Learning Sessions:

Corporate Finance (preview)

By AnalystPrep.com
Reading 34 Corporate Governance and ESG: An
Introduction

LOS 34a: describe corporate governance

LOS 34b: describe a companys stakeholder groups and compare interests

of stakeholder groups

LOS 34c: describe principalagent and other relationships in corporate

governance and the conflicts that may arise in these relationships

LOS 34d: describe stakeholder management

LOS 34e: describe mechanisms to manage stakeholder relationships and

mitigate associated risks

LOS 34f: describe functions and responsibilities of a companys board of

directors and its committees

LOS 34g: describe market and non-market factors that can affect
stakeholder relationships and corporate governance

LOS 34h: identify potential risks of poor corporate governance and

stakeholder management and identify benefits from effective corporate
governance and stakeholder management

LOS 34i: describe factors relevant to the analysis of corporate governance

and stakeholder management

LOS 34j: describe environmental and social considerations in investment

analysis
LOS 34k: describe how environmental, social, and governance factors may
be used in investment analysis
LOS 34a: Corporate Governance and ESG: An
Introduction
Corporate governance may be defined as the system of internal controls,
processes, and procedures by which a company is managed, directed or
controlled.Weak corporate governance practices have resulted in the failures of
many companies.

The corporate governance practices of countries tend to be different, and it is

also not strange for different corporate governance systems to coexist within a
single country.

Corporate governance systems generally reflect the influences of either

shareholder theory, stakeholder theory or a convergence of the two. Current
trends, however, point to an increase in convergence.

Shareholder theory posits that the most important responsibility of a companys

managers is to maximize shareholder returns. Stakeholder theory, on the other
hand, emphasizes the need for a company to consider the needs of all its
stakeholders and not just its shareholders. This includes the companys
customers, suppliers, creditors, employees and essentially anyone who has an
interest in the company.
Question
At a recent conference, the following statements were made about corporate
governance.

I. Countries tend to have similar corporate governance practices.

II. According to Shareholder theory, the most important responsibility of a

companys management is its customers.

III. There is a current trend towards convergence of shareholder and stakeholder

theories.

IV. Corporate governance is the system of internal controls and procedures by

which individual companies are managed.

Which of the statements regarding corporate governance is/are most accurate?

A. I and II only

B. II only

C. III and IV only

Solution

The correct answer is C.

Corporate governance practices can be different from country to country.

According to the Shareholder theory, the most important responsibility of a
companys management is its shareholders.
LOS 34b:Describe a companys stakeholder
groups and compare interests of stakeholder
groups
Corporate governance systems can be influenced by several stakeholder groups
which may or may not have conflicting interests.A companys primary
stakeholder groups include its shareholders, creditors, managers, other
employees, customers, suppliers, government/regulator, and its board of
directors.

By providing a company with equity capital, the shareholders of a company are

considered its owners. Their interests lie primarily in the profitability of the
company and anything which leads to an increase in the companys equity. In the
event of bankruptcy, shareholders receive proceeds only after all creditors
claims have been paid. Controlling shareholders hold sufficient shares in a
company to control the election of its board of directors and to influence
company resolutions. Minority shareholders, on the other hand, have far fewer
shares and limited ability to exercise control in voting activities.

The creditors of a company are the stakeholders who provide the company with
debt financing. Included in this category are bondholders and banks who expect
to receive periodic interest payments and principal repayments arising from
money that they lent to the company.

Creditors generally prefer stability in a companys operations and performance

as this tends to increase the likelihood that a company will generate sufficient
cash flow to pay back its debt obligations. In contrast, shareholders tend to
accept higher risks in return for a higher return potential from strong company
performance.

Managers and other employees tend to benefit when a company performs well
and are adversely affected when the companys financial position weakens. They
seek to maximize the value of their total remuneration while securing their jobs.
Their interests are therefore not surprisingly different from those of
shareholders, creditors, and other stakeholders. Something of potential benefit to
other stakeholders may be disadvantageous to them.
The board of directors is elected by the shareholders of the company and is
charged with the responsibility of protecting shareholders interests, providing
strategic direction and monitoring company and management performance.

