Corporate governance mechanisms

What is corporate governance, and where does it start?

Corporate governance is the system of checks, balances and incentives that manages conflicting interests among stakeholders. A sound structure helps the company follow outside rules and meet the needs of insiders, and it does so by striking a balance among groups. The mechanisms below are best learned by asking who holds each lever.

Corporate governancechecks, balances and incentives, built on reporting and audit

• Shareholders Memorize residual owners
  • General meetings and proxy voting Memorize AGM, EGM
  • Activism and lawsuits Use it resolutions, publicity, derivative suits
  • Control contests Memorize proxy contest, tender offer, hostile takeover
• Creditors Memorize contract and committee
  • Bond indenture Use it covenants and collateral
  • Creditor committees Memorize official in bankruptcy, ad hoc in distress
• Board and management Memorize delegation and defenses
  • Board committees Memorize audit, nominating/governance, compensation
  • Takeover defenses Memorize staggered board, shareholder rights plan
• Employees, customers and suppliers Know the idea contracts and law
  • Employees Know the idea labor law, unions, contracts, ESOPs
  • Customers and suppliers Know the idea contracts and social media
• Governments Use it rules from outside
  • Laws and regulation Use it stricter for finance, health, food, defense
  • Governance codes Use it comply or explain; listing rules

Reporting and transparency come first. Without them outsiders cannot know how the company is doing, or press for their interests. Public companies publish an annual report, audited annual statements, reviewed interim statements and a proxy statement that covers governance, ownership, pay, related-party transactions and risk factors. Most jurisdictions and exchanges require third-party auditors for the annual statements.

Private companies disclose only what regulation requires, or voluntarily. They give investors information in confidence, in a form and at a level that are negotiated rather than standardized, and usually without an audit, though they may obtain one to improve their terms.

Investors use these reports to judge performance, make valuation decisions, vote, and check compliance with debt contracts. Individual bondholders cannot track covenants themselves, so a trustee reports and manages payments on their behalf.

How do shareholders protect their interests?

As residual owners, shareholders use several levers.

Meetings and proxy voting

General meetings let shareholders discuss and vote on matters that are not delegated to the board. The annual general meeting (AGM) is held once a year. An extraordinary general meeting (EGM) is called when a matter needs shareholder approval, or when a specified minimum number of shareholders request one.

Shareholder meetingsmatters not delegated to the board

• Annual general meeting (AGM) Memorize once a year
  • Board member elections Memorize
  • Appointment of the independent auditor Memorize
  • Annual statements, dividends, director and auditor pay Use it
  • Equity-based pay plans and say on pay Use it say on pay is non-binding
• Extraordinary general meeting (EGM) Memorize when a matter needs approval, or shareholders request it
  • Special board elections Use it
  • Bylaw or articles amendments Memorize
  • Mergers, takeovers and asset sales Use it
  • Capital increases Use it
  • Voluntary liquidation Use it

Proxy voting lets a shareholder who cannot attend authorize someone else to vote, usually by an electronic or mailed ballot. It is the most common way investors take part. At the AGM, say on pay votes on executive pay are non-binding. They still let shareholders voice a view and so limit how freely directors can set pay.

Exam tip Routine and yearly means AGM: people, accounts, pay, auditor. Structural and one-off means EGM: bylaws, deals, capital, liquidation.

Activism and lawsuits

Shareholder activism is an investor strategy to compel a company to act in a desired way. The main aim is usually to raise value quickly, though some campaigns pursue social, political or environmental goals. Tactics include proxy fights, shareholder resolutions and publicizing the issue. Hedge funds are among the main activists, because most of their fees are performance-based and they face fewer restrictions on position size and borrowing than regulated funds, which have limits on position size, leverage and holding distressed or illiquid assets. Activism often narrows the company’s focus on what it does well, through asset sales and division closures.

A shareholder derivative lawsuit is brought by a shareholder on the company’s behalf against the board, management or a controlling shareholder who has failed to act in the company’s interest. It has nothing to do with derivative contracts. Many countries limit such suits, by setting a minimum shareholding or prohibiting them.

Control contests and defenses

Three routes change control.

• In a proxy contest (or proxy fight), a group seeking a board majority persuades shareholders to vote for its nominees.
• In a tender offer , a bidder invites shareholders to sell their shares directly.
• A hostile takeover is an attempt to buy the company without management’s consent.

The threat of losing their jobs gives directors and managers a reason to focus on shareholder wealth. The same threat can lead them to adopt defenses that hurt governance.

• Staggered board elections mean only part of the board is elected each year, so shareholders cannot replace the whole board at once.
• A shareholder rights plan (poison pill) lets other shareholders buy extra shares at a discount if one holder passes a set ownership percentage. That dilutes the bidder and raises the cost of a takeover.

$$Y = \left\lceil \frac{M}{S} \right\rceil$$

Here $M$ is the number of seats for a majority (more than half the board), $S$ is the number of seats elected each year and $Y$ is the number of annual elections, rounded up to a whole election. Assume the activist wins every seat that comes up.

