IFT Notes for Level I CFA® Program
R27 Introduction to Corporate Governance and Other ESG Considerations
4. Overview and Mechanisms of Stakeholder Management
Stakeholder management deals with identifying, prioritizing, communicating, effectively engaging, and managing the interests of various stakeholder groups and their relationships with a company.
4.1. Overview of Stakeholder Management
A stakeholder management framework to balance the interests of various stakeholder groups consists of the following:
- Legal infrastructure: This defines the rights allowed by law and the course of action one can take for violation of these rights.
- Contractual infrastructure: This defines the contractual agreement a company and its stakeholders enter into with the objective that the rights of both the parties are defined and protected.
- Organizational infrastructure: This defines the internal systems, procedures, and processes a company follows to manage its relationships with its stakeholders.
- Governmental infrastructure: This refers to the regulations imposed on companies.
4.2. Mechanisms of Stakeholder Management
Although governance practices for managing the interest of all stakeholders may vary from company to company and across countries, there are some common control elements and practices that are listed below:
- General Meetings
- General meetings provide an opportunity to shareholders to exercise their vote on major corporate issues. There are typically two types of general meetings:
- Annual general meetings: These are usually held within a certain period after the end of the fiscal year. During an AGM, a company’s annual performance is presented and discussed, and shareholders’ questions are answered.
- Extraordinary general meetings: These can be called anytime during the year, either by the company or shareholders, whenever a major resolution has to be passed such as an amendment to a company’s bylaws, mergers or acquisitions, or the sale of businesses.
- Number of votes required may be one of the following two types based on the type of resolution to be passed:
- For simple decisions, a simple majority of votes is sufficient.
- For material decisions, a supermajority vote is required, i.e., 75% of the votes must be in favor of a resolution to be passed.
- Proxy voting allows shareholders to authorize another individual to vote on their behalf at the AGM. In cumulative voting, shareholders may accumulate their votes to vote for one candidate in an election that involves more than one director.
- Board of Director Mechanisms
- The board is the bridge between shareholders and the management of the company. Since shareholders cannot be involved in every decision or day-to-day operations of the company, they exercise their voting rights to elect a board of directors that will participate in strategic decisions, oversee operations, perform audits, monitor management’s actions, and ensure governance systems are in place.
- The Audit Function
- The audit function refers to the controls, systems, and processes in place to ensure the company’s financial reporting/records are accurate. The objective is to prevent fraudulent reporting of financial information. There are two types of audits: internal and external. Internal audits are performed by an independent internal audit department, while external audits are conducted by independent auditors not associated with the company. The board of directors reviews the auditors’ reports for fairness and accuracy before presenting the financial statements to shareholders at the AGM.
- Reporting and Transparency
- Shareholders have access to all audited financial information of a company, its strategy, governance policies, remuneration policies, and other information through the company’s financial statements, website, press releases, etc. They use this information to assess a company’s performance, evaluate whether to buy or sell the shares of a company, and vote on key corporate issues.
- Policies on Related-party Transactions
- Policies on related-party transactions require directors and managers to disclose any transactions they have with the company that is a conflict of interest. Any transaction with a potential conflict of interest must be cleared by the board, excluding the director who has an interest.
- Remuneration Policies
- Remuneration packages have evolved from including variable components such as options and profit sharing to more restrictive ones such as granting shares that can be vested only after several years, or remuneration only after certain objectives are met. The objective is to align the interests of executives with the interests of shareholders and prohibit them from taking excessive risks for personal gains.
- Say on Pay
- Say on pay is what the term literally means, that is, the shareholders may express their views and vote on the remuneration of executives. First introduced in the United Kingdom in the early 2000s, it is now a widely accepted concept worldwide. Of course, whether the board accepts the shareholders’ views on pay varies from country to country, and is non-binding in many countries such as Canada, the United States, South Africa, etc.
5. Mechanisms to Mitigate Associated Stakeholder Risks
There are laws that often vary by jurisdiction, to protect creditors’ interests. Some of the most common provisions are:
- Indenture: It is a legal contract that defines the bond structure, the obligations of the issuer, and the rights of the bondholders.
- Covenants: These are terms specified within a bond indenture that state what a bond issuer may and may not do. The objective is to limit the risk of bondholders.
- Collaterals: These are financial guarantees that may be used to repay bondholders if an issuer defaults on periodic payments.
- Periodic information: Creditors expect the company to provide periodic financial information to monitor the risk exposure and ensure covenants are not violated.
5.1 Employee Laws and Contracts
Standard rights of employees in any country such as hours of work, pension and retirement plans, vacation and leave, are defined in labor laws. Companies strive to manage relationships with their employees to protect their best interests and avoid legal repercussions on violation of these rights. Employees form unions in many countries to collectively influence the management on issues they may face. Individual employee contracts define an employee’s rights and responsibilities, remunerations, and other benefits such as ESOPs. Companies might establish a code of ethics which defines the ethical behavior expected of employees.
5.2 Contractual Agreements with Customers and Suppliers
Companies enter into contracts with both customers and suppliers that define the products, services, any guarantee, after-sales support, payment terms, etc. It also defines the course of action in case one party violates the contract.
5.3 Laws and Regulations
Governments and regulatory agencies pass laws to protect the interests of consumers or specific stakeholders. Sensitive industries such as banks, health care, and food manufacturing companies have to comply with a rigorous regulatory framework.