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CFA ESG Investing > Chapter 5 - Governance Factors > Flashcards

Chapter 5 - Governance Factors Flashcards

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1
Q

Corporate Governance

A

Process and structure of overseeing the business and management of a company.

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2
Q

Key Points for Company’s Governance

(8 Points)

A
  • shareholder rights
  • success of intended company strategy, effectiveness of leadership to deliver it
  • executive pay
  • audit practices
  • board independence and expertise
  • transparency or accountability
  • related-party transactions
  • dual-class share structures
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3
Q

Accountability in Corporate Governance

(5 Points)

A

People need to be:
* given authority and responsibility to make decisions
* held accountable for consequences of decisions and effectiveness of work they deliver

Accountability of the accounts for financial and business performance of directors.

Diversified skill sets of directors to facilitate meaningful discussion and debate.

Engagement helps to ensure that board directors are accountable for actions.

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4
Q

Issues from combined Board Chair and CEO

(5 Issues)

A

Combined Board Chair and CEO hampers ability to:
* exercise their oversight responsibilities
* challenge and debate performance and strategic plans
* set the agenda, for both board meetings and company as a whole
* influence succession planning
* debate executive remuneration

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5
Q

Alignment in Corporate Governance

(7 Points)

A

Executive pay structure to align interest of management with interest of owners and avoid agency problem.

Agency Problem:
* professional managers (agents) may have different interest than the owners of the business (shareholders)
* through incentives and appropriate chains of accountability, corporate governance attempts alignment of interest between agents and owners

Alignment between Majority and Minority Shareholders:
* may demand additional disclosures or shareholder votes for major transactions by listed companies
* pre-emption rights - rights for existing shareholders to maintain position by buying new issued shares
* dual-class shares - multiple votes, usually for founders (common for technology businesses)

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6
Q

3 Key Board Committees

A
  • Nominations Committee: ensures that board is overall balanced, effective and management is accountable
  • Audit Committee: oversees financial reporting and audit to ensure accountability in accounts. Also oversees internal audits and risk (if no Risk Committee). Meet minimum twice a year.
  • Remuneration Committee: seeks to deliver proper alignment of interests through executive pay
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7
Q

Cadbury Report

(5 Points)

A
  • Issued by Cardbury Committee, which was formed in May 1991, after the Caparo and Polly Peck scandals
  • Issued in 1992 in UK
  • World’s first corporate governance code
  • Recommendations which companies should “Comply or Explain”
  • Many recommendations are still best practice today
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8
Q

Board Structures in different Countries

(2 Structures, 4 Points)

A

Two-Tier Boards:
* non-executive supervisory board overseeing management boards (e.g. Germany, Netherlands)

Single-Tier Boards:
* dominated by executive directors (e.g. Japan)
* combined CEO and Chair (e.g. USA, France)
* between above 2 models (e.g. UK)

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9
Q

Country with no official Corporate Governance Code

A

USA, due to coporate law being set at the individual states level.

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10
Q

“Comply or Explain”

A

Adherence to relevant standards or issuance of thoughtful and intelligent discussion how board deliver on underlying principle.

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11
Q

Greenbury Report

(3 Points)

A

(UK)
* following shocks around pay levels at newly privatized utilities
* revised UK Coporate Governance Code in 1995
* increased remuneration structure visibility, KPI-performance pay transparency and time horizons over which pay is released (min. 3 years for long-term schemes)

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12
Q

Sarbanes-Oxley Act

(3 Points)

A

(US)
* from 2002, following Enron, Tyco and WorldCom scandals
* lifted expectations for greater integrity in financial reporting
* created Public Company Accounting Oversight Board (PCAOB) as country’s audit standard setter and inspector

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13
Q

Impact of Ahold and Parmalat Failure

(3 Points)

A
  • 2003 in Europe
  • heightened standards of corporate governance
  • led to board and auditor independence across Europe
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14
Q

Impacts of 2008 Financial Crisis

(3 Points)

