Corporate Finance_ A Practical Approach

Explain effective corporate governance practice as it relates to the board of directors, andevaluate the strengths and weaknesses of a company’s corporate governance practice.. The cases

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Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic formats For more information about Wiley products, visit our web site at www.wiley.com Library of Congress Cataloging-in-Publication Data:

Corporate finance : a practical approach / [edited by] Michelle R Clayman, Martin S Fridson,

George H Troughton — 2nd ed.

p cm — (CFA Institute investment series ; 42)

Includes index.

ISBN 978-1-118-10537-5 (cloth); ISBN 978-1-118-21729-0 (ebk);

ISBN 978-1-118-21730-6 (ebk); ISBN 978-1-118-21731-3 (ebk)

1 Corporations—Finance I Clayman, Michelle R II Fridson, Martin S III Troughton, George H HG4026.C67 2012

658.15—dc23

2011039258 Printed in the United States of America

4.8 Ranking Conflicts between NPV and IRR 61

4.10 Popularity and Usage of the Capital Budgeting Methods 68

7.3 Risk Analysis of Capital Investments—Standalone Methods 867.4 Risk Analysis of Capital Investments—Market Risk Methods 92

8.3 Economic Profit, Residual Income, and Claims Valuation 106

2.3 Applying the Cost of Capital to Capital Budgeting and

2.1 Proposition I without Taxes: Capital Structure Irrelevance 2012.2 Proposition II without Taxes: Higher Financial Leverage

2.3 Taxes, the Cost of Capital, and the Value of the Company 205

2.7 The Optimal Capital Structure According to the Static

4.3 Valuation Equivalence of Cash Dividends and

2.2 Dividend Policy Matters: The Bird-in-the-Hand Argument 260

2 Managing and Measuring Liquidity 305

2 Mergers and Acquisitions: Definitions and Classifications 410

I am honored to introduce this second edition ofCorporate Finance: A Practical Approach,which promises to be an important and comprehensive discourse on corporate financialmanagement The significant additions in this edition and revisions to the first edition build

on the topic areas introduced in 2008 Furthermore, they bring much-needed practicaldimensions to the complex and dynamic aspects of corporate finance

Certainly, the global financial landscape has changed dramatically since the release ofthe first edition of this work The economic drama and financial carnage injected into themarketplace starting in late 2007 have penetrated the very core of financial thought andpractice and have challenged long-standing economic beliefs and relationships The effects oncorporate governance, capital structure, and budgeting caused by this extreme market vola-tility and economic upheaval have moved corporate treasurers and chief financial officers tothe front lines in their companies’ continuing pursuits of profitability and financial security.Only those institutions that can quickly adapt their financial management and corporatestructure to this “new normal” will survive well into the future The chapters in this editionhave been revised to take into consideration some of the profound changes that have affectedthis new global financial setting Yet, it is refreshing to note that no matter what economicenvironment exists in the future, sound, traditional financial management practices willalways be essential to the long-term success of any entity

The authors of these chapters are leading industry practitioners and recognized academicthought leaders Their unique perspectives and thorough understanding of their respectivetopic areas are invaluable in providing readers with a factual exposition of the subject matter

In addition, their commonsense approach of highlighting important learning outcomes andincorporating practical problem-solving tools gives readers techniques they can apply in real-world financial settings

Like the original text, this edition is assembled from readings used in the CFA gram curriculum The CFA Program is a comprehensive, self-directed, distance learningprogram administered by CFA Institute Since the early 1960s, the attainment of the CFAdesignation has been viewed as a significant achievement in the realm of finance and investmentmanagement Those who enter the CFA Program sit for three consecutive and rigorousexaminations that cover a broad range of important financial topics, including accounting,quantitative methods, equity and fixed-income analysis, portfolio management, and ethics.Most who enter this program already possess a strong record of achievement in the financialindustry, as well as advanced business degrees, but welcome the additional focus and com-prehensive curriculum of this designation program I am fortunate to have earned the CFAcharter and am proud to serve on the Board of Governors of CFA Institute

Pro-WHY THIS TEXT IS IMPORTANT

Competing in the global financial arena has been a far more daunting challenge during thisdecade than in earlier periods The scarcity of credit and risk capital following the globalfinancial challenges of the past few years, along with the evolution of emerging economies asformidable players on the world financial stage, demands that businesses operate at utmostefficiency Optimal financial management and peak operating effectiveness are prerequisitesnot only for success but also for survival And in order to successfully commit risk capital,companies must incorporate disciplined, systematic capital-budgeting techniques so as toallocate capital to only those projects with optimal returns Furthermore, companies must beable to understand the life spans of projects, effectively anticipate cash flow needs, andaccurately forecast lean periods in their liquidity to avoid potentially devastating shocks totheir financial and market health Also critical in this new financial environment is the ability

to properly analyze the effects of inflation, disinflation, foreign currency shocks, and latory risk on existing projects, as well as the ability to recognize capital-budgeting biases anderrors This book offers comprehensive insights into avoiding these common pitfalls

regu-In particular, the chapter on capital budgeting is instrumental in instilling in the readerthe discipline to anticipate extraneous influences on capital planning Another critical section

of the book concerns forecasting and evaluating the weighted average cost of capital that anentity faces Recent as well as long-term financial history has taught everyone the importance

of properly analyzing this crucial financial component The degree of assumed leverage, taxbenefits and implications of using debt over other forms of capitalization, the cost of debtversus common and preferred equity, and the impact of changes in debt ratings—all areessential areas of knowledge for company leaders The ability to use the cost of capital as aneffective discipline in organizational budgeting is yet another key component of continuedfinancial stability

In addition to the tools and techniques for measuring the cost of capital, the appropriateuse of financial leverage is an important topic in this text Clearly, increased leverageheightens the level of earnings volatility and, ultimately, the cost of equity and the overall riskattached to any company Properly understanding the prudent use of financial leverage as anearnings-enhancement vehicle is essential Furthermore, examining the degree of operatingleverage and the impact of cost structure on production is a vital component of measuringand evaluating the operating efficiency of any organization And last but not least, anincredibly large part of ultimately determining the financial competitiveness of a company issuccessfully anticipating and accounting for the effect of taxes

A key element of attracting investors and maintaining adequate sources of capital is fullyunderstanding how an entity manages its own equity in the context of dividends and sharerepurchases In addition, I cannot overstate the advantages of having a technical grasp of theeffects on financial statements of altering dividend policy or engaging in share buybacks orsecondary offerings, nor can I overemphasize the commensurate impacts on a company’seffective cost of capital and overall financial flexibility In this environment of heightenedinvestor focus on liquidity and financial health, effective working capital management is anecessity The text walks the reader through the important steps in successfully monitoring anoptimal cash balance, contains a primer on short-term investment instruments, and delvesinto accounts receivable and inventory management It also examines the benefits of short-term borrowing versus cash disbursements and other accounts payable strategies

Finally, the critical steps in a merger and acquisition strategy are defined and analyzed.This segment of the text highlights the effects of the successful use of these approaches onfirm competitiveness, scale, and market power and addresses the potential pitfalls of inte-gration and cost management Finally, this section examines the impact of taxes and regu-latory challenges on a potentially successful business combination tactic, as well as discussingwhen an acquisition posture makes sense.

