1. Corporate Governance Chapter 1
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2. 1. Introduction What is corporate governance?
Corporate governance is the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome the conflicts of interest inherent in the corporate form.
Hence, the importance of understanding the different forms of business.
Corporate governance affects the operational risk and, hence, sustainability of a corporation.
The quality of a corporation’s corporate of governance affects the risks and value of the corporation.
Effective, strong corporate governance is essential for the efficient functioning of markets.
Introduction
LOS: Explain corporate governance, describe the objectives and core attributes of an effective corporate governance system, and evaluate whether a company’s corporate governance has those attributes.
[p.1-2]
Corporate governance is the system that is used to overcome problems associated with the separation of managers and owners (hence, the need to understand different forms of business).
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3. 2. Corporate governance: Objectives and guiding principles
There are inherent conflicts of interest in corporations in which the ownership and management are separate.
Objectives of corporate governance:
To eliminate or mitigate conflicts of interest.
Particularly those between corporate managers and shareholders; and
To ensure that the assets of the company are used efficiently and productively and in the best interests of its investors and other stakeholders.
2. Corporate Governance: Objectives and Guiding Principles
LOS: Explain corporate governance, describe the objectives and core attributes of an effective corporate governance system, and evaluate whether a company’s corporate governance has those attributes.
[p. 2-3]
The separation of ownership and management is the basis for the agency relationship between managers (agents) and owners (principals). The emphasis is on corporate governance and how it affects the value of a business; hence, the relevance for analysts and investors.
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4. Core Attributes of an effective corporate governance system
Delineation of rights of shareholders and other stakeholders
Clearly defined manager and director governance responsibilities
Identifiable and measureable accountabilities
Fairness and equitable treatment in dealings
Transparency and accuracy in disclosures
Core Attributes of an Effective Corporate Governance System
LOS: Explain corporate governance, describe the objectives and core attributes of an effective corporate governance system, and evaluate whether a company’s corporate governance has those attributes.
[p. 3]
Core attributes: Delineation of the rights of shareholders and other core stakeholders;
Clearly defined manager and director governance responsibilities to stakeholders;
Identifiable and measurable accountabilities for the performance of the responsibilities;
Fairness and equitable treatment in all dealings between managers, directors, and shareholders; and
Complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position.
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5. 3. Forms of business and conflicts of interest
The form of business will dictate, in part, the relationship between the owners of the business and management.
The degree of separation may be minimal (e.g., sole proprietorship), or significant (e.g., large corporation).
When there is a separation between owners and managers, there is a potential for agency problems, which may affect the value of the business.
We will examine three business forms: the sole proprietorship, the partnership, and the corporation.
3. Forms of Business and Conflicts of Interest
LOS: Compare major business forms and describe the conflicts of interest associated with each.
[p. 3-6]
The interactions among the form of business, the agency relationships, and governance are key to valuation.
The form of business affects the likelihood of agency issues
Form → separation of management and owners → agency issues
Forms of business:
Sole proprietorship
Partnership
Corporation
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6. Sole proprietorship
A sole proprietorship is owned and operated by a single person
Sole proprietorships are the most numerous in terms of number of businesses.
Who bears governance risk in a sole proprietorship?
There are few risks with respect to governance from the perspective of the owner.
Creditors, including trade creditors, have the highest risk with respect to governance.
Sole Proprietorship
LOS: Compare major business forms and describe the conflicts of interest associated with each.
[p. 4]
The sole proprietorship is the simplest form of business.
There is often little separation between the owner and the manager(s) of the business; often, one in the same. Therefore, there is not much of an opportunity for a conflict of interest between the owner and manager(s)
Copyright © 2013 CFA Institute

7. Partnership A partnership has two or more owner/managers.
Who bears governance risk in a partnership?
There are few risks with respect to governance from the perspective of the owners, with ownership rights and responsibilities detailed in the partnership agreement.
Creditors, including trade creditors, have the higher risk with respect to governance.
Partnership
LOS: Compare major business forms and describe the conflicts of interest associated with each.