A
  • renewed focus on corporate culture and executive pay, and questions around audit
  • creation of stewardship codes
  • led to 2010 Dodd-Frank Act in USA (tightened standards for banks)
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15
Q

Dodd-Frank Act

(3 Points)

A
  • following 2008 Financial Crisis
  • established 2010 in USA
  • tightened standards for Banks
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16
Q

Impacts of Olympus Scandal

(3 Points)

A
  • 2011 in Japan
  • US$ 1,5bn in losses were hidden
  • together with Toshiba Scandal, helped fuel rapid advancements of Japanese Governance Standards
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17
Q

Current UK Corporate Governance Code

(6 Points)

A

Published in 2018.

18 Principles under 5 Themes:
* board leadership and company purpose
* devision of responsibilities
* composition, succession and evaluation
* audit, risk and internal control
* remuneration

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18
Q

Audit and Remuneration Committee Structure

A

Will be populated soley by independent non-executive directors.

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19
Q

Nominations Committee Structure

A

Should be formed by majority of independent non-executive directors.

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20
Q

Board Structure, Diversity, Effectiveness and Independence

(3 Points)

A
  • ideally, board membership should have a right mix of people with diversified and relevant skills, and right board culture to allow board members to contribute effectively
  • training for board members and board appraisals can help to address areas with lack of competency
  • board independence - board independent from management team, and operates with independence of thought so it can challenge management and previous decision-making
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21
Q

ICGN’s Global Governance Principles

(6 Principles)

A

Independance Criteria suggesting questions to an Individual who:
* had been executive at the company or a subsidiary, or an advisor to the company, without appropriate gap between employment and joining the board
* receives, or has received, incentive pay from the company, or receives fees additional to director fees
* has close family ties with any of the company’s advisers, directors or senior management
* hold 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
* has been a director of the company for a long enough period that their independence may have become compromised (norm 8-12 years)

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22
Q

Typical Executive Remuneration

A
  • fixed salary, usually increased annually
  • benefits, including pension scheme
  • annual bonus, often linked to achievment of KPIs, including ESG factors
  • share-linked incentives, linked to long-term performance (e.g. over 3 years)
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23
Q

Corporate Governance Reporting and Transparency

(3 Points)

A
  • board should present a fair, balanced and understandable assessment of the company’s position and prospects
  • companies may mask weakening performance through “alternative performance metrics” (APMs)
  • strong audit committee should strictly oversee the reporting process to ensure fair and balanced reporting. Strong and challenging auditor should intervene to prevent misleading of investors and highlight inconsistencies between financial statements and company reporting
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24
Q

European Securities and Markets Authority (ESMA) Guidelines

(3 Points)

A
  • issued in 2015
  • published set of guidelines on the use of APMs (alternative performance metrics)
  • require consistency, APMs not disclosed more prominently then official measures
25
Q

Corporate Governance Financial Integrity and Capital Allocation

(3 Points)

A
  • shareholders are concerned with capital allocation, in particular how much of its cashflow companies distribute to shareholders and how much it reinvests in existing or new business activities
  • determing appropriate level between debt and equity, and the issuance of shares
  • how much capital is returned to shareholders via dividends or decisions regarding share buybacks and issuance of shares
26
Q

Business Ethics

(3 Points)

A
  • investors expect companies to behave responsibly, beyond obedience of laws
  • usually, Audit Committee to oversee business ehtics as part of broader risk remit
  • company with robust ehtical approach will also have robust whistle-blowing procedures
27
Q

Ethical Business Approach Rules

(9 Rules)

A
  • corporate culture with set of expected behavioral standards for all staff, not tolerating inappropriate behaviors
  • 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 exploitative behavior, including conspiracy with rivals or other anti-competitive activity
  • avoiding bribery, corruption and fraudulent behavior
  • paying suppliers appropriately and promptly, not seeking unfair benefit from any dominant negotiating position
  • developing appropriate relationships with local communities near business operations, being ready to enter into dialogue on any key concerns they might have
  • approaching regulatory or political lobbying activity honestly and without seeking unfair advantage
  • seeking to pay appropriate level of tax by acting compliantly and recognizing that tax avoidance and evasion can be inappropriate
  • acknowledge that company’s reputation is valueable asset that can be harmed by unethical or inappropriate behavior by business or its staff
28
Q