WHAT HAS CHANGED SINCE THE FIRST EDITION

This second edition provides the reader with comprehensive updates on all topics, especiallywhere new techniques or technologies have emerged, and gears the learning outcomes,descriptions, and end-of-chapter exercises to the new economic realities of this decade Thesections on dividend policy, share repurchases, and capital structure have also been revisedand reconstructed These chapters contain significantly new content as well as updatedexercises

No book can provide a practitioner or student with a no-fail recipe for comprehensivesuccess in financial management, and most entities have discovered that challenges andimpacts generally appear from unexpected sources and directions The authors have tried tocreate a substantial taxonomy of corporate financial topics with real-world, commonsenseapplications as well as rigorous problems and exercises that allow readers to test their com-prehension of the subjects covered

This book will become an important resource for a wide array of individuals Some mayask whether the intricacies of capital budgeting, corporate liquidity, and dividend policy are

of interest to a cross section of practitioners, but as many have discovered over the past fiveyears, ignoring the key building blocks of an optimal corporate financial structure and a lean,competitive, and well-capitalized organization can be perilous Today’s corporate landscape,with all its volatility and high barriers to entry, requires that most members of a corporateentity be well schooled in the fundamentals of financial management Organizations todaymust deal with formidable foreign competition, an older workforce, and significant capitalinvestments in order to achieve critical scale A sound understanding of the capital man-agement techniques needed to maintain competitiveness and innovation is a necessity.Students will use this book either as a resource to gain a broad understanding of corporatefinancial practice or as a useful reference tool for quickly comprehending specific areas of thefinancial domain

The long-term performance of all organizations is based on sound decision making bytheir constituents, whose decisions have wide-ranging implications for the future soundness

of their companies I hope this book will prove to be a valuable resource for present andfuture members of these organizations

Matthew Scanlan, CFAPresident and CEORenaissance Institutional Management LLC

CFA Institute Board of Governors

We would like to thank the many individuals who played important roles in producingthis book.

The standards and orientation of the second edition are a continuation of those set forthe first edition Robert R Johnson, CFA, former senior managing director of CFA Institute,supported the creation of custom curriculum readings in this area and their revision Dennis

W McLeavey, CFA, initiated the project during his term as head of Curriculum ment Christopher B Wiese, CFA, oversaw final organization, writing, and editing of the firstedition for the CFA curriculum

Develop-First edition manuscript reviewers were Jean-Francois Bureau, CFA, Sean D Carr,Rosita P Chang, CFA, Jacques R Gagne´, CFA, Gene C Lai, Asjeet S Lamba, CFA, PimanLimpaphayom, CFA, and Zhiyi Song, CFA Chapter authors Pamela P Drake, CFA, andJohn D Stowe, CFA, provided notable assistance at critical junctures We thank all of theabove for their excellent and detailed work

For this second edition, Gregory Noronha, CFA, was added to the author lineup.Second edition manuscript reviewers were Evan Ashcraft, CFA, David K Chan, CFA, LeeDunham, CFA, Philip Fanara, CFA, Usman Hayat, CFA, William Jacobson, CFA, FrankLaatsch, CFA, Murli Rajan, CFA, Knut Reinertz, CFA, Sanjiv Sabherwal, Sandeep Singh,CFA, Frank Smudde, CFA, and Peter Stimes, CFA Jerald E Pinto, CFA, director, Cur-riculum Projects, had primary responsibility for the delivery of the revised chapters

INVESTMENT SERIES

CFA Institute is pleased to provide you with the CFA Institute Investment Series, whichcovers major areas in the field of investments We provide this best-in-class series for the samereason we have been chartering investment professionals for more than 45 years: to lead theinvestment profession globally by setting the highest standards of ethics, education, andprofessional excellence

The books in the CFA Institute Investment Series contain practical, globally relevantmaterial They are intended both for those contemplating entry into the extremely com-petitive field of investment management as well as for those seeking a means of keepingtheir knowledge fresh and up to date This series was designed to be user friendly andhighly relevant

We hope you find this series helpful in your efforts to grow your investment knowledge,whether you are a relatively new entrant or an experienced veteran ethically bound to keep up

to date in the ever-changing market environment As a long-term, committed participant inthe investment profession and a not-for-profit global membership association, CFA Institute

is pleased to provide you with this opportunity

THE TEXTS

One of the most prominent texts over the years in the investment management industry hasbeen Maginn and Tuttle’s Managing Investment Portfolios: A Dynamic Process The thirdedition updates key concepts from the 1990 second edition Some of the more experiencedmembers of our community own the prior two editions and will add the third edition to theirlibraries Not only does this seminal work take the concepts from the other readings and putthem in a portfolio context, but it also updates the concepts of alternative investments,performance presentation standards, portfolio execution, and, very importantly, individualinvestor portfolio management Focusing attention away from institutional portfolios andtoward the individual investor makes this edition an important and timely work

Quantitative Investment Analysis focuses on some key tools that are needed by today’sprofessional investor In addition to classic time value of money, discounted cash flowapplications, and probability material, there are two aspects that can be of value over tra-ditional thinking

The first involves the chapters dealing with correlation and regression that ultimatelyfigure into the formation of hypotheses for purposes of testing This gets to a critical skill thatchallenges many professionals: the ability to distinguish useful information from the over-whelming quantity of available data For most investment researchers and managers, their

analysis is not solely the result of newly created data and tests that they perform Rather, theysynthesize and analyze primary research done by others Without a rigorous manner by which

to explore research, you cannot understand good research or have a basis on which to evaluateless rigorous research

Second, the last chapter ofQuantitative Investment Analysis covers portfolio concepts andtakes the reader beyond the traditional capital asset pricing model (CAPM) type of tools andinto the more practical world of multifactor models and arbitrage pricing theory

Fixed Income Analysis has been at the forefront of new concepts in recent years, and thisparticular text offers some of the most recent material for the seasoned professional who is not

a fixed-income specialist The application of option and derivative technology to the staid province of fixed income has helped contribute to an explosion of thought in this area.Professionals have been challenged to stay up to speed with credit derivatives, swaptions,collateralized mortgage securities, mortgage-backed securities, and other vehicles, and thisexplosion of products has strained the world’s financial markets and tested central banks toprovide sufficient oversight Armed with a thorough grasp of the new exposures, the pro-fessional investor is much better able to anticipate and understand the challenges our centralbankers and markets face

once-International Financial Statement Analysis is designed to address the ever-increasingneed for investment professionals and students to think about financial statement analysisfrom a global perspective The text is a practically oriented introduction to financial state-ment analysis that is distinguished by its combination of a true international orientation, astructured presentation style, and abundant illustrations and tools covering concepts asthey are introduced in the text The authors cover this discipline comprehensively andwith an eye to ensuring the reader’s success at all levels in the complex world of financialstatement analysis

Equity Asset Valuation is a particularly cogent and important resource for anyone involved

in estimating the value of securities and understanding security pricing A well-informedprofessional knows that the common forms of equity valuation—dividend discount modeling,free cash flow modeling, price/earnings modeling, and residual income modeling—can all bereconciled with one another under certain assumptions With a deep understanding of theunderlying assumptions, the professional investor can better understand what other investorsassume when calculating their valuation estimates This text has a global orientation, includingemerging markets The second edition provides new coverage of private company valuationand expanded coverage of required rate of return estimation