A companys customers expect to receive value when they purchase its goods or
services. They tend to be more concerned with company stability and less with
financial performance.

Suppliers, just like creditors, are concerned with a companys ability to generate
cash flows sufficient to meet its financial obligations.

Governments and regulators seek to ensure that companies comply with the law
and act in a manner which safeguards the interests and well-being of the public.

Question
Corporate governance is a system that provides a framework that defines the
rights, roles, and responsibilities of various groups. Which one is not one of these
group?

A. Directors

B. Shareholders

C. Employees

Solution

The correct answer is C.

Corporate governance is a system that provides a framework that defines the

rights, roles, and responsibilities of Board members/Director
Shareholders/shareowners and company/management, not employees.
LOS 34c: Describe principal-agent and other
relationships in corporate governance and the
conflicts that may arise in these relationships
The term Principal-agent relationship or just simply Agency relationship is
used to describe an arrangement where one entity, the principal, legally appoints
another entity, the agent, to act on its behalf by providing a service or performing
a particular task.

The agent is expected to act in the best interests of the principal. It is however
not unusual for principal-agent relationships to lead to conflicts. The most
common example of this occurs when managers, acting as agents, do not act in
the best interests of the shareholders of the company (the principals).

Shareholder and Manager/Director Relationships

Directors and managers (agents) are expected to act in the best interests of the
shareholders (principal) by maximizing the companys equity value. These two
groups, however, tend to diverge on issues related to the risks that a company
should undertake. Managers and directors tend to act in a more risk-averse
manner in order to better protect their employment status, whereas
shareholders would want for directors and managers to accept more risk in
order to maximize equity value.

Additionally, managers usually have greater access to information and are more
knowledgeable about the companys affairs than the shareholders. This
information asymmetry makes it easier for managers to make strategic decisions
that are not necessarily in the best interests of shareholders.

Controlling and Minority Shareholder Relationships

Minority shareholders usually have limited or no control over management and
limited or no voice in director appointments or in major transactions that could
directly impact shareholder value. As a result, conflicts between minority and
controlling shareholders usually occur wherein the opinions or desires of the
minority shareholders are overshadowed by the influence of the controlling
shareholders.
Manager and Board Relationships
Whereas managers are involved in the day-to-day operations of a company, the
board of directors, especially the non-executive board members, are not. This
leads to information asymmetry and makes it difficult for the board to effectively
carry out its functions.

Creditor Versus Shareholder Interests

Creditors desire a company to undertake activities which promote stable
financial performance and maintain default risk at an acceptable level to
essentially guarantee a safe return of their principal and payment of interest.
Shareholders, on the other hand, prefer for the company to undertake riskier
activities which have strong earnings potential and are more likely to enhance
equity value. There is, therefore, a divergence in risk tolerance between these
two groups.

Other Stakeholder Conflicts

Examples of other conflicts between stakeholders include: conflicts between
customers and shareholders, conflicts between customers and suppliers, and
conflicts between shareholders and governments or regulators.

Question
Which of the following statements about principal-agency relationships is
accurate?

A. Shareholders and creditors tend to have similar risk tolerance with respect to
the investments that a company should undertake.

B. In a principal-agent relationship one entity, the agent, appoints another entity,

the principal, to act on its behalf.

C. Managers typically have greater access to information about the companys

affairs than the shareholders.
Solution

The correct answer is C.

Shareholders and creditors tend to have different risk tolerance with respect to
the investments that a company should undertake. In a principal-agent
relationship one entity, the principal, appoints another entity, the agent, to act on
its behalf.
LOS 34d: Describe stakeholder management
Proper stakeholder management is critical to the success of any organization. It
involves taking appropriate steps to identify, prioritize and understand each
stakeholder group in order to properly manage the relationships with them.
Effective communication and engagement are, therefore, necessary if an
organization wants to get the most out of its stakeholder management.

The approaches to stakeholder management may vary across

organizations.Typically, however, organizations try to balance stakeholder
interests as best as possible. This has the effect of limiting any potential conflicts.

Stakeholder Management Components

To assist with balancing stakeholder interests, corporate governance and
stakeholder management frameworks reflect legal, contractual, organizational,
and governmental infrastructures. These four components define the rights,
responsibilities, and powers of each stakeholder group.

