Level 1 CFA® Exam:
Corporate Governance & Stakeholder Management
Corporate governance is the system of internal controls (checks and balances), corporate procedures, and various incentives developed to help better manage a company and the interests of different stakeholders. It establishes the rights and obligations of various groups and aims at minimizing potential conflicts of interest between insiders, external shareowners, and other stakeholders.
Corporate governance within the investment industry is becoming more & more relevant. It is an important idea that can ensure not only the company’s efficiency but also the proper functioning of a market economy and the stability of the financial system.
There is no one agreed definition of corporate governance to be applied worldwide but the one we’ve just had tries to bring together the most essential aspects of this idea. When running their business, companies need to use resources more efficiently and see other stakeholders and members of the ecosystem. Before investment decisions are made, the efficiency of a company’s corporate governance and transparency of operations should be taken into account.
Due to the great impact that good corporate governance practices may have on sound capital markets, there is a consensus that countries and regions should aim at the convergence of the procedures and incentives that promote efficient corporate governance. Poor corporate governance means less transparency and confidence in markets and goes with more risks than benefits.
As we said in previous lessons, different stakeholders have different interests, which contributes to potential conflicts. To avoid conflicts of interest, it is necessary to understand the interests of different groups of stakeholders and to manage them successfully. This approach is called stakeholder management:
Stakeholder management is about identifying, prioritizing, and understanding the interests of stakeholder groups and then managing the company’s relationships with these groups.
Corporate governance and stakeholder management framework reflects the company’s legal, contractual, organizational, and governmental infrastructure which defines the rights, responsibilities, and powers of each group.
Successful communication and engagement with various stakeholders should be important to every company. It leads to many internal and external benefits.
Mechanisms of Stakeholder Management
There are various mechanisms and principles applied across companies, countries, and jurisdictions to manage stakeholders’ interests. Here are some examples of practices aimed at efficient stakeholder management:
- shareholder meetings,
- financial reporting and transparency,
- audit,
- remuneration policies,
- employment contracts,
- contractual agreements with creditors, customers, and suppliers,
- applicable laws and regulations, etc.
Due to the conflicting nature of stakeholder relationships, it is necessary to mitigate the associated risks. Here are some mechanisms available to stakeholders to protect their interests:
Shareholder Mechanisms
Shareholder mechanisms used to protect interests include:
- financial reporting and transparency,
- shareholder meetings,
- shareholder activism,
- shareholder derivative lawsuits,
- corporate takeovers.
Shareholders have access to information through various sources ranging from financial statements through the investor relations department to disclosures made on the company’s website and social media. All this to:
- reduce the information asymmetry,
- assess the board’s and management’s performance,
- make informed investment decisions,
- vote on key corporate matters.
general meetings = shareholders’ voting rights are exercised
annual general meeting (AGM) = has to be held within a certain period following the end of the fiscal year, purpose: present the company’s annual audited financial statements, present the company’s last year's performance, enable shareholders to participate in discussions and vote, address shareholder questions
extraordinary general meetings = can be called throughout the year for various purposes when shareholder approval is required (amendments to corporate bylaws)
proxy voting = when a shareholder authorizes another person, e.g., another shareholder, to vote on his or her behalf during a meeting s/he cannot attend; minority shareholders may use this way to strengthen their impact when they decide to collectively vote their shares
cumulative voting (as opposed to straight voting) = when a shareholder is allowed to accumulate all his or her shares to vote on a single candidate when the election involves more than one director; result: the likelihood of being represented by at least one director grows for the minority shareholders
shareholder activism = shareholders’ efforts (incl. lawsuit) to make some changes within the company or modify its behavior, esp. to increase shareholder value; often hedge funds are involved
shareholder derivative lawsuit = used by shareholder activists when a plaintiff shareholder acts on behalf of the company instead of the director who has failed to act in the best interest of the company
proxy contest (aka. proxy fight) = when shareholders are persuaded to vote for a group seeking to gain control of the board of directors
tender offer = when shareholders sell their interest directly to the group seeking control
hostile takeover = when a company wants to acquire another company without the consent of its management
Creditor Mechanisms
Creditor mechanisms used to protect interests include:
- bond indenture,
- financial reporting and transparency,
- creditor committees.
(...)