Investments: Principles of Portfolio and Equity Analysis provides an accessible yet rigorousintroduction to portfolio and equity analysis Portfolio planning and portfolio managementare presented within a context of up-to-date, global coverage of security markets, trading, andmarket-related concepts and products The essentials of equity analysis and valuation areexplained in detail and profusely illustrated The book includes coverage of practitioner-important but often neglected topics, such as industry analysis Throughout, the focus is onthe practical application of key concepts with examples drawn from both emerging anddeveloped markets Each chapter affords the reader many opportunities to self-check his orher understanding of topics In contrast to other texts, the chapters are collaborations ofrespected senior investment practitioners and leading business school teachers from aroundthe globe By virtue of its well-rounded, expert, and global perspectives, the book should be

of interest to anyone who is looking for an introduction to portfolio and equity analysis.The New Wealth Management: The Financial Advisor’s Guide to Managing and InvestingClient Assets is an updated version of Harold Evensky’s mainstay reference guide for wealth

managers Harold Evensky, Stephen Horan, and Thomas Robinson have updated the coretext of the 1997 first edition and added an abundance of new material to fully reflect today’sinvestment challenges The text provides authoritative coverage across the full spectrum ofwealth management and serves as a comprehensive guide for financial advisors The bookexpertly blends investment theory and real-world applications and is written in the samethorough but highly accessible style as the first edition.

Corporate Finance: A Practical Approach is a solid foundation for those looking to achievelasting business growth In today’s competitive business environment, companies must findinnovative ways to enable rapid and sustainable growth This text equips readers with thefoundational knowledge and tools for making smart business decisions and formulatingstrategies to maximize company value It covers everything from managing relationshipsbetween stakeholders to evaluating merger and acquisition bids, as well as the companiesbehind them The second edition of the book preserves the hallmark conciseness of the firstedition while expanding coverage of dividend policy, share repurchases, and capital structure.Through extensive use of real-world examples, readers will gain critical perspective intointerpreting corporate financial data, evaluating projects, and allocating funds in ways thatincrease corporate value Readers will gain insights into the tools and strategies used inmodern corporate financial management

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

 Explain corporate governance, describe the objectives and core attributes of an effectivecorporate governance system, and evaluate whether a company’s corporate governance hasthose attributes

 Compare major business forms and describe the conflicts of interest associated with each

 Explain conflicts that arise in agency relationships, including manager-shareholder conflictsand director-shareholder conflicts

 Describe responsibilities of the board of directors and explain qualifications and corecompetencies that an investment analyst should look for in the board of directors

 Explain effective corporate governance practice as it relates to the board of directors, andevaluate the strengths and weaknesses of a company’s corporate governance practice

 Describe elements of a company’s statement of corporate governance policies thatinvestment analysts should assess

 Explain the valuation implications of corporate governance

1 INTRODUCTION

The modern corporation is a very efficient and effective means of raising capital, obtainingneeded resources, and generating products and services These and other advantages havecaused the corporate form of business to become the dominant one in many countries Thecorporate form, in contrast to other business forms, frequently involves the separation ofownership and control of the assets of the business The ownership of the modern, publiccorporation is typically diffuse; it has many owners, most with proportionally small stakes in

the company, who are distant from, and often play no role in, corporate decisions sional managers control and deploy the assets of the corporation This separation of own-ership (shareholders) and control (managers) may result in a number of conflicts of interestbetween managers and shareholders Conflicts of interest can also arise that affect creditors aswell as other stakeholders such as employees and suppliers In order to remove or at leastminimize such conflicts of interest, corporate governance structures have been developed andimplemented in corporations Specifically, corporate governance is the system of principles,policies, procedures, and clearly defined responsibilities and accountabilities used by stake-holders to overcome the conflicts of interest inherent in the corporate form.

Profes-The failure of a company to establish an effective system of corporate governancerepresents a major operational risk to the company and its investors.1Corporate governancedeficiencies may even imperil the continued existence of a company Consequently, tounderstand the risks inherent in an investment in a company, it is essential to understand thequality of the company’s corporate governance practices It is also necessary to continuallymonitor a company’s practices, because changes in management, the composition of its board

of directors, the company’s competitive and market conditions, or mergers and acquisitions,can affect them in important ways

A series of major corporate collapses in North America, Europe, and Asia, nearly all ofwhich involved the failure or direct override by managers of corporate governance systems,have made it clear that strong corporate governance structures are essential to the efficient andeffective functioning of companies and the financial markets in which they operate Investorslost great amounts of money in the failed companies The collapses weakened the trust andconfidence essential to the efficient functioning of financial markets worldwide

Legislators and regulators responded to the erosion of trust by introducing strong newregulatory frameworks These measures are intended to restore the faith of investors incompanies and the markets, and, very importantly, to help prevent future collapses Never-theless, the new regulations did not address all outstanding corporate governance problemsand were not uniform across capital markets Thus, we may expect corporate governance-related laws and regulations to further evolve

The chapter is organized as follows: Section 2 presents the objectives of corporate ernance systems and the key attributes of effective ones Section 3 addresses forms of businessand conflicts of interest, and Section 4 discusses two major sources of governance problems

gov-In Section 5 we discuss standards and principles of corporate governance, providing threerepresentative sets of principles from current practice Section 6 addresses environmental,social, and governance factors Section 7 touches on the valuation implications of the quality

of corporate governance, and Section 8 summarizes the chapter

2 CORPORATE GOVERNANCE: OBJECTIVES

AND GUIDING PRINCIPLES

The modern corporation is subject to a variety of conflicts of interest This fact leads to thefollowing two major objectives of corporate governance:

external events

1 To eliminate or mitigate conflicts of interest, particularly those between managers andshareholders.

2 To ensure that the assets of the company are used efficiently and productively and in thebest interests of its investors and other stakeholders

How then can a company go about achieving those objectives? The first point is that itshould have a set of principles and procedures sufficiently comprehensive to be called acorporate governance system No single system of effective corporate governance applies to allfirms in all industries worldwide Different industries and economic systems, legal and reg-ulatory environments, and cultural differences may affect the characteristics of an effectivecorporate governance system for a particular company However, there are certain char-acteristics that are common to all sound corporate governance structures The core attributes

of an effective corporate governance system are:

 Delineation of the rights of shareholders and other core stakeholders

 Clearly defined manager and director governance responsibilities to stakeholders

 Identifiable and measurable accountabilities for the performance of the responsibilities

 Fairness and equitable treatment in all dealings between managers, directors, and shareholders

 Complete transparency and accuracy in disclosures regarding operations, performance, risk,and financial position

These core attributes form the foundation for systems of good governance, as well as forthe individual principles embodied in such systems Investors and analysts should determinewhether companies in which they may be interested have these core attributes

3 FORMS OF BUSINESS AND CONFLICTS OF INTEREST

The goal of for-profit businesses in any society is simple and straightforward: to maximizetheir owners’ wealth This can be achieved through strategies that result in long-term growth

in sales and profits However, pursuing wealth maximization involves taking risks A businessitself is risky for a variety of reasons For example, there may be demand uncertainty for itsproducts and/or services, economic uncertainty, and competitive pressures Financial risk ispresent when a business must use debt to finance operations Thus, continued access tosufficient capital is an important consideration and risk for businesses These risks, andthe inherent conflicts of interests in businesses, increase the need for strong corporategovernance

