CFA Certificate in ESG Investing Curriculum 2023 PDF

© CFA Institute. For candidate use only. Not for distribution. CHAPTER 5 Governance Factors LEARNING OUTCOMES Mastery The candidate should be able to: 5.1.1 explain the evolution of corporate governance frameworks: development of corporate governance; roles and responsibilities; systems and proc...

© CFA Institute. For candidate use only. Not for distribution. CHAPTER 5 Governance Factors LEARNING OUTCOMES Mastery The candidate should be able to: 5.1.1 explain the evolution of corporate governance frameworks: development of corporate governance; roles and responsibilities; systems and processes; shareholder engagement; minority shareholder alignment 5.1.2 assess key characteristics of effective corporate governance, and the main reasons why they may not be implemented or upheld: board structure, diversity, effectiveness, and independence; executive remuneration, performance metrics, and key performance indicators (KPIs); reporting and transparency; financial integrity and capital allocation; business ethics 5.1.3 assess and contrast the main models of corporate governance in major markets and the main variables influencing best practice: extent of variation of best practice; differences in legislation, culture, and interpretation 5.1.4 explain the role of auditors in relation to corporate governance and the challenges in effective delivery of the audit: independence of audit firms and conflicts of interest; auditor rotation; sampling of audit work and technological disruption; auditor reports; auditor liability; internal audit 5.1.5 assess material impacts of governance issues on potential investment opportunities, including the dangers of overlooking them: public finance initiatives; companies; infrastructure/private finance vehicles; societal impact 5.1.6 apply material corporate governance factors to: financial modeling; risk assessment; quality of management 266 Chapter 5 1 © CFA Institute. For candidate use only. Not for distribution. Governance Factors CORPORATE GOVERNANCE: ACCOUNTABILITY AND ALIGNMENT 5.1.1 explain the evolution of corporate governance frameworks: development of corporate governance; roles and responsibilities; systems and processes; shareholder engagement; minority shareholder alignment Corporate governance is the process and structure for overseeing the business and management of a company. From the Latin word for the steering of a boat, gubernare, governance incorporates that sense of guiding and controlling. Corporate governance has become more complex as the scale and complexity of companies have grown and as ownership has become more dispersed. As a result, the role of the board of directors has become more important. The board is responsible for representing the owners of the company and for holding management teams accountable for running the business in the interest of its owners. The effectiveness of the board depends on whether good corporate governance practices are applied. The principles that shape these practices have been developed over the years and codified into corporate governance codes. Increasingly, investors are expecting companies to disclose their corporate governance structures and processes so that external investors and other stakeholders can understand where the company stands on the spectrum of good governance. The types of issues that investors will address when considering a company’s governance include, but are not limited to: ► shareholder rights; ► the likely success of the intended company strategy, and the effectiveness of the leadership in place to deliver it; ► executive pay; ► audit practices; ► board independence and expertise; ► transparency or accountability; ► related-party transactions; and ► dual-class share structures. This chapter considers the G of environmental, social, and governance (ESG) factors, corporate governance, and gives readers insight into the core fundamentals of what the concept means, its history and development, global practices, and how governance analysis is used by investment professionals to deliver value to their clients and beneficiaries and minimize the risk of value destruction. What is Governance? Why Does It Matter? Corporate governance is the process by which a company is managed and overseen. There are different rules worldwide—governance grows out of the legal system of the country in which the company is incorporated—but at its heart, governance is about people and processes. Good governance also involves developing an appropriate culture that will underpin the delivery of strong business performance without excessive risk-taking through appropriate conduct of business operations. Good corporate governance should lead to strong business performance and long-term prosperity © CFA Institute. For candidate use only. Not for distribution. Corporate Governance: Accountability and Alignment to the benefit of shareholders and the company’s other stakeholders. The corporate culture needs to be supportive of that long-term business success in the interests of all stakeholders. While at its heart corporate governance is about people (the individuals in the boardroom and how they interact with the individuals outside the boardroom), in order to exercise their responsibilities effectively, board members are supported by processes. These processes bear an increased burden in large and complex companies; at smaller companies there is greater scope for individuals at the top to have direct knowledge across a business, but at larger companies this is impossible. Companies will typically have policies and codes of conduct in place, but they will rely on processes to be confident that those policies are indeed delivered in practice. Investors will judge a company’s governance based on the quality of its policies and processes and on the diligence and care with which the board oversees their implementation. Most fundamentally, they will judge governance by the quality and thoughtfulness of the people on the board. Assessing the effectiveness of corporate governance systems within a firm gives investors insight into the accountability mechanisms and decision-making processes that support all critical decisions affecting the allocation of investors’ capital and the likely delivery of long-term value. A company with sound governance is better able to address the key risks that the business faces, including environmental and social issues. Conversely, a company that is failing to manage a key long-term risk (again including environmental and social issues) may have an underlying governance failure that is blocking its ability to address the issue. In practice, corporate governance comes down to two A's: accountability and alignment. These concepts are reflected in many of the core elements of corporate governance standards and investor expectations. Accountability People need to be: ► given authority and responsibility for decision-making; and ► held accountable for the consequences of their decisions and the effectiveness of the work they deliver. Accountability and the Board Just as people are most effective when they are conscious of being accountable to someone—typically their manager—in the same way, senior executives need to feel accountable to the non-executive directors on their board. In turn, that board will be most effective when its non-executive members feel accountable to shareholders for effective delivery. Therefore, corporate governance has a strong focus on board structure and the independence of directors. The mixed skill sets of directors are also important, so that discussions and debate are appropriately informed by a range of perspectives and the risk of “groupthink” is avoided. Increasing diversity and the range of perspectives in the boardroom— through gender diversity, but also diversity in terms of professional backgrounds and experiences—has been demonstrated to deliver a more challenging culture and thus the greater accountability that is more likely to enhance long-term value. 