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
Corporate governance in Japan
• Structure: Single-tiered board structure with statutory auditors
• Aim: ensure independence of auditors
• Statutory auditors:
o In addition to the independent audit firm
o Usually 3 or 5 statutory auditors appointed by shareholders on three year rotations
o Independence questionable: appointed by family companies or lending banks
• Trend towards board with committees:
o Similar to a board of non-executive directors and committees
o Removes statutory auditors
• Zaibatsu conglomerates:
o Conglomerates that dominated Japanese economy
o Dismantled in 1945
o Perception that they acted as dead weights on strategic thinking
o Japanese Corporate Governance Code (2015)
Disclosure of cross shareholdings
Require at least one independent non-executive to be in place even where statutory auditors present
Corporate governance in the Netherlands
• Structure: Two-tiered board structure
• Aim: distance shareholders from operations and holding management accountable
• Supervisory board:
o 50 % shareholders appointment
o 50 % workforce appointment
• Case study AkzoNobel (2017):
o Takeover bid from PPG (US)
o Significant shareholders:
Wanted takeover to occur
Wanted EGM to oust the supervisory chair
o Supervisory board and company:
Didn’t come to negotiating table
Declined to have EGM
Argued value to shareholders and staff were insufficient
o Court decision by Enterprise Chamber (2017)
Backed board stance on bids
Political support – further takeover protections on Dutch firms made
o Result:
Two-tiered: keeps the shareholders at an arms-length
AkzoNobel sold speciality chems business and returned proceeds to shareholders
Resulted in board change as supervisory chair left
Corporate governance in Sweden
• Structure: dominance of major shareholders in registers and dual class of shares
• Aim: control from family vehicles despite controversial nature
• Investor AB:
o Wallenberg family vehicle
o Ownerships:
Atlas Copco (16.9% of the shares, 22.3% of the votes);
ABB (11.5% of the shares and votes);
AstraZeneca (3.9% of the shares and votes);
SEB (20.8% of the shares and votes);
Ericsson (7.2% of the shares, 22.5% of the votes);
Electrolux (16.4% of the shares, 28.4 % of the votes)
o Result:
Appoint the bulk of corporate boards in Sweden
Disproportionate influence
• Mitigation:
o Nomination committee at companies appointed among the shareholders
Shareholders asked to participate in order of shareholding
Until board fully populated
o Results in skilled and well-balanced boards
o Similar structures in other Scandinavian markets
Corporate governance in the USA
• Structure: USA only sole country to not have own Corporate Code of Governance
o Due to relationship between federal government and states
o Corporate law is a matter for states:
Led to race to bottom for tax revenues
Delaware won: ½ of publicly traded corporations
Delaware courts have dipropionate say
• Attempts to develop best practices:
o Commonsense Corporate Governance Principles (2016)
Berkshire Hathaway, BlackRock, General Electric, General Motors, JP Morgan Chase and Verizon Communications
Inner workings of corporate governance, board effectiveness and accountability and alignment through pay
o Investor Stewardship Group (ISC) (2018)
Coalition of investors
Relationship of US companies with shareholders
Stewardship Principles: reciprocal responsibilities of investors in response to corporate responsibilities
o Corporate Governance Policies of the Council of Institutional Investors (CII)
Range of corporate governance issues
Less principles, more positions that CII members will vote
o Securities and Exchange Commission (SEC)
Requirements for independence and skills of auditors
Standards set by Sarbanes-Oxley Act
Dodd-Frank legislation:
• ‘say on pay’ to approve executive remuneration
• ‘access to the proxy’ permits shareholders of certain criteria to add candidate to formal proxy statement
The independence of audit firms and conflict of issues
• Conflicts of interest:
o Independence paramount
o Audit firms offer other services (consulting and tax advise)
o Risks of close relationships with management
o Audit first staff sometime join companies they consult for
• Regulators:
o Tried to remove conflict of interests
o Lessened scope for audit companies to provide non-audit services
o EU:
Provide a list of non-audit services
Monetary limit on value of non-audit
o UK Competition and Markets Authority:
Separation of audit and non-audit arms of accountancy firms
• Behavioural independence:
o Tendency for individuals to seek consensus
o Counter to the role of the audit
Auditor rotation
• Audit market is concentrated
• EU: public companies must change auditors after 20 years at most – incumbent barred from competing after 20 years
• Issues as firms are unwilling to give up non-audit service contracts
• Lengthy tenders:
o Put pressure on independence – regulators and investors must constrain
o Deloitte has been auditing P&G since 1890
Sampling and audit work
• Sampling decisions:
o What is an appropriate level of sampling?
