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CORPORATE GOVERNANCE
CHAPTER 1
Nas Rabariniaina, CFA, FRM
Copyright © 2012 CFA Institute
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1. INTRODUCTION
WHAT IS CORPORATE GOVERNANCE?
• Corporate governance is the system of principles, policies, procedures and
clearly defined responsibilities used by stakeholders to overcome conflicts of interest inherent in the corporate
form.
ÿ Hence the importance of understanding the different forms of businesses.
• Corporate governance has an impact on operational risk and, therefore, on the viability of a
business.
ÿ The quality of a company's corporate governance affects the company's risks and value.
ÿ Effective and strong corporate governance is essential for the proper functioning of markets.
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2. CORPORATE GOVERNANCE: OBJECTIVES AND
GUIDING PRINCIPLES
• There are inherent conflicts of interest in companies in which ownership and management are
separated.
• Objectives of corporate governance:
ÿ Eliminate or mitigate conflicts of interest.
- in particular those between company directors and shareholders; and
ÿ Ensure that the company's assets are used efficiently and productively and in the best interests of its
investors and other stakeholders.
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ESSENTIAL ATTRIBUTES OF AN EFFECTIVE SYSTEM OF
CORPORATE GOVERNANCE
Clearly defined governance
responsibilities for managers
and directors
Identifiable and measurable
responsibilities
Delimitation of the rights of
shareholders and other
stakeholders
Fair and equitable treatment in
relationships
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Transparency and accuracy of
information
communicated
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3. BUSINESS FORMS
AND CONFLICTS OF INTEREST
The form of the business will dictate, in part, the relationship between the business owners and management.
ÿ The degree of separation may be minimal (e.g., a sole proprietorship) or significant (e.g. , a large
corporation).
ÿ When there is a separation between owners and managers, there is a risk of problems
agency, which can affect the value of the company.
ÿ We will examine three forms of business: the sole proprietorship, the partnership and the corporation.
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SOLE PROPRIETORSHIP
• A sole proprietorship is owned and operated by one person.
• Sole proprietorships are the most numerous in terms of number of businesses.
• Who bears the governance risk in a sole proprietorship?
ÿ From the owner's perspective, there are few governance risks.
ÿ Creditors, including trade creditors, pose the highest risk in terms of
governance.
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PARTNERSHIP
• A partnership has two or more owners/managers.
• Who bears the governance risk in a partnership?
ÿ There are few risks regarding governance from the owners' point of view, the rights of
ownership and responsibilities being detailed in the partnership agreement.
ÿ Creditors, including trade creditors, pose the highest risk in terms of
governance.
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COMPANY
• A corporation is a legal entity that has rights similar to those of an individual.
ÿ For example, a company can enter into contracts.
• Corporations account for the majority of business revenues worldwide.
ÿ Companies in the world: Limited Company (United Kingdom), Gesellschaft (German); Company
Anonymous (France), ÿÿ (China); ÿirket (Türkiye); ÿÿÿÿÿÿ (Thailand).
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ADVANTAGES OF THE CORPORATE FORM
1. A company can raise capital.
ÿ Grant equity interests (i.e., issue shares) or borrow (i.e., issue
bonds).
2. Owners do not necessarily need to know how to run the business.
ÿ The company hires experts to manage the business.
3. Title deeds are transferable.
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DISADVANTAGES OF THE CORPORATE FORM
1. Corporations are more heavily regulated than partnerships or businesses
individual.
ÿ For example, in the United States, there are state laws relating to corporations and the Securities and
Exchange Commission requires specific information.
2. Separation of owners and managers.
ÿ This is the agency relationship, in which one person (the agent) acts on behalf of another person (the
principal).
ÿ The potential conflict between owners and managers is the agency problem or the problem
principal-agent,
- Main players: shareholders
- Agents: Management and members of the board of directors
ÿ Conflicts of interest result in costs for this agency relationship.
