Corporate governance and ESG an introduction.
Here are the sections of this reading section 2 deals
with corporate governance overview. The key point
here is to understand the different descriptions
of corporate governance section 3 company stakeholders
here you need to be able to describe the different
stakeholder groups and compare their interests
section 4 stakeholder management. So you need
to understand the description of stakeholder management
section 5 deals with the board of directors and committees.
So you need to understand the functions and responsibilities
of the board of directors and the various committees.
Section 6 you need to understand the factors which
impact stakeholder relationships and corporate
governance section 7 deals with the various risks
associated with poor corporate governance and then
the benefits of having a good corporate governance
structure. Section 8 gives an overview of analyst
considerations in corporate governance. In other
words, when you as an analyst are evaluating the corporate
governance of a company, what are the items that
you need to look at and finally section 9 has to do
with ESG considerations. Here E stands for environmental
s is for social and G is for governance. Sections 1
through 8 largely cover the governance aspect.
Section 9 focuses primarily on environmental issues
and social issues. This is a very long and theoretical
reading and it will be almost impossible to remember
all the details but it is essential that you keep
your eye on the learning outcomes and make sure that
you remember the most important points. These are
the points that I've emphasized in this lecture.
In some cases I simply readout segments from
the curriculum and the benefit there is that the curriculum
expresses some points in a very good manner and hopefully
by listening to me you will be able to remember those
points. Also, this is a sort of reading that you can
easily listen to on your commute to work because
there are no calculations. So if you just hear it a
few times that will help you remember the most important
points. Section 2: corporate governance overview.
The first point here is that corporate governance
can be described in many different ways. Here is
one definition corporate governance is the system
of internal controls and procedures by which individual
companies are managed. It provides a framework
that defines the rights, roles and responsibilities
of management board controlling share owners and
minority or non-controlling share owners. Here is
another definition: corporate governance is the system
by which companies are directed and controlled
and a third definition is that corporate governance includes
a set of relationships between a company's management,
its board, its shareholders and other stakeholders.
Now given the different definitions of corporate
governance it is easy to imagine that corporate
governance practices vary from country to country.
And in fact, even within a particular jurisdiction
corporate governance practices can vary from company
to company. Very broadly speaking there are two
major theories which define specific corporate
governance practices. One theory is the shareholder
theory and this is the traditional theory, which
says that the most important responsibilities
of a company's managers is to maximize shareholder
returns. And in fact, you'll would find this definition
in many traditional textbooks. If you notice, the first definition
is somewhat aligned with shareholder theory because
it emphasizes the relationship between management,
the board and shareholders. The board in a sense represents
to shareholders. The third definition seems to
align with shareholder theory because not only
is it talking about the relationship between the
management, the board and shareholders, but it also
talks about other stakeholders, and this is something
we'll discuss in more detail later. This point related
to other influences is that specific corporate
governance practices are also influenced by the
historical, cultural, legal and political aspects
of a given region. While corporate governance systems
and practices vary from region to region, there
is some convergence which is underway. The idea
here is that even those specific practices might
vary but corporate governance principles should
be the same regardless of where a company is operating.
Section 3 has two subsections 3.1 deals with the
different stakeholder groups and their interests
3.2 deals with the principal-agent problem, which
has to do with the conflicts between different stakeholder
groups. Here is a quick view of the different stakeholders.
Perhaps the most important stakeholder is the shareholders.
Shareholders provide capital to the company and
they are in a sense the owners of the company. Shareholders
want the company to do well because as the company
value increases share price goes up and obviously
shareholders are happy. Now at large public companies
the shareholders elect a board of directors to oversee
the company management. So the board of directors
is responsible for helping establish the strategy
of the company and then ensuring that managers run
the company in alignment with the strategy and in
the best interest of the owners or shareholders.
The board of directors plays a central role in the
corporate governance framework and this group
will be discussed in a lot more detail later. Next
we come to creditors. Creditors are typically
banks or bondholders who provide capital to the
company and obviously, they expect a certain fixed
return from the company. Creditors do not hold voting
power and that's unlike the owners. So owners
elect the board of directors and owners also have
voting power over who comes on this board. Creditors
do not have that voting power. Creditors are interested
in the stability of a company. And as long as the company
is profitable enough to make principal payments
and interest payments the creditors are happy. Next
we come to suppliers. So suppliers provide goods and
services to the company and in return get paid. The interest of
suppliers is that they get paid as per their contract
and in a timely manner. As with creditors suppliers are also
interested in the company's ability to generate
sufficient cash in order to make the promised payments.
Customers buy goods and services from the company
and pay the company. Obviously the customers are
interested in getting the best possible goods and
services at the lowest possible price. Broadly speaking
we can have two categories of customers. We can either
have tactical customers or strategic customers
tactical customers are not impacted too much by
the performance of the company because if the company
is not doing too well customers will simply take
their business elsewhere. If a customer is a strategic
customer then they would be more interested in the
long-term stability and well-being of the company.
Finally, we come to the government or regulators.
The government or regulator is interested in ensuring
that the company is operating in the best interest
of the public and that the company is following the
law of the land the government also gets tax revenue
from the company. So in that sense, the government
is a major stakeholder. A quick word on stakeholders
in nonprofit organizations, here the perspective
is different relative to public companies. The board of directors are often called trustees
and the stakeholders would include the board of
directors / trustees, the managers and employees
who are part of the nonprofit organization. Instead
of customers we would typically have donors and
then there will be the people who benefit from the
nonprofit organization. A key role here is paid
by the trustees who need to ensure that the donations
coming in are used for the stated purpose of the nonprofit
organization. Section 3.2 principal-agent and
other relationships in corporate governance.