A firm’s ability to obtain capital and to control risk is perhaps most influenced by themanner in which it is organized Three of the predominant forms of business globallyare the sole proprietorship, the partnership, and the corporation Hybrids of these threeprimary business forms also exist, but we do not discuss them here because they are simplycombinations of the three main business forms With regard to the three primary businessforms, each has different advantages and disadvantages We will discuss each of them, theconflicts of interest that can arise in each, and the relative need for strong corporate gover-nance associated with each form However, a summary of the characteristics is provided inExhibit 1-1

EXHIBIT 1-1 Comparison of Characteristics of Business Forms

owner and business

owners and business

Sole proprietorships are the most numerous form of business worldwide, representing,for example, approximately 70 percent of all businesses in the United States, by number.2However, because they are usually small-scale operations, they represent the smallest amount

of market capitalization in many markets Indeed, the difficulties of the sole proprietor inraising large amounts of capital, coupled with unlimited liability and lack of transferability ofownership, are serious impediments to the growth of a sole proprietorship

From the point of view of corporate governance, the sole proprietorship presents fewerrisks than the corporation because the manager and the owner are one and the same Indeed,the major corporate governance risks are those faced by creditors and suppliers of goods andservices to the business These stakeholders are in a position to be able to demand the typesand quality of information that they need to evaluate risks before lending money to thebusiness or providing goods and services to it In addition, because they typically maintaindirect, recurring business relations with the companies, they are better able to monitor thecondition and risks of the business, and to control their own exposure to risk Consequently,

we will not consider sole proprietorships further in this chapter

3.2 Partnerships

A partnership, which is composed of more than one owner/manager, is similar to a soleproprietorship For the most part, partnerships share many of the same advantages anddisadvantages as the sole proprietorship Two obvious advantages of a partnership over a soleproprietorship are the pooling together of financial capital of the partners and the sharing ofbusiness risk among them However, even these advantages may not be as important as thepooling together of service-oriented expertise and skill, especially for larger partnerships.Some very large international partnerships operate in such fields as real estate, law, investmentbanking, architecture, engineering, advertising, and accounting Note also that larger part-nerships may enjoy competitive and economy-of-scale benefits over sole proprietorships.Partners typically overcome conflicts of interest internally by engaging in partnershipcontracts specifying the rights and responsibilities of each partner Conflicts of interestwith those entities outside the partnership are similar to those for the sole proprietorship andare dealt with in the same way Hence, we will not consider these conflicts further in thischapter

3.3 Corporations

Corporations represent less than 20 percent of all businesses in the United States but generateapproximately 90 percent of the country’s business revenue.3 The percentage is lowerelsewhere, but growing The corporation is a legal entity, and has rights similar to those of aperson For example, a corporation is permitted to enter into contracts The chief officers ofthe corporation, the executives or top managers, act as agents for the firm and are legallyentitled to authorize corporate activities and to enter into contracts on behalf of the business.There are several important and striking advantages of the corporate form of business.First, corporations can raise very large amounts of capital by issuing either stocks or bonds tothe investing public A corporation can grant ownership stakes, common stock, to individualinvestors in exchange for cash or other assets Similarly, it can borrow money, for example,bonds or other debt from individual or institutional investors, in exchange for interest pay-ments and a promise to pay back the principal of the loan Shareholders are the owners of thecorporation, and any profits that the corporation generates accrue to the shareholders

A second advantage is that corporate owners need not be experts in the industry ormanagement of the business, unlike the owners of sole proprietorships and partnerships wherebusiness expertise is essential to success Any individual with sufficient money can own stock.This has benefits to both the business and the owners The business can seek capital frommillions of investors, not only in domestic markets but worldwide

Among the most important advantages of the corporate form is that stock ownership iseasily transferable Transferability of shares allows corporations to have unlimited life A finaland extremely important advantage is that shareholders have limited liability That is, theycan lose only the money they have invested, nothing more

The corporate form of business has a number of disadvantages, however For example,because many corporations have thousands or even millions of nonmanager owners, they aresubject to more regulation than are partnerships or sole proprietorships While regulationserves to protect shareholders, it can also be costly to shareholders as well For example, thecorporation must hire accountants and lawyers to deal with accounting and other legal

documents to comply with regulations Perhaps the most significant disadvantage with thecorporation (and the one most critical to corporate governance) is the difficulty that share-holders have in monitoring management and the firm’s operations As a sole proprietor of asmall business, the owner will be able to directly oversee such day-to-day business concerns asinventory levels, product quality, expenses, and employees However, it is impossible for ashareholder of a large corporation such as General Motors or International Business Machines

to monitor business activities and personnel, and to exert any control rights over the firm Infact, a shareholder of a large firm may not even feel like an owner in the usual sense, especiallybecause corporations are owned by so many other shareholders, and because most owners of alarge public corporation hold only a relatively small stake in it

Agency relationships arise when someone, an agent, acts on behalf of another person,the principal In a corporation, managers are the agents who act on behalf of the owners, theshareholders If a corporation has in place a diligent management team that works in the bestinterests of its shareholders and other stakeholders, then the problem of passive shareholdersand bondholders becomes a nonissue In real life, unfortunately, management may not alwayswork in the stakeholders’ best interests Managers may be tempted to see to their own well-being and wealth at the expense of their shareholders and others to whom they owe a fiduciaryduty This is known as an agency problem, or the principal–agent problem The money ofshareholders, the principals, is used and managed by agents, the managers, who promise thatthe firm will pursue wealth-maximizing business activities However, there are potentialproblems with these relationships, which we will discuss next

4 SPECIFIC SOURCES OF CONFLICT:

AGENCY RELATIONSHIPS

Conflicts among the various constituencies in corporations have the potential to cause blems in the relationships among managers, directors, shareholders, creditors, employees, andsuppliers However, we will concentrate here on the relationships between (1) managers andshareholders, and (2) directors and shareholders These two relationships are the primaryfocus of most systems of corporate governance However, to the extent that strong corporategovernance structures are in place and effective in companies, the agency conflicts amongother stakeholders are mitigated as well For example, managers are responsible for maxi-mizing the wealth of the shareholders and minimizing waste (including excessive compen-sation and perquisite consumption) To the extent that managers do so, the interests ofemployees and suppliers are more likely to be met because the probability increases thatsufficient funds will be available for payment of salaries and benefits, as well as for goods andservices In this section, we will describe these agency relationships, discuss the problemsinherent in each, and will illustrate these agency problems with real-world examples Anunderstanding of the nature of the conflicts in each relationship is essential to a full under-standing of the importance of the provisions in codes of corporate governance

pro-4.1 Manager–Shareholder Conflicts

From the point of view of investors, the manager–shareholder relationship is the most criticalone It is important to recognize that firms and their managers, the shareholders’ agents,obtain operating and investing capital from the shareholders, the owners, in two ways First,although shareholders have a 100 percent claim on the firm’s net income, the undistributed

net income (the earnings remaining after the payment of dividends) is reinvested in thecompany We normally term this reinvested income retained earnings Second, the firm canissue stock to obtain the capital, either through an initial public offering (IPO) if the firm iscurrently privately owned, or through a seasoned equity offering (SEO) if the firm already hasshares outstanding By whatever means the firm obtains equity capital, shareholders entrustmanagement to use the funds efficiently and effectively to generate profits and maximizeinvestors’ wealth.

