Reading 40 LOS's

Question 1

LOS 40a: Define corporate governance

Answer 1

Corporate governance is the system of internal controls and procedures through which individual companies are managed. These practices seek to ensure that:

• Board members act in the best inerest of shareholders
• The company acts in a lawful and ethical manner in its dealings
• All shareholders have the same right to participate in governance of the company
• The board and its committess are structured to act independently from management and individuals or entities that have control over management
• Appropriate controls and procedures are in place covering management’s activities in running the company
• The company’s governance activities as well as its operating and financial activities are consistently reported to the shareholders

Question 2

LOs 40b: Describe practices related to board and committee independence, experience, compensation, external consultants, and frequency of elections, and determine whether they are supportive of shareowner protection

Answer 2

To protect their interests, shareholders and investors should consider whether:

• board members are independent
• Board members report their activities at least annually to shareholders and meet regularly without company management
• the board chair is also the present CEO or a former CEO of the company. This would give one person too much control
• Independent board members have a lead member if the board chair is not independent

Compensation and Related Party Transactions

Policies that cover related-party transactions ensure that board members remain independent and discourage them from the following practices:

• Receiving consultancy fees for work performed on behalf of the company
• Receiving finders fees for bringing merger, acqusisition, or sales partners to the company’s attention

A company should disclose all material related-party transactions or commerical relations it has with its board members

External Consultants

Board members should be able to hire experienced external consultants to guide them in decision-making, without having to gain approval from management. Investors should determine whether the board members are utilizing thier consultants and if they are paying them properly

Frequency of Elections

When reviewing the company’s policy for the election of board members, investors should consider whether:

• Shareholders elect members every year, or for staggered multiple-year terms. An annually elected board provides more flexibility whereas staggered boards can help protect the company from being taken over
• The board has filled a vacant position for a remaing term without shareholder approval
• Shareholders can vote to remove a board member
• The board is of the right size given the facts and circumstances of the company

Question 3

LOS 40c: Describe board independence and explain the importance of independent board members in corporate governance

Answer 3

Independence as its relates to board members, refers to the degree to which they are not biased or otherwise controlled by company management. To be considered independent board members should not have material relationships with:

• Independent board members constitute at least a majority of the board
• The company or its subsidiaries or members of its group, including former employees and executives
• Individuals, groups, or other entities that can exert significant influence on the company’s management, such as controlling individuals
• Executive managers, including family members
• Company advisers and their families
• Any entity that has a cross-directorship with the company

Question 4

LOS 40d: Identify factors that an analyst should consider when evaluating the qualifications of board members

Answer 4

Investors should evaluate the qualifications of board members based on whether they:

• Are able to make informed decisions about the company’s future with regard to finance, accounting, business, and law
• Are able to act with care and competence as a result of relevant understand of the companys products, legal metters, accounting, strategy, and risk
• have made public statements that provide an identification of their ethical perspectives
• Have had legal or regulatory problems while serving on the board of another company
• Have experience serving on other boards, particularly with companies known for having good corporate governance practices
• Serve on boards for number of other companies, which contrains the time needed to serve effectively on each board
• Regularly attend board and committee meetings
• Have committed to the needs of shareholders

Question 5

LOS 40f: Explain provisions that should be included in a strong corporate code of ethics

Answer 5

As part of the analysis of the company’s ethical standing, investors should determine whether the company:

• Gives the board access to relevant corporate info in a timely and comprehensive manner
• Has an ethical code, and whther that code prohibits any practices that would provide advantages to company insiders that are not also offered to shareholders
• Has an ethical code that the company promotes internally, and requires training for employees on compliance with the code
• Has designated someone who is responsible for corporate ethics
• Has an ehtical code that provides waivers from its prohibitions to certain levels of managment
• Has waived any of its code provisions during recent periods
• Regularly performs an audit of its ethical/governance policies and procedures to make improvements

When the code is weak, related-party transactions can be misused to benefit insiders at the expense of the company. A weak code also allows board members and families and managers to use company assets for personal use. To evaluate a company’s policies regarding person use of company assets, investors should determine whether the company:

• Has an ethical code or policies that place limits on insiders’ ability to use company assets for personal use
• Has lent or donated cash or other resources to insiders
• Has purchased property or other assets for management, board members
• Has leased assets to insiders

In evaluating corporate transparency, investors should analyze:

• The amount paid to key executives and the manner in which this compensation is provided to determine whether it is appropriate given the executives level of responsibilities and performance
• The size, purpose, means of financing and duration of share repurchase programs and price stabilization programs

Question 6

LOS 40e: Describe responsibilites of the audit, compensation, and nominations committees and identify factors an investor shold consider when evaluating the quality of each committee

Answer 6

Audit Committee

The audit committee’s main purpose is to ensure that the financial information presented to shareholders by the company is complete, accurate, reliable, relevant, and timely. It is responsible for hiring external auditors and ensuring that:

• The external auditors’ priorities are aligned with the best interest of the shareholders
• The auditor is free from management influence
• The info in the financial statements is complete, accurate, reliable, relevant, and timely
• The statements are in accordance to GAAP
• the audit is conducted in accordance with generally accepted auditing standards (GAAS)

Investors should determine whether:

• All the board members are independent
• The board submits the appointment of the external auditors to a vote of shareholders
• The audit committee has the authority to approve or reject other proposed nonaudit engagements with the external audit firm
• The committee controls the audit budget
• The committee under goes periodic training to stay educated about current financial issues

