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«1. Corporate Performance_ 3 2. Corporate Governance 15 3. Mergers and Acquisitions 29 4. Key Formulas _ 51 © 2014 Allen Resources, Inc. All rights ...»

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Many European countries require companies to file reports with information about the board’s activities and its compliance with regulations.

Concerning corporate governance, a board of directors should:

• develop corporate values and governance structures to set standards for ethical, fair and professional business conduct.

• determine that legal and regulatory requirements are met in a timely manner.

• develop strategic objectives that place shareholders first and address the company’s responsibilities to its other stakeholders.

• have accountability systems in place that define managers’ responsibilities and consequences if these responsibilities are not met.

• obtain sufficient information to monitor managers.

• meet regularly enough to perform these duties, and ensure that directors are trained and competent to perform these duties.

Board Factors to Evaluate Learning Objective: Understand the strengths and weaknesses of a firm’s corporate governance practice.

Learning Objective: List the elements of a firm’s statement of corporate governance policies that should be assessed by investors and analysts.

Director Composition and Independence By law, boards must be independent of management and objective. In practice, this means at least a majority of directors must be independent of management. Global best practice suggests that three-quarters of the board be independent. While some argue that the entire board should be independent, others argue that the expertise that inside directors bring to board discussions outweighs the disadvantages.

Independence can be measured as directors:

• who were not formerly employed by the firm.

• with no current or former business relationships with the firm.

• with no personal relationships with management.

• with no interlocking directorates, where a director of one company also serves on the board of another company which is tied to the first company.

• with no creditor relationship with the firm.

9-22 Study Guide for the Level II 2015 CFA® Exam - Reading Highlights Corporate Governance Outside Chairman of the Board There is an inherent conflict of interest if the company’s chief executive officer is also the chairman of the board. The chairman holds a great deal of power, for example, setting the agenda for board meetings, and an inside chairman could prevent the board from fulfilling its monitoring role. The chairman also may set the boardroom culture, one of healthy debate or one where dissent is not tolerated.

The argument for a combined CEO/board chairman states that the CEO is the most knowledgeable about the firm, and makes the most efficient and effective board chairman. This is countered by the argument that having the CEO on the board is sufficient to provide necessary information to directors.

Director Expertise Directors must be skilled in governance, although each director need not have all necessary skills as long as the board as a whole has the needed skills. Necessary skills include expertise in the industry, knowledge of financing, legal requirements, and accounting and auditing. It is helpful if the director has successfully managed his/her own firm. Directors should be ethical, and should be knowledgeable about strategic planning and risk management. Directors also should have sufficient time and energy to devote to directorial duties and should be committed to serving the interests of shareholders. This can be measured as the directors’ personal stock holdings in the firm and a lack of conflicts of interest described earlier in the reading.

Director Election In some firms, the entire board is elected each year. In other firms, directors are elected on a staggered basis, with say, for example, a third of the directors elected each year. Annual elections tend to better protect the interests of shareholders who have the opportunity to voice their opinions about every director, not just some of the directors, through their voting choices.

In addition, if dissenting shareholders wished to take over a company and only a third of the directors were elected each year, it could take years to control the board instead of a single election. Similarly, cumulative voting, potentially allows minority shareholders a greater say in corporate governance. With cumulative voting, all of an investor’s votes could be directed toward a particular director. For example, suppose five directors are going to be elected. An investor could vote for five candidates or, under cumulative voting, could place five times his number of shares for a single director.


The board’s actions should be reviewed annually, including:

• overall board effectiveness.

• effectiveness and performance of individual board members. For example, has each director attended meetings regularly and contributed positively to board activities?

9-23 ©2014 Allen Resources, Inc.

Study Session 9

• board committee effectiveness. Are current committees sufficient, or are new ones needed?

• an assessment about whether the board has the expertise to manage future operations. For example, is there a change in the industry or business climate that will require expertise not currently held by board members?

• a published report of board effectiveness in the proxy statement of U.S. companies and in the corporate governance report of European companies.

Outside Director Meetings Best practice suggests that independent directors should meet at least annually without inside directors or other managers present. Regulatory filings detail how often boards meet and whether independent directors meet separately.

Board Audit Function The board’s audit committee is charged with monitoring the firm’s financial reporting, other

corporate disclosures and internal control mechanisms. The audit committee should:

• only include outside directors.

• have members with the necessary financial, accounting, and legal expertise.

• oversee the firm’s internal auditing function, with internal auditors reporting to the board rather than management.

• receive full cooperation from management.

• have the resources necessary to complete its tasks, including the ability to hire and monitor external auditors and should meet independently with the firm’s auditors.

• review financial statements, question auditors, and determine the quality and transparency of the choices made in developing the firm’s financial reports.

Board Nominating Function Directors are generally nominated by the current board, after consulting with management. This means directors who favor management may be chosen. Best practices suggest that board candidates should be nominated by a nominating committee composed of independent directors.

The nominating committee should:

• identify potential candidates and determine standards for evaluating board and senior management candidates.

• review director and manager qualifications.

• document reasons for director or manager selection.