However, although the manager is responsible for advancing the shareholder’s bestinterests, this may not happen For example, management may use funds to try to expand thesize of the business to increase their job security, power, and salaries without consideration ofthe shareholders’ interests In addition, managers may also grant themselves numerous andexpensive perquisites, which are treated as ordinary business expenses Managers enjoy thesebenefits, and shareholders bear the costs This is a serious agency problem and, unfortunately,there are a number of recent real-world examples of their occurrence in corporations.Managers also may make other business decisions, such as investing in highly risky ven-tures, that benefit themselves but that may not serve the company’s investors well For example,managers who hold substantial amounts of executive stock options will receive large benefits

if risky ventures pay off, but will not suffer losses if the ventures fail By contrast, managerswhose wealth is closely tied to the company and who are therefore not well diversified maychoose to not invest in projects with a positive expected net present value because of excessiverisk aversion The checks and balances in effective corporate governance systems are designed

to reduce the probability of such practices

The cases of Enron (bankruptcy filing: 2001, in the United States) and Tyco (resignation ofCEO: 2002, in the United States) make clear that in the absence of the checks and balances

of strong and effective corporate governance systems, investors and others cannot necessarilyrely upon managers to serve as stewards of the resources entrusted to them Example 1-1, dealingwith Enron, illustrates the problems that can ensue from a lack of commitment to a corporategovernance system Example 1-2, dealing with Tyco, illustrates a case in which there wereinadequate checks and balances to the power of a CEO

EXAMPLE 1-1 Corporate Governance Failure (1)

Enron was one of the world’s largest energy, commodities, and services companies.However, it is better known today as a classic example of how the conflicts of interestbetween shareholders and managers can harm even major corporations and theirshareholders Enron executives, with the approval of members of the board of directors,overrode provisions in Enron’s code of ethics and corporate governance system thatforbade any practices involving self-dealing by executives Specifically, Enron’s chieffinancial officer set up off-shore partnerships in which he served as general partner As

an Enron executive, he was able to make deals with these partnerships on behalf ofEnron As a general partner of the partnerships, he received the enormous fees that thedeals generated.4

The role of complete transparency in sound corporate governance, including standable and accurate financial statements, cannot be overestimated Without full infor-mation, investors and other stakeholders are unable to evaluate the company’s financialposition and riskiness, whether the condition is improving or deteriorating, and whetherinsiders are aggrandizing themselves, or making poor business decisions, to the detriment oflong-term investors.

under-The partnerships served other useful purposes For example, they made it possible

to hide billions of dollars in Enron debt off of the company’s balance sheet, andgenerated artificial profits for Enron Thus, disclosure of the company’s rapidly dete-riorating financial condition was delayed, preventing investors and creditors fromobtaining information critical to the valuation and riskiness of their securities At thesame time, Enron executives were selling their own stock in the company

These egregious breaches of good governance harmed both Enron’s outsideshareholders and their creditors The bonds were becoming riskier but the creditorswere not informed of the deteriorating prospects The exorbitant fees the executivespaid themselves came out of the shareholders’ earnings, earnings that were alreadyoverstated by the artificial profits Investors did not receive full information about theproblems in the company until well after the collapse and the company’s bankruptcyfiling, by which time their stock had lost essentially all of its value

Most, if not all, of the core attributes of good governance were violated by Enron’smanagers, but especially the responsibility to deal fairly with all stakeholders, includinginvestors and creditors, and to provide full transparency of all material information on atimely basis

EXAMPLE 1-2 Corporate Governance Failure (2)

Tyco provides another well-known example of a corporate governance failure TheCEO of Tyco used corporate funds to buy home decorating items, including a $17,000traveling toilette box, a $445 pincushion, and a $15,000 umbrella stand He alsoborrowed money from the company’s employee loan program to buy $270 million-worth of yachts, art, jewelry, and vacation estates Then, in his capacity as CEO, heforgave the loan All told, the CEO may have looted the firm, and thereby its share-holders, of over $600 million.5

It is instructive that in court proceedings in the Tyco case, the CEO and hisrepresentatives have not argued that he did not do these things, but rather that it wasnot illegal for him to do so Tyco is a striking example of excessive perquisite con-sumption by a CEO

Two additional cases illustrate how false, misleading, or incomplete corporate disclosuremay harm investors and other stakeholders.

The severity of the agency problems of the companies discussed in Examples 1-1 through1-4 does not represent the norm, although the potential for serious conflicts of interestbetween shareholders and managers is inherent in the modern corporation Strong corporategovernance systems provide mechanisms for monitoring managers’ activities, rewarding goodperformance and disciplining those in a position of responsibility for the company to makesure they act in the interests of the company’s stakeholders

EXAMPLE 1-3 Corporate Governance Failure (3)

The Italian firm, Parmalat, was one of the world’s largest dairy foods suppliers Thefounders and top executives of Parmalat were accused of fictitiously reporting theexistence of a $4.9 billion bank account so that the company’s enormous liabilitieswould appear less daunting.6By hiding the true financial condition of the firm, theexecutives were able to continue borrowing The fraud perpetrated by Parmalat’s largestshareholders and executives hurt Parmalat’s creditors as well as the shareholders Par-malat eventually defaulted on a $185 million bond payment in November 2003 andthe company collapsed shortly thereafter

EXAMPLE 1-4 Corporate Governance Failure (4)

During the late 1990s, Adelphia, the fifth-largest provider of cable entertainment in theUnited States, and the company’s founders embarked on an aggressive acquisitioncampaign to increase the size of the company During this time, the size of Adelphia’sdebt more than tripled from $3.5 billion to $12.6 billion However, the founders alsoarranged a $2.3 billion personal loan, which Adelphia guaranteed, but this arrangementwas not fully disclosed to Adelphia’s other stakeholders.7In addition, it is alleged thatfictitious transactions were recorded to boost accounting profits.8 These actions byAdelphia’s owners were harmful to all of Adelphia’s nonfounder stakeholders, includinginvestors and creditors The company collapsed in bankruptcy in 2002

4.2 Director–Shareholder Conflicts

Corporate governance systems rely on a system of checks and balances between the managersand investors in which the board of directors plays a critical role The purpose of boards ofdirectors in modern corporations is to provide an intermediary between managers and theowners, the shareholders Members of the board of directors serve as agents for the owners,the shareholders, a mechanism designed to represent the investors and to ensure that theirinterests are being well served This intermediary generally is responsible for monitoring theactivities of managers, approving strategies and policies, and making certain that these serveinvestors’ interests The board is also responsible for approving mergers and acquisitions,approving audit contracts and reviewing the audit and financial statements, setting managers’compensation including any incentive or performance awards, and disciplining or replacingpoorly performing managers

The conflict between directors and shareholders arises when directors come to identifywith the managers’ interests rather than those of the shareholders This can occur when theboard is not independent, for example, or when the members of the board have business orpersonal relationships with the managers that bias their judgment or compromise their duties

to the shareholders If members of the board have consulting agreements with the company,serve as major lenders to the firm, are members of the manager’s family, or are from thecircle of close friends, their objectivity may be called into question Many corporations havebeen found to have inter-linked boards For example, one or more senior managers fromone firm may serve as directors in the companies of their own board members, frequently

on compensation committees Another ever-present problem is the frequently overly generouscompensation paid to directors for their services Excessive compensation may incline directors

to accommodate the wishes of management rather than attend to the concerns of investors.All of the examples cited in this section involve compliant or less than independent boardmembers In Section 5, we formulate the most important points to check in evaluating acompany’s corporate governance system

