LM02 Introduction to Corporate Governance and Other ESG Considerations

Part 1

1. Introduction

This reading covers:

• The various stakeholders of a company and their interests
• The principal-agent and other relationships between stakeholder groups
• Corporate governance mechanisms to manage stakeholder relationships
• The potential risks of poor corporate governance and the benefits from effective corporate governance
• ESG considerations in investment analysis
• ESG investment approaches

2. Stakeholder Groups

A stakeholder is any individual or group that has a vested interest in a company. The primary stakeholder groups of a company include:

• Shareholders and creditors: provide capital to finance the company’s activities
• Board of directors: Serves as the steward of the company
• Managers: Execute the strategy set by the board and run day-to-day operations
• Employees: Provide human capital for the day-to-day operations of the company
• Customers: Buy the company’s products and services
• Suppliers: Provide raw materials as well as goods and services that cannot be produced efficiently internally.
• Government and regulators: Dictate the rules and regulations governing the company.

Exhibit 1 from the curriculum illustrates these relationships.

Shareholder vs. Stakeholder Theory

Traditional corporate governance frameworks were based on the ‘shareholder theory’, however, many companies are now moving to corporate governance frameworks based on the ‘stakeholder theory’.

Shareholder theory: The goal of a company is to maximize shareholder returns. The interests of other stakeholders are considered only to the extent that they affect shareholder value.

Stakeholder theory: The company should consider the interests of all stakeholders, not just shareholders. This theory also gives more importance to ESG considerations by making them an explicit objective for the board of directors and management.

We will now look at each stakeholder group in detail.

Shareholders

Shareholders own shares in a corporation and are entitled to certain rights, such as the right to receive dividends and to vote on certain corporate issues.

A shareholder’s interests are typically focused on growth in corporate profitability that maximizes the value of the company.

Creditors/Debtholders

Banks and Private Lenders

• They generally hold a company’s debt till maturity.
• They typically have direct access to company management and insider information which reduces information asymmetries.
• As compared to public debt holders, banks and private lenders can exert a significant degree of influence on a company.
• Most banks and private lenders prefer companies to have less financial leverage as it implies less risk. They may, however, take very different approaches to lending. Some focus primarily on the collateral supporting their loan; others hold both debt and equity positions in the same company; some have an equity-like focus on the company; and some lend to businesses that they would be interested in owning if the company defaulted.

Public Debtholders (Bondholders)

• They rely on public information and the ratings provided by credit rating agencies to make their investment decisions.
• In return for the capital provided, they expect to receive periodic interest payments and repayment of principal at the end of the term.
• Unlike shareholders, they do not have voting rights.
• They have limited influence over a company’s operations.
• They generally seek to minimize downside risk and prefer stability in company’s operations and performance. This is in contrast to the interests of shareholders, who are willing to take higher risks for higher potential returns.

Board of Directors

A company’s board of directors is elected by shareholders to protect shareholders’ interests, monitor the company’s operations, and provide strategic direction.  The board is also responsible for hiring the CEO and overseeing management performance. A board can be composed on both inside and independent directors.

• Inside directors are major shareholders, founders, and senior managers.
• Independent directors do not have a material relationship with the company in terms of employment, ownership, or remuneration and are chosen for their experience of managing or directing other companies.

There is no standard structure or composition for the board of a company. The number of directors can vary depending on the size, structure, and complexity of operations of the company. However, most corporate governance standards require that board members have a diverse range of expertise, backgrounds, and competencies, with at least one-third of the board being independent.

Staggered board is a commonly followed practice, in which directors are divided into three groups and elected into office in consecutive years, so that all directors are not replaced at the same time. The advantage of a staggered board is that it allows for continuous strategy implementation. The disadvantage is that it limits shareholders’ ability to effect an immediate major change in control of the company.

Managers

Managers, led by the CEO are responsible for executing the strategy set by the board. They are also in charge of the company’s day to day operations.

Senior managers are typically compensated with a base salary, a short-term cash bonus, and a multi-year incentive plan that includes one or more forms of equity (such as options, time-vested shares, and performance-vested shares). As a result, in addition to acting to protect their employment status, managers may be motivated to maximize the value of their total remuneration.

Employees

Lower-level employees seek fair salary, good working conditions,  job security, career development opportunities, promotion, etc.

As compared to managers, equity ownership is a minor part of their compensation. Therefore, they are more interested in the company’s long-term stability, survival and growth.

Customers

Customers expect to receive products and services of good quality for the price paid. They also expect after-sales service, support, and guarantee/warranty for the period promised. In return, companies strive to keep their customers happy as this has a direct effect on its revenues. Of all the stakeholders, customers are least concerned about a company’s performance.