267 Chapter 5 Governance Factors The role of the chair of the board is vital in facilitating a balanced debate in the boardroom. Consequently, many investors prefer that the chair be an independent non-executive director. If the chair is not independent, and especially if that individual combines the role of chair with the role of CEO, this situation can lead to an excessive concentration of powers and hamper the board’s ability to: ► exercise their oversight responsibilities; ► challenge and debate performance and strategic plans; ► set the agenda, both for board meetings and for the company as a whole; ► influence succession planning; and ► debate executive remuneration. Exhibit 1 illustrates the flow of accountability through company structures and the investment chain. Exhibit 1: Chain of Accountability and Circle of Accountability Beneficiaries Asset owner Flow of accountability 268 © CFA Institute. For candidate use only. Not for distribution. Fund manager Corporate board Management Workforce Source: Paul Lee (2020). Accountability and Accounts Accurate accounts are needed for accountability. The annual accounts of the company represent the formal process of the directors making themselves properly accountable to the shareholders for financial and broader business performance, which is why the first item at many annual general meetings (AGMs) is acceptance of the report and accounts, often through a formal vote. Hence, the central importance of transparent and honest accounting by companies, and of the independence of the audit of those accounts by the auditor. Again, it is not by chance that the auditor reports formally to shareholders each year and is reappointed annually in most countries at the AGM. The integrity of the numbers that investors look at when assessing business performance is central to their ability to hold management and boards to account. The votes to “discharge” board directors in some countries (such as Germany) effectively absolve them of liability for any actions over the year and are usually dependent on the annual report providing a full, true disclosure of activity in the year and the position at year-end. © CFA Institute. For candidate use only. Not for distribution. Corporate Governance: Accountability and Alignment Alignment and the Agency Problem Alignment comes down to the challenge of the agency problem. Since the seminal publication of The Modern Corporation and Private Property by Adolf Berle and Gardiner Means in 1932 (seen by many as the starting point for the modern understanding of corporate governance), the agency problem has been identified as an inevitable consequence of the separation of ownership and control. The agency problem arises in that the interests of the professional managers—the agents—may not always be wholly aligned with the interests of the owners of the business, and so the company may not be run in the way the owners wish. This challenge is magnified at larger corporations, not least public companies, where ownership is fragmented among many investors owning a small fraction of the company. Any discussion of the agency problem needs to acknowledge that the issues it raises are not so simple that they can be solved by management and the board simply doing what they are instructed to do by the shareholders. First, it will usually be difficult to discern a single message from the shareholder base of most companies, which will include multiple investors. Even where there is a single shareholder or a clear single message from the shareholders, the duty of directors under the company law of most countries is to care for the success of the company and not of the shareholders directly. There is also a risk that directors will fail in their duty if they simply abdicate their responsibilities and respond thoughtlessly to the input received from shareholders. Promoting short-term share price increases is not the same thing as promoting the long-term success of the business. Furthermore, there can be agency problems within the investment chain itself, as a disconnect can develop between the interests of fund management firms and individual portfolio managers and those of their clients and/or ultimate beneficiaries. This agency problem is discussed in more detail in Chapter 9. Nonetheless, the challenge of the agency problem is a risk of some divergence between the interests of shareholders, on the one hand, and the interests of company directors and management, on the other. Corporate governance attempts to ensure that there is greater alignment of the interests of the agents with the interests of the owners, through both incentives and appropriate chains of accountability, to mitigate the potential negative consequences of the agency problem. Alignment and Executive Pay With regard to alignment, the major focus in terms of executive pay is always on addressing the agency problem and helping to ensure that executives are not subject to incentives to perform in their own interests and contrary to the interests of the owners. Thus, executive pay structures aim to align the interests of management with those of the owners, usually by creating a balanced compensation package that includes performance-related remuneration based on long-term goals and that vests over a long term. The goals ideally include a mix of key performance indicators (KPIs) related to business and share price performance. Many of the incentives often come with some form of equity linkage—which can, on occasion, make risk management more focused on share price than on the performance of the business itself. Accountability: Board Committees The three key committees of the board, usually required by corporate governance codes, are established to respond to each of the key challenges discussed above (accountability and the board, accountability and accounts, and alignment and executive pay). These committees are: ► The Nominations Committee (in some markets, this is called the Corporate Governance Committee or some combination of these terms) aims to ensure that the board overall is balanced and effective, ensuring that management is accountable. 269 270 Chapter 5 © CFA Institute. For candidate use only. Not for distribution. ► ► Governance Factors The Audit Committee oversees financial reporting and the audit, delivering accountability in the accounts. The Audit Committee also oversees internal audits (where they exist) and is responsible for risk oversight unless there is a separate risk committee. The Remuneration Committee (in some markets, this is called the Compensation Committee) seeks to deliver a proper alignment of interests through executive pay. The roles of these committees are considered more thoroughly in the next section. 