5 CORPORATE GOVERNANCE EVALUATION

An essential component of the analysis of a company and its risk is a review of the quality ofits corporate governance system This evaluation requires an assessment of issues relating tothe board of directors, managers, and shareholders Ultimately, the long-term performance of

a company is dependent upon the quality of managers’ decisions and their commitment toapplying sound management practice However, as one group concerned with the issuesobserves, “by analyzing the state of corporate governance for a given company, an analyst orshareholder may ascertain whether the company is governed in a manner that produces bettermanagement practices, promotes higher returns on shareholder capital, or if there is a gov-ernance and/or management problem which may impair company performance.”9

In the following sections we provide a set of guidelines for evaluating the quality ofcorporate governance in a company We reiterate that there is no single system of governancethat is appropriate for all companies in all industries worldwide However, this core set ofglobal best practices is being applied in financial markets in Europe, Asia, and North America.They represent a standard by which corporate practices may be evaluated

The information and corporate disclosure available in a specific jurisdiction will varywidely However, most large financial markets and, increasingly, smaller ones require asubstantial amount of information be provided about companies’ governance structures andpractices In addition, a few regulatory jurisdictions will require a subset of the criteria weshall give as part of registration, exchange listing, or other requirements.

The analyst should begin by carefully reviewing the requirements in effect for thecompany Information is generally available in the company’s required filings with reg-ulators For example, in the United States, such information is provided in the 10-K report,the annual report, and the Proxy Statement (SEC Form DEF 14A) All of these are filedwith the U.S Securities and Exchange Commission (U.S SEC), are available on the U.S.SEC website, usually are available on the company’s website, and are provided by thecompany to current investors as well as on request In Europe, the company’s annual reportprovides some information However, in an increasing number of EU countries, companiesare required to provide a report on corporate governance This report typically will provideinformation on board activities and decisions, whether the company has abided by itsrelevant national code, and explain why it departed from the code, if it has In addition,the announcement of the company’s annual general meeting should disclose the issues on theagenda that are subject to shareholder vote The specific sources of information will differ byjurisdiction and company

5.1 The Board of Directors

Boards of directors are a critical part of the system of checks and balances that lie at the heart

of corporate governance systems Board members, both individually and as a group, have theresponsibility to:

 Establish corporate values and governance structures for the company to ensure that thebusiness is conducted in an ethical, competent, fair, and professional manner

 Ensure that all legal and regulatory requirements are met and complied with fully and in atimely fashion

 Establish long-term strategic objectives for the company with a goal of ensuring that thebest interests of shareholders come first and that the company’s obligations to others aremet in a timely and complete manner

 Establish clear lines of responsibility and a strong system of accountability and performancemeasurement in all phases of a company’s operations

 Hire the chief executive officer, determine the compensation package, and periodicallyevaluate the officer’s performance

 Ensure that management has supplied the board with sufficient information for it to befully informed and prepared to make the decisions that are its responsibility, and to be able

to adequately monitor and oversee the company’s management

 Meet frequently enough to adequately perform its duties, and meet in extraordinary session

as required by events

 Acquire adequate training so that members are able to adequately perform their duties

Depending upon the nature of the company and the industries within which the pany operates, these responsibilities will vary; however, these general obligations are common

com-to all companies

In summarizing the duties and needs of boards of directors,The Corporate Governance ofListed Companies: A Manual for Investors10

states:

Board members owe a duty to make decisions based on what ultimately is best for thelong-term interests of shareowners In order to do this effectively, board membersneed a combination of three things: independence, experience and resources

First, a board should be composed of at least a majority of independentboard members with the autonomy to act independently from management Boardmembers should bring with them a commitment to take an unbiased approach inmaking decisions that will benefit the company and long-term shareowners, rather thansimply voting with management Second, board members who have appropriateexperience and expertise relevant to the Company’s business are best able to evaluatewhat is in the best interests of shareowners Depending on the nature of the business,this may require specialized expertise by at least some board members Third, there need

to be internal mechanisms to support the independent work of the board, including theauthority to hire outside consultants without management’s intervention or approval.This mechanism alone provides the board with the ability to obtain expert help inspecialized areas, to circumvent potential areas of conflict with management, and topreserve the integrity of the board’s independent oversight function [Emphasis added]

In the following sections we detail the attributes of the board that an investor orinvestment analyst must assess

5.1.1 Board Composition and Independence

The board of directors of a corporation is established for the primary purpose of serving thebest interests of the outside shareholders in the company Other stakeholders includingemployees, creditors, and suppliers are usually in a more powerful position to oversee theirinterests in the company than are shareholders The millions of outside investors cannot,individually or collectively, monitor, oversee, and approve management’s strategies andpolicies, performance, and compensation and consumption of perquisites

The objectives of the board are to see that company assets are used in the best long-terminterests of shareholders and that management strategies, plans, policies, and practices aredesigned to achieve this objective In a recent amendment to theInvestment Company Act of

1940 rules, the U.S SEC argues that a board must be “an independent force in [company]affairs rather than a passive affiliate of management Its independent directors must bring tothe boardroom a high degree of rigor and skeptical objectivity to the evaluation of [company]managements and its plans and proposals, particularly when evaluating conflicts of interest.”11Similarly, theCorporate Governance Handbook12observes:

Board independence is essential to a sound governance structure Without pendence there can be little accountability In the words of Professor Jeffrey Son-nenfeld of Yale University, “The highest performing companies have extremelycontentious boards that regard dissent as an obligation and that treat no subject asundiscussable.”

Clearly, for members who are appointed to the board to be in a position to best performtheir fiduciary responsibilities to shareholders, at a minimum a majority of the members must

be independent of management However, global best practice now recommends thatat leastthree-quarters of the board members should be independent

Some experts in corporate governance have argued that all members of the board should

be independent, eliminating the possibility of any senior executives serving on the board.Those who hold this position argue that the presence of managers in board deliberations maywork to the detriment of the best interests of investors and other shareholders by intimidatingthe board or otherwise limiting debate and full discussion of important matters Others arguethat with appropriate additional safeguards, such potential problems can be overcome to thebenefit of all stakeholders

Independence is difficult to evaluate Factors that often indicate a lack of independenceinclude:

 Former employment with the company, including founders, executives, or other employees

 Business relationships, for example, prior or current service as outside counsel, auditors, orconsultants, or business interests involving contractual commitments and obligations

 Personal relationships, whether familial, friendship, or other affiliations

 Interlocking directorships, a director of another company whose independence might beimpaired by the relationship with the other board or company, particularly if the directorserves on interlocking compensation committees

 Ongoing banking or other creditor relationships

Information on the business and other relationships of board members as well asnominees for the board may be obtained from regulatory filings in most jurisdictions Forexample, in the United States, such information is required to be provided in the ProxyStatement, SEC Form DEF 14A, sent to shareholders and filed with the SEC prior to share-holder meetings

5.1.2 Independent Chairman of the Board

Many, if not most, corporate boards now permit a senior executive of a corporation to serve asthe chairman of the board of directors However, corporate governance experts do not regardsuch an arrangement to be in the best interests of the shareholders of the company As theU.S SEC observes,

