Given the spate of U.S. corporate scandals in the early 2000s and the corporate governance failures associated with the 2008 financial crisis, this material is ripe testing fodder for CFAI.  Further, an analyst’s ability to detect corporate governance weakness ahead of the crowd, may position him/herself for juicy investment returns.

This week’s sheet aligns with Study Session 9 material in the <a href="https://financetrain.com/certification-guides/cfa-level-2-free-study-notes/">Level II CFA Program Curriculum</a> ©.

A reasonable question expectation is one to three questions on corporate governance and one to three questions on M&amp;A.  Neither topic will likely cover a full item set, but rather join with other corporate finance issues on combination item sets.

Material:

I.          Corporate Governance

II.        Mergers and Acquisitions (M&amp;A)

The material contained within this segment of corporate finance is heavily list driven and process driven.  Candidates may find it helpful to make flash cards of certain lists and processes.  Taken in combination, corporate governance and M&amp;A will likely make up no more than 5% (six questions) of the total exam.  If a candidate struggled with quant or economics, then corporate finance is a great section to emphasize for “points recovery”.  Another important consideration is that corporate finance questions have heavy linkages to <a href="https://financetrain.com/c/75/">financial reporting</a> and equity, which are two of the top tier subjects for the Level II exam.

CFA Level 2: Corporate Finance 2 – Introduction

<ul>
	<li>In a corporate business structure, management (i.e. the company’s executive leadership) and ownership (i.e. stockholders) are separated.</li>
	<li>It is not uncommon for a corporation to face decisions where the interests of management may be different from that of owners and other stakeholders (employees, business partners, and creditors).</li>
	<li>Corporate governance is the policy structure applied by the firm’s stakeholders to reduce the risks associated with inborn conflicts of interest.</li>
	<li>Corporate governance seeks to minimize the conflicts of interest between a company’s managers and its shareholders and facilitate the optimal use of corporate assets to maximize investor and stakeholder value.</li>
</ul>
Traits of an Effective Corporate Governance Structure

At a base level, an effective corporate governance structure will:
<ul>
	<li>Unambiguously outline the responsibilities of the board of directors and company managers for maintaining stakeholder relationships;</li>
	<li>Define the accountability for these responsibilities;</li>
	<li>State the rights of stockowners and stakeholders;</li>
	<li>Ensure fair treatment for interactions between the board of directors, the company’s management, and stockowners.</li>
	<li>Ensure accuracy and transparency for the company’s public financial reporting and business operations.</li>
</ul>

Introduction to Corporate Governance

Generally, businesses are legally organized in one of three forms:

Sole Proprietorship 

This is a business owned and operated by a single individual.
<ul>
	<li>The law makes no distinction between the individual and the business, so the individual assumes unlimited liability.</li>
	<li>The individual owner may face challenges in raising capital.</li>
	<li>Ownership of the sole proprietorship is transferred only by the full sale of the business.</li>
</ul>
Partnership

This is a business owned by multiple individuals.
<ul>
	<li>The owners of a partnership share in the unlimited legal liability risk.</li>
	<li>The ownership of a partnership cannot be transferred.</li>
	<li>Typically, the partners will use mutually agreed legal contracts to manage conflicts of interest among themselves.</li>
	<li>A partnership may be able to more easily raise capital than a sole proprietorship, but not as easily as a corporation.</li>
</ul>
Corporation 

This business is chartered by the laws of a government body.  The corporation, unlike the sole proprietorship or partnership, is a legally distinct entity from its owners.
<ul>
	<li>The corporation can quickly raise debt or equity capital.</li>
	<li>The corporation’s owners do not need any specific expertise to participate in the corporation.</li>
	<li>Ownership in a corporation can easily be transferred.</li>
	<li>Stock owners have only a limited legal liability (i.e., the worst case scenario is that the value of their shares drop to $0).</li>
	<li>Corporations are more heavily regulated than sole proprietorships or partnerships.</li>
	<li>Equity owners also face greater difficulty in overseeing the business operations of a corporation.</li>
	<li>Corporations also face more conflicts of interest than the other business organization structures.</li>
</ul>

Types of Business Organizations

The Agency Relationship: When one party (the agent = company management) acts for another party (the principal = shareholders), an agency relationship exists.

The Principal-Agent Problem: The situation where agents act in their own best financial interest rather than the interest of their principals.  This is an ongoing challenge for investors.