Suppliers

The primary interest of a supplier is to be paid on time for the products and services delivered to the company. Some suppliers are keen to maintain a good long-term relationship with companies as it is recurring business. Like customers, suppliers typically have an interest in the company’s long-term stability.

Governments

Government is a stakeholder as it collects taxes from companies and their employees. Governments seek to protect the interests of the general public and ensure the well-being of their nations’ economies.

3. Principal–Agent and Other Relationships

A principal-agent relationship arises when a principal hires an agent to carry out a task or a service (e.g. shareholders and managers/directors). An agent is obliged to act in the best interests of the principal and should not have a conflict of interest in performing a task. However, in reality, there are several conflicts of interest that arise in a principal-agent relationship, for example: information asymmetry.

Information asymmetry: Managers have greater access to information about a company’s performance and prospects as compared to outsiders such as shareholders and creditors. This information asymmetry reduces shareholders’ ability to assess managers’ true performance and vote out poor performers. Investors demand higher risk premiums and returns from companies that have greater information asymmetry.

In this section we will discuss a few examples of conflicts between principal-agents and other relationships.

Shareholder and Manager/Director Relationships

In this relationship, shareholders are the principals and managers/directors are the agents. Compensation is the main tool used to align the interest of managers/directors with those of the shareholders. In theory, stock grants/options offered as part of management compensation are intended to motivate managers to maximize shareholder value. However, in practice, the alignment of interests is rarely perfect. Three common examples of conflict of interests are:

• Entrenchment: If the overall level of manager/director compensation is excessive, they may try to avoid risk so as to not jeopardize the compensation they have been receiving.
• Empire building: If manager/director compensation is tied to the size of the company, it can lead to ‘growth for growth’s sake’; managers may pursue acquisitions and expansions that do not increase shareholder value.
• Excessive risk taking: Because option holders only participate in stock up moves, a compensation package that relies too heavily on stock grants/options may encourage excessive risk taking by management. Similarly, a compensation package with too little or no stock grants/options can have the opposite effect.

Agency costs: Agency costs arise due to conflicts of interest when an agent makes decisions for a principal. All public companies and large private companies are usually managed by non-owners. Therefore, an agency cost in the context of a corporation is a consequence of a  conflict of interest between managers and owners. Since outside shareholders are aware of this conflict, they will take steps that incur costs such as:

• Costs borne by owners to monitor the management of the company, e.g., expenses of the annual report, board of director expenses, etc.
• Costs borne by management to assure owners that they are maximizing the company value, e.g., the implicit cost of noncompete employment contracts and the explicit cost of insurance to guarantee performance.

The better a company is governed, the lower the agency costs.

Controlling and Minority Shareholder Relationships

Corporate ownership structures can be classified as:

• Dispersed: Many shareholders exist and none of them have the ability to individually exercise control over the company.
• Concentrated: An individual shareholder or a group has the ability to exercise control over the company.
• Hybrid: A combination of the above two types.

Share ownership alone may not necessarily reflect whether the control of a company is dispersed or concentrated. Controlling shareholders may be either majority shareholders or minority shareholders.

• Majority shareholders: Own more than 50% of a company’s shares.
• Minority shareholders: Own less than 50% of a company’s shares.

In companies with concentrated ownership, conflict of interest may arise between the controlling and minority (without control) shareholders. For example,

• Electing board of directors: Controlling shareholders have greater representation and influence in electing the board of directors that use straight voting. As a result, minority shareholders do not have much representation on the board.
• Takeover transactions: Corporate decisions taken by controlling shareholders impact the performance of a company, and consequently, shareholders’ wealth. Controlling shareholders exercise their influence on significant decisions such as takeover transactions.

Dual-Share Classes

An equity structure with multiple share classes tends to assign superior voting powers to one class and limited voting rights to other classes. The multiple-class structure allows controlling shareholders avoid dilution of their voting power when new shares are issued and to retain control of board elections, strategic decisions, and all other significant voting matters for an extended period of time — even if their ownership level falls below 50%.

Manager and Board Relationships

The management of the company is primarily responsible for the operations of a company and has access to all information about the company. Since the board relies on the management for information, its powers and monitoring ability is impacted if information is withheld by the management or only selective information is provided.

Shareholder vs. Creditor (Debtholder) Interests

There is a conflict of interest between the two suppliers of capital to a company under the following circumstances:

• Distribution of dividends: Creditors are concerned if a company pays excess dividends to shareholders that may impair its ability to service debt.
• Risk tolerance: Shareholders have a higher risk tolerance and prefer a company takes on more risk to generate higher returns. The better the performance of a company, the higher is the return shareholders can expect. Creditors are conservative and prefer a stable operating cash flow over higher returns as they do not have a claim to residual income.
• Increased borrowing: When a company increases its borrowing and fails to generate returns to service the debt, then the default risk faced by the creditors increases.

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