Chapter 5: Governance Factors Flashcards
What is Governance? Why does it matter?
Corporate governance is the process by which a company is managed and overseen.
Governance is about people and processes. Good governance also involves developing an appropriate culture that will underpin the delivery of strong business performance without excessive risk-taking and through appropriate conduct of business operations. Good corporate governance should lead to strong business performance and long-term prosperity to the benefit of shareholders and the company’s other stakeholders. The corporate culture needs to be supportive of that long-term business success in the interests of all stakeholders.
Corporate governance is about people (the individuals in the boardroom), in order to exercise
their responsibilities effectively, those board members are supported by processes.
Companies will typically have policies and codes of conduct in place, but they will rely on processes to be confident that those policies are indeed delivered in practice. Investors will judge a company’s governance based on the quality of its policies and processes and on the diligence and care with which the board oversees their
implementation. Most fundamentally, they will judge governance by the quality and thoughtfulness of the people on the board.
In practice, corporate governance comes down to two ‘A’s: accountability and alignment.
Accountability of the board
People need to be:
▶ given authority and responsibility for decision-making; and
▶ held accountable for the consequences of their decisions and the effectiveness of the work they deliver.
Board will be most effective when its non-executive members feel accountable to shareholders for effective delivery. Therefore, corporate governance has a strong focus on board structure and the independence of directors.
The mixed skillsets of directors are also important, so that discussions and debate are appropriately
informed from a range of perspectives and the risk of “group-think” is avoided. Increasing diversity and the range of perspectives in the boardroom, through gender diversity, but also diversity in terms of professional backgrounds and experiences, has been demonstrated to deliver a more challenging culture that is more likely to enhance long-term value.
The role of the chair of the board is vital in facilitating a balanced debate in the boardroom. Consequently, many investors prefer that the chair is an independent non-executive director. If the chair is not independent, and especially if that individual combines the role of chair with the role of CEO, this can lead to an excessive concentration of powers and hamper the board’s ability to:
▶ exercise their oversight responsibilities;
▶ challenge and debate performance and strategic plans;
▶ set the agenda, both for board meetings and for the company as a whole;
▶ influence succession planning; and
▶ debate executive remuneration.
Chain of accountability and circle of accountability
Flow of accountability:
Workforce > Management > Corporate board > Fund manager > Asset owner > Beneficiaries
Many of the largest asset owners are
either pension funds or insurance companies,
whose beneficiaries are ordinary individuals.
Some commentators note that these same individuals are workers, leading to a more satisfying (though not always accurate) circle of accountability.
Alignment and the agency problem
Alignment comes down to the challenge of the agency problem.
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.
First, it will usually be difficult to discern a single message from the shareholder base of most companies, which will include multiple investors.
Furthermore, there can be agency problems within the investment chain itself as a disconnect can develop between the interests of fund management firms and individual portfolio managers, and those of their clients and/or ultimate beneficiaries.
Nonetheless, the challenge of the agency problem is a risk of some divergence between the interests of shareholders on the one hand, and company directors and management on the other. Corporate governance attempts to ensure that there is greater alignment in the interests of the agents with the owners through incentives, but also through appropriate chains of accountability, to mitigate the potential negative consequences of the agency problem.
Alignment and executive pay
With regard to alignment, the major focus in terms of executive pay is always on addressing the agency problem and helping to ensure that executives are not subject to incentives to perform in their own interests and contrary to the interests of the owners. Thus, executive pay structures aim to align the interests of management with those of the owners, usually by creating a balanced compensation package that includes performance-related remuneration based on long-term goals and that vests over a long-term period. The goals ideally include a mix of key performance indicators (KPIs) related to business and share price performance.
Often, a significant portion of the incentives come with some form of equity linkage – though this can on occasions make risk management more focused on share prices than on the performance of the business itself.
Accountability: board committees
The three key committees of the board, usually required by corporate governance codes, are established to respond to each of the key challenges discussed above (Accountability and the board, Accountability and accounts, and Alignment and executive pay). These committees are:
- The Nominations Committee (in some markets, this is called the Corporate Governance Committee, or some combination of these terms) aims to ensure that the board overall is balanced and effective, ensuring that management is accountable.
- The Audit Committee oversees financial reporting and the audit, delivering accountability in the accounts. The audit committee will also oversee internal audit, where this exists, and unless there is a separate risk committee will have responsibility for risk oversight also.