Legal Infrastructure

The legal infrastructure defines the framework for legally establishing rights as
well as the remedial action to be taken for violations of these rights.

Contractual Infrastructure

The contractual infrastructure refers to the contractual arrangements which are

entered into by an organization and its stakeholders and which help to define
and secure the rights of both parties.An organization has the most control with
this component of stakeholder management.

Organizational infrastructure

The organizational infrastructure refers to the internal systems and governance

practices which an organization uses to manage its stakeholder relationships.
 Governmental Infrastructure

The governmental infrastructure refers to the regulations which are imposed on

an organization.

Question
The component of stakeholder management which refers to the internal systems,
governance procedures, and practices which are adopted and controlled by an
organization in managing its stakeholder relationships is called:

A. Organizational infrastructure

B. Contractual infrastructure

C. Legal infrastructure

Solution

The correct answer is A.

The organizational infrastructure refers to the internal systems, governance

procedures, and practices which are adopted and controlled by an organization
in managing its stakeholder relationships. The contractual infrastructure refers
to the contractual relationship between an organization and its stakeholders,
while the legal infrastructure is established by law.
LOS 34e: Describe mechanisms to manage
stakeholder relationships and mitigate
associated risks
In seeking to balance stakeholder interests, a company may employ various
mechanisms for stakeholder management. Common mechanisms include:
holding general meetings, electing a board of directors, having an audit function,
company reporting and transparency, policies on related-party transactions,
remuneration policies (including say on pay), and other mechanisms to manage
the companys relationship with its creditors, employees, customers, suppliers,
and regulators.

General meetings
General meetings provide shareholders with the opportunity to participate in
company discussions and to vote on major corporate matters.

Companies usually hold an annual general meeting (AGM) within a certain

period of time after the end of their financial year. The main purpose of an AGM
is to present shareholders with the annual audited financial statements of the
company, provide an overview of the companys performance over the year, and
address any shareholder concerns.

It is also possible for extraordinary general meetings to be called by the company

or by shareholders within the year whenever significant resolutions requiring
shareholder approval are proposed.

Ordinary resolutions require a simple majority of votes to be passed. These

usually relate to the approval of financial statements and the election of directors
and auditors. Special resolutions require a supermajority vote such as 75% of the
votes to be passed. These are usually reserved for decisions that are more
material in nature such as effecting amendments to bylaws or voting on a
proposed merger or takeover transaction.

Proxy voting allows shareholders who cannot attend a general meeting to

authorize another individual to vote on their behalf. It is the most common form
of investor participation in meetings. Minority shareholders tend to use proxy
voting in an attempt to increase their influence on companies.
Cumulative voting allows a shareholder to accumulate and vote all of his or
shares for a single candidate in an election involving more than one director. By
employing this process, minority shareholders have an increased likelihood of
being represented by at least one board director.

Board of directors
A board of directors is elected by company shareholders to provide oversight of
the company. The board appoints the top management of the company, is held
accountable by shareholders and is also responsible for the overall governance of
the company. The board dictates the strategic direction of the company, guides
and monitors managements actions towards executing the strategy and
evaluates management performance. The board also supervises the audit,
control, and risk management functions of the company as well as its compliance
with all applicable laws and regulations.

The Audit Function

The audit function describes the systems, controls, policies and procedures
which a company has in place to examine its operations and financial records. It
serves to limit insiders discretion with respect to the use of the companys
resources and its financial reporting and is also designed to mitigate fraud or
misstatements of accounting information.

There are two types of audit functions: internal audit functions and external
audit functions.

Internal audits are conducted by an independent internal audit department. The

role of internal audit is to provide independent assurance that a companys risk
management, governance, and internal control processes are operating
effectively.

External auditors, which are external to a company, perform audits of the

companys financial records with the objective of providing a reasonable and
independent assurance that they accurately reflect the companys financial
position. The board of directors usually receives and reviews the financial
statements and auditors reports as well as confirms their accuracy prior to them
being presented for shareholder approval at the AGM.
Reporting and Transparency
Shareholders are able to gain a range of financial and non-financial information
mainly through annual reports and other company disclosures. Access to this
information reduces information asymmetry between the shareholders and
managers and allows the shareholders to better assess the performance of the
company and to make informed decisions on company valuations.