2 FORMALIZED CORPORATE GOVERNANCE FRAMEWORKS 5.1.1 explain the evolution of corporate governance frameworks: development of corporate governance; roles and responsibilities; systems and processes; shareholder engagement; minority shareholder alignment Corporate failures and scandals have been a powerful driver for the formalization of corporate governance and the development of codes. When companies fail and investors lose money, there is often pressure for an improved approach. Examples include the Walker Review,1 following the 2008 financial crisis, and the recent Kingman2 and Brydon3 reviews in the wake of Carillion’s failure. See Scandals in Brief (below) for further (and international) discussion. Corporate Governance Codes The world’s first formal corporate governance code emerged in the United Kingdom in 1992. The Cadbury Committee had been brought together in May 1991 by the Financial Reporting Council, the London Stock Exchange, and the accounting profession to consider what were called “the financial aspects of corporate governance.” Its creation followed the Caparo and Polly Peck scandals. Caparo had mounted a successful takeover bid for Fidelity, only to subsequently discover that Fidelity’s profits were significantly overstated. The market had pumped up the share price of Polly Peck for years on the basis of financial reporting that later turned out to be misleading. The Cadbury Committee was created because of the perceived problems in accounting and governance. Once the committee began its work (but before the planned publication of its report), the Maxwell/Mirror Group scandal was beginning to emerge, and the Bank of Credit and Commerce International (BCCI) collapsed spectacularly in the wake of money laundering and other regulatory breaches. It was clear that much needed to change. 1 D. Walker, A Review of Corporate Governance in UK Banks and Other Financial Industry Entities: Final Recommendations (2009). Available at: https://​webarchive​.nationalarchives​.gov​.uk/​+/​www​.hm​ -treasury​.gov​.uk/​d/​walker​_review​_261109​.pdf. 2 Financial Reporting Council, Financial Reporting Council: Review 2018 (2018). Available at: www​.gov​ .uk/​government/​publications/​financial​-reporting​-council​-review​-2018. 3 D. Brydon, Assess, Assure and Inform: Improving Audit Quality and Effectiveness; Report of the Independent Review into the Quality and Effectiveness of Audit (2019). Available at: https://​assets​ .publishing​.service​.gov​.uk/​government/​uploads/​system/​uploads/​attachment​_data/​file/​852960/​brydon​ -review​-final​-report​.pdf. © CFA Institute. For candidate use only. Not for distribution. Formalized Corporate Governance Frameworks Much of what the Cadbury Committee recommended is still considered best practice today and has been incorporated into codes and guidelines globally. For example, the committee proposed that every public company should have an audit committee that meets at least twice a year. Notably, when the report was released, only two-thirds of the largest 250 companies in the UK had such committees at all (although nowadays they are commonplace). The report’s core theme is that no individual should have “unfettered powers of decision”; so, for example, the roles of chair and CEO should not be combined, as they frequently were at the time. A codified set of guidelines for good governance has grown from the basic concepts of accountability and alignment. Governance differs from country to country based on cultures and historical developments as well as local corporate law. At the most basic level, some countries, including Germany and the Netherlands, have two-tier boards, with wholly non-executive supervisory boards overseeing management boards; others have single-tier boards, with some dominated by executive directors (as in Japan), some having a combined CEO and chair (most commonly seen in the United States and France), and some lying in between these models (as in the UK). The Cadbury Code model of recommendations with which companies should comply or explain any non-compliance has also been followed throughout much of the world. It is now highly unusual for any market to be without an official corporate governance code. Since Japan adopted one in 2015, the USA is now the only major world market that does not have such a code, which is largely a consequence of corporate law being set at the individual state, rather than the federal, level. Most markets adopt the language of “comply or explain,” although the Netherlands favors “apply or explain,” and the Australians use the blunt “if not, why not?” The thought process, however, is the same: the code expects adherence to the relevant standard or the publication of a thoughtful and intelligent discussion of how the board delivers on the underlying principle. These discussions are gaining increased attention, not least because they offer the board an opportunity to explain how it operates to deliver value to the business on behalf of both shareholders and other stakeholders. Companies’ willingness to provide thoughtful discussions of their divergences from guidance varies. Some companies may look negatively on corporate governance, as they consider it inflexible. Indeed, there can be a risk that investors will approach corporate governance codes with inflexibility, expecting much more compliance than explanation—which is not the code’s intent. Sometimes, this apparent inflexibility can arise from a failure of communication, particularly due to the reliance on proxy advisory firms (a highly concentrated group led by ISS and Glass Lewis) to mediate some of the discussions on governance and voting matters. These advisory firms tend to adhere to the details of corporate governance codes in giving recommendations on how their clients might vote. Some argue that it is the role of the proxy adviser to interpret the standards strictly, and it is for the actual shareholder to apply the flexibility that arises from a closer understanding of the specific circumstances of the individual company. Under this analysis, the problem of inflexibility may arise more from the investor client’s tendency to follow the proxy adviser’s recommendations, with too little independent judgment about whether those recommendations are the right ones, than from the strictness of the recommendations themselves. These issues are discussed in more detail in Chapter 6. 