Evaluating Corporate Governance Policies and Procedures

Some benefits of effective corporate governance are:

• Better access to credit.
• Improved profitability.
• High returns and growth.
• Sustainable dividends.
• Good long-term share performance.
• Lower cost of capital.

Some drawbacks to companies with ineffective corporate governance are:

• Reputational damage.
• Reduced competitiveness.
• Share price volatility.
• Higher cost of capital.
• Reduced profitability.

A company’s behavior in the market and how it treats shareholders reflect its corporate governance quality. When evaluating a company’s corporate governance policy, the starting point for investors is to evaluate its board of directors.

Board Policies and Practices

A good place to start when evaluating a board’s effectiveness is its policies and practices. One aspect of the board’s effectiveness is its oversight role. In addition, ownership structure, legal environment, and industry diversity are factors that affect corporate governance issues in each capital market.

Board of Directors Structure

When evaluating the board structure, investors are more concerned about whether the structure gives enough insight, representation, and accountability. CEO duality is where the CEO also serves as chairperson of the board.

A company with CEO duality might have to appoint an independent director to protect investor interests.

Board Independence

The absence of an independent director on a board will lead management to act in a manner that is contrary to shareholder’s interests. Lack of independent directors on a board will increase investors’ perception of a company’s risk.

Board Committees

An important consideration by an investor when analyzing a corporation’s governance is the number of board committees and how they operate and the functionality of each committee. The presence of non-independent committee members might lead to biases, especially in allocating funds and remunerations in the committees.

Board Skills and Experience

A board with concentrated skills and experience may not have the required expertise to govern the company. On the other hand, a board with diverse skills and expertise that are not related to the company’s core business may be unsuccessful at governing the business. In addition, board members who serve on a board for a long tenure could be viewed negatively as directors being rigid in the corporation’s business.

Board Composition

Boards with fewer members with more diversity will govern a company more effectively than a board with more numbers and less diversity.

Executive Remuneration

There is increasing concern about excessive remuneration, especially the ratio between CEO pay to average worker pay. While evaluating a company’s executive remuneration, investors consider the effect of the remuneration policies on the company’s overall performance. Say-no-pay provisions give shareholders a chance to vote on remuneration issues. A claw-back policy allows a company to recover paid compensation from CEOs in case of misconduct, breach of law is uncovered. This makes the CEOs more careful in their decision-making.

Shareholder Voting Rights

Company founders and management who own dual-class shares have more voting power than ordinary shareholders; thus, they can benefit at the expense of ordinary shareholders. Therefore, when investing, investors need to be aware of the dual-class share structures.

Question

A company that has ineffective corporate governance is most likely to experience:

1. Better access to credit.
2. Share price volatility.
3. Lower cost of capital.

Solution

The correct answer is B.

The company’s share prices are highly volatile due to investor reactions to poor corporate governance policies.

A is incorrect. Companies with effective corporate governance are more likely to get access to credit faster because their corporate governance policies instill confidence in lenders that consider them less risky.

C is incorrect. This is also a benefit of effective corporate governance.

Reading 19: Environmental, Social, and Governance (ESG) Considerations in Investment Analysis

LOS 19 (b) Evaluate the effectiveness of a company’s corporate governance policies and practices.