This practice may contribute to the [company’s] ability to dominate the actions ofthe board of directors The chairman of a board can largely control the board’sagenda, which may include matters not welcomed by the [company’s manage-ment] Perhaps more important, the chairman of the board can have a sub-stantial influence on the boardroom’s culture The boardroom culture canfoster (or suppress) the type of meaningful dialogue between management andindependent directors that is critical for healthy governance It can support (ordiminish) the role of the independent directors in the continuous, active engagement

of management necessary for them to fulfill their duties A boardroom cultureconducive to decisions favoring the long-term interest of shareholders may bemore likely to prevail when the chairman does not have the conflicts of interestinherent in his role as an executive of the [company] Moreover, a board may be

more effective when negotiating with the [company] over matters such as the[compensation] if it were not at the same time led by an executive of the [company]with whom it is negotiating.13

Not all market participants agree with this view Many corporate managers argue that

it is essential for efficient and effective board functioning that the chairman be the seniorexecutive in the company They base their arguments on the proposition that only such

an executive has the knowledge and experience necessary to provide needed information

to the board on questions on strategy, policy, and the operational functioning of thecompany Critics of this position counter that it is incumbent upon corporate manage-ment to provide all such necessary information to the board Indeed, many argue that thisobligation is the sole reason that one or more corporate managers serve as members of theboard

Whether the company has separate positions for the chief executive and chairman of theboard can be determined readily from regulatory filings of the company If the positions arenot separate, an investor may doubt that the board is operating efficiently and effectively in itsmonitoring and oversight of corporate operations, and that decisions made are necessarily inthe best interests of investors and other stakeholders

Tradition and practice in many countries prescribes a so-called “unitary” board system,

a single board of directors However, some countries, notably Germany, have developed aformal system whose intent is to overcome such difficulties as lack of independence of boardmembers and lack of independence of the chairman of the board from company manage-ment The latter approach requires a tiered hierarchy of boards, a management boardresponsible for overseeing management’s strategy, planning, and similar functions, and anindependent supervisory board charged with monitoring and reviewing decisions of themanagement board, and making decisions in which conflicts of interest in the managementboard may impair their independence, for example, in determining managerial compensation.Clearly, independence of the chairman of the board does not guarantee that the boardwill function properly However, independence should be regarded as a necessary condition,even if it is not a sufficient one

5.1.3 Qualifications of Directors

In addition to independence, directors need to bring sufficient skill and experience to theposition to ensure that they will be able to fulfill their fiduciary responsibilities to investorsand other stakeholders Information on directors’ prior business experience and other bio-graphical material, including current and past business affiliations, can generally be found inregulatory filings

Boards of directors require a variety of skills and experience in order to function erly These skills will vary by industry although such core skills as knowledge of finance,accounting, and legal matters are required by all boards Evaluation of the members shouldinclude an assessment of whether needed skills are available among the board members.Among the qualifications and core competencies that an investor should look for in the board

prop-as a group, and in individual members or candidates for the board, are:

 Independence (see factors to consider in Section 5.1.1 above).

 Relevant expertise in the industry, including the principal technologies used in the businessand in financial operations, legal matters, accounting and auditing; and managerial con-siderations such as the success of companies with which the director has been associated inthe past

 Indications of ethical soundness, including public statements or writings of the director,problems in companies with which the director has been associated in the past such as legal

or other regulatory violations involving ethical lapses

 Experience in strategic planning and risk management

 Other board experience with companies regarded as having sound governance practices andthat are effective stewards of investors’ capital as compared to serving management’sinterests

 Dedication and commitment to serving the board and investors’ interests Board memberswith such qualities will not serve on more than a few boards, have an excellent record ofattendance at board meetings, and will limit other business commitments that require largeamounts of time

 Commitment to the needs of investors as shown, for example, by significant personalinvestments in this or other companies for which he or she serves as a director, and by anabsence of conflicts of interest

Such attributes are essential to the sound functioning of a board of directors and should

be carefully considered in any investment decision Board members may be selected as muchfor their general stature and name recognition as for the specialized expertise they bring

to their responsibilities However, the skills, knowledge, and experience we have describedare essential to effective corporate governance, oversight, and monitoring on behalf ofshareholders

5.1.4 Annual Election of Directors

Members of boards of directors may be elected either on an annual or a staggered basis Inannual votes, every member of the board stands for reelection every year Such an approachensures that shareholders are able to express their views on individual members’ performanceduring the year, and to exercise their right to control who will represent them in corporategovernance and oversight of the company Opponents argue that subjecting members toannual reelection is disruptive to effective board oversight over the company

Those who support election of board members on a staggered basis with reelection of only

a portion of the board each year, argue that such a scheme is necessary to ensure continuity ofthe knowledge and experience in the company essential for good corporate governance Criticsexpress the view that such a practice diminishes the limited power that shareholders have

to control who will serve on the board and ensure the responsiveness of board members toinvestor concerns, such as poor management performance and practices They also argue thatstaggered boards better serve the interests of entrenched managers by making the boardless responsive to the needs of shareholders, more likely to align their interests with those ofmanagers, and more likely to resist takeover attempts that would benefit shareholders to thedetriment of managers

Corporate governance best practice generally supports the annual election of directors asbeing in the best interests of investors When shareholders can express their views annually,either by casting a positive vote or by withholding their votes for poorly performing directors,directors are thought to be more likely to weigh their decisions carefully, to be better prepared

and more attentive to the needs of investors, and to be more effective in their oversight ofmanagement.

Information on directors’ terms and the frequency of elections may be obtained byexamining the term structure of the board members in regulatory filings

5.1.5 Annual Board Self-Assessment

Board members have a fiduciary duty to shareholders to oversee management’s use of assets,

to monitor and review strategies, policies and practices, and to take those actions necessary tofulfill their responsibilities to stakeholders It is essential that a process be in place for peri-odically reviewing and evaluating their performance and making recommendations forimprovement Generally, this evaluation should occur at least once annually The reviewshould include:

 An assessment of the board’s effectiveness as a whole

 Evaluations of the performance of individual board members, including assessments of theparticipation of each member, with regard to both attendance and the number and rele-vance of contributions made, and an assessment of the member’s willingness to thinkindependently of management and address challenging or controversial issues

 A review of board committee activities

 An assessment of the board’s effectiveness in monitoring and overseeing their specificfunctions

 An evaluation of the qualities the company will need in its board in the future, along with acomparison of the qualities current board members currently have

 A report of the board self-assessment, typically prepared by the nominations committee,and included in the proxy in the United States and in the corporate governance report inEurope

The process of periodic self-assessment by directors can improve board and companyperformance by reminding directors of their role and responsibilities, improving their under-standing of the role, improving communications between board members, and enhancing thecohesiveness of the board Self-assessment allows directors to improve not only their ownperformance but to make needed changes in corporate governance structures All of these willlead to greater efficiency and effectiveness in serving investors’ and other stakeholders’ interests.The process of self-assessment should focus on board responsibilities and individualmembers’ accountability for fulfilling these responsibilities It should consider both substantivematters and procedural issues, for example, evaluations of the adequacy and effectiveness of thecommittee structure The committees regarded as essential by corporate governance expertsinclude the auditing, nominations, and compensation committees, all of which should bestaffed by independent directors who are experts in the relevant areas (The specific functions ofthese committees will be considered in later sections.)

