Governance Factors Flashcards
Corporate governance
• Process by which a company is managed or overseen
• Grows from legal processes of country but more about people and processes
• Good governance:
o Developing appropriate work culture
o Strong business performance
o Long-term prosperity
o More likely to address environmental and social issues
• People:
o Individuals in the boardroom
o Must be supported by processes
• Processes:
o Increased burden in complex and large companies
o Larger companies – impossible to have direct knowledge across business
o Investors judge policies and processes and on diligence and care to see implementation
• Comes down to two A’s:
o Accountability
o Alignment
Accountability
• In practice:
o People given authority and responsibility for decision making
o But also held accountable for the consequences and effectiveness of the work they deliver
• Accountability and the board:
o Senior executives must feel accountable to non-executives on their board
o Non-executives must feel accountable to shareholders
o Corporate governance has strong focus on board structure and independence of directors
• Mixed mindset of directors:
o Avoid “group-think” – increase diversity
• Chair:
o Should be independent to CEO (avoids concentration of powers)
o Should allow board to:
Exercise oversight responsibilities
Challenge and debate performance and strategic plans
Set the agenda
Influence succession planning
Debate executive remuneration
Accountability and accounts
• Annual accounts represent formal process where directors make themselves accountable to shareholders
• First item at AGMs is acceptance of the report and accounts:
o Central importance of transparency
o Independence of auditor of accounts (re-appointed annually at AGM)
• Agency problem
o Consequence of separation of ownership and control
o Interests of the professional managers may not be aligned with the owners of business
o Magnified by larger corporations and public companies, everyone has a small part of the company
o Alignment solution:
Accountability chains
Incentives
• Executive pay
o Pay structures should align manager interests with owners
o Balanced compensation package:
Performance-related remuneration
Based on long-term goals
Vests over a long-term period
Includes mixture of KPIs and share price performance
o Key committees of the board:
Nominations Committee: ensures that board overall is balanced and effective, with accountable management
Audit Committee: oversees financial reporting and the audit
Remuneration Committee: seeks to deliver proper alignment through executive pay
Corporate governance codes UK and abroad
• First formal code in 1992
• Cadbury Committee
o Formed by Financial Reporting Council, LSE and accountants
o Followed Caparo and Polly Peck scandals – while operating also had BCCI and Mirror Group scandals
o Scandals basis: financial reporting that was misleading
• Recommendations from Cadbury Committee:
o Every public company should have audit committee meeting 2x per year
o No individual should have ‘unfettered powers of decision’ (combined chair/CEO)
• Governance depends on cultures and historical development:
o Two tiered boards: non-executive supervisory oversees management boards: Germany and Netherlands
o Single tiered boards:
Dominated with executive directors (Japan)
Combined CEO and chair (USA and France)
In between models (UK)
• Adherence to standard or discussion as to how board delivers on principle:
o Most markets: ‘comply or explain’
o Netherlands: ‘apply or explain’
o Australia: ‘if not, why not?’