271 272 Chapter 5 © CFA Institute. For candidate use only. Not for distribution. Governance Factors Just as the Caparo and Polly Peck scandals sparked the establishment of the Cadbury Committee, and the Mirror Group and BCCI scandals provided a firm context for the publication and acceptance of its report, later scandals have continued to fuel the development of governance standards around the world: ► In the UK, shocks around pay levels at newly privatized utilities led to the Greenbury Report, which revised the UK’s corporate governance code in 1995. It increased the visibility of remuneration structures and pressed toward transparency over the KPIs that drive performance pay and the time horizons over which pay is released (for long-term schemes, the time horizon is a minimum of three years). ► The Enron, Tyco, and WorldCom scandals in the USA led to the Sarbanes-Oxley Act in 2002. This law lifted expectations for greater integrity in financial reporting and created the Public Company Accounting Oversight Board (PCAOB) as the country’s audit standard setter and inspector, establishing a standard for auditor independence and challenge. ► The 2003 failures at Ahold and Parmalat in the Netherlands and Italy, respectively, led to pressure for heightened standards of corporate governance and for both board and auditor independence across Europe. No longer could Europe pretend that Enron represented a problem isolated to the USA. ► The financial crisis of 2008 led to various changes around the world and to a renewed focus on corporate culture and executive pay as well as questions around audit. It also led to the creation of stewardship codes, in the UK initially and then around the world. Most notable of the legislative changes was the 2010 Dodd-Frank Act in the USA (formally, the Dodd-Frank Wall Street Reform and Consumer Protection Act), which, among its multiple clauses, tightened standards for, and oversight of, banks. ► In Japan, the Olympus scandal of 2011–12 revealed long-running market deceit, whereby more than US$1.5bn (£1.07bn) in losses were hidden, apparently not for personal gain but to maintain the apparent health of the company and jobs for its workforce. When the much larger Toshiba revealed its own scandal of overstated profits in 2015, some felt that there might be something culturally wrong in Japanese companies that sought to hide the truth and failures of governance. The combination of these shocks has helped fuel the rapid advance of Japanese governance standards and also expectations for ESG disclosures across the market. SCANDALS IN BRIEF Enron (USA, 2001): An electric utility turned energy-trading business, Enron used a range of off-balance-sheet vehicles and other aggressive accounting techniques to appear hugely profitable, even on projects that had barely begun. Its collapse led to the dismantling of its auditor, Arthur Andersen, which split apart rapidly after some of its staff in Houston were discovered to have shredded documents linked to Enron and the US Securities and Exchange Commission’s (SEC) investigation. Governance failings included weak oversight of the executives (reinforced by the founder, Ken Lay, remaining as executive chair) by the non-executive directors. There were also failures of commission, most clearly the decision to waive the board’s own code of conduct to enable the CFO to participate personally in some of the off-balance-sheet structures whose purpose was to facilitate the removal of losses from Enron’s accounts. © CFA Institute. For candidate use only. Not for distribution. Formalized Corporate Governance Frameworks HIH (Australia, 2001): This insurer collapsed before ever revealing the scale of its multi-million-dollar losses for the last six months of 2000. Having grown rapidly, insured aggressively, and under-reserved, the business had insufficient assets to cover its liabilities by a huge margin: the deficit was estimated to be up to AU$5.3bn (£2.7bn). The Royal Commission that looked into the HIH scandal concluded that while the board was unusually well qualified (including insurance specialists and accounting experts), the way it operated was subservient to the CEO and failed to offer independent oversight and challenge. Management controlled the board agenda and the information provided to directors—who, in turn, failed to question assumptions and gain an independent view. The board also handled conflicts of interest poorly, or simply ignored them, and had only limited debate on major strategic decisions, including acquisitions. Tyco International (USA/Bermuda, 2002): When losses mounted from unsuccessful deals by this aggressive Bermuda-incorporated acquisition vehicle, questions were raised about the behavior of CEO Dennis Kozlowski. Allegations centered on inflated profits, but also on ill-gotten earnings by senior management. In the end, the trial of Kozlowski and of CFO Mark Swartz centered on payments of US$150mn (£107mn), which they claimed the board had authorized as their remuneration. They were convicted, but the suggested level of actual theft is believed to have exceeded US$500mn (£359mn). The culture at Tyco had long been one of lavish lifestyles for corporate leadership using corporate money and perks. Kozlowski had already grown accustomed to this culture prior to becoming CEO and extended it further. Deal-making (some 750 acquisitions in the four-year period up to 2001) became a basis for personal aggrandizement and even personal entertainment. Tyco apparently financed Kozlowski’s wife’s $2 million birthday party, for example. The board at best turned a blind eye to these behaviors, enabling this wasteful and unhealthy culture to persist. WorldCom (USA, 2002): The internal audit function of this telecom business uncovered its use of one of the simplest accounting deceits—booking current expenses as capital investment, boosting profits by some US$3.8bn (£2.7bn). A subsequent investigation concluded that, in total, assets were exaggerated by US$11bn (£7.9bn). The fraud was undertaken to hide falling growth in a more challenging market. At WorldCom, the board’s checks and balances worked, although belatedly. An internal audit team uncovered suspicious transactions (or, rather, suspicious accounting treatments of transactions) and raised them with the chair of the audit committee. Though the chair did not immediately call a meeting of the committee, he did invite the internal audit team to discuss the issues directly with KPMG, the external auditor; in the meantime, the internal audit team persisted with its work and uncovered the full scale of the misleading accounting. When the committee was finally called, it confronted the executives leading the finance function with full evidence from the internal audit and with the support of KPMG. Executive departures and public announcements—and an SEC investigation—followed. So did bankruptcy. Ahold (the Netherlands, 2002–03): Ahold was a Dutch grocery chain that went international through acquisitions, principally in the USA, in part because management had a 15% earnings growth target. Deteriorating performance was hidden through fraud—dubious joint venture accounting, hidden costs, and vendor rebates. 273 274 Chapter 5 © CFA Institute. For candidate use only. Not for distribution. Governance Factors While making decisions to grow internationally, the board failed to ensure that its skills and its processes also developed so that it could oversee the new broader spread of the business. Instead, the US operations faced more limited oversight and challenge than they might have, allowing frauds to develop without being uncovered until they were very substantial. Parmalat (Italy, 2003): False accounting spiraled from an initial 1990 decision by this Italian milk business to hide losses in its South American operations, mainly through inflating apparent revenues by double billing. In the end, in 2003, more than €4bn (£3.4bn) in cash and equivalents on the company’s reported balance sheet turned out to be imaginary. Parmalat’s fraud began the way many frauds begin—accounting sleight of hand to cover up local losses. The fraud got so big because the losses persisted and the fraud was not uncovered for more than a decade, while the scale of the hole in the profits, and the efforts needed to conceal it, snowballed. Again, it appears that board oversight of international operations was less effective than it