Policies on Related party transactions

A related party transaction is a business arrangement between two parties which
are connected by a special relationship which exists prior to the arrangement. A
companys policies on related party transactions establish the procedures for
disclosing information on these transactions and mitigating and managing any
conflicts of interest that may arise.

Related party policies and procedures aim to ensure that related party
transactions are conducted on an arms length basis and do not advance the
interests of the related party at the expense of the interests of the company or its
shareholders.

Remuneration Policies
Companies are increasingly establishing remuneration policies which discourage
short-term focus and excessive risk taking by managers. Long-term incentive
plans delay the payment of all remuneration until company strategic objectives,
namely performance targets, have been met. Some incentive plans include the
granting of shares rather than options to managers and restrict their vesting or
sale for several years or until retirement.

Regulators are placing increasing focus on company remuneration policies. In

some parts of the world, regulators require companies to base their
remuneration policies on long-term performance measures. In some instances
too, companies are required to adopt clawback provisions which allow them to
recover previously paid remuneration if certain events such as misconduct or
fraud are uncovered.

Say on Pay enables shareholders to vote on matters pertaining to executive

remuneration. This allows them to limit the discretion that directors and
managers have in granting themselves excessive or inadequate remuneration. It
is often criticized by opponents who believe that the board is better suited to
handling remuneration matters given the limited involvement of shareholders in
a companys strategic operations.

Contractual agreements with creditors

The rights of creditors are established by laws and provisions in the contracts
that are executed with a company.

Indentures are legal contracts which describe the structure of a bond, the
obligations of the issuer, and the rights of the bondholders. Covenants within
indentures enable creditors to specify the actions an issuer is obligated to
perform or prohibited from performing. Creditors often require a company to
provide periodic financial information in order to ensure that covenants are not
violated and default risk is not increased.

Collateral in the form of assets or financial guarantees are often used to

guarantee the repayment of debt to creditors.

Employee Laws and Contracts

The rights of employees are primarily secured through labor laws. Labor laws
define the standards for employees rights and responsibilities and cover matters
such as working hours, pension plans, hiring and firing practices and vacation
and leave entitlements. Unions seek to influence certain matters which affect the
well-being of employees on their jobs.

Employment contracts specify an employees rights and responsibilities but

typically do not cover every situation between employees and employers.

Effective human resource policies seek to attract and recruit high-quality

employees while providing remuneration, training/development and career
growth prospects in order to improve employee retention. Employee Stock
Ownership Plans (ESOPs) are also used to retain and motivate employees.

Companies sometimes use Codes of Ethics and business conduct to establish the
companys values and the standards of ethical and legal behavior which
employees are expected to follow.
Other Mechanisms
Other mechanisms for stakeholder management include contractual agreements
between companies and their customers and suppliers, as well as laws and
regulations.

Question
Which of the statements about the audit function is most likely accurate?

A. Internal audit guarantees that a companys risk management, governance and

internal control processes are operating effectively.

B. The audit function describes the systems, controls, policies and procedures
which a company has in place to examine its operations and financial records.

C. Internal auditors conduct annual audits of the companys financial records and
prepare the financial statements and auditors reports which are eventually
presented to shareholders for approval at the AGM.

Solution:

The correct answer is B.

Option A. is incorrect because internal audit cannot guarantee that a companys

risk management, governance and internal control processes are operating
effectively. It can only provide independent assurance that they are operating
effectively. Option C. is also incorrect because it is the external auditors and not
the internal auditors which conduct the annual audits of a companys financial
records which lead to the finalization of financial statements which are
eventually presented to shareholders for approval.
LOS 34 f: Describe functions and responsibilities
of a companys board of directors and its
committees
The board of directors provides oversight of the company and serves as the link
between its shareholders and managers. It has the ultimate responsibility of
ensuring that the company adopts proper corporate governance principles and
complies with all applicable laws and regulations.

