Chapter1-Corporate Governance

Describe Corporate Governance

Corporate governance may be defined as the system of internal controls, processes, and
procedures by which a company is managed, directed or controlled. Weak corporate
governance practices have resulted in the failures of many companies.

The corporate governance practices of countries tend to be different, and it is also not strange for
different corporate governance systems to coexist within a single country.

Corporate governance systems generally reflect the influences of either shareholder theory,
stakeholder theory or a convergence of the two. Current trends, however, point to an increase in
convergence.

Shareholder theory posits that the most important responsibility of a company’s managers is to
maximize shareholder returns. Stakeholder theory, on the other hand, emphasizes the need for a
company to consider the needs of all its stakeholders and not just its shareholders. This includes
the company’s customers, suppliers, creditors, employees and essentially anyone who has an
interest in the company.

Describe a Company’s Stakeholder Groups

Corporate governance systems can be influenced by several stakeholder groups which may or
may not have conflicting interests.

A company’s primary stakeholder groups include its shareholders, creditors, managers, other
employees, customers, suppliers, government/regulator, and its board of directors.

By providing a company with equity capital, the shareholders of a company are considered its
owners. Their interests lie primarily in the profitability of the company and anything which leads
to an increase in the company’s equity. In the event of bankruptcy, shareholders receive proceeds
only after all creditors’ claims have been paid. Controlling shareholders hold sufficient shares in
a company to control the election of its board of directors and to influence company resolutions.
Minority shareholders, on the other hand, have far fewer shares and limited ability to exercise
control in voting activities.

The creditors of a company are the stakeholders who provide the company with debt financing.
Included in this category are bondholders and banks who expect to receive periodic interest
payments and principal repayments arising from money that they lent to the company.

Creditors generally prefer stability in a company’s operations and performance as this tends to
increase the likelihood that a company will generate sufficient cash flow to pay back its debt
obligations. In contrast, shareholders tend to accept higher risks in return for a higher return
potential from strong company performance.

Managers and other employees tend to benefit when a company performs well and are adversely
affected when the company’s financial position weakens. They seek to maximize the value of
their total remuneration while securing their jobs. Their interests are therefore not surprisingly
different from those of shareholders, creditors, and other stakeholders. Something of potential
benefit to other stakeholders may be disadvantageous to them.

The board of directors is elected by the shareholders of the company and is charged with the
responsibility of protecting shareholders’ interests, providing strategic direction and monitoring
company and management performance.

A company’s customers expect to receive value when they purchase its goods or services. They
tend to be more concerned with company stability and less with financial performance.

Suppliers, just like creditors, are concerned with a company’s ability to generate cash flows
sufficient to meet its financial obligations.

Governments and regulators seek to ensure that companies comply with the law and act in a
manner which safeguards the interests and well-being of the public.

Relationships in Corporate Governance

The term ‘Principal-agent relationship’ or just simply ‘Agency relationship’ is used to describe an
arrangement where one entity, the principal, legally appoints another entity, the agent, to act on its
behalf by providing a service or performing a particular task.

The agent is expected to act in the best interests of the principal. It is however not unusual for
principal-agent relationships to lead to conflicts. The most common example of this occurs when
managers, acting as agents, do not act in the best interests of the shareholders of the company (the
principals).

Shareholder and Manager/Director Relationships

Directors and managers (agents) are expected to act in the best interests of the shareholders
(principal) by maximizing the company’s equity value. These two groups, however, tend to diverge
on issues related to the risks that a company should undertake. Managers and directors tend to act in
a more risk-averse manner in order to better protect their employment status, whereas shareholders
would want for directors and managers to accept more risk in order to maximize equity value.

Additionally, managers usually have greater access to information and are more knowledgeable
about the company’s affairs than the shareholders.  This information asymmetry makes it easier for
managers to make strategic decisions that are not necessarily in the best interests of shareholders.
Controlling and Minority Shareholder Relationships

Minority shareholders usually have limited or no control over management and limited or no voice in
director appointments or in major transactions that could directly impact shareholder value. As a
result, conflicts between minority and controlling shareholders usually occur wherein the opinions or
desires of the minority shareholders are overshadowed by the influence of the controlling
shareholders.

Manager and Board Relationships

Whereas managers are involved in the day-to-day operations of a company, the board of directors,
especially the non-executive board members, are not. This leads to information asymmetry and
makes it difficult for the board to effectively carry out its functions.

Creditor versus Shareholder Interests

Creditors desire a company to undertake activities which promote stable financial performance and
maintain default risk at an acceptable level to essentially guarantee a safe return of their principal and
payment of interest. Shareholders, on the other hand, prefer for the company to undertake riskier
activities which have strong earnings potential and are more likely to enhance equity value. There is,
therefore, a divergence in risk tolerance between these two groups.