[p. 5]
The partnership is a natural extension from the sole proprietorship, with more than one owner.
The owners often are managers of the business, with a partnership agreement, so there is little separation between owners and managers. Hence, there are few opportunities for conflicts of interest among partners and management.
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8. Corporation
A corporation is a legal entity that has rights similar to an individual.
For example, a corporation can enter into contracts.
Corporations account for most business revenue around the world.
Corporations around the world: Limited Company (U.K.), Gesellschaft (German); Societé Anonyme (France), 公司 (China); şirket (Turkey); บริษัท (Thailand)
Corporation
LOS: Compare major business forms and describe the conflicts of interest associated with each.
[p. 5-6]
The corporation is a legal entity, with major decisions made by the board of directors.
The members of the board of directors are elected by shareholders.
The board of directors monitor the company’s management on behalf of the shareholders.
Because of this agency relationship, there are potential conflicts between the agents (the management and the members of the board of directors) and the owners (the shareholders).
Copyright © 2013 CFA Institute

9. Advantages of the corporate form
A corporation can raise capital.
Grant ownership stakes (that is, issue stock) or borrow (that is, issue bonds).
Owners need not know how to run the business.
The corporation hires experts to manage the business.
Ownership interests are transferrable.
Advantages of the Corporate Form
LOS: Compare major business forms and describe the conflicts of interest associated with each.
[p. 5]
The advantages of the corporate form (raise capital, owners not managers, transferable ownership interests) set the corporate form apart from the partnership and sole proprietorship.
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10. Disadvantages of the corporate form
Corporations are more highly regulated than are partnerships or sole proprietorships.
For example, in the U.S. there are State laws pertaining to corporations and the Securities and Exchange Commission requires specific disclosures.
Separation of owners and managers.
This is the agency relationship, in which someone (the agent) acts on behalf of another person (the principal).
The potential conflict between owners and managers is the agency problem or principal-agent problem,
Principals: shareholders
Agents: Management and members of the board of directors
There are costs to this agency relationship arising from conflicts of interest.
Disadvantages of the Corporate Form
LOS: Compare major business forms and describe the conflicts of interest associated with each.
[pp. 5-6]
The disadvantages arise from:
the agency relationship (management/shareholder conflicts), and
governmental regulation of securities.
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11. 3. Forms of business and conflicts of interest
Characteristic
Sole Proprietorship
Partnership
Corporation
Ownership
Sole owner
Multiple owners
Unlimited ownership
Legal requirements and regulation
Few; entity easily formed
Numerous legal requirements
Legal distinction between owner and business
None
Legal separation between owners and business
Liability
Unlimited
Unlimited but shared among partners
Limited
Ability to raise capital
Very limited
Nearly unlimited
Transferability of ownership
Non-transferable (except by sale of entire business)
Non-transferable
Easily transferable
Owner expertise in business
Essential
Unnecessary
Forms of business and conflicts of interest
LOS: Compare major business forms and describe the conflicts of interest associated with each.
[p. 4-6]
Sole proprietorship
Partnership
Corporation
Exhibit 1-1, page 4
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12. 4. Specific sources of conflict: Agency relationships
Managers
Board of directors
Shareholders
Management–Shareholder conflicts
Specific Sources of Conflict: Agency Relationships
LOS: Explain conflicts that arise in agency relationships, including manager–shareholder conflicts and director–shareholder conflicts.
[p.6]
Diagram: two sources of conflicts in the corporate agency relationships
The specific conflicts are discussed in the next two slides.
Director–Shareholder conflicts
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13. Management–Shareholder Conflicts
Shareholders entrust management with funds from reinvested earnings or newly issued stock, which management invests.
The overarching objective is to maximize shareholders’ wealth.
Issue: Managers are human
Managers may be more interested in expanding the size of the business, bonuses based on earnings, taking on excessive risks, or job security.
Managers may consume excessive perquisites, or in effect, take advantage of their position to spend excessively on things for themselves.
Bottom line: there may be agency costs in terms of the explicit and implicit costs when managers do not act in the best interest of shareholders.
Effective corporate governance guards against agency costs.