o Has good insight been gained into the accuracy of underlying numbers?
• Depth of audit dependent on:
o Audit budget
o Auditors assessment of quality of company’s own systems and financial controls)
o Co-ordination between internal and external audit
• Big data:
o Using technology to consider every transaction
o Packages to spot anomalies in big groups of data
o Still need to consider information given intelligently
Enhanced auditor reports
• Three crucial elements:
o Scope of the audit:
How many parts of company and in what depth?
Business segments or geographies
Some may be ignored
o Materiality:
Level of transaction or valuation which the auditor spends little time
Large companies – can be USD 500 m
Extent of overall materiality used shows confidence of auditor in company’s own financial controls
• 75 %: typical threshold
• 50 %: low confidence in financial controls
o Key audit matters:
Handful of key areas of judgement in the accounts
Auditor reports choose to highlight areas of discussion and if the company reporting is conservative, neutral or aggressive
‘graduated audit’ – adds value to investors understanding
Auditor liability
- Auditors don’t provide more than they are required to due to liability
- Auditor has unlimited liability
- Even in LLPs – the individuals who are directly responsible can face losing everything
- Unclear how large liability risk is
Internal audit
• What is it?
o Can be outsourced
o Most of the time the function is part of the company, with reporting to executive team and Audit Committee
o Risk management role to ensure company’s procedures are delivered
• Variable status in different businesses
o Doesn’t exist in some organisations
o Effective delivery allows executives and non-executives to have confidence in delivery on the ground
o Changes happening in internal audit to help board and senior managers better protect assets, reputation and sustainability
Investor sentiment towards governance
• CFA Institute 2017 ESG survey
o 67 % take governance factors (EMEA = 74 %)
o 54 % take environmental and social factors
• Friede, Busch and Bassen’s 2015 ESG study:
o 62 % studies positive correlation between governance and corporate financial performance
o 58 % environmental
o 52 % social
• Wrong people (like Enron)
o Result in significant value erosion
o Risks to environmental and social issues
Case studies
• Theranos Board:
o Innovative blood testing technology
o Average age (less executives) of 73
o More people in 90s than had health experience
o Dual share class structure – founder held 99 % of voting rights
o Board met infrequently
o Outcome: US 700 m investments lost and estimate USD 10 bn valuation destroyed
o Key questions for investors:
Is there right mix of skills to oversee next stage of busines development?
Is there the right dynamic to allow views of appropriate skilled individuals on the board to be heard?
• Uber:
o Governance practices changed in wake of scandals
o CEO responsibilities reallocated, preferential voting adjusted, independence strengthened
• WeWork:
o IPO abandoned in 2019
o Dominant decision making position of CEO
o Absense of clear business model
• Consequences:
o Fines and additional liabilities
o Litigation and other costs
o Trust eroded and boycotting occurs
Fund managers integrating governance into decision making
• Threshold assessment:
o A formal minimum criterion before considering investment at any price
o Quality of management assessment: overall team and governance structure
• Risk assessment tool:
o Represented by level confidence on future earnings
o Implemented by multiple on earnings or level of confidence in the valuation range
• Valuation models:
o Negative governance:
Adding risk premium to cost of capital
Raising the discount rate
o If engagement can reverse:
Valuation can be enhanced by a stronger performance
Role of stewardship dialogue
• Many directly addressed at AGM agenda • Investors must vote on o Accepting the reports and accounts o Board appointments o Appointment of auditor and fees o Executive remuneration • Dialogue occurs throughout this year