Other Stakeholder Conflicts

Examples of other conflicts between stakeholders include: conflicts between customers and
shareholders, conflicts between customers and suppliers, and conflicts between shareholders and
governments or regulators.

Proper stakeholder management is critical to the success of any organization. It involves taking
appropriate steps to identify, prioritize and understand each stakeholder group in order to properly
manage the relationships with them. Effective communication and engagement are, therefore,
necessary if an organization wants to get the most out of its stakeholder management.

The approaches to stakeholder management may vary across organizations. Typically, however,
organizations try to balance stakeholder interests as best as possible. This has the effect of limiting
any potential conflicts.

Stakeholder Management Components

 To assist with balancing stakeholder interests, corporate governance and stakeholder management
frameworks reflect legal, contractual, organizational, and governmental infrastructures. These four
components define the rights, responsibilities, and powers of each stakeholder group.

 Legal Infrastructure

The legal infrastructure defines the framework for legally establishing rights as well as the remedial
action to be taken for violations of these rights.

 Contractual Infrastructure

The contractual infrastructure refers to the contractual arrangements which are entered into by an
organization and its stakeholders and which help to define and secure the rights of both parties. An
organization has the most control with this component of stakeholder management.

 Organizational infrastructure

The organizational infrastructure refers to the internal systems and governance practices which an
organization uses to manage its stakeholder relationships.

 Governmental Infrastructure

The governmental infrastructure refers to the regulations which are imposed on an organization.

Mechanisms to Manage Stakeholder Relationships

In seeking to balance stakeholder interests, a company may employ various mechanisms for
stakeholder management. Common mechanisms include: holding general meetings, electing a board
of directors, having an audit function, company reporting and transparency, policies on related-party
transactions, remuneration policies (including say on pay), and other mechanisms to manage the
company’s relationship with its creditors, employees, customers, suppliers, and regulators.

General meetings
General meetings provide shareholders with the opportunity to participate in company discussions
and to vote on major corporate matters.

Companies usually hold an annual general meeting (AGM) within a certain period of time after the
end of their financial year. The main purpose of an AGM is to present shareholders with the annual
audited financial statements of the company, provide an overview of the company’s performance
over the year, and address any shareholder concerns.
It is also possible for extraordinary general meetings to be called by the company or by shareholders
within the year whenever significant resolutions requiring shareholder approval are proposed.

Ordinary resolutions require a simple majority of votes to be passed. These usually relate to the
approval of financial statements and the election of directors and auditors. Special resolutions require
a supermajority vote such as 75% of the votes to be passed. These are usually reserved for decisions
that are more material in nature such as effecting amendments to bylaws or voting on a proposed
merger or takeover transaction.

Proxy voting allows shareholders who cannot attend a general meeting to authorize another
individual to vote on their behalf. It is the most common form of investor participation in meetings.
Minority shareholders tend to use proxy voting in an attempt to increase their influence on
companies.

Cumulative voting allows a shareholder to accumulate and vote all of his or shares for a single
candidate in an election involving more than one director. By employing this process, minority
shareholders have an increased likelihood of being represented by at least one board director.

Board of directors
A board of directors is elected by company shareholders to provide oversight of the company. The
board appoints the top management of the company, is held accountable by shareholders and is also
responsible for the overall governance of the company. The board dictates the strategic direction of
the company, guides and monitors management’s actions towards executing the strategy and
evaluates management performance. The board also supervises the audit, control, and risk
management functions of the company as well as its compliance with all applicable laws and
regulations.

The Audit Function

The audit function describes the systems, controls, policies and procedures which a company has in
place to examine its operations and financial records. It serves to limit insiders’ discretion with
respect to the use of the company’s resources and its financial reporting and is also designed to
mitigate fraud or misstatements of accounting information.

There are two types of audit functions: internal audit functions and external audit functions.

Internal audits are conducted by an independent internal audit department. The role of
internal audit is to provide independent assurance that a company’s risk management, governance,
and internal control processes are operating effectively.

External auditors, which are external to a company, perform audits of the company’s financial
records with the objective of providing a reasonable and independent assurance that they accurately
reflect the company’s financial position. The board of directors usually receives and reviews the
financial statements and auditors’ reports as well as confirms their accuracy prior to them being
presented for shareholder approval at the AGM.

Reporting and Transparency

Shareholders are able to gain a range of financial and non-financial information mainly through
annual reports and other company disclosures. Access to this information reduces information
asymmetry between the shareholders and managers and allows the shareholders to better assess the
performance of the company and to make informed decisions on company valuations.