Management-Shareholder Conflicts
LOS: Explain conflicts that arise in agency relationships, including manager–shareholder conflicts and director–shareholder conflicts.
[pp. 6-10]
Example 1-1 : Enron
Creating special purpose vehicle, SPV (a.k.a. special purpose entity, SPE), with the Enron’s CFO receiving fees for deals between Enron and the SPVs.
Hiding debt off-balance sheet (through special purpose vehicles)
Example 1-2: Tyco International
Use of corporate funds for personal expenses
Example 1-3: Parmalat
Reporting assets the company did not have (accounting mis-reporting)
Example 1-4: Adelphia
Undisclosed personal loan between Adelphia and founders/managers
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14. Director–shareholder conflicts
The board of directors are an intermediary between the shareholders and management, and represent shareholders’ interests by:
Monitoring managers;
Approving strategies and policies;
Approving mergers and acquisitions;
Approving audit contracts;
Reviewing audit contracts and financial contracts;
Establishing management compensation;
Disciplining poorly performing managers.
A conflict may arise if the board members align with management.
Director-Shareholder Conflicts
LOS: Explain conflicts that arise in agency relationships, including manager–shareholder conflicts and director–shareholder conflicts.
[p. 10]
Director-Shareholder conflicts arise when the interests of directors (who may also be managers) diverge from those of shareholders.
Note: Sarbannes-Oxley (2002) addressed conflicts with respect to the audit committee and the compensation committees (which, pre-SOX, could be comprised of managers/insiders).
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15. Responsibilities of the Board of Directors
Establish corporate values and governance structures for the company;
Ensure that all legal and regulatory requirements are met and complied with fully and in a timely fashion;
Establish long-term strategic objectives for the company;
Establish clear lines of responsibility and a strong system of accountability and performance measurement;
Hire the chief executive officer, determine the compensation package, and periodically evaluate the officer’s performance;
Ensure that management has supplied the board with sufficient information for it to be fully informed and prepared to make the decisions that are its responsibility, and to be able to adequately monitor and oversee the company’s management;
Meet regularly to perform its duties;
Acquire adequate training.
Responsibilities of the Board of Directors
LOS: Describe responsibilities of the board of directors and explain qualifications and core competencies that an investment analyst should look for in the board of directors.
[p. 11]
Responsibilities
Establish corporate values and governance structures for the company to ensure that the business is conducted in an ethical, competent, fair, and professional manner;
Ensure that all legal and regulatory requirements are met and complied with fully and in a timely fashion;
Establish long-term strategic objectives for the company with a goal of ensuring that the best interests of shareholders come first and that the company’s obligations to others are met in a timely and complete manner;
Establish clear lines of responsibility and a strong system of accountability and performance measurement in all phases of a company’s operations;
Hire the chief executive officer, determine the compensation package, and periodically evaluate the officer’s performance;
Ensure that management has supplied the board with sufficient information for it to be fully informed and prepared to make the decisions that are its responsibility, and to be able to adequately monitor and oversee the company’s management;
Meet regularly to perform its duties, and in extraordinary session as required by events;
Acquire adequate training so that members are able to adequately perform their duties.
Bottom line: Be prepared to carry out the board’s fiduciary duty to shareholders, which means that the board members will carry out its monitoring of management on behalf of shareholders effectively.
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16. 5. Corporate Governance Evaluation: Board of director Attributes
The board should be comprised primarily of independent directors (that is, not insiders)
The Chairman of the Board should be independent;
Directors should be qualified;
There should be a regular election of members of the Board;
There should be a regular self-assessment of the Board;
The board should hold separate meetings of the independent directors;
The board should require audit oversight by independent directors who have sufficient expertise in finance, accounting, and the law.
Corporate Governance Evaluation: Board of Director Attributes
LOS: Describe responsibilities of the board of directors and explain qualifications and core competencies that an investment analyst should look for in the board of directors.
[p ]
The board should be comprised primarily of independent directors.