Board Composition
Boards with one-tier structures comprise a mix of executive and non-executive
directors. The executive directors are employed by the company and are usually
members of senior management, while the non-executive directors are external
to the company and bring objectivity to the decision-making
process. Independent directors are non-executive directors which do not have a
material relationship with the company with respect to employment, ownership
or remuneration.

In boards with two-tier structures, the supervisory and management boards are
independent of each other. The chairperson of the supervisory board is typically
external to the company while the Chief Executive Officer (CEO) usually chairs
the management board.

In some countries such as the United States, many companies have CEO duality
in which the CEO also serves as the chairperson of the board. The CEO and
chairperson roles are however becoming increasingly separated.

Functions and Responsibilities of the Board

Duty of care and duty of loyalty are two well-established elements of directors
responsibilities. The Organization for Economic Co-operation and Development
(OECD) Principles of Corporate Governance indicate that duty of care requires
board members to act on a fully informed basis, in good faith, with due diligence
and care, while duty of loyalty is the duty of the board member to act in the
interest of the company and shareholders.
The board:

Guides and approves the companys strategic direction

Delegates strategy implementation to senior management

Reviews corporate performance and determines relevant course of action

Hires and fires senior managers

Ensure leadership continuity through succession planning for the CEO and
other key executives

Sets the overall structure of the companys audit and control systems

Oversees reports by internal audit, the audit committee and external

auditors

Board of Directors Committees

The board of directors typically establishes committees and delegates some of its
responsibilities to these committees. Some of the
mostcommoncommitteesinclude:

1. Audit Committee The audit committee is responsible for recommending

the appointment of an independent external auditor and proposing the
auditors remuneration. The audit committee also monitors the companys
financial reporting process, including the application of accounting
policies. It also presents an annual audit plan to the board and monitors its
implementation by the internal audit function which it supervises.
2. Governance Committee The governance committee ensures that the
company adopts good corporate governance practices.
3. Remuneration Committee The remuneration or compensation committee
develops remuneration policies for the directors and key executives of the
company and presents them for approval by the board or shareholders.
4. Nomination Committee This committee establishes the nomination
procedures and policies, including eligibility criteria for board
directorship.
 5. Risk Committee This committee supervises the risk management
function of the company.
6. Investment Committee The investment committee reviews material
investment opportunities proposed by management, such as expansion
plans or acquisitions, and considers their viability.

Question
Which of the following board committees helps to ensure that the board
composition is well balanced and aligned with the companys governance
principles?

A. Governance committee

B. Nomination Committee

C. Audit Committee

Solution:

The correct answer is B.

The Nomination Committee establishes the nomination policies and procedures

including the identification of qualified candidates for director positions. The
other answers are incorrect as neither the Governance or Audit committees are
involved in the selection process for new directors.
LOS 34g: Describe market and non-market
factors that can affect stakeholder relationships
and corporate governance
Both market and non-market related factors can affect stakeholder relationships
and corporate governance. Market factors are those factors which are related to
the capital markets, while non-market factors are those that are not related to
the capital markets.

Market Factors
Market factors include shareholder engagement, shareholder activism,
competition, and takeovers.

1. Shareholder Engagement involves a companys interactions with its

shareholders, namely through AGMs and analyst calls.
2. Shareholder activism refers to the efforts of shareholders to create a
change within a company or to modify company behavior with the primary
objective being to increase shareholder value.
3. Shareholders usually compare the earnings reports and market share of a
company with those of its competitors and use the comparison to judge the
performance of the managers and/or board. Corporate takeovers can be
pursued in several ways. In a proxy fight, shareholders are persuaded to
vote for a group seeking a controlling position on the companys board. In
a tender offer, shareholders sell their interests directly to the group
seeking control, while in a hostile takeover an attempt is made by one
company to acquire another company without the consent of the
companys management.

