1. READING 34 CORPORATE GOVERNANCE AND ESG: AN INTRODUCTION
Corporate finance
READING 34
CORPORATE GOVERNANCE AND ESG: AN INTRODUCTION
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2. THIS READING COVERS
Understanding of corporate governance
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3. CORPORATE GOVERNANCE “the system of internal controls and procedures
by which individual companies are managed.
It provides a framework that defines
rights, roles and responsibilities
of various groups…. within an organization.
At its core, corporate governance is the arrangement of checks, conflicting interests between insiders and external shareowners.”
- The Corporate Governance Of Listed Companies: A Manual For Investors; CFA Institute publication
…contd
LOS a: Describe Corporate Governance
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4. Minimizes and manages conflicts of interest
Stakeholders are not managers of the company. Not all are involved in the direct working of the company.
Therefore, conflict of interest arises among various groups of people linked with the company –
Owners and management (internal group)
Directors, creditors, employees, customers, other stakeholders (external group)
Corporate governance, thus, is the construct within which the company is managed
Minimizes and manages conflicts of interest
It ensures transparency in working
Effective and sustained channel of communication (with shareholders)  Core of Corporate Governance
Shareholder’s theory
To ensure shareholder’s interest is not compromised:
Etiquette - Checks & balances
Code of Conduct - Charter of responsibilities
Discipline
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5. Good practices in corporate governance
Board members act:
In the best interest of shareholders
Independently from management and other entities
Company functions in a lawful and ethical manner when dealing with shareholders
All shareholders have same rights. Their rights to participate in the company’s governance is clearly communicated.
Company’s activities – operating, financial, governance – are reported to the shareholders.
The reports be fair, accurate, timely, complete, reliable and relevant.
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6. Primary stakeholders of a corporation
Shareholders
OWNERS
Have residual interest
Have voting rights
Have interest in profitability & growth
Company grows – values of their ownership rises
Board of Directors
Represent the owners in managing employees
Responsible for protecting shareholder’s interest
In charge of senior managers (hiring, their compensation, etc.)
Set strategies to drive the company
Monitor financial performance and other ongoing activities
Senior Managers
Receive compensation (salary + bonus (based on their performance) + other benefits)
Their interest includes continued employment & increasing compensation
LOS b: Describe a company’s stakeholder groups and compare interests of stakeholder groups
…contd
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7. Their interest lies in sustainability of the firm
Employees
Their interest lies in sustainability of the firm
More on the personal level, they are interested in the value of their pay, training, career opportunity, working conditions,
Creditors
Provide for debt capital
Primary owners of the firm’s bonds
No voting rights in management decisions
Their interest lies in the interest promised and principal repayment.
Suppliers
Supply resources to the firm
Have interest in on going relationship with the firm, their own profits from trade,
Short-term creditors
Interest in solvency and growth of the firm
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8. Principal-agent relationship
Cause of conflict: difference of interests of the agent and the principal
Agents are hired to fulfill the interest of the principal.
However, agents may have other interests.
Conflicts can be reduces by imposing underwritten standards.
Example: Insurance company and insurance agents
LOS c: describe principal-agent and other relationships in corporate governance and the conflicts that may arise in these relationships
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9. Other corporate relationships
Shareholders [principal]
Management/ board member [Agents]
Reasons of conflicts:
Difference in risk taking capacity
Make decision in favor of one at the cost of another
Information asymmetry
Shareholder vs. manager/directors
Minority shareholders vs. controlling shareholders (a single majority owner or a group that owns majority shares)
Reasons of conflicts:
Control over voting rights
Effects of majority shareholders on working of the company (causing to enter into a related party transaction and/or any such agreements)
Benefits during special events (like acquisition)
Among various shareholder groups
LOS c
Shareholder vs. creditors
Managers vs. Board
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10. Stakeholders management
INFRASTRUCTURES
to manage stakeholder relationship
Management of the company’s relation with its stakeholders
Understanding stakeholder’s interests
Maintaining effective communication with stakeholders
Legal infrastructure
To identify the laws and legal resources for reference in case of violation of stakeholders rights
Contractual infrastructure
Contracts that define rights and responsibilities of company & stakeholder
Organizational infrastructure
Corporate governance procedures (internal systems, practices to help manage relationship)
Governmental infrastructure
Regulations to which the company should comply
LOS d: Describe stakeholder management
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11. mechanisms to manage stakeholder relationships
Annual General Meetings
Ordinary Resolutions
Approval of auditor
Election of directors
Special resolutions
Merger and takeovers
Amendment of corporate bylaws
Voting
Board of directors mechanism
Reporting and maintaining transparency
Remuneration policies
Contracts with creditors, customers, suppliers, etc
Complying with laws and regulations
LOS e: Describe mechanisms to manage stakeholder relationships and mitigate associated risks
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12. Board of directors Board Structure: One tier Board Two tier board
Representatives of the owners
Board of directors
Appointed to ensure good corporate governance
Duty to act keeping in mind the long term interest of the shareholders
Board Structure:
Any number of directors
Often directors with niche expertise (e.g. Risk manager, Finance officer, etc.)