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3. BUSINESS FORMS AND
CONFLICTS OF INTEREST
Characteristic
Sole
proprietorship
Partnership
Company
Property
Sole proprietor
Multiple Owners Unlimited Ownership
Legal requirements and
regulations
Few in number;
easily formed entity
Few in number; easily
formed entity
requirements
Legal distinction between owner and
None
None
Legal separation between
business
Civil liability
Many legal
owners and the company
Unlimited
Unlimited but shared
Limited
between partners
Ability to raise capital
Very limited
Transferability of ownership Not transferable (except by sale of
Limited
Almost unlimited
Non-transferable
Easily
transferable
the entire business)
Owner's expertise in business
Essential
Essential
Useless
Exhibit 1-1, page 4
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4. SPECIFIC SOURCES OF CONFLICT:
RELATIONS BETWEEN AGENCIES
Conflicts between management and
shareholders
Managers
Board
of Directors
Shareholders
Conflicts between directors and shareholders
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CONFLICTS BETWEEN MANAGEMENT AND SHAREHOLDERS
• Shareholders entrust management with funds from reinvested profits or newly issued shares, which
management invests.
• The primary objective is to maximize shareholder wealth.
• Question: Managers are human
ÿ Managers may be more interested in expanding company size, based bonuses
on profits, excessive risk-taking or job security.
ÿ Executives may consume excessive perks or, in fact, take advantage of their position
to spend excessively on themselves.
ÿ In summary, there may be agency costs in terms of explicit and implicit costs when managers do not
act in the best interests of shareholders.
• Effective corporate governance helps protect against agency costs.
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DIRECTOR-SHAREHOLDER CONFLICTS
• The board of directors is an intermediary between shareholders and management, and represents the
shareholders' interests:
ÿ Those responsible for monitoring;
ÿ Approve strategies and policies;
ÿ Approve mergers and acquisitions;
ÿ Approve audit contracts;
ÿ Review audit contracts and financial contracts; ÿ Establish
executive compensation; ÿ Discipline
underperforming managers.
• Conflict may arise if board members align with management.
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RESPONSIBILITIES OF THE
BOARD OF DIRECTORS
• Establish the company's values and governance structures; • Ensure
that all legal and regulatory requirements are met and complied with
fully and in a timely manner;
• Establish long-term strategic objectives for the company; •
Establish clear lines of responsibility and a solid system of accountability and measurement of
performances;
• Hire the CEO, determine the compensation package and periodically evaluate the
director's performance;
• Ensure that management has provided the board of directors with sufficient information to ensure that it is
fully informed and prepared to make the decisions required of it, and that it is able to adequately monitor
and supervise the management of the company;
• Meet regularly to carry out its functions;
• Acquire adequate training.
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5. ASSESSMENT OF CORPORATE GOVERNANCE:
ATTRIBUTES OF THE BOARD OF DIRECTORS
• The board must be composed primarily of independent (i.e. non-insider) directors.
• The chairman of the board of directors must be independent; •
The directors must be qualified;
• A regular election of the members of the board of directors must take place;
• The board should conduct regular self-assessment; • The board should hold
separate meetings for independent directors; • The board should require that audit oversight
be carried out by independent directors with sufficient expertise in finance, accounting and law.
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5. CORPORATE GOVERNANCE ASSESSMENT :
ATTRIBUTES OF THE BOARD OF DIRECTORS (CONTINUED)
• The nomination committee must be composed of independent directors;
• The remuneration committee must be composed of independent directors;
• The board of directors should be able to engage outside counsel;
• The board of directors must disclose governance policies;
• The board of directors must ensure disclosure and transparency
adequate;
• The board should require disclosure of any related party transactions;
• The board of directors must respond to non-binding proxy votes from
shareholders.
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MONETARY AUTHORITY OF SINGAPORE
GUIDELINES AND REGULATIONS
ON CORPORATE GOVERNANCE
Principle 1: Every institution must be governed by an effective board of directors.
Principle 2: The board of directors must be composed of a strong and
independent, able to exercise objective judgment on the company's affairs, independently
of management and major shareholders.
Principle 3: The board of directors must establish and enforce guidelines
clear responsibilities throughout the institution.
Principle 4: There must be a formal and transparent procedure for appointment
new directors to the Board.
Principle 5: A formal evaluation of the effectiveness of the board as a whole and
of the contribution of each director to the effectiveness of the board must be carried out.
Principle 6: In order to fulfill their responsibilities, board members must receive full, adequate and
timely information before board meetings and on an ongoing basis from
management.