Remuneration Policies
Companies are increasingly establishing remuneration policies which discourage short-term focus
and excessive risk taking by managers. Long-term incentive plans delay the payment of all
remuneration until company strategic objectives, namely performance targets, have been met. Some
incentive plans include the granting of shares rather than options to managers and restrict their
vesting or sale for several years or until retirement.

Regulators are placing increasing focus on company remuneration policies. In some parts of the
world, regulators require companies to base their remuneration policies on long-term performance
measures. In some instances too, companies are required to adopt claw back provisions which allow
them to recover previously paid remuneration if certain events such as misconduct or fraud are
uncovered.

‘Say on Pay’ enables shareholders to vote on matters pertaining to executive remuneration. This
allows them to limit the discretion that directors and managers have in granting themselves excessive
or inadequate remuneration. It is often criticized by opponents who believe that the board is better
suited to handling remuneration matters given the limited involvement of shareholders in a
company’s strategic operations.

Contractual agreements with creditors

The rights of creditors are established by laws and provisions in the contracts that are executed with a
company.

Indentures are legal contracts which describe the structure of a bond, the obligations of the issuer,
and the rights of the bondholders. Covenants within indentures enable creditors to specify the actions
an issuer is obligated to perform or prohibited from performing. Creditors often require a company to
provide periodic financial information in order to ensure that covenants are not violated and default
risk is not increased.

Collateral in the form of assets or financial guarantees are often used to guarantee the repayment of
debt to creditors.
Employee Laws and Contracts

The rights of employees are primarily secured through labor laws. Labor laws define the standards
for employees’ rights and responsibilities and cover matters such as working hours, pension plans,
hiring and firing practices and vacation and leave entitlements. Unions seek to influence certain
matters which affect the well-being of employees on their jobs.

Employment contracts specify an employee’s rights and responsibilities but typically do not cover
every situation between employees and employers.

Effective human resource policies seek to attract and recruit high-quality employees while providing
remuneration, training/development and career growth prospects in order to improve employee
retention. Employee Stock Ownership Plans (ESOPs) are also used to retain and motivate employees.

Companies sometimes use Codes of Ethics and business conduct to establish the company’s values
and the standards of ethical and legal behavior which employees are expected to follow.

Other Mechanisms
Other mechanisms for stakeholder management include contractual agreements between companies
and their customers and suppliers, as well as laws and regulations.

Functions and Responsibilities of a Company’s Board of

Directors and its Committees

The board of directors provides oversight of the company and serves as the link between its
shareholders and managers. It has the ultimate responsibility of ensuring that the company adopts
proper corporate governance principles and complies with all applicable laws and regulations.

Board Composition
Boards with one-tier structures comprise a mix of executive and non-executive directors. The
executive directors are employed by the company and are usually members of senior management,
while the non-executive directors are external to the company and bring objectivity to the decision-
making process.  Independent directors are non-executive directors which do not have a material
relationship w/ith the company with respect to employment, ownership or remuneration.

In boards with two-tier structures, the supervisory and management boards are independent of each
other. The chairperson of the supervisory board is typically external to the company while the Chief
Executive Officer (CEO) usually chairs the management board.
In some countries such as the United States, many companies have “CEO duality” in which the CEO
also serves as the chairperson of the board. The CEO and chairperson roles are however becoming
increasingly separated.

Functions and Responsibilities of the Board

Duty of care and duty of loyalty are two well-established elements of directors’ responsibilities. The
Organization for Economic Co-operation and Development (OECD) Principles of Corporate
Governance indicate that duty of care “requires board members to act on a fully informed basis, in
good faith, with due diligence and care”, while duty of loyalty “is the duty of the board member to
act in the interest of the company and shareholders.”

The board:

– Guides and approves the company’s strategic direction

– Delegates strategy implementation to senior management

– Reviews corporate performance and determines relevant course of action

– Hires and fires senior managers

– Ensure leadership continuity through succession planning for the CEO and other key executives

– Sets the overall structure of the company’s audit and control systems

– Oversees reports by internal audit, the audit committee, and external auditors

Board of Directors’ Committees

The board of directors typically establishes committees and delegates some of its responsibilities to
these committees. Some of the most common committees include:

1. Audit Committee – The audit committee is responsible for recommending the appointment of
an independent external auditor and proposing the auditor’s remuneration. The audit
committee also monitors the company’s financial reporting process, including the application
of accounting policies. It also presents an annual audit plan to the board and monitors its
implementation by the internal audit function which it supervises.
2. Governance Committee – The governance committee ensures that the company adopts good
corporate governance practices.
3. Remuneration Committee – The remuneration or compensation committee develops
remuneration policies for the directors and key executives of the company and presents them
for approval by the board or shareholders.
 4. Nomination Committee – This committee establishes the nomination procedures and policies,
including eligibility criteria for board directorship.
5. Risk Committee – This committee supervises the risk management function of the company.
6. Investment Committee – The investment committee reviews material investment
opportunities proposed by management, such as expansion plans or acquisitions, and
considers their viability.