Corporate Governance in Australia

(4 Points)

A
  • single-tier board
  • CEO is often only executive director
  • not subject to re-election by shareholders
  • shareholder resolutions relatively common
29
Q

Corporate Governance in France

(5 Points)

A
  • vast majority single-tier board
  • board chairman and CEO same person
  • 40% of directors female
  • 1/3 of board members from employees
  • double voting rights for some shareholders
30
Q

Corporate Governance in Germany

(4 Points)

A
  • two-tier board
  • management board and supervisory board
  • supervisory board: 1/2 shareholders, 1/2 employees
  • chairman of supervisory board often a former executive (min. 2 years gap)
31
Q

Corporate Governance in Italy

(4 Points)

A
  • single-tier board
  • single executive director and independent chair
  • “voto di lista” - 30% of the board reserved for minority shareholders only
  • statutory auditor to affirm legality of board actions, subject to election
32
Q

Corporate Governance in Japan

(3 Points)

A
  • hybrid board structure
  • most board members are executive directors
  • min. 2 indepedent non-executive directors on every board
33
Q

Corporate Governance in Netherlands

(2 Points)

A
  • two-tier board
  • shareholder appoint supervisory board
34
Q

Corporate Governance in Sweden

(2 Points)

A
  • two-tier board
  • nomination committee appointed among shareholder (largest shareholders invited to participate in decending order)
35
Q

Corporate Governance in UK

(5 Points)

A
  • single-tier board
  • 30% female board membership
  • discourages combined chair and CEO
  • independent non-executive directors form majority of the board
  • board is responsible for audit and risk
36
Q

Corporate Governance in USA

(4 Points)

A
  • single-tier board
  • no Corporate Governance Code as it’s a matter of the states
  • board chairman and CEO same person
  • Sarbanes-Oxley Act and Dodd-Frank Act are closest to a Corporate Governance Code for USA
37
Q

Commonsense Corporate Governance Principles

(4 Points)

A

(US)
* published in July 2016 and revised in October 2018
* coalition of company representatives and largest US investors
* focus on board effectiveness, accountability and alignment through pay

38
Q

Investor Stewardship Group’s (ISG) Corporate Governance Principle

(for US listed companies) (3 Points)

A
  • (US) effective since 2018
  • created by a coalition of investors
  • more about relationships between companies and shareholders then governance
39
Q

Council of Institutional Investors (CII) Coporate Governance Policies

(2 Points)

A
  • CII are representative of long-term investors in USA
  • indication of likely positions of CII members on issues that might go to shareholder vote or public policy debate
40
Q

Roles of the Auditor

(4 Points)

A
  • provides independent review of financial reports prepared by management
  • provides assurance that those reports fairly represent the performance and position of the business (true and fair)
  • audit is sampling process and not an absolute assurance that all numbers are right
  • highlight inconsistencies between financial statements and other reporting by the company
41
Q

Audit Methods for ESG

(3 Points)

A
  • 3rd party certification of data and information included in ESG report
  • provision of independant guarantee that both data and analysis are credible and accurate
  • attestation that published communication from management details how activities are transparently reported for ESG issues
42
Q

Compromisation of independence of Auditors

(2 Points)

A
  • non-audit services like consultancy and tax advisory services may compromise independence of audit firms and create conflict of interest
  • auditor rotation is compulsory in some countries, e.g. every 20 years in EU
43
Q

Enhanced Auditor Reports

(3 Points)

A

Enhanced Auditor Reports include 3 crucial elements:
* scope of audit: parts of company the audit has covered and in what debth
* materiality: value of transaction or valuation below which auditor spends little time (up to $500m for big companies); performance materiality number - indicates extend to which auditor trusts companies financial system (75% typical, 50-60% low)
* key audit matters: key areas of judgement in the accounts, including indication whether companies reporting is conservative, neutral or aggressive