–  –  –

Board Compensation Function One of the most important functions of the board is setting compensation for top managers. The compensation package should be designed to motivate managers to work in the best interests of shareholders. This is a particularly controversial issue. The business press has reported many examples of managers receiving multimillions of dollars of compensation while the company is failing. Management compensation should be linked to performance and should be similar to what executives of comparable companies are receiving.

Compensation packages can include:

• straight salary.

• perquisites, such as insurances, a company jet, and personal services.

• bonuses, generally tied to some performance measure such as firm earnings. In general, having bonuses tied to long-term performance, rather than short-term measures, will benefit shareholders.

• stock options, stock grants and restricted stock. Restricted stock, for example, might not be available to the executive until a certain time period had passed. Stock grants are becoming more popular than stock options. Firms must now expense stock options; in the past it did not need to account for these. Excessive stock options or grants could dilute current shareholders’ equity holdings. The possible dilution from stock options is measured through share overhang, the number of shares granted in unexercised options compared to the total number of shares outstanding. Repricing refers to the company’s lowering the exercise price of stock options when the stock price falls. When stock options are far out of the money, in other words, the exercise price is below the current stock price, managers must work very hard to bring up the stock price to give their options value. Repricing means that managers can obtain value from their options more quickly, an advantage not enjoyed by investors if the stock prices fall.

Outside Consultants Boards should be able to hire independent legal and expert consultants as needed. These experts could help in determining the firm’s compliance with laws and regulations, or provide information about specialized operations of the firm.

Policy Statement Firms should have a statement of their corporate governance policies. The statement should


• ethics code.

• director and management responsibilities.

• board self-assessments, management assessments, and reports of directors’ investigations and evaluations.

• director training.

9-25 ©2014 Allen Resources, Inc.

Study Session 9 Financial Disclosure Financial information must be correct, clear, timely, and complete. High quality financial

reporting is characterized by:

• conservative assumptions about benefit plans and revenue and expense recognition, including expensing new operation start up costs.

• provisions for lawsuits or other possible contingencies.

• reduced use of off-balance-sheet financing, and complete disclosure about these activities.

• minimal nonrecurring gains and non-cash earnings.

• using LIFO, last in first out, inventory accounting.

• sufficient bad debt reserves.

• using accelerated depreciation and quick write-off of intangible assets from acquisitions.

• accounting for contracts with the completed contract method.

• lower capitalization of interest, overhead, and computer software.

The firm’s reports should also include its strategic goals, corporate governance policies, organizational structure, business risks, insider transactions, and compensation policies and amounts.

Insider Transactions The company’s financial statements should disclose insider and related party transactions. For example, are revenues or costs being hidden in transactions with a subsidiary company or are transfers made to executives through loans?

Proxy Votes The board should be responsive to proxy votes, decisions made by a majority of shareholders in issues voted on at annual meetings. While the board is not required to act on shareholder votes, a board that is responsive to its shareholders will be responsive to shareholders concerns.

Impact on Valuation Learning Objective: Detail the implications of environmental, social, and governance risk for valuing firms.

All other things being equal, firms with greater risk exposure should have lower equity valuations. Savvy analysts will explicitly incorporate risks into their valuation analysis by reading a firm’s annual reports (including Form 10K) - specifically, the sections dealing with business risks, legal proceedings, and management’s discussion of the firm’s financial condition and recent operating results.

9-26 Study Guide for the Level II 2015 CFA® Exam - Reading Highlights Corporate Governance Environmental Risk Firms face increasingly significant risk from environmental factors. For example, a mining firm may face steep liability risk for cleanup and environmental restoration after a mine is no longer profitable to operate. Short of legislative relief and, effectively, a transfer of cleanup costs to taxpayers, such firms may face bankruptcy and thus deserve a substantial valuation discount.

Global warming may also impair the valuation of some current farmland, where inadequate rainfall (or less frequent, more severe rainfall) may result in soil erosion, leaving the land less arable. Efforts to combat global warming tend to focus on limiting greenhouse gas emissions in various ways, from improved fuel efficiency standards for motor vehicles to caps on greenhouse emissions for factories. Another response to an environmental risk was the banning of chlorofluorocarbons (CFCs). CFCs were once common in chemical refrigerants and aerosols, but when it became clear they were damaging the protective ozone layer, they were phased out. Such legislative and regulatory actions have far-reaching effects (operational and financial) for many companies, not just those firms directly affected.

Environmental factors can create legal and reputational risk for companies found to be out of compliance with environmental laws, or even worse, deliberately polluting.

Social Risk Social risks also can lead to discounts in the valuation of firms. Sometimes firms are targeted for boycott, which is an attempt to suppress consumer demand for a firm’s products and services, while simultaneously shifting demand to their competitors. A well-known attempt of a consumer boycott occurred in 2012, directed against privately-held fast-food restaurant Chick-Fil-A. The issue centered on gay marriage and contributions the company had made to controversial antigay groups. The boycott backfired when supporters of the restaurant’s position organized a specific day to patronize the restaurant, significantly boosting sales.

Boycotts are seldom successful; when they are, it is because a number of key criteria are met.

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