Factors that can Affect Stakeholder Relationships and

Corporate Governance
Both market and non-market related factors can affect stakeholder relationships and corporate
governance. Market factors are those factors which are related to the capital markets, while non-
market factors are those that are not related to the capital markets.

Market Factors
Market factors include shareholder engagement, shareholder activism, competition, and takeovers.

1. Shareholder Engagement involves a company’s interactions with its shareholders, namely

through AGMs and analyst calls.
2. Shareholder activism refers to the efforts of shareholders to create a change within a
company or to modify company behavior with the primary objective being to increase
shareholder value.
3. Shareholders usually compare the earnings reports and market share of a company with those
of its competitors and use the comparison to judge the performance of the managers and/or
board.
4. Corporate takeovers can be pursued in several ways. In a proxy fight, shareholders are
persuaded to vote for a group seeking a controlling position on the company’s board. In a
tender offer, shareholders sell their interests directly to the group seeking control, while in a
hostile takeover an attempt is made by one company to acquire another company without the
consent of the company’s management.

Non-market Forces
Non-market forces include the company’s legal environment, the role of the media, and the corporate
governance industry.

1. Legal environment – A company’s legal environment can significantly impact the rights and
remedies of stakeholders. In civil law systems, laws are created primarily through statues and
codes enacted by legislature. In contrast, in common law systems, laws are created both from
statutes that are enacted by legislature and by judges through judicial opinions. Regardless of
the prevailing legal system, creditors are generally more successful in seeking remedies in
court to enforce their rights than shareholders are.
 2. The Media can quickly spread information and shape public opinion. Social media, in
particular, has become a tool that shareholders are increasingly using to protect their interests
or influence corporate matters.
3. With the increased importance of corporate governance, the demand for external corporate
governance services has grown considerably. As a result, an industry which provides
corporate governance services such as governance ratings and proxy advice has developed.

Potential Risks of Poor Corporate Governance

Weaknesses in corporate governance practices and stakeholder management processes expose a
company and its stakeholders to several risks. The reverse scenario is that effective corporate
governance and stakeholder management practices can create several benefits for a company and its
stakeholders.

Potential Risks
1. One stakeholder group may benefit unfairly at the expense of other stakeholder groups due to
weaknesses in a company’s control systems.
2. Managers could make poor investment decisions which benefit them but are detrimental to
the company’s shareholders.
3. A company’s exposure to legal, regulatory and reputational risks could become heightened.
For example, a company may be subject to an investigation by a regulatory authority due to a
violation of laws and regulations. The company could also receive lawsuits from one of its
stakeholders due to some form of impropriety. These could potentially damage the reputation
of the company and lead to significant legal costs.
4. A company’s ability to honor its debt obligations may become hindered. This exposes it to
bankruptcy risk if its creditors decide to take legal action against it.

Potential Benefits
1. Operational efficiency could be improved
2. A company’s control systems may be enhanced due to the proper functioning of its audit
committee and the effectiveness of its audit systems.
3. Operating and financial performance could be improved which may lead to a reduction in the
costs that are associated with weak control systems.
4. Business and investment risk may be lowered, thus reducing a company’s cost of capital and
its default risk.
Factors Relevant to the Analysis of Corporate Governance
There are several factors which analysts consider when assessing a company’s corporate governance
structure and stakeholder management. These factors can provide important insights into the quality
of management and the sources of potential risk.

Factors
The factors which analysts look at include:

1. Economic Ownership and Voting Control: Corporations usually have a voting structure

which involves one vote for each share. Shareholders are however exposed to significant risk
when economic ownership becomes separated from control. Dual-class structures, in which
shares are commonly divided into two classes with one having superior voting rights to the
other (for example, class A and class B shares), is a popular way in which voting power can
be separated from economic ownership. Analysts are particularly interested in determining
the extent to which this separation occurs.
2. Board of Director Representation: Analysts look at available information to determine
whether the experience and skill sets of board members are aligned with the current and
future needs of the company. It is quite possible that a board’s composition is appropriate for
a particular point in time in the company’s history but may need changing in order to adjust
to new business needs. Additionally, a board composition that is dominated by long-tenured
board members may restrict the board’s ability to adapt to change.
3. Remuneration and Company Performance . Analysts assess the components of remuneration
plans to determine if they support or conflict with key performance drivers. This assessment
is somewhat subjective but there are certain warning signs that may lead to further scrutiny 1.
4. The Effect of Investors in the company: Investor behavior can limit or enhance the process of
effecting corporate changes. For example, a sizable affiliated shareholder can shield a
company from the voting done by outside shareholders. Shareholder activism can also create
a substantial turnover in a company’s shareholder composition.
5. The Strength of Shareholder’s Rights. Analysts are interested in determining whether the
rights of the shareholders in a company are strong, weak, or average when compared with
other companies.
6. The Management of Long-Term Risks. Analysts may consider how a company manages its
long-term risks as a significant factor in their overall assessment of the company.

1
These warning signs include:

– Plans which offer little alignment with shareholders’ interests

– Plans which exhibit little variation in results over multiple years

– Plans which have excessive payouts relative to companies with comparable performance

– Plans which have specific strategic implications

– Plans that are based on incentives which are from an earlier period in the company’s life

Factors in Investment Analysis

Environmental, social and governance factors are collectively referred to by the acronym “ESG”.
ESG integration is the practice of considering environmental, social, and governance factors in the
investment process, and can be implemented across all asset classes, including equities, fixed
income, and alternative investments.

Sustainable investing (SI) and responsible investing (RI) are sometimes used interchangeably with
ESG integration. Socially Responsible Investing (SRI) is an investment strategy that is said to
incorporate ESG issues, but which has been historically represented by the practice of excluding
companies and industries from investment consideration on the grounds that they oppose an
investor’s moral or ethical values.

Managers and investors tend to define and implement ESG mandates in many different ways. As a
result, there are often differences among investors regarding which ESG factors should be considered
in the investment process and to what extent they should be implemented within a portfolio.

Objective of the firm

Value Maximization

The objective in corporate finance can be stated broadly as maximizing the value of the entire
business, more narrowly as maximizing the value of the equity stake in the business, or even
more narrowly as maximizing the stock price for a publicly traded firm. The potential side costs
increase as the objective is narrowed.

Why Corporate Finance Focuses on Stock Price Maximization

1. Stock prices are the most observable of all measures that can be used to judge the
performance of a publicly traded firm. Unlike earnings or sales, which are
updated once every quarter or once every year, stock prices are updated
constantly to reflect new information coming out about the firm. Thus, managers
receive instantaneous feedback from investors on every action that they take. A
good illustration is the response of markets to a firm announcing that it plans to
acquire another firm. Although managers consistently paint a rosy picture of
every acquisition that they plan, the stock price of the acquiring firm drops at the
time of the announcement of the deal in roughly half of all acquisitions,
suggesting that markets are much more skeptical about managerial claims
2. If investors are rational and markets are efficient, stock prices will reflect the
long-term effects of decisions made by the firm. Unlike accounting measures like
earnings or sales measures, such as market share, which look at the effects on
 current operations of decisions made by a firm, the value of a stock is a function
of the long-term health and prospects of the firm. In a rational market, the stock
price is an attempt on the part of investors to measure this value. Even if they err
in their estimates, it can be argued that an erroneous estimate of long-term value
is better than a precise estimate of current earnings.

MAXIMIZE STOCK PRICES: THE BEST-CASE SCENARIO

If corporate financial theory is based on the objective of maximizing stock prices, it is worth
asking when it is reasonable to ask managers to focus on this objective to the exclusion of all
others. There is a scenario in which managers can concentrate on maximizing stock prices to the
exclusion of all other considerations and not worry about side costs. For this scenario to unfold,
the following assumptions have to hold.

1. The managers of the firm put aside their own interests and focus on maximizing
stockholder wealth. This might occur either because they are terrified of the power stockholders
have to replace them (through the annual meeting or via the board of directors) or because they
own enough stock in the firm that maximizing stockholder wealth becomes their objective as
well.

2. The lenders to the firm are fully protected from expropriation by stockholders. This can
occur for one of two reasons. The first is a reputation effect, i.e., that stockholders will not take
any action that hurts lenders now if they feel that doing so might hurt them when they try to
borrow money in the future. The second is that lenders might be able to protect themselves fully
by writing covenants proscribing the firm from taking any action that hurts them.

3. The managers of the firm do not attempt to mislead or lie to financial markets about the
firm’s future prospects, and there is sufficient information for markets to make judgments about
the

4. There are no social costs or social benefits. All costs created by the firm in its pursuit of
maximizing stockholder wealth can be traced and charged to the firm.