Independent director: a director who is not an insider,
who is not employed or has not been employed by the company,
who does not have a business relationship or a personal relationship with a manager,
who does not have a directorship with another company that has either a relationship with the company or with a manager, or
who has a credit or banking relationship with the company.
The Chairman of the Board should be independent.
There are differences of opinion regarding this, but in general independence is preferred.
Directors should be qualified.
Qualifications: Independence, relevant expertise, ethical soundness, experience, commitment to serve, commitment to shareholders.
There should be a regular election of members of the Board.
Staggered board of directors v. annual elections: differences of opinions (continuity v. displace poor performing board members).
There should be a regular self-assessment of the Board.
Useful in continual improvement of the Board.
The board should hold separate meetings of the independent directors.
Opportunity to meet without management or others with self-interest.
The board should require audit oversight by independent directors who have sufficient expertise in finance, accounting, and the law.
While this seems obvious, this was not the case in many of the scandal-plagued companies.
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17. 5. Corporate Governance Evaluation: Board of director Attributes (continued)
The nominating committee should be comprised of independent directors;
The compensation committee should be comprised of independent directors;
The board should be able to hire outside counsel;
The board should disclose governance policies;
The board should ensure adequate disclosure and transparency;
The board should require disclosure of any related-party transactions;
The board should respond to shareholders’ non-binding proxy votes.
Corporate Governance Evaluation: Board of Director Attributes (continued)
LOS: Describe responsibilities of the board of directors and explain qualifications and core competencies that an investment analyst should look for in the board of directors.
[pp ]
The nominating committee should be comprised of independent directors.
This may seem obvious, but allowing management to nominate board members is creating potential conflicts of interest.
The compensation committee should be comprised of independent directors.
This may seem obvious, but allowing management to set their own pay is problematic.
The board should be able to hire outside counsel.
Necessary for addition, independent counsel on legal matters (e.g., evaluation of compliance).
The board should disclose governance policies, which should include the Code of Ethics.
Though disclosure does not ensure compliance, it at least shows awareness on the part of the board.
The board should ensure adequate disclosure and transparency.
The board should require disclosure of any related-party/insider transactions.
This is to avoid some of the problems with the scandal-plagued companies, such as Enron.
The board should respond to shareholders’ non-binding proxy votes.
These votes are non-binding, but the board should acknowledge these and should consider these votes.
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18. Monetary Authority of Singapore Guidelines and Regulations on Corporate Governance
Principle 1: Every Institution should be headed by an effective Board.
Principle 2: There should be a strong and independent element on the Board which is able to exercise objective judgment on corporate affairs independently from management and substantial shareholders.
Principle 3: The Board should set and enforce clear lines of responsibility and accountability throughout the Institution.
Principle 4: There should be a formal and transparent process for the appointment of new directors to the Board.
Principle 5: There should be a formal assessment of the effectiveness of the Board as a whole and the contribution by each director to the effectiveness of the Board.
Principle 6: In order to fulfill their responsibilities, Board members should be provided with complete, adequate and timely information prior to board meetings and on an on-going basis by the management.
Monetary Authority of Singapore Guidelines and Regulations on Corporate Governance
LOS: Describe responsibilities of the board of directors and explain qualifications and core competencies that an investment analyst should look for in the board of directors.
LOS: Explain effective corporate governance practice as it relates to the board of directors, and evaluate the strengths and weaknesses of a company’s corporate governance practice.
[pp ]
These principles and guidelines (this slide and the next) are illustrative of a set of principles that address the attributes of a good governance system.
Discussion question: How well do the Monetary Authority of Singapore’s guidelines line up with the previous enumerated Corporate Governance Evaluation Board of Directors Attributes?
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19. Guidelines and Regulations on Corporate Governance (continued)
Principle 7: There should be a formal and transparent procedure for fixing the remuneration packages of individual directors. No director should be involved in deciding his own remuneration.
Principle 8: The level and composition of remuneration should be appropriate to attract, retain and motivate the directors to perform their roles and carry out their responsibilities.
Principle 9: The Board should establish an Audit Committee with a set of written terms of reference that clearly sets out its authority and duties.
Principle 10: The Board should ensure that there is an adequate risk management system and sound internal controls.