• Why companies look negatively at corporate governance
o Proxy advisory firms (ISS and Glass Lewis) – advise clients how to vote
o They stick to the details of the governance codes = inflexibility
o Better for individual shareholders to apply flexibility and look at closer
Scandals post Cadbury Committee
• Greenbury report (1995)
o Cause: Shock around pay levels at newly privatised utilities
o Result: Increased visibility of remuneration structures and clarity around KPIs that drive pay, introduction of longer time horizons for pay
• Sarbanes-Oxley Act (2002)
o Cause: Enron, Tyco, Worldcom scandals due to poor financial reporting
o Result: Public Company Accounting Oversight Board (PCAOB), standard setter and inspector – allowing auditor independence and challenge
• Ahold and Parmalat (2003)
o Cause: Italy and Netherlands scandals due to poor corporate governance
o Result: Auditor independence and board independence made crucial in Europe
• Dodd-Frank Act (2010)
o Cause: Poor corporate culture, executive pay structure and auditing, resulting the financial crisis (2008)
o Result: Tightened oversight of banks
• Japan, Olympus (2011-12) and Toshiba (2015) scandals
o Cause: Market deceit to maintain health of company and jobs for its workforce
o Result: Japanese governance standards introduced and ESG disclosures to market
Engagement and issues being a minority shareholder
• Shareholder engagement:
o Dialogue between companies and their investors
o Investors express clear views about areas of concern such as ESG matters
o Ensures board of directors are accountable for actions
• Minority shareholders:
o Such as institutional investors
o Important they are not exploited by dominant shareholder
o Protections:
Built in company law
Exist in listing rules
In corporate governance codes
Issues and rules for minority shareholders
• Controlling shareholders siphon money out the company in ways that don’t benefit the larger shareholder base:
o UK listing regime class tests are applied:
Class 2 transactions: if transaction affects more than 5 % of company’s assets, profits, value or capital, there must be additional disclosures
Class 1 transactions: it affects more than 25 % of all of them, there must be a shareholder vote based on detailed justifications
• Company could issue shares resulting in dilution of minority shareholders:
o Pre-emptive rights: company should not issue shares without giving existing shareholders the right to buy a sufficient amount in order to maintain existing shareholding (excluding in USA)
o Large equity funding: called a ‘rights issue’ – often controversial as at discount to prevailing share price
o Smaller equity funding: up to 5 % or 10 %, vote for non-pre-emptive in AGM – less cumbersome
• Dual class shares:
o One class (the better one):
Restricted to founders of company or early group
Receive multiple votes
Unlike subsequent shares that are freely traded on stock market
o Driver of dual class shares:
Success of technology businesses
Founders have retained voting control
Issue: feel less accountable to broader shareholder base
Solution: Sunset clause – dual issues offer stability at start-up but become issue over longer periods – unification of classes after 7 years
Corporate Governance Code UK (2018)
• 18 Principles under 5 themes:
o Board leadership and company purpose
o Division of responsibilities
o Composition, succession and evaluation
o Audit, risk and internal control
o Remuneration
• 3 principal board committees:
o Audit committee – solely independent non-executives
o Nominations committee
o Remuneration committee – solely independent non-executives
o Finance may also have risk committee
• Guide to Board Effectiveness
o Provides questions to assist board members on whether they are fully effective
o Provides questions to ask management on corporate culture
o First theme, board leadership and company purpose
Board structure, diversity, effectiveness and independence
• People aspect:
o Need right people with relevant skills and experience
o Need a culture to effectively have a boardroom debate
• An issue of high importance in business:
o More than one person should have knowledge of issue
o Must consider refreshment of skills
o Strategy evolves means the needs of board change
• Avoid groupthink:
o Most important: diversity of thought
o Also important: gender, race, age, culture, experience
• Chair role:
o Bring out contributions from each board member
o Indicator of good chair: quality of board overall – good directors tend to stay at good boards as feel effective
o Bad board – means weak board appraisals – little change or surfacing of problems
• Independence vital – ICGN Global Governance Principles, there should be questions about individuals who:
o Had been an executive at the company, subsidiary, or an advisor and there hasn’t been appropriate gap between employment and joining the board
o Receives or has received incentive pay from company
o Has close ties with any advisors, directors or senior management
o Holds cross-directorships and has links with other directors
o Significant shareholder in the company