Non-market Forces
Non-market forces include the companys legal environment, the role of the
media, and the corporate governance industry.
 1. Legal environment A companys legal environment can significantly
impact the rights and remedies of stakeholders. In civil law systems, laws
are created primarily through statues and codes enacted by legislature. In
contrast, in common law systems, laws are created both from statutes that
are enacted by legislature and by judges through judicial opinions.
Regardless of the prevailing legal system, creditors are generally more
successful in seeking remedies in court to enforce their rights than
shareholders are.
2. The Media can quickly spread information and shape public opinion. Social
media, in particular, has become a tool that shareholders are increasingly
using to protect their interests or influence corporate matters.
3. With the increased importance of corporate governance, the demand for
external corporate governance services has grown considerably. As a
result, an industry which provides corporate governance services such as
governance ratings and proxy advice has developed.

Question
Which of the following statements is most likely accurate?

A. In a proxy fight, shareholders are persuaded to vote for a group seeking a

controlling position on the companys board of directors

B. In a hostile takeover, shareholders sell their interests directly to a group

seeking control of the company

C. In a tender offer, an attempt is made by one entity to acquire another company

without the consent of the companys management.

Solution:

The correct answer is A.

Options B. and C. are incorrect because the definitions have been interchanged.
In other words, a tender offer describes a situation where shareholders sell their
interests directly to a group seeking control of the company, while in a hostile
takeover an attempt is made by one entity to acquire another company without
the consent of the companys management.
LOS 34h: Identify potential risks of poor
corporate governance and stakeholder
management and identify benefits from effective
corporate governance and stakeholder
management
Weaknesses in corporate governance practices and stakeholder management
processes expose a company and its stakeholders to several risks. The reverse
scenario is that effective corporate governance and stakeholder management
practices can create several benefits for a company and its stakeholders.

PotentialRisks

1. One stakeholder group may benefit unfairly at the expense of other

stakeholder groups due to weaknesses in a companys control systems.
2. Managers could make poor investment decisions which benefit them but
are detrimental to the companys shareholders.
3. A companys exposure to legal, regulatory and reputational risks could
become heightened. For example, a company may be subject to an
investigation by a regulatory authority due to a violation of laws and
regulations. The company could also receive lawsuits from one of its
stakeholders due to some form of impropriety. These could potentially
damage the reputation of the company and lead to significant legal costs.
4. A companys ability to honor its debt obligations may become hindered.
This exposes it to bankruptcy risk if its creditors decide to take legal action
against it.

PotentialBenefits

1. Operationalefficiencycouldbeimproved
2. A companys control systems may be enhanced due to the proper
functioning of its audit committee and the effectiveness of its audit
systems.
3. Operating and financial performance could be improved which may lead to
a reduction in the costs that are associated with weak control systems.
 4. Business and investment risk may be lowered, thus reducing a companys
cost of capital and its default risk.

Question
Which of the following is a benefit of an effective corporate governance
structure?

A. Default risk may increase

B. Managers may make decisions which benefit them but not the shareholders

C. Operating performance may improve

Solution:

The correct answer is C.

Improvement in operational and financial performance is a potential benefit of

an effective corporate governance structure. A is incorrect because effective
corporate governance leads to a decrease in default risk, not an increase. B is
incorrect due to the fact that when managers make decisions which only benefit
them, they are not considering the interests of other stakeholders, namely
shareholders.
LOS 34i: Describe factors relevant to the analysis
of corporate governance and stakeholder
management
There are several factors which analysts consider when assessing a companys
corporate governance structure and stakeholder management. These factors can
provide important insights into the quality of management and the sources of
potential risk.

Factors
The factors which analysts look at include:

1. Economic Ownership and Voting Control: Corporations usually have a

voting structure which involves one vote for each share. Shareholders are
however exposed to significant risk when economic ownership becomes
separated from control. Dual-class structures, in which shares are
commonly divided into two classes with one having superior voting rights
to the other (for example, class A and class B shares), is a popular way in
which voting power can be separated from economic ownership. Analysts
are particularly interested in determining the extent to which this
separation occurs.
2. Board of Director Representation: Analysts look at available information
to determine whether the experience and skill sets of board members are
aligned with the current and future needs of the company. It is quite
possible that a boards composition is appropriate for a particular point in
time in the companys history but may need changing in order to adjust to
new business needs. Additionally, a board composition that is dominated
by long-tenured board members may restrict the boards ability to adapt
to change.
3. Remuneration and Company Performance: Analysts assess the
components of remuneration plans to determine if they support or conflict
with key performance drivers. This assessment is somewhat subjective but
there are certain warning signs that may lead to further scrutiny1.
4. The Effect of Investors in the Company: Investor behavior can limit or
enhance the process of effecting corporate changes. For example, a sizable
affiliated shareholder can shield a company from the voting done by
outside shareholders. Shareholder activism can also create a substantial
turnover in a companys shareholder composition.
 5. The Strength of Shareholders Rights: Analysts are interested in
determining whether the rights of the shareholders in a company are
strong, weak, or average when compared with other companies.
6. The Management of Long-Term Risks: Analysts may consider how a
company manages its long-term risks as a significant factor in their overall
assessment of the company.
1These warning signs include:

Plans which offer little alignment with shareholders interests

Plans which exhibit little variation in results over multiple years

Plans which have excessive payouts relative to companies with

comparable performance

Plans which have specific strategic implications

Plans that are based on incentives which are from an earlier period in the
companys life

Question
Which of the following most accurately reflects an analysts sentiments towards
board composition?

A. A board with a significant number of long-tenured board members is better

able to adapt to change than one with short-tenured members.

B. Once an optimal board structure is derived, there is no need to change the

board composition to adjust to changing business needs.

C. Analysts attempt to determine whether the experience and skill sets of board
members are aligned with the current and future needs of a company.
Solution

The correct answer is C.

Analysts are concerned with whether or not a companys board composition is

aligned with a companys needs, both now and in the future. A is incorrect
because long-tenured board members are usually slower to adapt to changing
circumstances. B is incorrect because there is no such thing as an optimal board
structure. It makes economic sense for a boards composition to change with
changing times.
LOS 34j-k: Describe environmental and social
considerations in investment analysis
Environmental, social and governance factors are collectively referred to by the
acronym ESG. ESG integration is the practice of considering environmental,
social, and governance factors in the investment process, and can be
implemented across all asset classes, including equities, fixed income, and
alternative investments.

Sustainable investing (SI) and responsible investing (RI) are sometimes used
interchangeably with ESG integration. Socially Responsible Investing (SRI) is an
investment strategy that is said to incorporate ESG issues, but which has been
historically represented by the practice of excluding companies and industries
from investment consideration on the grounds that they oppose an investors
moral or ethical values.

Managers and investors tend to define and implement ESG mandates in many
different ways. As a result, there are often differences among investors regarding
which ESG factors should be considered in the investment process and to what
extent they should be implemented within a portfolio.

ESG Factors Considered in the Investment Analysis Process

Pollution prevention, energy efficiency, reduced emissions, and adherence to
environmental safety and regulatory standards are some of the key
environmental factors which are considered in the investment analysis process.

With respect to the influence of social factors on the investment analysis process,
consideration is usually given to human rights issues and welfare concerns in the
workplace as well as the impact of product development on the community.

ESG Implementation
ESG integration can be implemented through several methods, namely negative
screening, positive screening, best-in-class, thematic investing, and impact
investing.

Negative screening or exclusionary screening describes the practice of excluding

certain sectors or companies from investment consideration due to the nature of
their underlying business activities or other environmental or social concerns.
Positive screening and best-in-class strategies select investments which have
favorable ESG characteristics. Positive screening focuses on companies which
embrace positive ESG-related principles such as companies with policies
promoting pollution prevention. The best-in-class approach seeks to identify
companies which record the highest ESG score in their industry.

Thematic investing emphasizes a single factor, such as energy efficiency or

climate change.

Impact investing seeks to achieve targeted social or environmental objectives

along with measurable financial returns through engagement with a company or
by directly investing in projects or companies. It can be executed through various
asset classes and investment vehicles, often through direct transactions, such as
venture capital investing.

Question
Which of the following is not an ESG implementation method?

A. worst-in-class

B. positive screening

C. impact investing

Solution

The correct answer is A.

Worst-in-class is not the name of an ESG implementation strategy. On the flip
side, best-in-class describes an ESG approach which seeks to identify the best
ESG-scoring companies in each industry. B and C are incorrect because positive
screening and impact screening are both examples of ESG implementation
methods.