might have been. Further, audit checks and balances seem to have failed. At the time, Italy had a rule requiring a change in audit firm every nine years. Parmalat sidestepped this rule by changing the parent company’s auditor, Grant Thornton, but retaining them internationally. The market missed signals that appear obvious in retrospect, not least Parmalat’s reported profit margins being far in excess of peers’. Satyam (India, 2009): The founder and chair admitted to falsifying the accounts of this IT services company. For around five years, the company had inflated revenues using thousands of false invoices; the auditor had apparently failed to check the bank statements that might have uncovered the fraud. The entire board was removed by regulators, the chair was jailed, and following a lengthy regulatory procedure, the company’s auditor, PwC, was banned in 2018 from auditing any Indian public company for two years. The founder’s confession followed a proposed related-party transaction whereby Satyam would buy a real estate company from him. Though announced, the plan was retracted within a few hours after a highly negative response from shareholders—and the news that the World Bank would no longer do business with the company, barring it for eight years. The World Bank alleged that Satyam had provided improper benefits to its staff and had failed to provide proper accounts for its charges. Once problems emerged, as is so often the case, the fraud rapidly unraveled and the founder’s losses in real estate ventures were revealed. The board had provided limited oversight and had perhaps believed the myth of the company’s success and rapid growth. The extensive fraud was also missed by the audit process. Olympus (Japan, 2011–12): Following his appointment, new CEO Michael Woodford soon became concerned about the profitability of Olympus. He was ousted but acted as a whistle-blower. Slowly it emerged that the Japanese camera maker had hidden losses for many years, principally through over-priced acquisitions whereby some of the excess fees paid were returned to the company to cover losses and shore up its finances. Like many Japanese companies, Olympus was run by long-standing executives who had sought to protect the company at all costs, with remarkably few independent checks and balances. They had clearly concluded that hiding losses through convoluted schemes was preferable to honesty about the company’s issues and the potential negative consequences for its workforce. Also, the supposedly independent oversight from the statutory auditors failed because they too appear to have lacked independence from the company (or at least enough of them did). © CFA Institute. For candidate use only. Not for distribution. Shareholder Engagement and Alignment 275 Volkswagen (Germany, 2015): Volkswagen was revealed to have cheated on US emissions tests on its diesel engines through software, so-called defeat devices. Although, on the face of it, this was not a governance scandal, many investors had long been concerned about the lack of accountability at the German company, where the voting shares were predominantly held by the founding families, the local government, and the government of Qatar. The differential voting rights served to entrench these groups, enabling them to dominate the board. Management was thus able to operate in an insular and unaccountable way. Furthermore, the company’s culture was driven by the view that engineers always knew best and that their actions were largely above criticism. The company needed an engineering response to the new diesel regulations, but when it failed to find one that worked on the road, it chose to seek one that at least worked during testing. The board, accustomed to not having to listen to external voices, never felt the need to ask enough questions to uncover the issue. Wirecard (Germany, 2020): Wirecard, a hard-driving fintech and global payments processor, collapsed in June 2020 when long-running allegations of fraud and questionable accounting were largely confirmed by a special audit. The audit revealed that some €1.9bn (£1.6bn) were missing from its accounts. It became apparent that substantial elements of its business in the Middle East and Asia were no more than an elaborate sham and that the core payments-processing operations in Europe were barely profitable. One of the most remarkable aspects of the scandal was the way that the press investigation—persistently pursued by the Financial Times—was fought at each step by the German regulator, BaFin, which was supposed to be overseeing the business. Apparently, both the regulator and the board were so taken by the opportunity for Europe to build its own fintech star that they failed to spot the red flags about the business and failed to ask enough questions as it expanded overseas. The auditor also failed to identify warning signs, especially around the overseas operations. SHAREHOLDER ENGAGEMENT AND ALIGNMENT 5.1.1 explain the evolution of corporate governance frameworks: development of corporate governance; roles and responsibilities; systems and processes; shareholder engagement; minority shareholder alignment Shareholder engagement is the active dialogue between companies and their investors, with the latter expressing clear views about areas of concern (which often include ESG matters). Engagement helps ensure that the board directors are accountable for their actions, which hopefully in time helps to improve the quality of their decision-making. Engagement is discussed in depth in Chapter 6. For minority shareholders—which institutional investors will almost always be—a crucial issue is that they not be exploited by the dominant or controlling shareholders. In many cases, protections for minorities are built into company law, and they often exist in listing rules and other formal protections. These protections are usually bolstered 3 276 Chapter 5 © CFA Institute. For candidate use only. Not for distribution. Governance Factors by corporate governance codes, but the issues are so fundamental (because they relate to avoiding exploitation of minorities and protection of their ownership rights) that in most countries, minority shareholders benefit from underlying legal protections. Exploitation of minorities could involve money being siphoned out of the business in ways that benefit the controlling shareholders but not the wider shareholder base, which explains why there are typically higher disclosure requirements around related-party transactions and rights for non-conflicted shareholders to approve them. Minority shareholders will also be unwilling to see the company they invested in change dramatically without their having the chance to vote on the issue. For example, in the UK listing regime, class tests are applied as follows: ► If a transaction affects more than 5% of any of a company’s assets, profits, value, or capital, there must be additional disclosures (Class 2 transactions). ► If a transaction affects more than 25% of any of a company’s assets, profits, value, or capital, there must be a shareholder vote to approve the deal based on detailed justifications (Class 1 transactions). Another key area for shareholder protection is pre-emption rights. These rights ensure that an investor has the ability to maintain its position in the company. Fundamental to many markets’ company laws (though not, for example, in