formation of a separate committee frees up the membership of that committee to include executives as

appropriate.

6- The investment committee

An investment committee is responsible for reviewing significant investment opportunities. This may include
large projects or acquisitions as well as major disposals. Usually, the executive side of the business will have
prepared the proposal and the investment committee will review it and challenge it to ensure it is in line with
business objectives.

The various subcommittees, their membership and their responsibilities vary between different jurisdictions, and
occasionally also between different industries – for example, listed companies often have prescribed committee
structures required by regulations.

Factors affecting stakeholder relations

1- Market Factors

a) Shareholders
Engagement with shareholders is governed by law at its most basic level – for example, the requirement
to hold an annual general meeting or AGM to discuss financial and strategic matters with shareholders.
However, there is a growing tendency for businesses to seek engagement beyond and outside of the
legal minimum. This can be beneficial as it reduces the risk of shareholder activism, it can help
businesses to manage the narrative with shareholders and it can reduce sudden and disruptive
interventions from shareholders in the future.

Shareholder activism refers to the positive intervention in company matters by groups of shareholders
to force a company to act in the desired manner. This may include drawing contentious issues to the
attention of the press, or proposing shareholder resolutions to change company policy. For example
shareholders may intervene if they feel decisions are being made that in the best interest of the directors
as opposed to the shareholders.

b) Competition
Competition provides a benchmark to understand an organisations performance. Shareholders and other
stakeholders will therefore compare the performance of the organisation to competitors or other
comparable organisations and potentially seek to intervene if they feel the organisation is
underperforming.

c) Mergers and acquisitions

In many markets, mergers and acquisitions are common. These can be encouraged by opportunists
looking for a short-term gain.

A hostile takeover bid is where the management of the target company does not wish an acquisition to
go ahead. In such circumstances regulations typically require the management of the target company to
make offers made for the business known to the shareholders of the target company to enable them to
make up their own mind.

Various techniques are used to reduce the risk of unwanted takeovers – often put in place by target
company directors to protect their position. For example, a “poison pill” may be used – an onerous term
associated with a financial instrument – a bond may for example be irredeemable – so never due to be
repaid – however, it may contain a term that says if the company is taken over it will be instantly
redeemable at an enormous premium. This means any company buying the business would need to
accept a sudden and immediate huge outflow of value due to this poison pill. Such terms are often
considered anti-competitive and illegal by the courts.
 d) Staggering director elections
The practice of staggering director elections may reduce the ability of shareholders to replace the entire
board at any one time so does to a limited degree protect incumbent members of the board from
shareholder activism.

Again, this is not best practice – remember the directors have a duty to act in the best interests of the
shareholders.

2- Non-market Factors

a) Legal framework
The legal framework of the country being considered will have a significant influence on both. The legal
framework will set the ‘rules of engagement’, in other words how business is to be conducted, as well as
laying out the rights of, responsibilities of and remedies available to the respective stakeholders.

The legal framework generally consists of statutes and other formal legislation, and common law.
Common law is judgement and interpretation through judicial opinion.

Creditors are afforded better protection under the law than shareholders in general given that they have
explicit contracts in place to enforce their rights. Shareholder rights are often more complex.

b) Media
The media also plays a significant role. It can shape public opinion on issues such as boardroom pay,
and highlight practices that may stimulate shareholder activism or activism from other stakeholders such
as customers who may refuse to buy from a business that has had its reputation damaged in the press.

Their ability to shape public opinion also attracts the interests of politicians, who then often legislate in
sympathy with public opinion.

Social media serves to ensure that issues and concerns are circulated quickly and visibly and so is a
significant concern of modern business in managing the relationship with stakeholders. Businesses are
often active on social media to help manage the narrative.

c) Advisory industry
There is a growing advisory industry for corporate governance. These advisors and may get involved in
rating businesses according to their governance practices and providing them with advice to improve.
They are very influential therefore in corporate governance practically.

RISK ASSOCIATED WITH POOR CORPORATE GOVERNANCE

In essence, sound corporate governance improves the performance of the business. Let us consider some of
the risks of having poor corporate governance procedures in place:

1. Poor internal controls

Sound corporate government should ensure adequate risk management and internal control systems are in
place and operating. The lack of these systems can lead to various issues such as an increased incidence of
fraud, and a lack of focus in the organisation on consistently trying to achieve agreed-upon objectives. It can
also lead to excessive waste. Many of the large corporate scandals relating to corporate governance
happened because of a subsequent compromise of the internal control environment allowing inappropriate
activities to take place, such as fictitious accounting entries.
2. Poor quality decisions
The overriding duty of the board is to act as agents for their principles the shareholders and sound corporate
governance should help ensure that this happens. With poor corporate governance, decisions may be made
to suit others such as the board of directors and executives, to the detriment of shareholders. A lack of
scrutiny by the shareholders as a result of poor corporate governance may also do little to discourage
directors in this sense.

