IFT Notes for Level I CFA^® Program

R31 Introduction to Corporate Governance and Other ESG Considerations

Part 1

1. Introduction

This reading gives an overview of corporate governance, the stakeholders of a company, describes how companies manage various stakeholders, the role played by the board of directors, the risks in a corporate governance structure, what corporate governance issues are relevant for investment professionals, and environmental and social considerations for investors.

2. Corporate Governance Overview

The curriculum defines corporate governance as “the system of internal controls and procedures by which individual companies are managed.” Corporate governance defines the rights, roles, and responsibilities of various groups within an organization and how they interact. One of the goals of a good corporate governance system is to minimize the conflict of interests between the stakeholders within a company and external shareholders.

Corporate governance practices differ from country to country, and even within a country several governance systems may be practiced. Most corporate governance systems are based on one of these two theories or a combination of both: stakeholder theory and shareholder theory.

Shareholder theory is based on the premise that the goal of a company is to maximize shareholder returns.

Stakeholder theory is based on the premise that a company’s focus is not restricted to shareholders, but extends to other stakeholders as well such as its customers, employees, suppliers, etc.

3. Company Stakeholders

A corporate governance system considers the needs of several stakeholder groups, some of whom may have conflicting interests. This section covers the various stakeholder groups in a corporation and the possible conflicts across these groups.

3.1. Stakeholder Groups

The primary stakeholder groups of a corporation include shareholders, creditors, managers and employees, a board of directors, customers, suppliers, and governments/regulators. We look at each group in detail now.

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.

There are two types of shareholders in a company:

Controlling shareholders who hold a significant percentage of shares in a company, which gives them the power to control how the board of directors is elected. They also have the power to not vote in favor of a resolution; due to a lack in the majority, the resolution may not be passed. Examples of a resolution put to vote include: the number of shares to buyback, merger of a company, winding up of a division, etc.
Non-controlling shareholders are minority shareholders who hold a relatively smaller proportion of a company’s outstanding shares. They have limited voting rights.

Creditors

Creditors are suppliers of debt financing to a company such as bondholders and banks. Some of the key characteristics and rights of creditors are listed below:

Unlike equity shareholders, they do not have voting rights.
They have limited influence over a company’s operations.
They may impose restrictions on what a company can and cannot do through covenants.
In return for the capital provided, they expect to receive periodic interest payments and repayment of principal at the end.
Unlike equity shareholders, they do not directly benefit from a company’s strong performance and prefer stability in a company’s cash flows.

Managers and Employees

Senior managers and employees are compensated for their work at a company through salary and bonuses linked to individual and company performance, stock options, etc. Lower level employees seek fair salary, career development through training, good working conditions, promotion, etc. Managers and employees are directly affected by a company’s performance. They can expect to receive a good payout when the company does well and similarly face layoffs when the performance is poor. They have conflicting interests with other stakeholders in situations like a takeover.

A Board of Directors

A company’s board of directors is elected by the company’s shareholders to protect their interests, monitor the company’s operations and performance of the management, and participate in strategic discussions about the company. Directors are experienced individuals and often experts in their fields who enjoy a good reputation in the business community. They must keep a tab on the company’s operations to ensure shareholders’ interests are protected. There are two ways in which a board is often structured:

One-tier structure comprises a single board of directors. Executive directors (internal) are either employees or senior managers of a company. Non-executive directors (external) are not employees of the company. This type of board structure is often found in India, the United States, and the United Kingdom.
Two-tier comprises two boards: a supervisory board of primarily non-executive directors, and a management board of executive directors. The supervisory board monitors the management board. This type of board structure is often found in Germany, China, Finland, etc.

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

A supplier’s interest in a company is limited to being paid for the products and services supplied to a company. Some suppliers are keen to maintain a good long-term relationship with companies as it is recurring business. Suppliers are primarily concerned that a company has a good operating performance and steady cash flow so as to pay their dues.

Governments/Regulators

Government is a stakeholder as it collects taxes from companies. It is in the interest of governments and regulators to pass laws and regulations to ensure the interests of the investors are protected. The state of a country’s economy, output, import/export, employment, and capital flows are all affected by how well companies function in a country.

3.2. Principal-Agent and Other Relationships in Corporate Governance

A principal-agent relationship arises when a principal hires an agent to carry out a task or a service. 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 and we look at a few of them in this section.

Shareholder and Manager/Director Relationships

In this relationship, shareholders are the principals and managers/directors are the agents. Shareholders elect the board of directors and assign them the responsibility to act in their best interests by maximizing equity value. Examples of situations that may lead to a conflict of interest between shareholders and managers/directors are as follows:

Firm value versus personal benefits of managers: Investors want the firm value to be maximized, whereas managers are more interested in maximizing their compensation.
Levels of risk tolerance: Investors with diversified portfolios may have the ability to tolerate higher levels of risk taken by a specific company in their portfolio as the risk will be diversified. Managers and directors, however, tend to play safe and avoid taking risky decisions so as to protect their employment.
Information asymmetry: Managers have greater access to information, and they may leverage this knowledge to make decisions that are not necessarily aligned with the best interests of the shareholders.
Insider influence: If insiders exert influence over directors which prevents them from exercising control or monitoring properly, then this leads to a conflict of interest.
Preferential treatment of shareholders: If directors are biased towards certain powerful investors, then it will not be fair to the other shareholders.

Controlling and Minority Shareholder Relationships

Controlling shareholders are shareholders with a controlling stake and significant authority to influence decision-making in a company. Minority shareholders, on the other hand, have limited or no control over the management. Situations where the two ownership structures lead to a conflict of interest are as follows:

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.
Impact on corporate performance: 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.
Related-party transactions: When a controlling shareholder enters into a financial transaction between the company and a related third-party supplier that is not in the best interests of the company, it leads to conflicting interests for the minority shareholders. For example, if the third-party supplier is a relative/spouse of the controlling shareholders who supplies products at above-market prices, then the controlling shareholder stands to gain at the expense of the company/minority shareholders.
Difference in voting powers: An equity structure with multiple share classes tends to assign superior voting powers to one class and limited voting rights to other classes leading to a conflict of interest.

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 limited if information is withheld by the management or only selective information is provided.

Shareholder versus Creditor 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.

Other Stakeholder Conflicts

Examples of other conflict of interests among other stakeholders are as follows:

Conflict between customers and shareholders: When a company charges higher prices for its products but lowers its safety features.
Conflict between customers and suppliers: When a company offers lenient credit terms to customers that affects its ability to pay suppliers.
Conflict between shareholders and governments/regulators: When a company uses reporting practices to reduce its tax burden that benefits shareholders.