Corporate Finance Chapter1

CORPORATE GOVERNANCE
CHAPTER 1
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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 corporations corporate of governance affects the risks and

value of the corporation.
Effective, strong corporate governance is essential for the efficient

functioning of markets.
Copyright 2013 CFA Institute
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.
CORE ATTRIBUTES OF AN EFFECTIVE

CORPORATE GOVERNANCE SYSTEM
Clearly defined manager

and director governance
responsibilities
Identifiable and
measureable
accountabilities
Delineation of rights
of shareholders and
other stakeholders
Fairness and equitable
treatment in dealings
Transparency and accuracy

in disclosures
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.
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.
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.
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); Societ Anonyme (France), (China); irket (Turkey);
(Thailand)
ADVANTAGES OF THE CORPORATE FORM

1. A corporation can raise capital.
Grant ownership stakes (that is, issue stock) or borrow (that is, issue bonds).
2. Owners need not know how to run the business.
The corporation hires experts to manage the business.
3. Ownership interests are transferrable.
DISADVANTAGES OF THE CORPORATE FORM

1. 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.
2. 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.
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3. FORMS OF BUSINESS AND

CONFLICTS OF INTEREST
Characteristic
Sole Proprietorship Partnership
Corporation
Ownership
Sole owner
Multiple owners
Unlimited ownership
Legal requirements and

regulation
Legal distinction between
owner and business
Few; entity easily

formed
None
Few; entity easily

formed
None
Liability
Unlimited
Ability to raise capital
Very limited
Unlimited but shared

among partners
Limited
Numerous legal
requirements
Legal separation
between owners and
business
Limited
Transferability of ownership
Non-transferable
(except by sale of
entire business)
Essential
Owner expertise in business
Nearly unlimited
Non-transferable
Easily transferable
Essential
Unnecessary
Exhibit 1-1, page 4

11
4. SPECIFIC SOURCES OF CONFLICT:

AGENCY RELATIONSHIPS
ManagementShareholder conflicts
Managers
Managers
Board
Board of
of
directors
directors
Shareholders
Shareholders
DirectorShareholder conflicts
12
MANAGEMENTSHAREHOLDER 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.
13
DIRECTORSHAREHOLDER 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.
14
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 officers 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 companys
management;
Meet regularly to perform its duties;
Acquire adequate training.
15
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.
16
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.
17
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.
18
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.
19
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 Institutions 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 arms length basis.
20
ORGANISATION FOR ECONOMIC CO-OPERATION AND

DEVELOPMENT (OECD)
PRINCIPLES OF CORPORATE GOVERNANCE
I
The rights of shareholders
II
The equitable treatment of shareholders
III
The role of stakeholders in corporate governance
IV
Disclosure and transparency
The responsibilities of the board
21
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 companys sustainability and valuation.
Environment
Pollution
Disclosures
Social
Workplace
issues
Product quality
and safety
Community
interaction
Governance
Effective
governance
22
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
23
7. VALUATION IMPLICATIONS OF CORPORATE

GOVERNANCE
Benefits from a strong
corporate governance
Risks of weak
corporate governance
24
RISKS OF WEAK CORPORATE GOVERNANCE
Accounting risk
The risk that a
companys
financial
statement
recognition and
related
disclosures are
incomplete,
misleading, or
materially
misstated.
Asset risk
The risk that the
firms 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 selfserving and may
not be in the
best long-term
interest of
shareholders.
25
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.
26
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.
27
SUMMARY (CONTINUED)
The specific sources of conflict in corporate agency relationships are managershareholder.
The responsibilities of board members, both individually and as a group, are to
establish corporate values and effective governance structures for the
company.
28
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 managements 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.
29

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CORPORATE GOVERNANCE

Hence, the importance of understanding the different forms of business.

Corporate governance affects the operational risk and, hence, sustainability of

The quality of a corporations corporate of governance affects the risks and

Effective, strong corporate governance is essential for the efficient

Copyright 2013 CFA Institute

2. CORPORATE GOVERNANCE: OBJECTIVES

To eliminate or mitigate conflicts of interest.

Copyright 2013 CFA Institute

CORE ATTRIBUTES OF AN EFFECTIVE

Clearly defined manager

Copyright 2013 CFA Institute

Transparency and accuracy

The degree of separation may be minimal (e.g., sole proprietorship), or

When there is a separation between owners and managers, there is a

We will examine three business forms: the sole proprietorship, the

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

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

Copyright 2013 CFA Institute

ADVANTAGES OF THE CORPORATE FORM

2. Owners need not know how to run the business.

The corporation hires experts to manage the business.

3. Ownership interests are transferrable.

Copyright 2013 CFA Institute

DISADVANTAGES OF THE CORPORATE FORM

2. Separation of owners and managers.

This is the agency relationship, in which someone (the agent) acts on

Copyright 2013 CFA Institute

3. FORMS OF BUSINESS AND

Sole Proprietorship Partnership

Legal requirements and

Few; entity easily

Few; entity easily

Ability to raise capital

Unlimited but shared

Owner expertise in business

Exhibit 1-1, page 4

4. SPECIFIC SOURCES OF CONFLICT:

Copyright 2013 CFA Institute

Managers may be more interested in expanding the size of the business,

Managers may consume excessive perquisites, or in effect, take advantage

Effective corporate governance guards against agency costs.

Copyright 2013 CFA Institute

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.

Copyright 2013 CFA Institute

5. CORPORATE GOVERNANCE EVALUATION:

Copyright 2013 CFA Institute

5. CORPORATE GOVERNANCE EVALUATION:

Copyright 2013 CFA Institute

MONETARY AUTHORITY OF SINGAPORE

GUIDELINES AND REGULATIONS

Every Institution should be headed by an effective Board.

There should be a strong and independent element on the Board

There should be a formal and transparent process for the