3. Legal, regulatory and reputational risks

Poor practices may constitute breaking the law in some cases – especially in rules-based jurisdictions like
the USA.

Even if the law isn’t being broken, specific regulations for example like those required by local stock
exchanges could lead to sanctions such as fines or ultimately being delisted.

In addition, anything that is considered to be poor practice may lead to a bad reputation. Particularly in a
competitive marketplace a loss of reputation may mean a loss of business from customers, and an inability
to attract investment.

4. Solvency risks
A lack of sound governance may lead to an insufficient focus on activities in the business to ensure a going
concern. For example, if creditor covenants are not adhered to this could trigger a technical default with the
creditor potentially taking action to recover their funds at a time when the company may not be able to afford
it.

In short, the benefits of sound corporate governance are twofold:

 Firstly, stopping bad things from happening

In terms of stopping bad things from happening, sound corporate governance will hopefully reduce the
incidence of fraud and dysfunctional decision-making in the organisation as well as inappropriate risk-taking.

 Secondly, ensuring good things happen

In terms of ensuring good things happen, sound corporate governance will promote improved internal
controls which will help to ensure the efficient and effective operation of the business. This in turn should
lead to improved financial performance and adherence to contractual requirements in relation to loans.

Sound corporate governance also engenders trust amongst the investing community – if investors trust the
board of directors, their perceived level of risk is lower. This in turn will have a beneficial effect on share
price as we shall see later on in the module.

Factors relevant to the analysis of corporate governance and stakeholder management issues
Given the role poor corporate governance has played in individual corporate failures and wider issues such as
the global financial crisis in 2008, analysts are increasingly focusing on the quality of corporate governance
when assessing an organisation.

Areas an analyst may focus on might include:

1- Shareholders and voting rights

Generally speaking, a one-share-one-vote system applies, although care must be taken to examine the
rights of different classes of shareholder if they exist. For example, ‘A’ shares may be one share one vote,
whereas ‘B’ shares may be one share 10 votes – and reserved for family members.

Sometimes the class of share dictates what the shareholder is able to vote on. For example – voting on
board membership. This can significantly influence ultimately who controls and runs the organisation, so
careful consideration of these shareholders’ motivations is important in the assessment of an organisation.
 Analysts should take note of who the major shareholders are as this will affect the governance and
performance of the business.

For example, in many jurisdictions cross shareholdings are common – this is where company A own shares
in company B and company B own shares in company A. this can lead to businesses supporting each
other’s proposals, whether or not there in the direct interest of the other shareholders.

If there is an affiliated shareholder such as a family or private equity fund that owns sufficient share capital,
this can protect the board from the other shareholders seeking to pass resolutions. This being the case, the
affiliated shareholder has significant influence and they should be borne in mind in any assessment of
corporate governance and control.

If there are shareholder activists holding shares in a company being assessed, these activists can
significantly influence the sentiments of others, so they often exert more influence than just their voting rights
would suggest.

Shareholders rights can vary from country to country, and can also vary between companies depending on
how the company is constituted, for example in terms of its memorandum and articles of association. An
analyst should make sure they understand the nature and extent of shareholder rights. For example, a share
may not afford voting rights on all matters.

2- Background of the board

Basic information is usually available about the board of directors’ background, experience and skills. The
analyst should ensure they consider the independence, experience, and diversity of the board as well as the
term of their directors’ service contracts. A shorter term contract holds directors more immediately to account
for their performance.

3- Remuneration schemes of executives

Remuneration schemes should be scrutinised by the analyst to ensure that they incentivise appropriate
behaviour. The availability of this information will depend on the location of the business.

In general, there will be three elements to directors’ remuneration – basic pay and benefits, short-term
incentive plans (such as annual bonuses based on annual profits) and long-term incentive plans. The analyst
should clarify what criteria needs to be met in order to earn any variable element.

Scheme elements to be wary of would include:

 Cash based payouts only and no shares - this may mean objectives are not aligned with shareholders
 Performance related elements that don’t seem to produce much variation in payout from year to year –
this casts doubt on the true performance related nature of the scheme
 Plans that produce payouts significantly in excess of benchmark comparisons
 Plans with significant elements relating to now less relevant criteria. For example, in the early stages of
its life a business may focus on revenue growth. It may be inappropriate for remuneration to be paid in
relation to revenue growth later in the life of the business as the business matures.

