Chapter 5: Governance Factors Flashcards
What is governance? And what do investors do to assess it?
- Corporate governance is the process by which a company is managed and overseen
- Board members are supported by processes to exercise their responsibilities effectively
- Investors will judge a company’s governance based on the quality of its policies and processes and the diligence and care with which the board oversees their implementation
What are the two key things that governance needs to ensure?
- Accountability
- Alignment
What is accountability?
- Gives authority and responsibility for decision-making
- Held accountable for consequences of decision making and effectiveness of it
What is the chain of accountability?
- Beneficiaries
- Asset owner
- Fund Manager
- Corporate Board
- Management
- Work Force
What are disadvantages of having the CEO as Chair of the Board?
- Hampers the boards’ ability to
○ Exercise oversight responsibilities
○ Challenge and debate performance and
strategic plans
○ Set the agenda
○ Influence succession planning
○ Debate renumeration - Investors prefer if the Chair is an independent non-executive director
What is alignment and what problems does it adress?
- Agency problems have been recognized as an inevitable consequence of separation of ownership and control
- The agency problem arises in that the interest of these professional managers (control) - the agents - may not always be aligned with the interests of the owners
- Corporate governance attempts to ensure that there is greater alignment through incentives and appropriate chains of accountability
What are the key committees of a Board?
- Nomination committee - aims to ensure that the board is balanced and effective, ensuring management is accountable
- Audit committee - oversees financial reporting and audit, delivering accountability
- Renumeration committee - seeks alignment through executive pay
What is the most common phrase when it comes to governance codes?
- “Comply or Explain”
What is the Cadbury Committee, why was is started and what did it suggest?
- Brought together in 1991 by Financial Reporting Council and London Stock Exchange
- Followed Caparo and Polly Peck scandals
- Proposed that every company should have an audit committee meeting at least twice a year
- Role of Chair and CEO should not be combined
Why do some companies think that governance codes are inflexible?
- Some companies consider governance codes as inflexible, because proxy advisory firms tend to adhere to governance codes when giving voting recommendations
- Inflexibility also arises from investors’ clients tendency to follow proxy recommendations with too little judgment if voting decision is right
What is shareholder engagement?
- Shareholder engagement is the active dialogue between companies and their investors
- Shareholders express their views and concerns
- Engagement helps the board of directors remember that they are accountable
What is minority shareholder exploitation and what can be done about it?
- Money could be syphoned off from the company in a way that benefits majority shareholders
- Explains why there are typically higher disclosure requirements around related party transactions and rights for non-conflicting shareholders approval
What are class tests?
- Minority shareholders need to approve large investment , if
- A Transaction affects more than FIVE 5% of a company’s assets, profits, value or capital
- If it affects more than TWENTY-FIVE 25% of shareholders
What are pre-exemption rights?
- Ensure that investors have ability to maintain position in a company
- Company should not issue shares without giving existing shareholders the right to buy a sufficient amount in order to maintain their existing shareholding
What are dual-class shares?
- Some shares have double voting rights
- Typically given to founders/management
- Can lead to less accountable management
What are the principles of the Principles UK Corporate Governance Code?
○ Board leadership and company purpose
○ Division of responsibility
○ Composition, succession, evaluation
○ Audit, risk and internal control
○ Remuneration
- Audit Committee - Only independent non-executive directors
- Nomination Committee
- Renumeration Committee - Only independent non-executive directors
What are key properties of the board structure, diversity, effectiveness and independence
- Diversity of thought, gender, race, culture, nationality and experience
- Chair needs to bring out the contribution of each board member -> vital for board effectiveness
- Clearest indicator for effective board is the quality of individual board members
- Board appraisals - required under many corporate governance codes - help board become more effective in bringing problems to light
- Board independence is a key concern
According to the ICGN’s Global Governance Principles what questions the independence of the board?
Provides criteria for investor perspective on independence..
Suggests that there will be questions about the independence of an individual who…
○ Individual has been executive at company, subsidiary or advisor and without gap
○ Individual receives, or has received, incentive pay from company, or addition directors’ fee
○ Individual has close family ties with company advisers, directors or senior management
○ Individual hold cross-directorships or has significant links with other directors
○ Individual is a significant shareholder in the company or associated with an significant shareholder
- Has been director of company for too long
What are challenges for shareholders when it comes to management remuneration?
- In a public company, Investors cannot directly negotiate pay with management
- Remuneration committee does that
- Challenge - Directors’ obligation is to the success of the individual company, while shareholders in most cases have an eye for the broader market
- Shareholders may be more concerned with a ratcheting effect of increased pay across market as a whole
- Arguments about executive pay arise from difference between mindset of board and shareholders
What is the executive pay structure?
- Fixed salary (usually increases annually) -
- Benefits (including pension, percentage of salary, more generous) -
- Annual bonus - Metrics will be predominantly financial metrics, but also includes ESG performance
- Share-linked incentives (often in form of long-term incentive plan) - pays out in shares, that need to be held for a certain amount of time, based on total shareholder return and earning per share
How can investors integrate governance into investment decisions?
- Investors integrate governance factors into their investment decision by
○ Threshold assessment
○ Risk assessment tool - Valuation models - adding a risk premium to the cost of capital or raising discount rate
What can investors influence through votes?
- Accepting the reports and accounts
- Board appointments
- Appointment of auditor and perhaps fees
- Executive remuneration
What is included in an enhanced audit report?
- SCOPE of the audit - how many parts of the company and in what depth
- MATERIALITY - The level of transaction or valuation below which the auditor spends little time - Investors should be interested in segments
- KEY AUDIT MATTERS - conservative, neutral or aggressive “graduated audits” adds value to investors understanding
How long till auditors have to change in the EU?
20 years, tender after 10 years
Why Audit Matters and What Matters in Audit?
- Auditor provides independent pair of eyes assessing the financial reports prepared by the management
- Provides assurance that those reports fairly represents the performance of the business
- There is no absolute assurance - Auditing is a sampling process