The company, however, may need to establish additional committees For example, for amutual fund company, these might include a securities valuation committee responsible forsetting policies for the pricing of securities, and monitoring the application of the policies bymanagement For a high technology company, the committees might include one tasked withthe valuation of intellectual property, or perhaps, management’s success in creating newintellectual property through its investments in research and development

In evaluating the effectiveness of the corporate governance system and specifically, theboard of directors, an investment professional should consider the critical functions specific to

a particular company and evaluate whether or not the board’s structure and membershipprovides adequate oversight and control over management’s strategic business decision-making and policy-making.

5.1.6 Separate Sessions of Independent Directors

Corporate governance best practice requires that independent directors of the board meet atleast annually, and preferably quarterly, in separate sessions—that is, meetings without thepresence of the management, other representatives, or interested persons (for example, retiredfounders of the company) The purpose of these sessions is to provide an opportunity forthose entrusted with the best interests of the shareholders to engage in candid and frankdiscussions and debate regarding the management of the company, their strategies and pol-icies, strengths and weaknesses, and other matters of concern Such regular sessions wouldavoid the suggestion that directors are concerned with specific problems or threats to thecompany’s well-being Separate sessions could also enhance the board’s effectiveness byimproving the cooperation among board members, and their cohesiveness as a board, attri-butes that can strengthen the board in the fulfillment of its responsibilities to shareholders.Regulatory filings should indicate how often boards have met, and which meetings wereseparate sessions of the independent directors The investment professional should be con-cerned if such meetings appeared to be nonexistent, infrequent, or irregular in occurrence.These could suggest a variety of negative conclusions, including the presence of a “captive,”that is, nonindependent board, inattention or disinterest among board members, lack ofcohesion and sense of purpose, or other conditions that can be detrimental to the interests ofinvestors

5.1.7 Audit Committee and Audit Oversight

The audit committee of the board is established to provide independent oversight of thecompany’s financial reporting, nonfinancial corporate disclosure, and internal control sys-tems This function is essential for effective corporate governance and for seeing that theirresponsibilities to shareholders are fulfilled

The primary responsibility for overseeing the design, maintenance, and continuingdevelopment of the control and compliance systems rests with this committee At a minimumthe audit committee must

 Include only independent directors

 Have sufficient expertise in financial, accounting, auditing, and legal matters to beable to adequately oversee and evaluate the control, risk management, and compliancesystems, and the quality of the company’s financial disclosure to shareholders and others

It is advisable for at least two members of the committee to have relevant accounting andauditing expertise

 Oversee the internal audit function; the internal audit staff should report directly androutinely to this committee of the board, and, when necessary report any concernsregarding the quality of controls or compliance issues

 Have sufficient resources to be able to properly fulfill their responsibilities

 Have full access to and the cooperation of management

 Have authority to investigate fully any matters within its purview

 Have the authority for the hiring of auditors, including the setting of contractual sions, review of the cost-effectiveness of the audit, approving of nonaudit services provided

provi-by the auditor, and assessing the auditors’ independence

 Meet with auditors independently of management or other company interest partiesperiodically but at least once annually.

 Have the full authority to review the audit and financial statements, question auditorsregarding audit findings, including the review of the system of internal controls, and todetermine the quality and transparency of financial reporting choices

Strong internal controls, risk management, and compliance systems are critical to acompany’s long-term success, the meeting of its business objectives, and enhancing the bestinterests of shareholders Nearly all of the major corporate collapses have involved an absence

of effective control systems, or the overriding of the systems by management to achieve theirown interests and objectives to the detriment of those of investors

The internal audit function should be entirely independent and separate from any

of the activities being audited Internal auditors should report directly to the chairman ofthe audit committee of the board of directors The board should regularly meet with theinternal audit supervisor and review the activities and address any concerns

In evaluating the effectiveness of the board of directors, an investor should review thequalifications of the members of the audit committee, being alert to any conflicts of interest thatindividual members might have, for example, having previously been employed or otherwiseassociated with the current auditor or the company, determine the number of meetings held

by the committee during the year and whether these meetings were held independent

of management A report on the activities of the audit committee, including a statement

on whether the committee met independently and without the presence of management,should be included in the proxy in the United States and in the corporate governance report

in Europe

The audit committee should discuss in the regulatory filings the responsibilities andauthority it has to evaluate and assess these functions, any findings or concerns the committee haswith regard to the audit, internal control and compliance systems, and corrective action taken.5.1.8 Nominating Committee

In most corporations, currently, nominations of members of the board of directors and forexecutive officers of the company are made by members of the board, most often at therecommendation of, or in consultation with, the management of the company In suchcircumstances, the criteria for selection of nominees may favor management’s best interests atthe expense of the interests of shareholders This is all the more important because in the usualcase, shareholders have no authority to nominate slates of directors who might best representthem Consequently, corporate governance best practice requires that nominees to the board

be selected by a nominating committee comprising only independent directors Theresponsibilities of the nominating committee are to

 Establish criteria for evaluating candidates for the board of directors

 Identify candidates for the general board and for all committees of the board

 Review the qualifications of the nominees to the board and for members of individualcommittees

 Establish criteria for evaluating nominees for senior management positions in the company

 Identify candidates for management positions

 Review the qualifications of the nominees for management positions

 Document the reasons for the selection of candidates recommended to the board as a wholefor consideration

Given the pivotal role that the members of the nominating committee have in senting and protecting the interests of investors and other stakeholders, it is essential that thequalifications of these members be carefully reviewed in assessing the long-term investmentprospects of a company Particular attention should be paid to evaluating their independence,the qualities of those selected for senior management positions, and the success of businesseswith which they’ve been associated This information is available in the regulatory filings ofthe company.

repre-5.1.9 Compensation Committee

Ideally, compensation should be a tool used by directors, acting on behalf of shareholders, toattract, retain, and motivate the highest quality and most experienced managers for thecompany The compensation should include incentives to meet and exceed corporatelong-term goals, rather than short-term performance targets

Decisions regarding the amounts and types of compensation to be awarded to seniorexecutives and directors of a company are thought by many corporate governance experts to

be the most important decisions to be made by those in a position of trust Reports abound ofcompensation that is excessive relative to corporate performance, awarded to executives bycompliant boards The problem has been particularly acute in the United States, but examplesare found worldwide

In recent years, a practice has developed of gauging levels of compensation awards basednot upon company objectives and goals but rather by comparison to the highest levels ofcompensation awarded in other companies This occurs whether the reference companies arerelevant benchmarks or not, and has caused compensation packages in many cases to beunrelated to the performance of the company Needless to say, such excessive compensation ishighly detrimental to the interests of shareholders

In one well-known case, that of the New York Stock Exchange, the compensation of thechief executive was a substantial proportion of the net earnings of the Exchange and con-siderably higher than the compensation awarded to senior executives of comparable com-panies The facts that have come to light in the case suggest that the compensation committee

of the board was not independent as measured by the usual criteria, was not expert incompensation matters and did not seek outside counsel, was not well informed on the details

of the compensation package, and acquiesced in management’s proposal of its own pensation.14This case is currently the subject of extensive legal and regulatory action.Several different types of compensation awards are in common use today:

com- Salary, generally set by contractual commitments between the company and the executive

or director

 Perquisites, additional compensation in the form of benefits, such as insurance, use ofcompany planes, cars, and apartments, services, ranging from investment advice, taxassistance, and financial planning advice to household services

 Bonus awards, normally based on performance as compared to company goals andobjectives

 Stock options, options on future awards of company stock

 Stock awards or restricted stock