The first point is to understand the principal-agent
relationship. This relationship is also called
the agency relationship and is fairly straightforward
the principal hires an agent to perform certain
duties. Now since the principal has hired the agent
the agent needs to act in the best interest of the
principal. The potential conflict is where the agent
act in his own best interest rather than the best
interest of the principal. Now let's apply this to the shareholder and
manager/director relationship. The shareholders
are the owners of a company, they elect the directors
so we can say the principal in this context is the
shareholder who elects the directors, the directors
are responsible for hiring the managers and then
the managers in essence run the company. So the directors
set the strategy for the company and then oversee
the managers. They need to ensure that the managers
are running the company in the best interest of the
shareholders. SO in this context, the shareholders are the principal
and the directors / managers are the agents. So what
are the possible conflicts of interest? As we said earlier, the major interest
of shareholders is that the value of the firm is maximized.
The managers on the other hand will possibly be more
interested in their own personal benefits. So they
would want their compensation to be maximized their
perks or perquisites to be maximized and herein
lies a potential conflict because if the managers
are paying themselves too much that is negatively
impacting the value of the firm. Another possible
issue has to do with risk tolerance. Now generally shareholders
will be well diversified so they would want the company
to take an appropriate level of risk so as to maximize
the value of the firm. The managers on the other hand
might be somewhat risk-averse because in addition
to maximizing their compensation managers also
want job security. So they are more likely to engage
in projects that are relatively safe. So that's
one potential mismatch between the risk tolerance
level of shareholders and managers. Now there is another possible situation
also, this is where senior managers have stock options
and let's say we have a situation where the options
are just out of the money. In this case managers might
be tempted to take excessive risk because when they
take risk there is a chance that the company will
do well and the options will become in the money and
this level of risk might be suitable for the senior
managers with stock options, but it might not be
the appropriate level of risk for the shareholders.
So the larger point is that there is a potential mismatch
between the risk tolerance of shareholders / owners
and the managers. Another issue has to do with information
asymmetry clearly the managers have a lot more information
about the company relative to shareholders and
they might make decisions that are not in the best
interest of shareholders and shareholders will
not have enough information to evaluate the decisions
made by managers. Another conflict arises when
the board is influenced by insiders. So we have the
shareholders who elect the board of directors and
the board of directors is responsible for overseeing
the managers. If this board of directors is dominated
by company insiders then clearly there is an issue because
the board then will be acting in the interest of
managers rather than shareholders. Conflicts
can also arise between controlling shareholders
and minority shareholders. Now consider a situation
where a given shareholder has 51% of the votes and
the minority shareholders have 49%. In this case,
the controlling shareholders can vote in a way that
benefits them and in a way that hurts the minority
shareholders. The curriculum gives a couple of
examples of how this can happen. So there was a situation
where a given company had a controlling shareholder
and then there were minority shareholders when the
company was sold, the deal was negotiated such that
the controlling shareholders got a higher price
for their shares relative to what the minority shareholders
got for their shares. Another conflict can happen
with related third-party transactions. So let's say
that this controlling stakeholder has an ownership
stake in another company. Let's call this the third
party. If the controlling stakeholder also owns
this third-party company potentially this company
could buy goods and services here at prices that
are above market value. Now when this happens, obviously
the third party benefits this company loses out
but the controlling stakeholders benefit because
they also have ownership over here since the company
loses out the minority shareholders lose out. So
this is another possible area of conflict between
controlling and minority shareholders. Related
to this is a situation where we have an equity structure
with multiple share classes. So if you have let's say
share classes A & B where share class A has voting
rights but share class B does not then obviously
the shareholders with voting rights will execute
transactions which are beneficial to them and potentially
not beneficial to the other owners of the company
who do not have voting rights. Manager and board relationships
so we have a board of directors, which is responsible
for overseeing the managers of a company in a situation
where we largely have independent directors who
are not involved in the day-to-day running of the
company we can have a potential issue whereby
the managers do not provide sufficient information
to the board. And if the board doesn't have sufficient
information, then they cannot adequately oversee
the managers. Shareholder vs. Creditor interests.
Now this is fairly straightforward. We have a company
the company gets money from the shareholders and
also from creditors. The shareholders are interested
in maximizing the value of the company so the shareholders
would like the company to take projects that are
somewhat risky so that the overall return is maximized.
The creditors on the other hand are going to be more
risk-averse. The creditors would prefer that the
company engages in relatively low-risk projects
so that the risk of default is minimized. There are
a few other conflicts that you need to be aware of.
One is the conflict between customers and shareholders
obviously customers would like that the company
sells products and services at as low a price as possible
which would impact the value of the firm. We have
a contract between customers and suppliers, customers
would like easy payment terms but if a company is
getting late payments from customers then that
impacts their ability to pay suppliers in time.
There is also a potential conflict between shareholders
and governments or regulators in the sense that
shareholders would like to adopt accounting practices
that minimize taxes. Another example would be in
the banking sector where the regulator would like
to see relatively high equity capital whereas
the owners and shareholders would prefer to have
lower equity capital so that return on Equity is high.