both executive and non-executive directors, with a focus on collective decision-making and oversight.
Governance Structures Across Major Markets - Key Market Differences (Germany)
Co-Determination: German companies often include employee representatives on their supervisory boards, a practice known as co-determination, which enhances workforce engagement but can complicate decision-making.
Case Study: Volkswagen’s governance structure, which includes significant input from employee representatives and state shareholders, played a role in the company’s handling of the emissions scandal.
Governance Structures Across Major Markets - Key Market Differences (USA)
State-Specific Corporate Laws: In the USA, corporate governance is heavily influenced by state laws, particularly those of Delaware, which offers flexible rules that are attractive to many corporations.
Lack of Unified Governance Code: Unlike in Europe, the USA does not have a single corporate governance code, leading to variations in practices across companies.
Shareholder Activism: The rise of shareholder activism in the USA, exemplified by cases like Carl Icahn’s involvement with Apple, demonstrates the growing influence of shareholders on
corporate governance.
Governance Structures Across Major Markets - Key Market Differences (France)
Joint Auditors and Double Voting Rights: French companies often appoint joint auditors and may offer double voting rights to long-term shareholders, practices designed to enhance oversight and encourage long-term investment.
Example: The governance structure at companies like L’Oréal and Renault reflects these unique practices.
Governance Structures Across Major Markets - Key Market Differences (Japan)
Cultural Influences and Reforms: Japan’s governance practices are influenced by cultural factors such as consensus-driven decision-making and long-term employment. Recent reforms, including the introduction of independent directors, aim to improve transparency and shareholder engagement.
Case Study: The Olympus scandal highlighted the need for stronger governance reforms in Japan, leading to changes in board structure and oversight practices
Governance Structures Across Major Markets - Key Market Differences (Australia)
If Not, Why Not? Approach: Australia’s governance framework allows companies flexibility in their governance practices, requiring them to explain any deviations from recommended guidelines.
Influence of Superannuation Funds: Australia’s large pension funds, or superannuation funds, play a significant role in corporate governance, often advocating for strong ESG practices
Governance Structures Across Major Markets - Key Market Differences (Netherlands and Sweden)
Role of Major Shareholders: In these countries, major shareholders often have significant influence over governance decisions, including the appointment of directors and the approval of strategic initiatives.
Nomination Committees: In Sweden, nomination committees typically include representatives of the largest shareholders, ensuring that board appointments align with shareholder interests.
Evolution of the Audit Function
Historical Context: The modern audit function has evolved over time,
becoming a critical component of corporate governance. It provides an
independent assessment of a company’s financial health and compliance with accounting standards.
Importance of Independence: Auditor independence is crucial for ensuring
that financial statements are free from bias and accurately reflect the
company’s financial position. This independence is safeguarded by rules that limit the provision of non-audit services by the auditing firm.
Audit Practices
Financial Statement Review: Auditors review a company’s financial statements to ensure that they are prepared in accordance with generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS).
Sustainability Reporting: Increasingly, auditors are also tasked with reviewing sustainability reports, providing assurance that the company’s ESG disclosures are accurate and reliable. Enhanced
Auditor Reports: Enhanced auditor reports, which include key audit matters and additional insights into the audit process, provide greater transparency and help investors understand the company’s financial risks and governance practices.
Case Study: The collapse of Enron and the role of Arthur Andersen in the scandal led to significant changes in audit practices, including the passage of the Sarbanes-Oxley Act, which strengthened auditor independence and established the Public Company Accounting Oversight Board (PCAOB)
Governance in Investment Decision-Making - material Impact of Governance
Risk Assessment: Poor corporate governance can lead to financial mismanagement, legal penalties, and reputational damage, all of which can negatively impact investment returns. Conversely, strong governance practices can enhance risk management and contribute to long term value creation.
Case Examples: The downfall of companies like Lehman Brothers and Theranos illustrates how governance failures can lead to catastrophic losses for investors.
Governance in Investment Decision-Making - Investment and Stewardship
Active Ownership: Investors increasingly play an active role in corporate governance through engagement and voting, influencing decisions on executive pay, board appointments, and ESG practices.
Proxy Voting: Institutional investors use their voting rights to push for better governance practices, such as separating the roles of CEO and chair, or requiring more independent directors on the board.
Stewardship Codes: In many markets, stewardship codes encourage investors to actively engage with the companies they invest in to promote long-term value creation and sustainable practices.
