L31. Introduction to corporate governance and other ESG considerations Flashcards
Learning outcomes
a. Describe corporate governance
b. Describe a company’s stakeholder groups and compare interests of stakeholder groups
c. Describe principal-agent and other relationships in corporate governance and the conflicts that may arise in these relationships
d. Describe stakeholder management
e. Describe mechanisms to manage stakeholder relationships and mitigate associated risks
f. Describe functions and responsibilities of a company’s board of directors and its committees
g. Describe market and non-market factors that can affect stakeholder relationships and corporate governance
h. Identify potential risks of poor corporate governance and stakeholder management and identify benefits from effective corporate governance and stakeholder management
i. Describe factors relevant to the analysis of corporate governance and stakeholder management
j. Describe environmental and social considerations in investment analysis
k. Describe how environmental, social, and governance factors may be used in investment analysis
ESG
Known as environmental, social and governance are areas that investors have become more attentive wrt a company’s operations
Corporate governance
Defined as the system of internal controls and procedures by which individual companies are managed
- provides framework that defines the rights, roles and responsibilities of various groups within the organisation
- CG is the arrangement of checks, balances, and incentives a company needs in order to minimise and manage the conflicting interests between insiders and external share owners
Shareholder theory and stakeholder theory
shareholder theory takes the view that most important responsibility of a company’s managers is to maximise shareholder returns
stakeholder theory broadens a company’s focus beyond the interests of only its shareholders to its customers, suppliers, employees, and others who have interest in the company
Company stakeholders
Interest of one group may conflict with another
Type of stakeholder groups
a) shareholders
- owns shares of stock and are entitled to certain rights such as to receive dividends and vote on corporate issues
- in case of bankruptcy, shareholders receive proceeds only after creditors claims are paid
- shareholder interests are typically focused on growth in corporate profitability that maximise value of company’s equity
- shareholders maintain control over company through their power to elect board of directors (representative of shareholders)
- controlling shareholders –> particular shareholder or block of shareholders holding a percentage of shares that gives them significant voting power
- minority shareholders –> holding small portion of company’s shares resulting in limited ability to exercise control in voting activities
b) creditors
- bond holders and banks are the company’s lenders and the providers of debt financing
c) managers and employees
- conflict with this group and another may arise. eg company presented with takeover may be attractive to shareholders but jeopardise interests of managers in preserving their employment at the company
d) board of directors
- elected by shareholders to protect shareholders’ interests, provide strategic director and monitor company and management performance
- structured as one tier or two tier
- one tier consists of single board of directors, composed of executive and non executive directors. executive (internal) are employees and non executive (external) are not employees [USA, India, UK)
- two tier consists of 2 separate boards 1) supervisory board which composed of non executive directors and 2) management board which composed of executive directors. Supervisory board oversees management board [China, Netherlands, Finland, Germany]
e) customers
f) suppliers
g) governments/ regulators
- seek to protect interest of general public and ensure well being of nation’s economies
Principal- agent relationship
Also known as agency relationship is created when a principal hires and agent to perform a particular task or service
- involves obligations, trust and expectations of loyalty; agent is expected to act in the best interests of the principal
- Shareholder and manager/director relationships
- in some cases managers may seek to maximise personal benefits to the detriment of shareholders’ interest - Controlling and minority shareholder relationships
- opinions of minority shareholders are often outweighed or overshadowed by influence of controlling shareholders especially if companies adopt straight voting (one vote for each share owned) - Manager and board relationships
- board may not have sufficient information to make a decision especially for non executive boards - Shareholder Vs creditor interests
- shareholder are more risk averted as they believe with high risks comes with high return. however creditors just want stability so that their principal and interest payments are fulfilled
Stakeholder management
Because interests are different, organisations usually adopt mechanisms more efficiently to manage stakeholder relationships
Stakeholder management involves identifying, prioritising, and understanding the interests of stakeholder groups, and on that basis, manage the company’s relationships with these groups
Most important basis is effective communication and effective engagement
To balance these interest, CG and stakeholder management frameworks reflect a legal, contractual, organisational, and governmental infrastructure that defines rights, responsibilities, and powers of each group
- legal infrastructure = framework for rights established by law and the availability or ease of legal recourse for any violation