the USA) is the idea that a company should not issue shares without giving existing shareholders the right to buy an amount sufficient to maintain their existing shareholding. Because these rights come before the prerogative of potential external investors, they are called pre-emptive, and the existence of these rights is why a large equity fundraising by companies is often called a “rights issue.” As rights issues are cumbersome, particularly if a company is issuing a relatively small number of shares, companies typically seek authority at AGMs to issue a relatively small proportion of shares (up to 5% or 10%) non-pre-emptively—that is, without having to offer them fairly to existing shareholders. Investors are usually prepared to grant such authority but with certain protections in place. Even where issues are not on a fully pre-emptive basis, there is usually an expectation that the larger institutional shareholders will be offered a so-called soft pre-emption, meaning an allocation equivalent to their existing shareholding but in a less formal, less legalistic way (which may enable the issuance to be made more swiftly). Larger issuances are more controversial, as are issues at a price possibly less than the prevailing share price. An example of a particularly unpopular model with defenders of minority shareholder rights is the “general mandate” resolutions in Hong Kong SAR, which seek to enable issuance of up to 20% of the share capital, potentially at a discount. There is a clear detriment from such transactions to the existing shareholders. A final area in which minority shareholders can feel exploited is the mechanism of dual-class shares. Typically, one of the classes is restricted to the founders of a company (or a limited group chosen early in a company’s life), who receive multiple votes compared to the class of shares that subsequent shareholders can invest in— the shares that are usually more freely traded on the stock market (and those issued freely as compensation to staff, particularly in the case of US technology businesses). Moreover, management, which typically benefits directly from multiple voting rights and often voting control, will feel less accountable to the broader shareholder base, with whose interests management is less aligned. Dual-class shares are often frowned upon by many investors and are rare outside the USA (though Volkswagen, as discussed in the Scandals in Brief section, is a European example). They are, however, becoming more visible and more common because of the current success of technology businesses, the founders of which have been keen to retain voting control. The Council for Institutional Investors, the main organization © CFA Institute. For candidate use only. Not for distribution. Characteristics of Effective Corporate Governance: Board Structure and Executive Remuneration 277 for US institutions, has taken a nuanced stance on dual-class stock,4 recognizing that it can provide some stability in the early life of a company, but urging that it be subject to sunset clauses so the two classes are unified after, at most, seven years (the time horizon after which academic evidence suggests that dual-class stock will usually have a negative performance impact). Controversially, Snap Inc. (the parent company of Snapchat) took the dual-class stock route further and issued shares without any voting rights at all; indeed, given that the company indicated there was little likelihood of a dividend, the instruments sold were actually more like warrants than shares. CHARACTERISTICS OF EFFECTIVE CORPORATE GOVERNANCE: BOARD STRUCTURE AND EXECUTIVE REMUNERATION 5.1.2 assess key characteristics of effective corporate governance, and the main reasons why they may not be implemented or upheld: board structure, diversity, effectiveness, and independence; executive remuneration, performance metrics, and key performance indicators (KPIs); reporting and transparency; financial integrity and capital allocation; business ethics The current iteration of the Corporate Governance Code in the UK was published in 2018. It includes 18 principles under five themes: ► board leadership and company purpose; ► division of responsibilities; ► composition, succession, and evaluation; ► audit, risk, and internal control; and ► remuneration. These themes are consistent across most of the world’s corporate governance codes, as are (largely) the expectations and duties of the three principal board committees that almost all major companies have in place: ► the audit committee (sometimes the audit and risk committee); ► the nominations committee (sometimes the corporate governance committee or some combination of the two); and ► the remuneration committee (or the compensation committee in the USA; some companies also now incorporate into the name some reflection of a responsibility to the broader employee base). The expectation is that the audit and remuneration committees will be populated solely by independent non-executive directors, and such directors should form a majority of the nominations committee (the chair should not lead this committee while it is seeking to appoint a successor). Some companies will establish other board committees to address issues ad hoc or on an ongoing basis, but they should use appropriate judgment in how those committees should best be populated. For example, most financial services businesses now have a separate risk committee, which is 4 Council of Institutional Investors, Dual-Class Stock (2021). Available at: www​.cii​.org/​dualclass​_stock. 4 278 Chapter 5 © CFA Institute. For candidate use only. Not for distribution. Governance Factors usually made up of independent non-executive directors. Other companies may have sustainability committees, or committees considering their key operational risks— such as a people committee at companies highly dependent on their workforce or a health and safety committee. Such committees assist the board in overseeing major exposures and in dealing with the workload of oversight. They are not compulsory, and certainly at smaller businesses, this workload is likely to be handled by the audit committee or by the board itself. The Code also determines appropriate disclosures to make the workings of the board transparent and to demonstrate their effectiveness to shareholders. Published alongside the 2018 Code was a Guide to Board Effectiveness, which applies the same structure as the Code under the same five themes. It provides not only guidance but also questions to assist board members in considering whether they are being fully effective in their roles. The guide also provides questions that board members might choose to ask management to gain additional clarity on corporate culture. Almost half of the main body of the guide is taken up with the first theme, board leadership and company purpose—essentially, this theme focuses on culture, strategy, and maintaining appropriate relationships with key stakeholders. While this guide is a UK document that is explicitly aimed at assisting boards, the themes are useful to investors in considering the effectiveness of governance globally. Board Structure, Diversity, Effectiveness, and Independence As governance at its core is about people, the key to exercising effective governance is having the right people with relevant skills and experience around the boardroom table, as well as having