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2022 Curriculum CFA Program Level I Corporate Finance

Introduction to Corporate Governance and Other ESG Considerations

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Introduction

Weak corporate governance is a common thread found in many company failures. Lack of proper oversight by the board of directors, inadequate protection for minority shareholders, and incentives at companies that promote excessive risk taking are just a few of the examples that can be problematic for a company. Poor corporate governance practices resulted in several high-profile accounting scandals and corporate bankruptcies over the past several decades and have been cited as significantly contributing to the 2008–2009 global financial crisis.

In response to these failures, regulations have been introduced to promote stronger governance practices to protect financial markets and investors. Academics, policy makers, and other groups have published numerous works discussing the benefits of good corporate governance and identifying core corporate governance principles believed to be essential to ensuring continuous, well-functioning capital markets and the stability of the financial system.

The investment community has also demonstrated a greater appreciation for the importance of good corporate governance. The assessment of a company’s corporate governance structure and controls, including consideration of conflicts of interest and transparency of operations, has been an essential factor in investment analysis. More data availability and demands for better governance have increased the weight of corporate governance in the investment decision-making process. In addition, investors have become more attentive to environmental and social issues related to a company’s operations. Collectively, these concepts often are referred to as environmental, social, and governance (ESG).

Section 1 of this reading provides an overview of corporate governance, including its underlying principles and theories. Section 2 discusses the various stakeholders of a company and conflicts of interest that exist among stakeholder groups. Section 3 describes the principal–agent and other relationships in corporate governance and the conflicts that may arise in these relationships. Section 4 describes stakeholder management, reflecting how companies manage their relationships with stakeholders. Section 5 focuses on mechanisms to manage stakeholder relationships and mitigate associated risks. Section 6 focuses on the role of the board of directors and its committees as overseers of the company. Section 7 explores certain key factors that affect stakeholder relationships and corporate governance. Section 8 highlights the risks and benefits that underlie a corporate governance structure. Section 9 synthesizes corporate governance concepts that should be considered by investment professionals. Finally, Section 10 discusses the growing use of environmental, social, and governance factors in investment analysis and portfolio construction processes.

Learning Outcomes

The member should be able to:

  • describe corporate governance;
  • describe a company’s stakeholder groups and compare interests of stakeholder groups;

  • describe principal–agent and other relationships in corporate governance and the conflicts that may arise in these relationships;

  • describe stakeholder management;

  • describe mechanisms to manage stakeholder relationships and mitigate associated risks;

  • describe functions and responsibilities of a company’s board of directors and its committees;

  • describe market and non-market factors that can affect stakeholder relationships and corporate governance;

  • identify potential risks of poor corporate governance and stakeholder management and identify benefits from effective corporate governance and stakeholder management;

  • describe factors relevant to the analysis of corporate governance and stakeholder management;

  • describe environmental and social considerations in investment analysis;

  • describe how environmental, social, and governance factors may be used in investment analysis.

Summary

The investment community has increasingly recognized the importance of corporate governance as well as environmental and social considerations. Although practices concerning corporate governance (and ESG overall) will undoubtedly continue to evolve, investment analysts who have a good understanding of these concepts can better appreciate the implications of ESG considerations in investment decision making. The core concepts covered in this reading are as follows:

  • Corporate governance can be defined as a system of controls and procedures by which individual companies are managed.
  • There are many systems of corporate governance, most reflecting the influences of either shareholder theory or stakeholder theory, or both. Current trends, however, point to increasing convergence.
  • A corporation’s governance system is influenced by several stakeholder groups, and the interests of the groups often diverge or conflict.
  • The primary stakeholder groups of a corporation consist of shareholders, creditors, managers and employees, the board of directors, customers, suppliers, and government/regulators.
  • A principal–agent relationship (or agency relationship) entails a principal hiring an agent to perform a particular task or service. In a corporate structure, such relationships often lead to conflicts among various stakeholders.
  • Stakeholder management involves identifying, prioritizing, and understanding the interests of stakeholder groups and on that basis managing the company’s relationships with stakeholders. The framework of corporate governance and stakeholder management reflects a legal, contractual, organizational, and governmental infrastructure.
  • Mechanisms of stakeholder management may include general meetings, a board of directors, the audit function, company reporting and transparency, related-party transactions, remuneration policies (including say on pay), and other mechanisms to manage the company’s relationship with its creditors, employees, customers, suppliers, and regulators.
  • A board of directors is the central pillar of the governance structure, serves as the link between shareholders and managers, and acts as the shareholders’ internal monitoring tool within the company.
  • The structure and composition of a board of directors vary across countries and companies. The number of directors may vary, and the board typically includes a mix of expertise levels, backgrounds, and competencies.
  • Executive (internal) directors are employed by the company and are typically members of senior management. Non-executive (external) directors have limited involvement in daily operations but serve an important oversight role.
  • Two primary duties of a board of directors are duty of care and duty of loyalty.
  • A company’s board of directors typically has several committees that are responsible for specific functions and report to the board. Although the types of committees may vary across organization, the most common are the audit committee, governance committee, remuneration (compensation) committee, nomination committee, risk committee, and investment committee.
  • Stakeholder relationships and corporate governance are continually shaped and influenced by a variety of market and non-market factors.
  • Shareholder engagement by a company can provide benefits that include building support against short-term activist investors, countering negative recommendations from proxy advisory firms, and receiving greater support for management’s position.
  • Shareholder activism encompasses a range of strategies that may be used by shareholders when seeking to compel a company to act in a desired manner.
  • From a corporation’s perspective, risks of poor governance include weak control systems; ineffective decision making; and legal, regulatory, reputational, and default risk. Benefits include better operational efficiency, control, and operating and financial performance, as well as lower default risk (or cost of debt).
  • Key analyst considerations in corporate governance and stakeholder management include economic ownership and voting control, board of directors representation, remuneration and company performance, investor composition, strength of shareholders’ rights, and the management of long-term risks;
  • ESG investment approaches range from value-based to values-based. There are six broad ESG investment approaches: Negative screening, Positive screening, ESG integration, Thematic investing, Engagement/active ownership, and Impact investing.
  • Historically, environmental and social issues, such as climate change, air pollution, and societal impacts of a company’s products and services, have been treated as negative externalities. However, increased stakeholder awareness and strengthening regulations are internalizing environmental and societal costs onto the company’s income statement by responsible investors.

Looking for more research and resources on ESG? Check out our ESG Investing and Analysis hub.