44
Q

Auditor Liability

(2 Points)

A
  • individual members of audit firm still face unlimited liability on audit failures, even if the firm is a limited liability partnership
  • most cases of audit failures were settled outside the court, so actual precedents are rare
45
Q

Internal Audit

(3 Points)

A
  • part of the company itself
  • reports to executives, usually dotted line reporting to audit committee
  • ensures a company’s procedures and expected behaviours are delivered in practice
46
Q

Links between ESG Factors and Financial Performance

(3 Studies)

A
  • 62% of studies showed positive correlation between Governance and Financial Performance
  • 58% of studies showed positive correlation between Environment and Financial Performance
  • 55% of studies showed positive correlation between Social and Financial Performance
47
Q

Governance Issues at the Board

(2 Points)

A
  • wrong people around boardroom table are less likely to make best decision
  • boards need to have right mix of skills and experience and an array of perspectives in the boardroom
48
Q

Integrating Governance into Investment Process

(4 Points)

A
  • as threshold assessment: minimum criterion of governance to consider before making investment
  • as risk assessment: level of confidence about future earnings
  • negative governance characteristics: by adding risk premium or higher discount rates
  • alternative: companies with weak governance can be an engagement and investment opportunity if it can be improved via active dialogue or proxy voting
49
Q

Annual Voting Decisions

(4 Decisions)

A
  • accepting the report and accounts
  • board appointments
  • appointment of auditor, and perhaps their fees
  • executive remuneration
50
Q

Governance in Sovereign Debth

(3 Points)

A
  • different from governance at other asset classes
  • sovereign debth governance means effectiveness and robustness of the state and its institutions, the approach to the rule of law and general business environment
  • gaining assurance that economy can prosper through good governance, so that sovereign debt obligations can continue to be covered
51
Q

AGM

(4 Points)

A

Annual General Meeting
* held once a year
* a formal gathering of shareholders to conduct official business of a company
* shareholders have the right to make some decisions about the future of the company, and these meetings are the occasions when those decisions are made
* agendas very much depend on the law of the state or country of the company’s incorporation

52
Q

EGM

(4 Points)

A

Extraordinary General Meeting
* held at special occasions for specific urgent matters
* a formal gathering of shareholders to conduct official business of a company
* shareholders have the right to make some decisions about the future of the company, and these meetings are the occasions when those decisions are made
* agendas very much depend on the law of the state or country of the company’s incorporation

53
Q

Materiality at Companies

(4 Points)

A
  • core consideration in ESG investing
  • factor is material if it will drive long-term financial value in a particular business
  • not every ESG factor is material at every company all the time
  • core challenge for ESG investors is to identify the factors that are material to a business at a particular time
54
Q

Quantum

A

The amount paid to executives, aggregated across all forms of remuneration. Higher quantum leads to media and investor attention, and tension between the company and its shareholders is likely to escalate.

55
Q

Pre-Emptive Rights

(2 Points)

A
  • rights that ensure that an investor has the ability to maintain its position in the company
  • company should not issue shares without giving existing shareholders the right to buy an amount sufficient to maintain their existing shareholding
56
Q

Equity

A

The amount of money that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company’s debt was paid off in the case of liquidation.

57
Q

Governance in Private Equity

(2 Points)

A
  • companies financed by private equity are more likely to be highly indebted, leading to little margin for error, even in an otherwise well-functioning governance system
  • private equity investors are often directly represented on the board, therefore boards are often more responsive and less subject to investor misinformation
58
Q

Extraterritorial Laws

A

Company can be guilty of an bribery or corruption offense anywhere in the world it is involved in.

59
Q

Dual-Class Shares

(2 Points)

A

Typically, founders of a company (or a limited group chosen early in a company’s life), who receive multiple votes compared to the class of shares that subsequent shareholders can invest in (common for technology businesses).

Management will feel less accountable to the broader shareholder base as they benefit from holding dual-class shares.

CFA ESG Investing (10 decks)

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