Remuneration Committee

This committee should ensure that various forms of compensation offered to executives encourage them to behave in a manner that enhances the company’s long- term performance and profitability. The committee can further these goals by:

• Including only independent board members on the committee
• Linking executive compensation to long-term profitability
• Use only independent compensation consultants who report solely to the committee
• Communicate with the shareholders about compensation
• Develope clear explinations of compensation

Investors should determine whether the committee adequately represents shareholders’ interest. The should determine whether:

• the compenstaion offered to management is appropriate
• The committee adequately articulates its compensation philosophy
• Executive compensation is linked to long-term profitability
• Members of the committee attend meetings during the year
• The company provides detailed info about compensation to shareholders
• Whether potential conflicts of interest exist between the compensation committee and the company

Nominations Committee

Responsible for:

• recruiting new board members
• regularly examining the performance of existing board members along with thier independence
• Creating nominations policies and procedures
• Preparing for the succession of executive management and the board

Investors should review the following:

• Company reports over several years to determine if the committee has recruited good board members
• The background of existing board members and if new nominees complement the boards current portfolio of talents
• How the committee finds new board members
• the attendance records of board members at regular and special meetings

FINAL NOTE

Shareholders should:

• Encourage companies to provide frequent and meaningful communications about strategy and long-term vision, including transparent financial reporting that reflects the company’s progress towards its goals
• Encourage the inclusion of statements concerning long-term corporate strategy in all company communications
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Question 7

LOS 40g: Evaluate, from a shareowner’s perspective, company policies related to voting rules, shareowner sponsored proposals, common stock classes, and takeover defenses

Answer 7

Voting Rules

Ownership Structure and Voting Rights

When assessing the ownership structure of a company, an investor should consider:

• There are different classes of shares and how voting rights differ between them
• The company has safeguards in its articles of organization or by-laws that protect the interest of shareholders with inferior voting rights
• The company was recently privatized by a government anf whether the selling government has retained voting rights
• The super-voting rights granted to certain classes of shareholders have impaired the company’s ability to raise equity capital in the future

Proxy Voting

In order to evaluate whether a particular company permits proxy voting, investors should consider whether it:

• Requires shareholder’s presence at the annual general meeting for them to vote
• Coordinates the timing of its annual general meeting with other companies in its region to ensure that all of them hold their meetings on the same day but in different locations. This prevents shareholders from being able to attend all meetings
• Permits proxy voting by means of paper ballot, electronic voting, proxy voting services, or some other remote mechanism
• Gives shareholders enough time between the release of the proxy and the vote date to consider their options

Confidential Voting and Vote Tabulation

In determining whether a particular company allows them to vote anonymously, investors should consider whether:

• The company uses a third-party entity to count shareowner votes
• The company or its third-party agent retains voting records
• The company provides “timely disclosure” of annual meeting voting results
• The vote is subject to an audit to ensure accuracy
• Shareholders are permitted to vote only if they are present

Cumulative Voting

Cumulative voting enables shareholders to cast the cumulative number of votes alloted to their shares in favor of one or a limited number of board nominees. This structure effectively improves the chances that shareholder interests will be represented on the board

Voting for Other Corporate Changes

Shareholders should evaluate their ability to effect changes to a company’s

• Articles of organization
• by-laws
• governance structures
• voting rigths and mechanisms
• poison pills
• change-in-control provisions
• board members

Investors should determine whether they:

• Will have an opportunity to vote on the sale of their company
• will have the right to vote on certain aspects of executive compensation
• have the right to vote against directors
• have the right to approve a new anit-takeover measure

They should also review issues such as:

• Share buy-back programs
• amendments to corporate charters and by-laws
• Issuance of new capital

Shareowner Proposals

Shareowner-Sponsored Board Nominations

To evaluate whether shareholders can propose nominees to the board, investors should determine:

• Under what circumstances can shareholders nominate board members
• How the company handles contested board elections

Shareowner- Sponsored Resolutions

Investors should evaluate shareholders’ ability to submit resolutions for consideration at the company’s annual general meeting by determing whether:

• The company requires a simple majority, 2/3rds, or some other majority to pass resolutions
• initiatives proposed by shareholders will benefit the long-term interests of all shareholders
• Any “advance notice provision” exists in the jurisdiction that would require a shareowner to give notice of proposal a certain amount of time before an annual meeting

Advisory or Binding Shareowner Proposals

Investors should determine if the board and management are actually required to implement proposals approved by shareholders by considering whether:

• The company has implemented or ignored shareholder approved proposals in the past
• The company requires a supermajority vote to approve changes to its by-laws and articles of organization
• Regulatory agencies have had to presure the company to act on the terms of approved shareholder initiatives

Other Shareholder Rights Issues

Shareowner Legal Rights

Investors should determine whether:

• Local legal statutes permit shareholders to initiate legal actions against management or board members
• The regulator has taken action in other cases to enfore shareholder rights or to prevent the denial of their rights
• Shareholders are permitted to take legal action to enforce fraud charges against management or the board

Takeover Defenses

When reviewing a company’s anti-takeover measures, investors should:

• Inquire whether shareholder approval is required before implementation of such anti-takeover measures
• Find out whether the company has received any formal acquisition interest in the past
• Consider the possibility that management will use the company’s cash and available credit lines to pay hostile bidder to forgo takeover
• Consider wheter changes of control issues are likely to invite pressure on the seller to change the terms of a proposed acquisition or merger
• Consider whether change-in-control provisions will trigger large severance packages to executives
• Understand whether the company is involved in any cross-shareholding arrangements with other companies