Guidelines and Regulations on Corporate Governance (continued)
LOS: Describe responsibilities of the board of directors and explain qualifications and core competencies that an investment analyst should look for in the board of directors.
LOS: Explain effective corporate governance practice as it relates to the board of directors, and evaluate the strengths and weaknesses of a company’s corporate governance practice.
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20. Guidelines and Regulations on Corporate Governance (continued)
Principle 11: The Board should ensure that an internal audit function that is independent of the activities audited is established. Principle 12: The Board should ensure that management formulates policies to ensure dealings with the public, the Institution’s policyholders and claimants, depositors and other customers are conducted fairly, responsibly and professionally. Principle 13: The Board should ensure that related party transactions with the Institution are made on an arm’s length basis.
Guidelines and Regulations on Corporate Governance (continued)
LOS: Describe responsibilities of the board of directors and explain qualifications and core competencies that an investment analyst should look for in the board of directors.
LOS: Explain effective corporate governance practice as it relates to the board of directors, and evaluate the strengths and weaknesses of a company’s corporate governance practice.
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21. Organisation for Economic Co-Operation and Development (OECD) Principles of Corporate Governance
The rights of shareholders II
The equitable treatment of shareholders
III
The role of stakeholders in corporate governance IV
Disclosure and transparency V
The responsibilities of the board
Organisation for Economic Co-Operation and Development (OECD) Principles of Corporate Governance
LOS: Explain effective corporate governance practice as it relates to the board of directors, and evaluate the strengths and weaknesses of a company’s corporate governance practice.
[pp , including Example 1-6]
The OECD principles are another example of a set of principles for a good quality governance system.
Discussion questions
Consider General Electric’s Governance Principles on pp. 25 – 31. Examining each of the 19 provisions, are these consistent with good corporate governance? Why or why not?
Consider General Electric’s Board of Directors. Is this an effective board? Why or why not?
Total of 19 directors
17 independent
1 not independent
The Chairman of the Board is also the CEO
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22. 6. Environmental, social, and governance factors
ESG risk exposure
Environmental, social, and governance (ESG) risk is the risk associated with the management of environment, social, and governance issues.
Involves mitigating risks and managing these risks when they arise.
ESG risk affects the company’s sustainability and valuation.
Environment
Pollution
Disclosures
Social
Workplace issues
Product quality and safety
Community interaction
Governance
Effective governance
Environmental, social, and governance factors
LOS: Describe elements of a company’s statement of corporate governance policies that investment analysts should assess.
[p ]
We have come to understand the valuation implications of ESG (environmental, social, and governance) factors, especially in light of scandals that affect corporate value:
Financial/governance: Enron (2001), Tyco International (2002), Health South (2003)
Environmental: BP Oil (2010)
Social: Halliburton & bribery (2010); Wal-Mart & bribery in Mexico (2012); Siemens AG & bribery (2008); “sweatshop” conditions for manufacturers for U.S. companies (on going)
Methods for mitigating ESG risks:
Whistle-blower programs
Independent board of directors
Policies on bribery, corruption
Compliance program
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23. Examples of ESG risks
Legislative and regulatory risk (that is, the role of governments)
Legal risk (for example, lawsuits)
Reputational risk
Operating risk
Financial risk
Examples of ESG Risks
LOS: Describe elements of a company’s statement of corporate governance policies that investment analysts should assess.
[p ]
Examples of risks:
Legislative and regulatory risk: The risk that governmental laws and regulations directly or indirectly affecting a company’s operations will change with potentially severe adverse effects on the company’s continued profitability and even its long-term sustainability.
Example: EPA regulations that require production curtailment (e.g. coal)
Legal risk: The risk that failures by company managers to effectively manage ESG factors will lead to lawsuits and other judicial remedies, resulting in potentially catastrophic losses for the company.
Example: Triad Group (medical products) filed for bankruptcy in September 2012 due to product liability lawsuits for its contaminated alcohol wipes.