How do creditors protect themselves?

The rights of creditors come from law and from the contracts they sign. A bond indenture is the legal contract that sets out the structure of the bond, the issuer’s obligations and the bondholders’ rights. It requires the company to do some things (affirmative covenants), prohibits others (negative covenants), and can require assets to be pledged as collateral.

In some countries an official creditor committee, especially for unsecured bondholders, is formed when a company files for bankruptcy and represents bondholders in restructuring or liquidation. When a company is struggling to meet its indenture, a group of bondholders may form an ad hoc committee to approach it with restructuring options. Its members do not officially represent all holders, but their interests are usually aligned.

What do the board and its committees do?

Boards delegate work to committees made up of some of their members. Three are recommended by most governance codes, and some exchanges require them. They report and recommend. The board keeps the ultimate responsibility and must review and challenge what they say.

Board of directorsdelegates work, keeps the responsibility

• Audit committee Memorize independent; a financial expert
  • Financial reporting and accounting policies Use it
  • Internal audit Use it independence and competence
  • External auditor Memorize recommends appointment and fee
• Nominating/governance committee Memorize independent
  • Director selection Use it criteria, search, election process
  • Governance policies Use it code, charters, ethics, conflicts of interest
• Compensation committee Memorize independent
  • Director and executive pay Use it performance criteria
  • Short-termism controls Use it shares not options, long vesting, long-term plans

The audit committee is the most widely required. Best practice is that it is wholly independent and includes at least one director with accounting or financial expertise. It monitors financial reporting and the choice of accounting policies, supervises internal audit, recommends the external auditor and its fee, meets the auditors, and follows up on problems. Some audit committees also oversee IT security.

The nominating/governance committee is usually independent. It appraises candidates for director and manager roles, sets nomination policy and criteria, and oversees the election process. It also oversees the governance code, the charters of the board and its committees, the code of ethics and the conflict-of-interest policy, including related-party transactions, and makes sure they are applied.

The compensation committee proposes pay policy for directors and key executives and sets performance criteria. Laws and best practice require its members to be independent, because management should not assess its own performance. Variable pay (profit sharing, stock, options) depends on company or share price results. It fails if managers can gain at the company’s expense without bearing the downside, so companies increasingly design plans against short-termism. Common features are granting shares rather than options, restricting vesting or sale for several years or until retirement, and long-term incentive plans that delay pay until strategic targets are met.

Some industries add committees: risk committees in financial services, investment committees in insurers.

Go deeper Why hedge funds dominate activism

Hedge fund managers earn most of their fees from returns, so a successful campaign pays them directly. They can also borrow to build large stakes and are not bound by the position limits that cap regulated funds. A mutual fund may have to stay under a maximum position size or avoid distressed holdings, which limits what it can do on its own, although large funds sometimes use their influence to encourage change.

Go deeper Why a non-binding say on pay vote still matters

A vote that cannot force a change still tells the board how its largest owners feel before the next election. Boards that lose or nearly lose the vote usually change the plan. Where the law requires the vote, as in the United States, it limits directors’ discretion in granting excessive or inadequate pay.

What do employees, customers, suppliers and governments use?

Employees. Companies manage employee relationships to respect their rights, avoid legal and reputational risk, and attract and keep staff. Rights are mainly protected by labor law, which sets standards on hours, benefits and leave. Employees in most countries may form unions to bargain on pay and conditions. In some countries, such as Germany, Austria and Luxembourg, employees have seats on the board or supervisory board of companies above a certain size. Employment contracts set individual rights and duties. An employee stock ownership plan (ESOP) grants shares or cash from a fund, usually with vesting periods, to retain staff and align their interests with the company.

Customers and suppliers. Contracts set out the products, prices, payment terms, guarantees, after-sale relationship and remedies for breach. Social media gives customers, owners and others a cheap, instant way to broadcast their views and damage a reputation, which adds pressure on managers and directors.

Governments. Laws protect property and contract rights and particular groups such as consumers or the environment, and regulators monitor compliance. Industries that affect the public or the national interest face more regulation: financial services, health care, food and agriculture, defense. Many regulators also publish governance codes of guiding principles for listed companies, applied on a comply or explain basis: a company discloses that it follows each recommendation or explains why it does not. Some countries have no national code and rely on corporate law (such as Chile) or exchange listing rules (such as India). The United States has securities laws enforced by the Securities and Exchange Commission (SEC), exchange listing rules (for example, majority-independent boards) and state corporate law, mainly Delaware’s, in effect doing the job of a code.

Go deeper A country with no national governance code

Governance can still be enforced without a code. In the United States, securities law, exchange listing requirements and the corporate law of the state of incorporation together set most of the rules. An analyst checking a foreign issuer should find out which of the three layers applies, because it decides what a company must disclose and what it can simply choose to do.