the right board culture to enable each of them to contribute effectively to boardroom debate. This goal is easily summarized but difficult to achieve. As can be seen from the case study sample of BHP’s annual report disclosures on its board skills and diversity, there are multiple skills that boards seek to have available within the boardroom, often many more than the number of individual directors. If an issue is of high importance to the business, the usual expectation is that more than one person should have knowledge of that issue, because a board will rarely feel comfortable relying on a single perspective, particularly as that person may not always be available. Compromises need to be made, and plans need to be considered for the future to prepare for expected departures from the board—and to respond to unexpected changes (such as death or conflicts of interest). Of course, a board can have access to specialist skills through advice from experts invited to present at board meetings or to provide input in other ways. A question to consider is what skills and experience are regularly needed around the boardroom table and what skills and experience would be better accessed on an occasional, independent advisory basis. One skill set, or at least depth of understanding, increasingly expected for every board concerns climate change—as highlighted by the specific attention to this issue in the BHP disclosures. Not every board can have a climate scientist, and indeed few boards may actually want one. But all boards need to be competent in dealing with the business complexities of the issues around climate change, so that they can appropriately consider how to adjust their business models and investment approach to reflect the coming scrutiny on greenhouse gas emissions. A company that fails to consider this issue is likely to misspend capital expenditures either currently or in the near future, as it invests in assets that will not have the same value in a carbon-constrained world—having a board with climate change competency could help avoid this waste. To achieve this goal, it is likely that education and training will be needed, for at least some directors. A growing number of appropriate courses are available. Boards may also increasingly have to consider skills and training in other areas, such as environmental and social risk. © CFA Institute. For candidate use only. Not for distribution. Characteristics of Effective Corporate Governance: Board Structure and Executive Remuneration As well as training for directors, boards must consider the need for refreshment of skills, which have a half-life and will decrease over time. The needs of the board will also change over time as its strategy evolves, and it is important to keep the skills matrix updated. The issue of director tenure and independence is discussed below. There are many types of diversity needed for a board to be successful, though the most important is diversity of thought. The other types include diversity of gender, race, age, culture, nationality, economic background, and experience, each of which can also often help to deliver diversity of thought. The aim is to avoid groupthink in the boardroom, which may lead to a lack of questioning and challenge. While this broad concept of diversity—diversity of thought—is well understood, most diversity initiatives focus on the most visible issues: gender and race. A number of markets now have quotas for female directors (notably Norway, which pioneered the approach, and France), and most are moving toward an expectation that at least 30% of public company directors should be women. The issue of racial diversity has been actively debated in the USA for some years, and the UK’s 2017 Parker Review called for at least one non-white director on every FTSE-100 company board by 2021 and on every FTSE-250 board by 2024.5 A 2022 update of the review (https://​assets​.ey​.com/​ content/​dam/​ey​-sites/​ey​-com/​en​_uk/​topics/​diversity/​ey​-what​-the​-parker​-review​-tells​ -us​-about​-boardroom​-diversity​.pdf ) noted that 89 of the FTSE-100 companies had met the goal by the end of 2021 and that some 55% of the FTSE-250 had also already reached the goal. These initiatives gained fresh impetus from the momentum of the Black Lives Matter campaign in 2020, which could mean that more change is likely. An effective chair brings out the contributions of each board member, which is less visible to outsiders but is a vital part of delivering board effectiveness. Investors can gain some insight into how the chair operates in the boardroom from direct dialogue with the chair and with other board members, but often the clearest indicator is the quality of the individuals on the board overall. Good directors tend not to join boards that do not allow them to contribute effectively, or if they do, they are quick to leave them. The unfortunate consequence of all this for those who invest broadly is that weak boards tend to remain weak and it is difficult to improve them without substantive changes. Board appraisals (sometimes known as board assessments or self-assessments) are required under many corporate governance codes and can help boards to become more effective by bringing problems to the surface. Some investors are often cynical about these appraisals, as weak boards and weak chairs can relatively easily limit their impact without its being apparent to investors. It is hard to determine whether a board appraisal has been effective—though it has a better chance of succeeding if it is an external process with an independent facilitator rather than simply an internal review. In some markets, both the delivery and the findings of board appraisals are expected to be disclosed, which can help investors gain insight into a company. 5 UK Government, Ethnic Diversity of UK Boards: The Parker Review (2017). Available at: www​.gov​.uk/​ government/​publications/​ethnic​-diversity​-of​-uk​-boards​-the​-parker​-review. 279 280 Chapter 5 © CFA Institute. For candidate use only. Not for distribution. Governance Factors CASE STUDIES BHP Annual Report 2021, pp. 82–83: Disclosures on Board Skills, including Specifically on Climate Change Matters and Diversity Board Skills and Experience Total Directors Mining Senior executive who has: ► deep operating or technical mining experience with a large company operating in multiple countries; ► successfully optimized and led a suite of large, global, complex operating assets that have delivered consistent and sustaining levels of high performance (related to cost, returns and throughputs); ► successfully led exploration projects with proven results and performance; ► delivered large capital projects that have been successful in terms of performance and returns; and ► a proven record in terms of health, safety and environmental performance and results. Oil and gas Senior executive who has: ► deep technical and operational oil and gas experience with a large company operating in multiple countries; ► successfully led production operations that have delivered consistent and sustaining levels of high performance (related to cost, returns and throughputs); ► successfully led exploration projects with proven results and performance; ► delivered large capital projects that have been successful in terms of performance and returns; and ► a proven record in terms of health, safety and environmental performance and results. 