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
What is included in the reviewing financial statements and annual reports? What about the first half of the report?
- Auditor checks and assures the financial statement in detail
- Their role in relation to words and number in the more discursive first half of the report in less stringent
○ Auditors must read and should comment/report
if they discovery inconsistency
○ Comments are usually not visible to
shareholders - Outcomes of audit are largely invisible to shareholders
- New enhanced audit reports give greater insight
What is the issue with the Independence of audit firms and conflict of interest?
- Large audit firms typically offer non-audit services to companies they audit
- Investors should check how much audit forms get paid for non-audit and audit
- EU has regulated
○ List of non-audit services
○ Monetary limit on overall value - Behavioural independence - tendency of people to seek consensus, avoid disagreement and conflict
What is part of business ethics?
- Ethical approach will include
○ Whistle-blowing
○ Behavioural standard
○ High standard of health and safety
○ Avoiding collusion and other anti-competitive
behaviour
○ Paying suppliers and not seeking to benefit from
unfair negotiating position
○ Developing appropiate relationship with local
communities
○ No lobbying against legisation
○ Pay fair amount of tax, no tax avoidance - Acknowledging that company’s reputation is a valuable asset
What can be said about Financial integrity and capital allocation?
- Key concern shareholders and investors have about a company’s strategy is capital allocation
- Importantly, the crucial decision for the board is to allocate capital between different businesses and make the most of opportunities
- Capital structure is crucial area - companies without debt on their balance sheet are considered inefficient and failing to drive returns
- But financial crises should risk of excessive debt to generate greater revenue and return on equity - risk of insolvency in downturn
- Sustainable capital structure means that there is a compromise between extremes of maximizing returns on equity in the short term and making company long-term resilient to downturn
Who should lead Reporting and transparency ?
- Fair, balanced and understandable
- 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 comes from the auditor
What are Alternative Performance Metrics ?
- Investors can learn about weaknesses in management through Alternative Performance Metrics (APM)
Measures that are adjusted or underlying
What is a red flag that indicates poor governance?
- Another red flag that management that is trying to conceal stuff is when numbers from annual report do not tally with the numbers revealed in the financial accounts in the back half of the report
What is the agency problem?
The misalignment between the managers and the owner
- inevitable consequence of the separation of ownership & control
- arises when interest of managers may not be wholly aligned with interests of the owners of the business
What were keys of Japan’s first governance code?
Japanese Corporate Governance Code
- Discourages maintenance of cross-shareholdings and requires increasing independence on Japanese boards through having at least one independent non-executive director
- Increasing independence on Japanese boards, requiring at least one independent non-executive to be in place on every obard, even where statutory auditor model is still in use
In absense of country-wide governance standards in US, what are some attempts to establish market-led best practices?
1) The Commonsense Corporate Governance Principles
2) The Investor Stewardship Group’s (ISG) Corporate Governance Principles for US Listed Companies
3) The Corporate Governance Policies of the Council of Institutional Investors (CII)
In combination, (1) and (2) represent a corporate governance code as it would be understood elsewhere in the world
What are some challenges that auditors face?
- Due to their sampling approach, they tend to review material issues only (for large companies, this can be as high as $500M
- Depth of sampling is highly dependent on auditor’s assessment of the quality of the company’s own systems and financial controls
- Auditing is a sampling process trying to identify anomalies that can then be followed up
** NOTE **
Regulators have intervened to remove the most obvious conflicts of interest, which has led to a significant decline in recnet years of the scope for auditors to provide non-audit services to audit clients (so this is not an issue anymore)
According to Friede, Busch, and Bassen’s 2015 meta study on ESG and financial performance, which ESG factor has the strongest correlation to financial performance?
GOVERNANCE
- 62% of studies they reviewed showed a positive correlation between governance and corporate financial performance
- 58% of environmental studies and 55% of social studies showed same correlation
Concept of audit in terms of providing certain levels of assurance
Auditors are important as they provide an independent set of eyes assessing financial reports and provide SOME assurance that those reports fiarly represent the performance and position of the business.
There’s no absolute assurance that the numbers are correc,t nor is there certainty that there is no fraud within the business.
What are the three key board committees found at a company board?
1) The Nominations Committee
2) The Audit Commitee
3) The Remuneration Commitee
(NRA)
They serve to address key challenges:
Accountability and the board –> Nominations
Accountability and accounts –> Audit
Alignment and executive pay –> Remuneration
Which countries most likely have a single executive on the board whom bears responsibility of both CEO and Chair?