- contractual infrastructure = shaped by contractual arrangements entered into by company and stakeholders that help define and secure rights of both parties
- organisational infrastructure = internal system, governance procedures and practices adopted and controlled by company in managing its stakeholders relationships
- governmental infrastructure = regulations imposed on companies
Mechanisms of stakeholder management
- General meetings
- also known as general assemblies, enable shareholders to participate in discussions and vote on major corporate matters and transactions that are not delegated to board of directors
- required to hold AGM within a certain period following end of fiscal year
- purpose is to present shareholders with annual audited financial statements, provide overview of the company’s performance and activities and address shareholder questions
- election of directors also held at AGM and in some countries required to approve financial statements, discharge directors, appoint external auditors or vote on remuneration of the board and or top management
- extraordinary general meeting (EGM) can be called by company or shareholders throughout the year when significant resolutions requiring shareholder approval are proposed; such as company’s bylaws, mergers or acquisitions or sale of significant assets
- depending on the voting purpose, different decisions would require different requirements such as supermajority votes to be passed
- Proxy voting
- process that enables shareholders who are unable to attend a meeting to authorise another individual to vote on behalf
- most common form of investor participation in general meetings
- cumulative voting enables each shareholder to accumulate and vote all his shares for a single candidate in an election involving more than 1 director
- Board of director mechanisms
- shareholders monitor BOD’s performance through exercise of voting power and participation in general meetings - Audit function
- represents systems, control, and policies/procedures in place to examine the company’s operations and financial records
- internal audits are conducted by an independent internal audit function or department
- external audits are independent from the company and conduct an annual audit of the company’s financial and records to provide reasonable and independent assurance of the accuracy of financial statements and their fair representation of the financial position - Reporting and transparency
- shareholders have access to a range of information concerning the company typically through annual reports, proxy statements, disclosures on websites, investor relations department and other means of communication such as social media
- information is essential to reduce extent of information asymmetry between shareholders and managers, access performance of company and of its directors and managers, make informed decisions in valuing company and deciding to purchase, sell or transfer shares, vote on key matters/changes
- Policies on related party transactions
- ensure that related party transactions are handled fairly and do not advance the interests of related party at the expense of interest of company or other shareholders - Remuneration policies
- typically includes a variable component; such as profit sharing that is contingent on corporate performance
- design incentive plans that discourage short termism or excessive risks taken by manager
- many regulators are enforcing the clawback provisions to allow a company to recover previously paid remuneration should events such as misconduct/breach of law are uncovered - Say on Pay
- enables shareholders to vote on executive remuneration matters
- in some countries it is mandatory and binding, but others not
Mechanisms to mitigate associated stakeholder risks
- Contractual agreements with creditors
- One such provisions is indenture where it is a legal contract that describes the structure of a bond, obligations of the issuer and the rights of bondholders
- to limit creditors’ risk during the term of bond or loan, debtholders may choose to impose covenants within indentures or contracts. Covenants are terms and conditions of lending agreements, enabling creditors to specify the actions an issuer is obligated or prohibited to perform
- Collaterals are another tool often used by creditors to guarantee payment, representing assets or financial guarantees that are above and beyond an issuer’s promise to repay its obligations
- companies usually hire a financial institution to act as trustee and monitor the issue on behalf of the class of bondholders
- Employee laws and contracts
- employee rights secured through labor laws
- some countries allow employees to create unions who seek to influence certain matters affecting employees - Contractual agreements with customers and suppliers
- contract should also specify actions to be taken and recourse available if either party breaches terms - Laws and regulations
Composition of BOD
- most CG codes require that board include a diverse mix of expertise, backgrounds and competencies which also includes age, gender and racial diversity
- 1 tier structure includes mix of executive and non executive directors
- independent director is a specific type of non-executive director that does not have a material relationship with the company with regard to employment, ownership or remuneration
- 2 tier structure has 2 separate boards, the supervisory and management boards that are independent of each other
- staggered boards = election process whereby directors are typically divided into multiple classes that are elected separately in consecutive years; one class every year
