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IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

R31 Introduction to Corporate Governance and Other ESG Considerations

Part 3


 

5.  Board of Directors and Committees

In this section, we look at the functions and responsibilities of a company’s board of directors.

5.1.     Composition of the Board of Directors  

There is no standard structure or composition for the board of a company. It varies by company size, complexity of operations, and geography. Some common board structures are discussed below:

  • One-tier structure: It is a mix of executive (internal) and non-executive (external) directors.
  • Two-tier structure: Consists of two tiers, a supervisory board and a management board. Members serving on one board are generally restricted from serving on other board, or there is a limit on members that can serve on both boards.
  • CEO Duality: CEO duality is when the CEO also serves as the chairperson. The roles are usually kept separate in most countries to maintain independence. If there is no CEO duality, then, as an alternative, a lead independent director is appointed to oversee the functioning of independent directors.

Staggered board is a commonly followed practice where directors are divided into three groups and elected into office in consecutive years, so that all of them are not replaced simultaneously.

5.2.     Functions and Responsibilities of the Board

Two primary responsibilities of the board are:

  • Duty of care: Requires board members to act on a fully informed basis, in good faith, with due diligence and care.
  • Duty of loyalty: A board member must act in the best interests of the company and shareholders, and not act in their own self-interest.

Other responsibilities of the board are as follows:

  • Guides and approves the company’s strategic direction.
  • Evaluates the performance of senior executives.
  • Ensures effectiveness of audit and control systems.
  • Ensures that an appropriate enterprise risk management system is in place.
  • Reviews proposals for corporate transactions and changes.

5.3.     Board of Directors Committees

The board of directors delegates specific functions to individual committees that, in turn, report to the board on a regular basis. The number of committees and their composition may vary based on jurisdiction and industry. Some committees such as the audit is a regulatory requirement in most jurisdictions.

Audit Committee

The functions of the audit committee are as follows:

  • Oversee the audit and control systems.
  • Monitor the financial reporting process.
  • Supervise the internal audit function.
  • Appoint the independent external auditor.

Governance Committee

The functions of the governance committee are as follows:

  • Develop and oversee implementation of good corporate governance policies and a code of ethics.
  • Periodically review and update the policies for any regulatory changes.
  • Ensure compliance of the policies.

Remuneration or Compensation Committee

The functions of the remuneration committee are as follows:

  • Develop remuneration policies for directors and executives, and present them to the board for approval.
  • Set performance criteria for managers and evaluate their performance.
  • Oversee implementation of employee benefit plans, pension plans, and retirement plans.

Nomination Committee

The functions of the nomination committee are as follows:

  • Identify and recommend qualified candidates who can serve as directors.
  • Establish nomination procedures and policies to keep the board independent as per good-governance principles.

Risk Committee

The risk committee is responsible for defining the risk policy and risk appetite of the company. It monitors the implementation of risk management and periodically reviews, reports, and communicates its findings to the board.

Investment Committee

The functions of the investment committee are as follows:

  • Review investment plans proposed by the management, such as new projects, acquisitions and expansion plans, and divestitures.
  • Formulating the investment strategy and policies for a company.

6.  Factors Affecting Stakeholder Relationships and Corporate Governance

6.1.     Market Factors

Among the market factors that affect stakeholder relationships in a company, we focus on shareholder engagement, shareholder activism, and competitive forces.

Shareholder Engagement

Companies engage with shareholders periodically through events such as annual general meetings and analyst calls to primarily discuss financial performance and any strategic issues. However, companies see a benefit in interacting with them more often to counter negative recommendations.

Shareholder Activism

Shareholder activism refers to the tactics used by shareholders to influence companies to act in their favor. Often, their primary objective is to increase shareholder value. The strategies used by shareholders include shareholder derivative lawsuits, proxy battles, proposing shareholder resolutions, and publicity on issues of contention.

Competition and Takeovers

Shareholders prefer corporate takeover if the management of a company underperforms. The commonly used methods for corporate takeovers are as follows:

  • Proxy contest: A group attempting to take a controlling position on a company’s board of directors influences shareholders to vote for them.
  • Tender offer: An offer by a group seeking to gain control to purchase a shareholder’s shares.
  • Hostile takeover: One company tries to acquire another company by bypassing the management and directly going to the company’s shareholders.

6.2.     Non-market Factors

This section focuses on non-market factors that affect stakeholder relationships, such as a company’s legal environment, media’s role, and the corporate governance industry.

Legal Environment

The rights of stakeholders depend on the law of the country the company operates in. There are primarily two law systems.

  • Common law system: This is considered to offer better protection for stakeholders as laws can be created both by legislature and judges. This system is found in the United Kingdom, United States, India, etc.
  • Civil law system: This is considered restrictive for stakeholders as laws can be created only by passing legislation.

Creditors are more successful in winning legal battles when the terms of indenture are violated. In contrast, shareholders find it difficult to prove in court that a manager/director has not acted in their best interests.

The Media

Regulators are keen on introducing corporate governance reforms or pass new laws to protect the stakeholders, especially in the aftermath of 2008-09 financial crisis. Social media is a low-cost, effective tool used by stakeholders to protect their interests, garner support on corporate issues, or use it for negative publicity against a corporate.

The Corporate Governance Industry

The corporate governance industry is a concentrated one. The genesis for the demand for external corporate governance services was a rule introduced by the Securities and Exchange Commission (SEC) in 2003. The SEC mandated that all US-registered mutual funds must disclose their proxy voting records annually. As a result, institutional investors hire experts to help them with proxy voting and corporate governance monitoring.


Corporate Finance Corporate Governance and ESG Part 3