- The Remuneration Committee (in some markets, this is called the Compensation Committee) seeks to deliver a proper alignment through executive pay.
Corporate Governance Codes
The world’s 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.
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.
The committee’s core theme is that no individual should have ’unfettered powers of decision‘; so, for example, the roles of chair and CEO should not be combined, as they frequently were at the time.
A codified set of guidelines for good governance has grown from the basic concepts of accountability and alignment. 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).
Development of the governance standards
The Greenbury report: 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).
Sarbanes-Oxley Act 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.
2010 Dodd-Frank Act in the USA: tightened standards for, and oversight of, banks.
Shareholder engagement and minority shareholder alignment
Shareholder 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 are accountable for their actions, which hopefully in time helps to improve the quality of their decision-making.
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.
Another key area for shareholder protection is pre-emption rights. These rights ensure that an investor has the ability to maintain its position in the company. Fundamental in many markets’ company laws (excluding USA, for example) is that a company should not issue shares without giving existing shareholders the right to buy a sufficient amount in order to maintain their existing shareholding. Because these rights come before
potential external investors, they are called pre-emptive, and the existence of these rights is why a large equity fundraising by companies is often called a ‘rights issue’.
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. Even where issues are not on a fully pre-emptive basis there is usually an expectation that the larger institutional shareholders will be offered so-called ‘soft pre-emption’, meaning an allocation equivalent to their existing shareholding but in a less formal, legalistic way (that may enable the issuance to be made more swiftly). Larger issuances are more controversial, as are issues possibly at a price less than the prevailing share price.
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 (and those issued freely as compensation to staff, particularly in the case of US technology businesses). 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.
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.
5 themes of the Corporate Governance Code in the UK (2018)
It includes 18 principles under five themes:
▶ board leadership and company purpose;
▶ division of responsibilities;
▶ composition, succession and evaluation;
▶ audit, risk and internal control; and
▶ remuneration.
These themes are consistent across most of the world’s corporate governance codes, as are (largely) the expectations and duties of the three principal board committees that almost all major companies have in place:
▶ the audit committee (sometimes the audit and risk committee);
▶ the nominations committee (sometimes the corporate governance committee or some combination of the two); and
▶ the remuneration committee (or the compensation committee in the USA. Some companies also now
incorporate some reflection of a responsibility to the broader employee base in the name).
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).
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. While this is a UK document which is explicitly aimed at assisting boards, the themes are useful to investors
when considering the effectiveness of governance globally.
The ICGN’s Global Governance Principles
The ICGN’s Global Governance Principles set out an unusually complete investor perspective on independence criteria; these extend and elucidate some of the criteria embedded in standards in various Codes around the world. These suggest that there will be questions about the independence of an individual who:
▶ had been an executive at the company, a subsidiary or an adviser to the company, and there was not an appropriate gap between their employment and joining the board;
▶ receives, or has received, incentive pay from the company, or receives fees additional to directors’ fees;
▶ has close family ties with any of the company’s advisers, directors or senior management;
▶ holds cross-directorships or has significant links with other directors through involvement in other companies or bodies;
▶ is a significant shareholder in the company, or is an officer of, or otherwise associated with a significant shareholder, or is a nominee or formal representative of a shareholder or the state; and
▶ has been a director of the company for a long enough period that independence may have become
compromised.
The intent is not to suggest that boards should never include directors whose independence is questioned.
Indeed, such individuals may provide useful skills and perspectives. However, every board needs a sufficient weight of clearly independent individuals such that it is able to operate independently and is not subject to bias or inappropriate influence.
Investors recognise that independence is a state of mind, and that some individuals can be fully independent notwithstanding some of the issues raised while others, whatever their appearance of independence, will only ever support a CEO or dominant shareholder. One of the challenges for
investors is being able to identify both these sorts of individual.
Ethical approach to business will encompass issues such as:
▶ corporate culture and having a set of expected behavioural standards for all staff, not tolerating inappropriate behaviours;
▶ treating employees fairly, by upholding 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.
Usually, the audit committee is asked to oversee business ethics as part of its broader risk remit, but different companies address these issues through different structures. A company with a robust ethical approach and culture will have robust whistle-blowing procedures in place which are well-publicised to staff and to which all employees (and perhaps others, such as contractors and suppliers) have access. 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.