Functions and responsibilites of boards
- responsibility to consider interest of all stakeholders
- elements of responsibilities are duty of care and duty of loyalty
- according to OECD’s principles of CG, duty of care ‘requires board members to act on a fully informed basis, in good faith with due diligence and care
- duty of loyalty ‘is the duty of the board member to act in the interest of the company and shareholders
- BOD do not engage in daily operations but delegated to management
- BOD guides and approves coy’s strategic direction, taking into consideration the company’s risk profile
- BOD delegates implementation to senior management, but oversees the execution of the strategy and establishes milestones to monitor progress in reaching objectives
- BOD also reviews corporate performance and determines relevant courses of action accordingly; can monitor and evaluate management’s performance and determine if remuneration is aligned
- BOD also responsible for selecting, appointing and terminating employment of senior managers
- BOD main responsibilities is to ensure leadership continuity through succession planning for CEO and key executives
- BOD ensure effectiveness of audit and control systems by setting the overall structure and overseeing the implementation for financial reporting practices and its fairness and accuracy
- BOD also ensure company has appropriate enterprise risk management
Board of directors commiittees
- Establish committees that focus on specific functions
- provide recommendations that are reported to board on regular basis
- Audit committee
- most common
- overseeing audit and control systems and ensure effectiveness
- recommends the appointment of independent external auditors and proposing remuneration
- both internal and external auditors report to committee - Governance committee
- ensure coy adopts good CG practices
- sometimes responsible to oversee annual evaluation of board - Remuneration or compensation committee
- Nomination committee
- identifies candidates who are qualified to serve as directors and recommends their nomination for election by shareholders - Risk committee
- determine risk policy, profit and appetite of the company - Investment committee
- reviews material investment opportunities proposed by management and considers viability
- such as acquisitions, large projects, expansion plans
Market factors affecting stakeholder relationships and CG
market factors = related to capital markets
- Shareholder engagement
- involves coy’s interaction with its shareholders
- such as annual shareholder meeting and analysts calls
- Shareholder activism
- refers to strategies used by shareholders to attempt to compel a company to act in a desired manner
- primary motivation of activist shareholders is to increase shareholder value
- Competitions and takeovers
- traditional view of market for corporate control (takeover market) is one in which shareholders of a company hire and fire management to achieve better resource utilisation
- can be pursued in diff ways
a) proxy contest (or fight): shareholders persuaded to vote for a group seeking controlling position on BOD
b) tender offer: shareholders selling their interests directly to the group seeking to gain control
c) hostile takeover: attempt by one entity to acquire a company without consent of company’s management
Non - Market factors affecting stakeholder relationships and CG
- Legal environment
- some countries have a common law system to offer superior protection of interests of shareholder and creditors relative to those who adopt a civil law system
- key difference lies in the ability of a judge to create laws
- in civil law systems, laws are created primarily through statues and codes enacted by legislature
- role of judges is limited to rigidly apply the statues and codes to specific case
- in contrast, in common law systems, laws are created both from statutes enacted by legislature and by judges through judicial opinions
- shareholders and creditors have ability to appeal to a judge to rule against management actions and decisions
- regardless of systems, creditors usually more successful in seeking remedies than shareholders as breach in contract more straightforward than proving if director or manager breached duty owed to shareholders
- Role of media
- can shape public opinion
- can motivate politicians and regulators to introduce CG reforms or enforce laws that protect shareholders and society at large
- CG industry
- with increased importance and relevance of corporate governance among investors, demand for external corporate governance services has grown considerably
- vendors have influence in CG practices, and corporations are compelled to pay attention to ratings and recommendation produced by the CG industry
CG and stakeholder management risk and benefits
Risks for poor governance and SM
- Weak control systems
- one group may benefit at the expense of another
- could have adverse effect on company’s resources, performance and value
2. Ineffective decision making
- Legal, regulatory, and reputational risk
- may be subjected to investigation by government or regulatory authorities for violation of applicable laws
- may also be exposed to lawsuits filed by shareholders, employees or creditors
4. Default and bankruptcy risks
Benefits of effective governance and SM
- Operational efficiency
- clarifies the delegation of responsibilities and reporting lines across company - Improved control
- help identify and manage risks at early stages - Better operating and financial performance
- can help improve decision making process and respond faster to market factors - Lower default risk and cost of debt
