Corporate Governance

Question 1

Who are the primary stakeholders of a corporation?

Answer 1

1. Shareholders
2. The board of directors
3. Senior management
4. Employees
5. Creditors
6. Suppliers.

Question 2

When does the principal-agent relationship arise?

When may conflicts arise?

Answer 2

The principal-agent relationship refers to owners employing agents to act in their interests.

Conflicts can arise because the agent’s incentives may not align with those of the owner or, more generally, because the interests of one group within a corporation are not the same as those of other groups.

Question 3

What is corporate governance?

Answer 3

Corporate governance refers to the internal controls and procedures of a company that delineate the rights and responsibilities of various groups and how conflicts of interest among the various groups are to be resolved.

Shareholders, creditors, boards of directors, employees, customers, suppliers, and government have different mechanisms with which to manage their stakeholder relationships with companies.

Question 4

Name some of the mechanisms shareholders, creditors, boards of directors, employees, customers, suppliers, and government have to manage their stakeholder relationships with companies.

Answer 4

Creditor Mechanisms

• Indenture
• Covenants
• Collateral

Board of Directors and Management Mechanisms

-Audit Committee
- Governance Committee
- Risk Committee

Other Committees*

Employee, Customer, and Supplier Mechanisms
-Laws, Contracts and unions

Government Mechanisms
- Civil Law
- Common Law

Question 5

What is a consequence of good Corporate governance?

What is a consequence of poor corporate governance?

Answer 5

Good corporate governance can improve operational efficiency and performance, reduce default risk, reduce the cost of debt, improve financial performance, and increase firm value.

The risks of poor governance include weak control systems, poor decision making, legal risk, reputational risk, and default risk

Question 6

What is ESG investing?

Answer 6

The use of environmental, social, and governance (ESG) factors in making investment decisions is referred to as ESG investing.

Many issues can be considered in this context, including harm or potential harm to the environment, risk of loss due to environmental accidents, the changing demographics of the workforce, and reputational risks from corrupt practices or human rights abuses.

Question 7

What are some methods of integrating ESG concerns or factors in portfolio construction

Answer 7

Negative screening: Removing companies based on their ESG factors. Concerned industries are mining, oil extraction and transport, and tobacco. Specific companies that might be excluded are those with poor records on corruption and human rights (labor) practices. Company scores based on a range of ESG concerns are often used in negative screening to identify companies that should be excluded.

Positive screening: , investors attempt to identify companies that have positive ESG practices. For example, a portfolio manager may focus on environmental sustainability, employee rights and safety, and overall governance practices. Often a scoring system across a set of ESG factors is used to identify companies for inclusion in portfolios.

A related approach, the relative/best-in-class approach, seeks to identify companies within each industry group with the best ESG practices. By constructing portfolios of these companies, a manager can preserve the index sector weightings in the portfolio while still taking advantage of opportunities to profit from (or simply to support) positive ESG practices.

Full integration refers to the inclusion of ESG factors or ESG scores in traditional fundamental analysis. A company’s ESG practices are included in the process of estimating fundamental variables, such as a company’s cost of capital or future cash flows. To the extent that ESG practices will affect such variables, integrating them into the analysis can help in determining which companies are currently overpriced or underpriced.

Thematic investing refers to investing in sectors or companies in an attempt to promote specific ESG-related goals, such as more sustainable practices in agriculture, greater use of cleaner energy sources, improved management of water resources, or the reduction of carbon emissions.

Engagement/active ownership investing refers to using ownership of company shares or other securities as a platform to promote improved ESG practices. Share ownership is used to initiate or support (through share voting) positive ESG changes. Contact with senior management or board members to promote such changes is also an active ownership strategy. Recently, this strategy has been used to promote reduction in a company’s carbon footprint, increased wages, or other social and environmental goals, which may or may not be associated with improved financial results over time.

Another approach to ESG investing is green finance. Green finance refers to producing economic growth in a more sustainable way by reducing emissions and better managing natural resource use. An important part of green finance is the issuance of green bonds, bonds for which the funds raised are used for projects with a positive environmental impact. Issuance of green bonds has increased significantly in recent years, led by issuance in the United States and in China, which is prioritizing improvement in environmental conditions.