Corporate Conflicts of Interest in the Agency Context
<ul>
	<li>Corporate Managers vs. Equity Owners
<ul>
	<li>Managers may not always act in the best interests of stockholders.</li>
	<li>Executives may initiate unprofitable business ventures in order to expand their internal influence.</li>
	<li>Managers may treat perks, such as excessive use of corporate jets, as regular operating expenses.</li>
	<li>Managers also may make investments with corporate capital, which do not offer equity owners an appropriate risk adjusted return.</li>
	<li>The checks and balances of a well-conceived corporate governance plan will help reduce management-shareholder agency problems.</li>
</ul>
</li>
	<li>The Board of Directors vs. Shareholders
<ul>
	<li>The board plays a critical role in corporate checks and balances as well as business execution by approving strategic plans, approving mergers, selecting or removing executives, selecting auditors, and reviewing <a title="Financial Statements: Structures and Relationship" href="https://financetrain.com/financial-statements-structures-and-relationship/">financial statements</a>.</li>
	<li>Theoretically, the board oversees company management to ensure that shareholder interests are promoted.</li>
	<li>In reality, the board may side with the interests of management.  This can more readily occur when the board is not independent, that is when board members have close ties (business or personal) to management.</li>
	<li>The board may also posture to receive excessive compensation, which increases the risk of siding with management over stockowners.</li>
</ul>
</li>
</ul>

Conflicts of Interest in a Corporate Environment

When an analyst evaluate the investment quality of a corporation’s debt or equity, he/she should look at the following board of director elements:
<ul>
	<li>Board Independence: The analyst must review the board’s roster to determine if one or more board members could be subject to management influence.</li>
<ul>
	<li>In some instances company executives actually sit on the board.</li>
	<li>Board members who lack independence may not be company executives, but could have close personal or business ties to management.</li>
	<li>Analysts should look for a board that is at minimum three quarters (75%) independent.</li>
	<li>Arguments have been made that a board should be 100% independent and that no company executives may serve on the board.</li>
</ul>
	<li>Independent Chairman of the Board: At a substantive number of public companies, the board chairman is also the CEO of the company.  The argument is that the board requires this type of insider expertise.</li>
	<li>Director Election Process: The full annual election of directors is considered to be more investor friendly than a staggered election schedule, where only a portion of the board sets are elected each year.</li>
	<li>Director Qualifications: Do board members possess sufficient expertise to oversee the company?</li>
	<li>Board Self-Assessment: are board members, at a minimum, reviewing their own performance on an annual basis?</li>
	<li>Separate Sessions for Independent Members: If the board is not 100% independent, are the independent members holding at least annual meetings that exclude the presence of company management?</li>
	<li>Board Audit Committee: The audit committee should be 100% independent and meet regularly throughout the year to review financial reporting, non-financial public disclosures, and internal control practices.</li>
	<li>Board Nominating Committee: Nominees to the board should be selected by a committee that is 100% independent.</li>
	<li>Board Compensation Committee: Analysts should determine if executive compensation is tied to the attainment of long-term goals rather than short term financial metrics.</li>
	<li>Independent Legal Counsel: The board needs access to appropriate resources so independent legal and other expert advice can be called upon.</li>
</ul>

Assessing The Board of Directors

Companies with quality corporate governance systems can be better positioned to drive higher returns for investors.

Alternatively, poor corporate governance systems can negatively affect a company’s valuation.

Companies with poor corporate governance expose investors to the following risks:
<ul>
	<li>Accounting Risk: a company with poor corporate governance may be more likely to issue misleading or inaccurate <a title="Financial Statements: Structures and Relationship" href="https://financetrain.com/financial-statements-structures-and-relationship/">financial statements</a>.</li>
	<li>Asset Risk: without strong corporate governance, a company’s management may be more inclined to misuse assets.</li>
	<li>Liability Risk: a company with poor corporate governance may enable managers to assume too much <a title="Introduction to Capital Structure and Leverage" href="https://financetrain.com/introduction-to-capital-structure-and-leverage/">financial leverage</a> and put equity <a title="Value at Risk (VaR)" href="https://financetrain.com/value-at-risk-var/">value at risk</a>.</li>
	<li>Strategic Risk: without proper corporate governance, management may engage in business transactions which are not in the long term interests of equity valuation.</li>
</ul>

Investment Valuation and Corporate Governance

Corporate Finance Part 2

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COURSE

Corporate Finance Part 2

LESSONS