USA and France; single-tier
Which country has company boards dominated by executive directors?
Japan; single-tier board?
What distinguishes UK’s board of directors model?
Moderate… single-tier
Which countries have two-tier board structure?
Germany & Netherlands
Two-tier boards with wholly non-executive supervisory boards overseeing management boards
What is auditor’s role relating to financial statements and the rest of the annual report and accounts?
- Checks and assures the financial statements in detail
- Comments if they discover something that is inconsistent with what they have learned through the process of the audit (especially with inconsistencies with numbering in the financial reporting)
What are key elements of disclosure in new enhanced auditor’s reports?
1) Scope of the audit
2) Materiality
3) Key audit matters
What were the issues with Theranos scandal wrt their board?
Non-executive directors in board were exclusively male, mostly with military or foreign services backgrounds rather than medical or scientific experience, average age of 73.
There were more former secretaries of state in their 90s on the board than people with medical training
None had expertise with regards to blood testing (not even basics)
What stemmed from Enron, Tyco, WorldCom scandals?
Sarbanes-Oxley Act (2002)
- Lifted expectations for greater integrity in financial reporting
- Public Company Accounting Oversight Board (PCAOB) was set as country’s audit standard setter and inspector
- Established standard for auditor independence and challenge
What is the maximum period audit firm can remain in role of auditor of EU public company?
20 years
Concentration of audit market makes it difficult to addres sissues of auditor independence and effectiveness
Auditors must tender audit after 10 yrs
What did Carter, Simpkins, and Simpson’s 2003 study of Forbes 1000 firms find?
Positive relationships between presence of women or minorities on board and firm value (as measured by Tobin’s Q)
How does importance of corporate governance change with public vs private company?
Governance is equally an issue of importance
Companies with poor governance risk destroying value or atl east adding less value that their potential
Governance efforts in Europe accelerated after two major scandals in 2003; what were these scandals?
Ahold and Parmalat (2003)
Ahold - Netherlands
Parmalat - Italy
Led to pressure for heightened standards of corporate governance and both board and auditor independence across Europe
UK was inspirated by which scandal to develop its first stewardship code?
2008 financial crisis and The Walker review
recent Kingman and Brydon reviews in wake of Carillion’s failure..
What was the name of the first governance code?
Cadbury
- Emerged in the UK in 1992
The Cadbury Commitee was brought together in May 1991 by Financial Reporting Council, the London Stock Exchange, and the accounting profession to consider what were called ‘the financial aspects of corporate governance’
Created followed the Caparo and Polly Peck scandals..
Maxwell/Mirror Group scandal also concurrent with publication
How can analyst incorporate governance rating into company risk profile?
Raise the discount rate applied within model to reflect additional risk
What is a challenge related to world of big data & auditing?
Lots of data and methods leveraging different technologies..
Challenge to assessing every transaction is spotting anomalies among barrage of data, not simply checking that the numbers add up
Importance of the role of Chair of company board?
Important to be independent
Sets agenda for board meetings and for company as a whole
Influences succession planning
Debates executive remuneration
If Chair and CEO role are combined, this can lead to excessive concentration of powers and hamper board’s ability to exercise oversight responsibilities
Types of diversity to seek in board?
Thought
Gender
Race
Age
Culture
Nationality
Experience
What’s one issue impacting auditor conflict of interests?
How much an audit firm is being paid for its audit work vs consultancy work.
Independence of an audit firm is critical
Large audit firms (including Big Four) typically offer non-audit services (Consulting work & Tax advice, principally) to companies that they audit, despite obvious risks raised from conflictsof interest
Investors often assess potential conflicts of interest by loking at how much an audit firm is being paid for its audit work vs its consultancy work and whether company has a policy to limit this risk, though this is not the only sign of conflicts
What are the types of issues investors will address when considering a company’s governance?
- 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
- Dual-class share structures
Where was Comply or Explain coined?
Cadbury Code
- Corporate Governance Code emerging from UK in 1992 which addressed the financial aspects of corporate governance
Internal vs External audit
Internal audit is simply a risk-management role. Doesn’t add much weight and is not relevant in context of external audit (relevant)
What are the main Corporate Governance limitations by having a joint Chair and CEO?
Excessive concentration of powers and hampers 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
- Debate executive remuneration
What models have identified best practices of Corporate Governance?
ICGN Principles & OECD Principles
Which country does not currently have a corporate governance code?
USA