One tier Board
Single board (internal + external directors)
Internal – mostly the senior level managers
External – non-executive; independent directors;
Chairman  CEO (not always)
Two tier board
Supervisory board -
Management board – executive directors; led by CEO
Both operate independently
LOS f: describe functions and responsibilities of a company’s board of directors and its committees
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13. Features of a effective boards:
Should be independent
Should meet regularly without the management team
CEO should not be the Chairman
Suppliers/ customers should not be on the board
Board members should be qualified and experienced enough
They should attend meetings regularly
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14. Board Elections: Electing all the members is done in the same meeting
Each election is for multiple years
For staggered board: elections are held every year for some board positions
Board members are allowed to fill a vacancy in/till other board member’s term
Shareholders can vote to remove a board member (under certain circumstances)
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15. Board Responsibilities:
Selecting senior management (and their compensation, bonus, etc.)
Setting strategies,
Approving capital structure changes
Approving on acquisitions and other large investments
Reviewing company performance
Establishing and monitoring internal controls
Monitoring risk management system
Preparing fair financial reports
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16. Nominations committee
BOARD COMMITTEE
Ensuring that financial reports are complete, reliable, relevant and timely
Audit committee
Guaranteeing good corporate governance practices in the organization
Governance committee
Distinguishing and suggesting directors; nominating them for election
Nominations committee
Recommending the amounts and types of compensation to be paid
Compensation committee
Establishing enterprise risk management; planning and monitoring it’s implementation
Risk committee
Surveying opportunities
Investment committee
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17. Market factors that affect stakeholder relationships and corporate governance
Communication and contact with shareholders
AGM, analysts meetings
Pressure by Activists shareholders
Affects on voting
Raising issues to other shareholders
Taking up tender offer to have gain over maximum votes
Proxy fight
To seek proxies of shareholders to vote
Threat of hostile takeover
Existence of anti-takeover provisions
LOS g describe market and non-market factors that can affect stakeholder relationships and corporate governance
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18. Corporate governance industry
NON-Market factors that affect stakeholder relationships and corporate governance
Legal environment
Media
Corporate governance industry
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19. Risks of poor corporate governance and stakeholder management
Weak corporate governance  weak functional control of audits and board
Advantage to some stakeholders over others
Accounting fraud, poor recordkeeping
Absence / poor monitoring over managers
Legal and reputational risks
Violation of stakeholders’ rights
LOS h: identify potential risks of poor corporate governance and stakeholder management and identify benefits from effective corporate governance and stakeholder management
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20. benefits of effective corporate governance and stakeholder management
Improvement in operational efficiency
Effective control and monitoring
Better operating results
Reduction in debt default and bankruptcy risk; thus the cost of debt
Better financial performance
greater company value
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21. Factors relevant to analysts
Company ownership and voting structure
Board composition
Management incentives and remuneration
Shareholder composition
Relative strength of shareholders’ rights
Long-term-risk’s management
LOS i: describe factors relevant to the analysis of corporate governance and stake holder management
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22. ESG – environmental, social and governance factors
ESG integration – act of considering ecological, social and administration elements in speculation procedure
Aka ESG investing , sustainable investing, responsible investing
Issues considered:
Harm or potential harm to the environment
Risk of loss due to environmental accidents
Changing demographics
Changing work preference
Etc.
LOS j: describe environmental and social considerations in investment analysis
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23. ESG- for investment analysis
Negative screening
Most common strategy
Excludes certain industries/ sectors
Positive screening
Distinguishes companies with strong ESG-related standards
Thematic investing
Strategies using single factors
LOS k: Describe how environmental, social and governance factors may be used in investment analysis
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