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GUIDELINES AND REGULATIONS ON THE
CORPORATE GOVERNANCE (CONTINUED)
Principle 7: A formal and transparent procedure must be established for
set the remuneration of individual directors. No director shall be involved in
deciding his or her own remuneration.
Principle 8: The level and composition of remuneration must be
appropriate to attract, retain and motivate directors to fulfill their role and assume
their responsibilities.
Principle 9: The board of directors must establish an audit committee
with a written mandate clearly defining its powers and functions.
Principle 10: The board of directors must ensure that there is an adequate risk management system
and sound internal controls.
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GUIDELINES AND REGULATIONS ON
CORPORATE GOVERNANCE (CONTINUED)
Principle 11: The board of directors shall ensure that an internal audit function independent of
audited activities are implemented.
Principle 12: The board of directors shall ensure that management formulates policies aimed at
ensure that relations with the public, the institution's policyholders and applicants, depositors
and other customers are conducted in a fair, responsible and professional manner.
Principle 13: The board of directors must ensure that transactions between related parties with the
institution are carried out on an arm's length basis.
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ORGANISATION FOR ECONOMIC COOPERATION AND
DEVELOPMENT (OECD)
PRINCIPLES OF CORPORATE GOVERNANCE
• Shareholders’ rights
I
II
• Fair treatment of shareholders
• The role of stakeholders in corporate governance
III
IV
V
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• Disclosure and transparency
• Responsibilities of the board of directors
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6. ENVIRONMENTAL, SOCIAL AND
GOVERNANCE
Exposure to ESG risks
• Environmental, social and governance (ESG) risk is the risk associated with the management of
environmental, social and governance issues.
- It's about mitigating risks and managing those risks when they arise.
• ESG risk affects the sustainability and valuation of the company.
Environment
• Pollution
• Disclosures
Social
• Workplace
issues
Governance
• Effective governance
• Product quality and
safety
• Interaction with the
community
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EXAMPLES OF ESG RISKS
• Legislative and regulatory risk (i.e. the role of governments)
• Legal risk (e.g., lawsuits) • Reputational risk
• Operational risk
• Financial risk
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7. THE IMPLICATIONS OF CORPORATE GOVERNANCE IN TERMS OF VALUE
Benefits from strong
corporate
governance
Risks associated with
poor
corporate
governance
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RISKS ASSOCIATED WITH POOR GOVERNANCE
CORPORATE
Asset risk
Risk of
liability
• The risk that a
company's financial
statement
accounting and
• The risk that the
company's
• The risk that
related disclosures
may be
incomplete,
managers
or directors.
Accounting risk
misleading, or
materially erroneous.
assets are
misappropriated by
management will
incur
excessive
obligations that
destroy the
value of
equity .
Strategic policy
risk
• The risk that
managers enter
into transactions
or take other
business
risks that are selfserving and not
in the best
long-term interests
of shareholders.
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BENEFITS OF STRONG GOVERNANCE
Evidence suggests that:
ÿ companies with good governance have achieved better results in terms of
investment.
ÿ companies with strong shareholder rights outperformed those with weak protections
weak.
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8. SUMMARY
ÿ Corporate governance is a system of principles, policies, procedures and
clearly defined responsibilities.
ÿ The objectives of a corporate governance system are (1) to eliminate or mitigate conflicts of interest
among stakeholders, particularly between managers and shareholders, and (2) to ensure that the
company's assets are used efficiently and productively and in the best interests of investors and other
stakeholders.
ÿ A company's failure to implement an effective system of corporate governance
represents a major operational risk for the company and its investors.
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SUMMARY (CONTINUED)
• Specific sources of conflict in corporate agency relationships are manager-
shareholder.
• The responsibilities of board members, both individually and as
group, consist of establishing corporate values and effective governance structures for the company.
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SUMMARY (CONTINUED)
• Companies engaged in corporate governance often provide a statement of
corporate governance policies. Analysts should evaluate:
ÿ the code of ethics; statements on the responsibilities of directors in matters of
monitoring, control and review;
ÿ statements on management's responsibilities for information and access to
administrators in internal company functions;
ÿ reports of examinations, evaluations and conclusions of the administrators;
ÿ board and committee self-assessments; management self-assessments; and
ÿ administrator training policies.
• Weak corporate governance systems give rise to risks, including the risk
accounting, asset risk, liability risk and strategic policy risk.
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