Customer & Supplier Mechanisms
Customer & supplier mechanisms used to protect interests include:
- contractual agreements,
- social media.
Companies enter into contractual agreements that specify:
- the product/service under the agreement,
- prices/fees,
- payment terms,
- after-sale relationship,
- guarantees,
- rights and responsibilities of each party, etc.
Moreover, a very powerful tool that can be used e.g. by customers is social media, where people can both promote and criticize the company’s goods or services. This information is available immediately and on a large scale.
Moreover, a very powerful tool that can be used e.g. by customers is social media, where people can both promote and criticize the company’s goods or services. This information is available immediately and on a large scale.
Government Mechanisms
Government mechanisms used to protect interests include:
- regulations,
- corporate governance codes,
- common law vs civil law systems.
As a rule, companies do their best to adopt internal governance and compliance procedures and abide by the relevant laws and regulations, e.g. on financial reporting and transparency.
Importantly, the countries with a common law system (e.g., USA, UK, India) are thought to protect the interests of shareholders and creditors better than those with a civil law system (e.g., Germany, France, Japan). Civil law is when the law is created by the legislature in the form of statutes and codes, which are a rigid base for a judge to apply in court. Under the common law system, the law is created by both the legislature and judicial opinions, which means that judges may create law. This is why shareholders and creditors can go to court with disputes that are not determined in statutes or codes. Since creditors’ disputes usually concern a breach of contract or the like, they are more likely to succeed in court than shareholders whose disputes are usually less straightforward.
If a company adopts poor corporate governance or leaves stakeholders’ interests unmanaged, it may create many risks, including legal, reputational, operational, and financial risks. Poor corporate governance may encourage misconduct. Also, the company’s ability to identify and manage its risks is impeded.
Good corporate governance and stakeholder management involve many benefits, including better company relationships and improved control processes, higher operational efficiency and financial performance, as well as a lower level of risk.
Risk of Poor Governance vs Benefits of Good Governance
POOR CORPORATE GOVERNANCE >> when one group benefits at the expense of another and the stakeholders’ interests are NOT balanced
Risks of poor governance:
- weak control systems (e.g. poor audit procedures or insufficient scrutiny by the board),
- ineffective decision-making (caused by e.g. information asymmetry between the managers and shareholders or bad executive remuneration policy),
- legal and regulatory risks (compliance weakness leads to possible lawsuits or investigations),
- reputational risk (caused by e.g. badly managed conflicts of interest),
- default and bankruptcy risks (poor corporate governance can hinder the company’s financial position and its ability to meet debt obligations).
GOOD CORPORATE GOVERNANCE >> when the interests of managers and directors are aligned with the interests of shareholders while balancing the interests of other stakeholders
Benefits of good governance:
- operational efficiency (owing to clearly defined and delegated duties),
- effective control at all corporate levels,
- better operating and financial performance (thanks to e.g. improved decision-making process or proper remuneration policies),
- enhanced valuation and stock performance (good transparent practices build investors’ trust and allow them to make educated investment decisions),
- lower default risk or cost of debt (mitigated by e.g. a well-functioning audit system, creditors’ rights protection, control of information asymmetry).
When assessing a company’s corporate governance and stakeholder management, analysts should consider – among other things – the company’s ownership and voting structure, significant investors, management’s remuneration, skills of the board, shareholders’ rights (weak/average/strong compared with peers?), the company’s ability to manage long-term risks and growth, etc.
Level 1 CFA Exam Takeaways for Corporate Governance & Stakeholder Management
star content check off when done- Corporate governance is the system of internal controls (checks and balances), corporate procedures, and various incentives developed to help better manage a company and the interests of different stakeholders.
- Stakeholder management consists of identifying, prioritizing, and understanding the interests of stakeholder groups and then managing the company’s relationships with these groups.
- Mechanisms of stakeholder management include shareholder meetings, financial reporting and transparency, remuneration policies, employment contracts, contractual agreements with creditors, customers, and suppliers, or applicable laws and regulations.
- The more the manager’s interests are aligned with the shareholders’ interests, the better. That’s a key element of good corporate governance, which is associated with multiple benefits and balanced stakeholders’ interests.
- Poor corporate governance is associated with various risks because the stakeholders’ interests are NOT balanced and one group can benefit at the expense of another.