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CFA ESG Investment > Chapter 5: Governance Factors > Flashcards

Chapter 5: Governance Factors Flashcards

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1
Q

What is governance? And what do investors do to assess it?

A
  • 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.
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2
Q

What are the two key things that governance needs to ensure?

A
  • Accountability

- Alignment

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3
Q

What is accountability?

A
  • Gives authority and responsibility for decision-making

- Held accountable for consequences of decision making and effectiveness of it

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4
Q

What is the chain of accountability?

A
  • Beneficiaries
  • Asset owner
  • Fund Manager
  • Corporate Board
  • Management
  • Work Force
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5
Q

What are disadvantages of having the CEO as Chair of the Board?

A 
- 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
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6
Q

What is alignment and what problems does it adress?

A
  • Agency problems has been recognized as 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
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7
Q

What are the key committees of a Board?

A
  1. Nomination committee - aims to ensure that the board is balanced and effective, ensuring management is accountable
  2. Audit committee - oversees financial reporting and audit, delivering accountability
  3. Renumeration committee - seeks alignment through executive pay
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8
Q

What is the most common phrase when it comes to governance codes?

A
  • “comply or explain”
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9
Q

What is the Cadbury Committee, why was is started and what did it suggest?

A
  • Brought together in 1991 by Financial Reporting Council and London Stock Exchange
  • Followed Caparo and Polly Peck scandales
  • Proposed that every company should have an audit committee meeting at least twice a year
  • Role of chair and CEO should not be combined
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10
Q

Why do some companies think that governance codes are inflexible?

A
  • Some companies consider governance codes as inflexible, because proxy advisory firms tend to adhere to governance codes when giving voting recommendations
  • Inflexibility also arrises from investors’ clients tendency to follow proxy recommendations with too little judgement if voting decision is right.
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11
Q

What is shareholder engagement?

A
  • 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
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12
Q

What is minority shareholder exploitation and what can be done about it?

A
  • 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
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13
Q

What are class tests?

A
  • minority shareholders need to approve large investment , if
  • A Transaction affects more htna 5% of a company’s assets, profits, value or capital
  • If it affects more than 25% of shareholders
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14
Q

What are pre-exemption rights?

A
  • Ensure that investors has 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
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15
Q

What are dual-class shares?

A
  • Some shares have double voting rights - given to founders/management - less accountable management
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16
Q

What are the principles of the Principles UK Corporate Governance Code?

A 
○Board leadership and company purpose
○ Division of responsibility
○ Composition, succession, evaluation
○ Audit, risk and internal control
○ Renumeration
- Audit Committee - Only independent non-executive directors
- Nomination Committee - 
- Renumeration Committee - Only independent non-executive directors
17
Q

What are key properties of the board structure, diversity, effectiveness and independence

A
  • 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
18
Q

According to the ICGN’s Global Governance Principles what questions the independence of the board?

A

○ 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

19
Q

What are challenges for shareholders when it comes to management renumeration?

A
  • In a public company, Investors cannot directly negotiated pay with management
  • Renumeration 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
20
Q

What is the executive pay structure?

A
  1. Fixed salary (usually increases annually) -
  2. Benefits (including pension, percentage of salary, more generous) -
  3. Annual bonus - Metrics will be predominantly financial metrics, but also includes ESG performance
  4. 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
21
Q

How can investors integrated governance into investment decisions?

A
  • 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
22
Q

What can investors influence through votes?

A
  • Accepting the reports and accounts
  • Board appointments
  • Appointment of auditor and perhaps fees
  • Executive numeration
23
Q

What is included in an enhanced audit report?

A
  1. Scope of the audit - how many parts of the company and in what depth
  2. Materiality - The level of transaction or valuation below which the auditor spends little time - Investors should be interested in segments
  3. Key audit matters - conservative, neutral or aggressive “graduated audits” adds value to investors understanding
24
Q

How long till auditors have to change in the EU?

A

20 years, tender after 10 years

25
Q

Why Audit Matters and What Matters in Audit?

A
  • 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
26
Q

What is included in the reviewing financial statements and annual reports? What about the first half of the report?

A
  • 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
27
Q

What is the issue with the Independence of audit firms and conflict of interest?

A
  • 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
  • Behavioral independence - tendency of people to seek consensus, avoid disagreement and conflict
28
Q

What is part of business ethics?

A
  • Ethical approach will include
    ○ Whistle-blowing
    ○ Behavioral 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
29
Q

What can be said about Financial integrity and capital allocation?

A
  • 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
30
Q

Who should lead Reporting and transparency ?

A
  • Fair, balanced and understandable
  • Reporting and transparency is led first y the management team, and then overseen by the audit committee and the board as a whole
  • Independent challenge comes from the auditor
31
Q

What are Alternative Performance Metrics ?

A
  • Investors can learn about weaknesses in management through Alternative Performance Metrics (APM)
    Measures that are adjusted or underlying
32
Q

What is a red flag that indicates poor governance?

A
  • Another red flag that management 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

CFA ESG Investment (9 decks)

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