IFT Notes for Level I CFA® Program
R31 Introduction to Corporate Governance and Other ESG Considerations
7. Corporate Governance and Stakeholder Management Risks and Benefits
7.1. Risks of Poor Governance and Stakeholder Management
In this section, we analyze the risks a company faces due to a poor governance structure.
Weak Control Systems
Weak control systems and poor monitoring can affect a company’s performance and value. One example is that of Enron where auditors failed to uncover fraudulent reporting that ultimately affected many stakeholders.
Poor decisions include managers avoiding good investment opportunities to maintain a low-risk profile or taking on excessive risk without properly evaluating potential investments. Both decisions are not in the interests of shareholders. Such decisions may result from:
- Information asymmetry: When managers have access to more information than board members/shareholders.
- Outsized remuneration: High remuneration not aligned with long-term strategic goals may result in managers taking excessive risks for personal gains.
- Related-party transactions: Transactions in which managers have a material interest and are not in the interest of the company, will affect the value of the company.
Legal, Regulatory, and Reputational Risks
Improper implementation and monitoring of corporate governance procedures may result in the following risks:
- Legal: Stakeholders such as shareholders, creditors and employees may file lawsuits against the company if their rights are violated.
- Regulatory: Government/regulator may choose to take action if the applicable laws are violated.
- Reputational: A company may be subjected to negative publicity by investors/analysts if there is an improperly managed conflict of interest.
Default and Bankruptcy Risks
Poor corporate governance may affect the company’s performance, which in turn may affect the company’s ability to service its debt. If creditors’ rights are violated and they choose to take legal action on defaulting debt, the company may be forced to file for bankruptcy.
7.2. Benefits of Effective Governance and Stakeholder Management
The benefits of good corporate governance and balancing the interests of managers, board members, company’s stakeholders, and shareholders are as follows:
- Operational efficiency: A good governance structure ensures that all employees of a company have a clear understanding of their responsibilities and reporting structures. The operational efficiency of a company is improved when good governance structure is combined with strong internal control mechanisms.
- Improved control: Good governance implies improved control at all levels to help a company manage its risk efficiently. Control can be improved with a good audit committee, complying with laws and regulations, and introducing procedures to handle related-party transactions.
- Better operating and financial performance: A company’s operating and financial performance can be improved with good governance practices. Proper remuneration for management, mitigation of lawsuits against the company, and improving the decision-making of its managers to make the right investments are ways that will help in improving the performance of a company.
- Lower default risk and cost of debt: A company’s cost of debt and default risk can be reduced by protecting creditors’ rights, ensuring proper audits are conducted, and that there is no information gap between the company and its creditors.
8. Analyst Considerations in Corporate Governance and Stakeholder Management
In the aftermath of several corporate scandals in the early 2000s and global financial crisis of 2008-09, fundamental analysts have now begun focusing on corporate governance issues as part of their analysis of a company. In this section, we look at the areas analysts focus on when assessing a company’s corporate governance and stakeholder management system.
8.1. Economic Ownership and Voting Control
Analysts must examine the voting structure of publicly traded companies. Any structure where voting power is not equal to the percentage of shares owned or one vote for one share results in risks for investors. Examples of voting structures where economic ownerships are separate from control are as follows:
- Dual-class structures: In this structure, there are two classes where one class has a superior voting power than the other. For example, one class may carry one vote per share, whereas another may carry several votes per share.
- Electing board members: Another mechanism is where one class of stock has the power to elect a majority of the board, while another class has the right to elect only a minority of the board.
8.2. Board of Directors Representation
Analysts assess whether the experience, tenure, diversity, and skills of the current board of directors match the current and future needs of a company. The curriculum cites the example of a European pharmaceutical company going through financial distress. The company’s performance turned around for the better when non-executive directors with financial expertise were added to the board. Several years later, when a medical crisis hit the company, the company failed to respond by bringing in someone with medical expertise to the board. The shares fell as they continued to retain the previous directors.
8.3. Remuneration and Company Performance
If information on executives’ remuneration is available, then analysts must assess whether the remuneration plans are aligned with the performance drivers of the company. Some of the warning signs analysts must look out for are as follows:
- Plans such as cash payout and no equity, offer little alignment with shareholders.
- Performance-based plans that have a full payout irrespective of a company’s performance.
- Plans that have an excessive payout relative to comparable companies with a comparable performance.