4- Risk management
The organisations ability to manage risks should be assessed – for example, if there is a significant amount
of fines, accidents regulatory penalties or interventions or other investigations, this may indicate that risk
management procedures are inadequate.

ENVIRONMENTAL AND SOCIAL IMPACT OF BUSINESS AND CORPORATE

GOVERNANCE

As social and environmental issues are increasingly seen as key in society, increasingly corporate governance
seeks to ensure sound corporate citizenship, in other words, ensuring that organisations effectively discharge
their duty for corporate social responsibility. The relationship between environmental and social factors, and
governance is, therefore, known collectively as “ESG”.

Sustainable investing and socially responsible investing

 Sustainable investing and responsible investing refer to investing in companies that manage their
resources in a more sustainable way. In this context, “resources” refers to more than just financial resources
– it would encompass environmental, social and human capital.

Sustainability in general refers to “not compromising the future by the way in which we behave today” – so in
other words building these capitals rather than exhausting them.

 Socially responsible investing typically means something subtly different – it means not investing in
businesses that produce items that deviate from the investors’ beliefs – such as the production of weapons
for example. In more recent times this definition has broadened to include investing in companies that are
positively socially responsible, such as businesses that take particular care of the environment in their
activities.

Whereas, is it can be argued that socially responsible investing and sustainable investing are a moral
imperative, there is also an argument to suggest that given society is increasingly broadly supportive of such
investments, they are also more likely to be financially successful. Customers are increasingly more likely to
purchase from an organisation that has strong environmental credentials for example. This commonality
between financial and social objectives is useful to avoid a conflict of interest between a board’s fiduciary duty to
its shareholders and ESG.

For example, in 2010 the deep water horizon explosion in the Gulf of Mexico ended up costing BP tens of
billions of dollars in fines, contributions and cleanup costs. Poor environmental performance leads to poor
financial results.

Social issues are also increasingly a concern in society – this may include working conditions of employees, or
an organisation’s impact on the community and environment in which suppliers work.

Global Reporting Initiative (‘GRI’)

Increased attention in relation to environmental and social issues has led to increased disclosures by businesses
to demonstrate their performance in this area. For example, the Global Reporting Initiative (‘GRI’) is a voluntary
reporting framework that encourages businesses to report on their economic, environmental, and social
performance – sometimes known as “triple bottom line reporting”.

ESG and investment analysis

The nature and significance of ESG issues will vary from business to business and sector to sector. For
example, a transport business may be particularly concerned with the amount of carbon-based pollution it
produces, whereas this may be less of an issue for a financial advisory business.

Typical environmental issues to be considered in investment analysis would include:

 Natural resources management such as the management of forests, rivers and oceans
 The use of carbon-based fuels
 Water use
 Adherence to environmental regulations.

If regulations change and reduce, for example, pollution limits this could have significant financial implications for
a business that historically has needed to produce more pollution than the new pollution limit now allows – they
may need to invest in new equipment or otherwise change their business model.
Poor environmental management can lead to a damaged reputation and loss of sales, as well as fines, legal
damages and rectification costs.

Typical social issues to be considered in ESG would include:

 Human rights
 Workers welfare – including health and safety
 Developing safe products
 Community impact

It’s also worth noting that commercially, a happy and safe workforce tend to be more productive and this
contributes towards the financial performance of the business so focusing on social factors can enhance
financial performance.

ESC implementing approaches

Businesses can adopt several approaches when implementing ESG, a few possible approaches include:

1- Negative screening refers to excluding certain sectors that typically transgress economic and social
objectives – for example, a fund may refuse to invest in coal mining companies on the basis that extracting
fossil fuels contributes to global warming ultimately.

2- Positive screening or best-in-class refers to investing in businesses with an unusually favourable ESG
performance. For example, a company with particularly good social and environmental policies may be
ranked highly in a positive screening test.

3- ESG integration or ESG incorporation Involves ensuring that ESG considerations are considered in the
qualitative and quantitated framework used to assess investments, alongside more traditional measures.

4- Thematic investing is concerned with investing in companies that follow a certain theme such as renewable
energy, or combatting climate change. These usually follow significant social trends, so investing in them
often provides both a moral and a financial reward.

5- Impact investing seeks to achieve social and environmental objectives by direct investment in a company
or projects, such as providing funding to create renewable energy for use within a business