12 4 2 Global experience Global experience working in multiple geographies over an extended period of time, including a deep understanding of and experience with global markets, and the macro-political and economic environment. 10 Strategy Experience in enterprise-wide strategy development and implementation in industries with long cycles, and developing and leading business transformation strategies. 11 Risk Experience and deep understanding of systemic risk and monitoring risk management frameworks and controls, and the ability to identify key emerging and existing risks to the organisation. 12 Commodity value chain expertise End-to-end value or commodity chain experience – understanding of consumers, marking demand drivers (including specific geographic markets) and other aspects of commodity chain development. 8 © CFA Institute. For candidate use only. Not for distribution. Characteristics of Effective Corporate Governance: Board Structure and Executive Remuneration Total Directors 12 Financial expertise Extensive relevant experience in financial regulation and the capability to evaluate financial statements and understand key financial drivers of the business, bringing a deep understanding of corporate finance, internal financial controls and experience probing the adequacy of financial and risk controls. 12 Relevant public policy expertise Extensive experience specifically and explicitly focused on public policy or regulatory matters, including ESG (in particular climate change) and community issues, social responsibility and transformation, and economic issues. 5 Health, safety, environment and community Extensive experience with complex workplace health, safety, environmental, and community risks and frameworks. 10 Technology Recent experience and expertise with the development, selection, and implementation of leading and business transforming technology and innovation, and responding to digital disruption. 5 Capital allocation and cost efficiency Extensive direct experience gained through a senior executive role in capital allocation discipline, cost efficiency 11 Twelve Directors meet the criteria of financial expertise outlined above. The Risk and Audit Committee Report contains details of how its members meet the relevant legal and regulatory requirements in relation to financial experience. Board Skills and Experience: Climate Change “Board members bring experience from a range of sectors, including resources, energy, finance, technology and public policy. The Board also seeks the input of management and other independent advisers. This equips them to consider potential implications of climate change on BHP and its operational capacity, as well as understand the nature of the debate and the international policy response as it develops. In addition, there is a deep understanding of systemic risk and the potential impacts on our portfolio. The Board has taken measures designed to ensure its decisions are informed by climate change science and expert advisers. The Board seeks the input of management (including Dr Fiona Wild, our Vice President Sustainability and Climate Change) and other independent advisers. In addition, our Forum on Corporate Responsibility (which includes Don Henry, former CEO of the Australian Conservation Foundation and Changhua Wu, former Greater China Director, the Climate Group) advises operational management teams and engages with the Sustainability Committee and the Board as appropriate.” 281 282 Chapter 5 © CFA Institute. For candidate use only. Not for distribution. Governance Factors Board Tenure and Diversity (as at 30 June 2021) Source: BHP (2021).6 Board independence is also a key concern. The aim must be to have a board that is independent of the management team and operates with independence of thought so that it can challenge both management and previous decision-making at the company (including prior board decisions). The ICGN’s Global Governance Principles set out an unusually complete investor perspective on independence criteria; these extend and elucidate some of the criteria embedded in standards in various Codes around the world. These criteria suggest that there will be questions about the independence of an individual who: ► had been an executive at the company or a subsidiary, or an adviser to the company, and there was not an appropriate gap between their employment and joining the board; ► receives, or has received, incentive pay from the company, or receives fees additional to directors’ fees; ► has close family ties with any of the company’s advisers, directors, or senior management; ► holds cross-directorships or has significant links with other directors through involvement in other companies or bodies; ► is a significant shareholder in the company, or is an officer of, or otherwise associated with, a significant shareholder, or is a nominee or formal representative of a shareholder or the state; and ► has been a director of the company for a long enough period that their independence may have become compromised. The intent is not to suggest that boards should never include directors whose independence is questioned. Indeed, such individuals may provide useful skills and perspectives. However, every board needs a sufficient weight of clearly independent individuals so that it is able to operate independently and is not subject to bias or inappropriate influence. Investors recognize that independence is a state of mind, and that some individuals can be fully independent notwithstanding some of the issues raised, while others, whatever their appearance of independence, will support only a CEO or a dominant shareholder. One of the challenges for investors is being able to identify both sorts of individuals. 6 BHP, Annual Report 2021 (2021). Available at: https://​www​.bhp​.com/​investors/​annual​-reporting/​ annual​-report​-2021. © CFA Institute. For candidate use only. Not for distribution. Characteristics of Effective Corporate Governance: Board Structure and Executive Remuneration Most investors would prefer that a company acknowledge that an individual will not be perceived as independent (for one of the various reasons) but will nevertheless bring real value to the business, rather than assert that the individual remains fully independent notwithstanding some obvious challenge(s). As ever, the way a board approaches an issue in its disclosures will determine how shareholders consider it. The issue of length of tenure on the board and independence is generally recognized around the world (though it is not acknowledged as an issue in some major markets, most notably the USA), though different standards are applied. As can be seen in Exhibit 2 (from the OECD Corporate Governance Factbook 2019), different markets have different expectations as to how long it takes for independence to erode. Investors may often seek to apply a single global standard, while companies may expect that their local standard will be respected. Exhibit 2: Definition of Independent Directors: Maximum Tenure Length of maximum tenure 16 14 12–15 YEARS No Independence 12 Belgium France Luxembourg Poland Portugal Spain Denmark Slovak Republic Slovenia 10 8 6 4 2 Blue denotes Rule/regulation Black italic denotes Code 8–10 YEARS No Independence Estonia Greece India Israel Latvia Lithuania Peru Saudi Arabia 8–10 YEARS Explain Indonesia Singapore United Kingdom