- Remuneration plans or payouts that are based on achieving specific strategic objectives. Analysts must assess whether these are also aligned with company’s long-term objectives. For example, FDA approval for a drug, or cost savings on a production process.
- Plans based on incentives from an earlier period in the company’s life cycle. For example, remuneration plans for executives in a company that is currently in mature phase is still based on revenue growth as earlier.
8.4. Investors in the Company
Analysts must assess the composition of investors in a company. They must examine, in particular, if the following types of investors are present as it can affect the outside shareholders:
- Cross-shareholdings where a large publicly traded company holds a minority stake in another company.
- Affiliated stakeholders can protect a company from the results of voting by outside shareholders.
- Activist shareholders have the ability to change the shareholder composition in a short span of time.
8.5. Strength of Shareholders’ Rights
Analysts must assess whether the shareholder rights of a company are strong, average, or weak relative to investors’ rights of other comparable companies. They must assess if shareholders have the rights to remove the directors from a board or support/resist external initiatives.
8.6. Managing Long-Term Risks
Analysts must assess the management quality of the company to understand how it manages long-term risks. There are several instances where poor management of long-term risks has resulted in a fall of share prices and negatively impacted the company’s reputation. Poor management may result in repeated fines, lawsuits, regulatory investigations, etc.
9. ESG Considerations for Investors
The curriculum defines ESG integration as the practice of considering environmental, social, and governance factors in the investment process. Some of the terms related to ESG integration are defined below:
- Sustainable investing and responsible investing: These terms are used interchangeably with ESG integration.
- Socially responsible investing: This refers to the practice of excluding investments that are against the moral values of investors such as investing in tobacco companies.
- Impact investing: This refers to the practice of investing in companies with an objective of meeting social or environmental targets along with financial returns.
9.1. ESG Market Overview
There is a growth in awareness about ESG related issues among investors because of huge losses as a result of environmental disasters and class action lawsuits in recent times. The curriculum cites the example of the 2010 explosion of the Deepwater Horizon oil rig in the Gulf of Mexico, which resulted in a loss of life, and tens of billions of dollars in fines to BP plc.
9.2. ESG Factors in Investment Analysis
The environmental and social factors considered in investment analysis are listed below:
- Natural resource management.
- Pollution prevention.
- Water conservation.
- Energy efficiency and reduced emissions.
- Existence of carbon assets.
- Compliance with environmental and safety standards.
- Human rights and welfare concerns in the workplace: staff turnover, employee training and safety, keeping the morale of employees high, and employee diversity are factors that can potentially affect a company’s competitive advantage.
- Product development.
- Minimizing social risks is beneficial to a company as it can lower company’s costs.
9.3. ESG Implementation Approaches
Some methods for implementing ESG are as follows:
- Negative screening: This involves exclusion of certain sectors or companies or practices from a fund or portfolio on the basis of specific ESG criteria. For example, companies engaged in fossil fuel extraction or garment companies employing child labor.
- Positive screening: Positive screening strategy involves inclusion of certain sectors, companies, or practices in a fund or portfolio on the basis of specific ESG criteria. For instance, these companies may have policies focused on the well-being and safety of its employees, and strive towards protecting employee rights.
- Relative/best-in-class: Relative/best-in-class approach involves investment in sectors, companies, or projects selected for superior ESG performance relative to industry peers.
- Full integration: This refers to the integration of qualitative and quantitative ESG factors into traditional security and industry analysis (e.g., as inputs into cash flow forecasts and/or cost-of-capital estimates). The focus is to determine if a company is properly managing its ESG resources.
- Overlay/portfolio tilt: This strategy involves tilting an investment portfolio towards certain investment strategies or products to change specific aggregate ESG characteristics of a fund or investment portfolio to a desired level e.g. a desired carbon footprint.
- Risk factor/risk premium investing: This strategy involves including ESG information in the analysis of systematic risks such as smart beta or factor investing.
- Thematic investing: This strategy picks investments based on a theme or single factor, such as energy efficiency or climate change. An increasing trend world over is the increasing demand for energy and water. Companies that provide solutions to these socio-economic problems make for attractive investments.
- Engagement/active ownership: This strategy involves achieving targeted social or environmental objectives along with measurable financial returns by using shareholder power to influence corporate behavior. Examples include venture capital investing, green bonds (wherein proceeds are used by the issuer to fund environmental-related projects).