Reputational risk: Companies whose managers have demonstrated a lack of concern for managing ESG factors in the past, so as to eliminate or otherwise mitigate risk exposures, will suffer a diminution in market value relative to other companies in the same industry that may persist for a long period of time.
Example: Child labor issues
Operating risk: The risk that a company’s operations may be severely affected by ESG factors, even to the requirement that one or more product lines or possibly all operations might be shut down.
Example: Weather catastrophes that affect inputs
Financial risk: The risk that ESG factors will result in significant costs or other losses to the company and its shareholders. Any of the above sources of risk can affect a company and its financial health, sometimes severely.
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24. 7. Valuation implications of corporate governance
Benefits from a strong corporate governance
Risks of weak corporate governance
Valuation implications of corporate governance
LOS: Explain the valuation implications of corporate governance
[p. 39]
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25. Risks of weak corporate governance
Accounting risk
The risk that a company’s financial statement recognition and related disclosures are incomplete, misleading, or materially misstated.
Asset risk
The risk that the firm’s assets may be misappropriated by managers or directors.
Liability risk
The risk that management will enter into excessive obligations that destroy the value of shareholders’ equity.
Strategic policy risk
The risk that managers may enter into transactions or incur other business risks that are self-serving and may not be in the best long-term interest of shareholders.
Risks of Weak Corporate Governance
LOS: Describe elements of a company’s statement of corporate governance policies that investment analysts should assess.
[p. 39]
Risks associated with a weak governance:
Accounting risk: The risk that a company’s financial statement recognition and related disclosures, upon which investors base their financial decisions, are incomplete, misleading, or materially misstated.
Enron
Sunbeam
Asset risk: The risk that the firm’s assets, which belong to investors, will be misappropriated by managers or directors in the form of excessive compensation or other perquisites.
Adelphia
Tyco International
Liability risk: The risk that management will enter into excessive obligations, committed to on behalf of shareholders, that effectively destroy the value of shareholders’ equity; these frequently take the form of off-balance-sheet obligations.
Strategic policy risk: The risk that managers may enter into transactions, such as mergers and acquisitions, or incur other business risks, that may not be in the best long-term interest of shareholders, but which may result in large payoffs for management or directors.
Discussion question:
Netflix adopted a poison pill in November 2012 that is effective once an unwanted suitor’s equity interest reaches 10%. Carl Icahn owns 10% of Netflix and says that this poison pill is an example of “poor corporate governance”. Why would the poison pill (a.k.a. shareholders rights plan), which allows shareholders to buy new preferred stock (one right per share for 1/1000 a share of stock) if an investor acquires 10% of the company, be considered “poor corporate governance”?
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26. Benefits from strong governance
Evidence suggests that:
companies with strong governance had greater investment performance.
companies with strong shareholders’ rights outperformed those with weak protections.
Benefits from Strong Governance
LOS: Explain the valuation implications of corporate governance.
[p ]
Evidence is consistent with both developed and developing markets: strong governance enhances value.
Copyright © 2013 CFA Institute

27. 8. Summary
Corporate governance is the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities.
The objectives of a corporate governance system are (1) to eliminate or mitigate conflicts of interest among stakeholders, particularly between managers and shareholders, and (2) to ensure that the assets of the company are used efficiently and productively and in the best interests of the investors and other stakeholders.
The failure of a company to establish an effective system of corporate governance represents a major operational risk to the company and its investors.
8. Summary
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28. Summary (continued)
The specific sources of conflict in corporate agency relationships are manager- shareholder.
The responsibilities of board members, both individually and as a group, are to establish corporate values and effective governance structures for the company.
8. Summary (continued)
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29. Summary (continued)
Companies committed to corporate governance often provide a statement of corporate governance policies. Analysts should assess:
the code of ethics; statements of the oversight, monitoring, and review responsibilities of directors;
statements of management’s responsibilities with respect to information and access of directors to internal company functions;
reports of directors’ examinations, evaluations, and findings;
board and committee self-assessments; management self-assessments; and
training policies for directors.
Weak corporate governance systems give rise to risks including accounting risk, asset risk, liability risk, and strategic policy risk.
8. Summary (continued)
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