o Has been director long enough to compromise independence
• OECD Corporate Governance Factbook:
o Markets have different estimations of how long to compromise independence
o 12-15 years: Belgium and France (no independence)
o 8-10 years: Estonia and India (no independence)
o 8-10 years: Singapore and UK (explain)
Executive remuneration
• Conflict of interest:
o Shareholders cannot negotiate management remuneration
o Rely on remuneration committees (led by non-executive directors)
Directors: success of the individual company, willing to pay to retain best talent
Shareholders: concerned about ratcheting of pay, care for the broader market
• Four categories of executive pay:
o Fixed salary, usually annually increased
o Benefits, pension (% of salary, usually above wider employee base)
o Annual bonus
o Share-linked incentive (long-term incentive plan (LTIP))
• Bonus and equity-linked portions:
o Some deferred for two or three years
o Predominantly on financial metrics or targets:
Total shareholder return (TRS)
Earnings per share (EPS)
o 20 % around non-financial like ESG
• Problems arise:
o Lack of trust – shareholder vote against schemes that they previously supported and management get ongoing payments for failure
o Leads to compromised remuneration structures rather than value driven structure
o Further quantum (pay to executives) leads to media and investor attention, escalating tensions
o Pay ratios: often 100 to 1: growing tensions around income and wealth disparity
• Matching outcomes:
o Investor won’t oppose pay package if share price and dividend performance has been good
o Companies consider the business itself
o Leads to a disconnect in expectations
Reporting and transparency
• Expectations:
o Fair, balanced and understandable assessment of the company’s position and prospects
o Audit committee – has the responsibility to oversee reporting process
• Alternative performance metrics (APMs)
o Referred to as ‘adjusted’ or ‘underlying’
o Can be used to obscure issue
o European Securities and Markets Authority (ESMA) – guidelines for APMs in 2015
o International Accounting Standards Board (IASM) – Exposure Draft of Primary Financial Statements (2019) – must publish permitted alongside adjusted
Financial integrity and capital allocation
• Concept of a legacy business:
o Company retains a legacy business when opportunity has moved on
o Shareholders almost always want to dispose of older businesses
o Management understands complexities and less open-minded
o Board must decide how to allocate capital between businesses and have dialogue with investors around preferences
• Capital structure:
o Companies without debt are considered inefficient and failing to drive full returns
o Debt loading can be dangerous:
Risk of insolvency if interest rates rise or downturn in business
o Sustainable capital structure:
Short term: Maximise returns on equity
Long term: Make company entirely robust
• Share buybacks, issuance of shares and dividends:
o Key to boards and shareholders
o Dividends:
Sustainable level to ensure future business success
Low dividend pay-out causes concerns if has lots of cash (issue in Japanese businesses)
Business ethics
• Abiding by laws of country of incorporation
o Many jurisdictions have extraterritorial laws e.g. US Foreign Corrupt Practices Act
o Company is guilty regardless of country of bribery
• Investors expect more than law:
o Broader responsibilities and business ethics
o Ethical approach to business:
Corporate culture and having expected behavioural standards for staff
Treating employees fairly
Acknowledging that company’s reputation is a valuable asset
• Whistle-blowing procedures:
o Robust and well-publicised
o Allow concerned party to raise issues
o Overseen by the audit committee
Overview Structural Differences
• Germany, Netherlands, Scandinavia and China: two-tiered board structure
• USA and France: single executive sits on the board and has positions of chair and CEO
• Japan: single-tiered board dominated by executive directors with one or handful of non-executive directors
• Other countries: single-tiered boards have a few executive directors and a majority of non-executives (one as chair)
• Best practices:
o ICGN Principles
o Organisation for Economic Co-operation and Development (OECD) Principles
• Source of detail:
o OECD’s Corporate Governance Factbook on 49 juristictions
Corporate Governance in Germany
• Structure: Two-tiered board structure
• Aim: distance shareholders from operations and holding management accountable
• Supervisory board:
o 50 % shareholders appointment
o 50 % workforce appointment
• Advantages:
o Co-determination
o Allows longer-term decisions and staff support
• In working:
o Strategy developed by management and supervisory boards working together
o Management initiate strategy ‘thoughts’
o Supervisory board holds management to account
All major transactions require supervisory board approval
• Challenges:
o Shareholder portion of board could dominate decision making
o Kodex Principle 7: Supervisory board chair should be available to investors
The access is difficult but slowly improving
