Mechanisms to Manage Stakeholder Relationships and Mitigate Associated Risks

In seeking to balance stakeholder interests, a company may employ various mechanisms in stakeholder management. Common mechanisms include: holding general meetings, electing a board of directors, having an audit function, company reporting and transparency, policies on related-party transactions, and remuneration policies (including say on pay). These mechanisms regulate a company’s relationship with its creditors, employees, customers, suppliers, and regulators.

General Meetings

General meetings provide shareholders with the opportunity to participate in company discussions and to vote on major corporate matters.

Companies usually hold an annual general meeting (AGM) within a certain period of time after the end of their financial year. The main purpose of an AGM is to present shareholders with the annual audited financial statements of the company, provide an overview of the company’s performance over the year, and address any shareholder concerns.

It is also possible for extraordinary general meetings to be called by the company or shareholders within the year. This should happen whenever significant resolutions requiring shareholder approval are proposed.

Ordinary resolutions require a simple majority of votes to be passed. These usually relate to the approval of financial statements and the election of directors and auditors. Special resolutions require a supermajority vote such as 75% of the votes to be passed. Special resolutions are more material in nature. Examples include effecting amendments to bylaws, voting on a proposed merger or takeover transaction.

Proxy Voting

Proxy voting allows shareholders who cannot attend a general meeting to authorize someone else to vote on their behalf. It is the most common form of investor participation in meetings. Minority shareholders tend to use proxy voting in an attempt to increase their influence in companies.

Cumulative Voting

Cumulative voting allows a shareholder to accumulate and cast or vote all of his or her shares for a single candidate in an election involving more than one director. By employing this process, minority shareholders have an increased likelihood of being represented by at least one board director.

Board of Directors

A board of directors is elected by company shareholders to provide oversight of the company. The board appoints the top management of the company, is held accountable by shareholders, and is responsible for the overall governance of the company. The board dictates the strategic direction of the company, guides and monitors management’s actions towards executing the strategy, and evaluates management performance. The board also supervises the audit, control, and risk management functions of the company as well as its compliance with all applicable laws and regulations.

The Audit Function

The audit function describes the systems, controls, policies, and procedures which a company has in place to examine its operations and financial records. It serves to limit insiders’ discretion concerning financial reporting and use of the company’s resources. It is also designed to mitigate fraud or misstatements of accounting information.

There are two types of audit functions: internal audit functions and external audit functions.

Internal Audit

Internal audits are conducted by an independent internal audit department. The role of an internal audit is to provide independent assurance that a company’s risk management, governance, and internal control processes are operating effectively.

External Audit

These are outsourced auditors. They perform audits of the company’s financial records to provide a reasonable and independent assurance that they accurately reflect the company’s financial position. The board of directors usually receives and reviews the financial statements and auditors’ reports. Further, the board confirms the accuracy of audit financial statements and auditors’ reports. It is upon the approval of the board that the statements and reports are presented to shareholder at the annual general meeting for their approval.

Reporting and Transparency

Shareholders can gain a range of financial and non-financial information mainly through annual reports and other company disclosures. Access to this information reduces information asymmetry between shareholders and managers. In the end, transparency allows shareholders to appraise the company and to make informed decisions on company valuations.

Policies on Related-party Transactions

A related party transaction is a business arrangement between two parties that are connected by a special relationship that exists before the arrangement. A company’s policies on related-party transactions establish the procedures for disclosing information on these transactions thereby mitigating and managing any conflicts of interest that may arise.

Related-party policies and procedures aim to ensure that related-party transactions are conducted at an arm’s length and do not advance the interests of the related-party at the expense of the interests of the company or its shareholders.

Remuneration Policies

Companies are increasingly establishing remuneration policies that discourage short-term focus and excessive risk-taking by managers. Long-term incentive plans delay the payment of all remuneration until company strategic objectives, namely performance targets, have been met. Some incentive plans include allocation of shares rather than options to managers and restricting their vesting or sale for several years or until retirement.

Regulators are placing an increasing focus on company remuneration policies. In some parts of the world, regulators require companies to base their remuneration policies on long-term performance measures. In some instances too, companies are required to adopt clawback provisions that allow them to recover previously paid remuneration if certain events such as misconduct or fraud are uncovered.

‘Say on Pay’ enables shareholders to vote on matters about executive remuneration. This allows them to limit the discretion that directors and managers have in granting themselves excessive or inadequate remuneration. It is often criticized by opponents who believe that the board is better suited to handling remuneration matters given the limited involvement of shareholders in a company’s strategic operations.

Contractual Agreements with Creditors

The rights of creditors are established by laws and provisions in the contracts that are executed with a company.

Indentures are legal contracts that describe the structure of a bond, the obligations of the issuer, and the rights of the bondholders. Covenants within indentures enable creditors to specify the actions an issuer is obligated to perform or prohibited from performing. Creditors often require a company to provide periodic financial information to ensure that covenants are not violated and default risk is not increased.

Collateral in the form of assets or financial guarantees is often used to guarantee the repayment of debt to creditors.

Employee Laws and Contracts

The rights of employees are primarily secured through labor laws. Labor laws define the standards for employees’ rights and responsibilities and cover matters such as working hours, pension plans, hiring and firing practices, and vacation and leave entitlements. Unions seek to influence certain matters which affect the well-being of employees on their jobs.

Employment contracts specify an employee’s rights and responsibilities. However, they do not cover every situation between employees and employers.

Effective human resource policies seek to attract and recruit high-quality employees while providing remuneration, training or development, and career growth prospects to improve employee retention. Employee Stock Ownership Plans (ESOPs) are also used to retain and motivate employees.

Companies sometimes use Codes of Ethics and business conduct to establish the company’s values and standards of ethical and legal behavior that employees are expected to follow.

Other Mechanisms

Other mechanisms for stakeholder management include contractual agreements between companies and their customers and suppliers, as well as laws and regulations.

Question

Which of the statements about the audit function is most likely accurate?

A. Internal audit guarantees that a company’s risk management, governance, and internal control processes are operating effectively.

B. The audit function describes the systems, controls, policies, and procedures which a company has in place to examine its operations and financial records.

C. Internal auditors conduct annual audits of the company’s financial records and prepare the financial statements and auditors’ reports which are eventually presented to shareholders for approval at the AGM.

Solution

The correct answer is B.

Option A is incorrect because internal audit cannot guarantee that a company’s risk management, governance, and internal control processes are operating effectively. It can only provide independent assurance that they are operating effectively.

Option C is also incorrect because it is the external auditors and not the internal auditors who conduct the annual audits of a company’s financial records. Their audit generates financial statements and audit reports which are eventually presented to shareholders for approval.

Reading 31 LOS 31e:

Describe mechanisms to manage stakeholder relationships and mitigate associated risks