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Investors should make corporate governance check on public companies before investing Back  
Robert Johnson argues that investors must examine public companies’ corporate governance policies before investing or they risk putting their money into the next Enron.
Corporate governance breakdowns have led to some of the most spectacular corporate collapses in recent memory - Enron, Parmalat, Royal Dutch Petroleum/Shell Transport. Losses of tens of billions of dollars of investors’ capital proved that the existing set of corporate checks and balances could not protect shareholders from the misplaced priorities of board members and the misappropriation of company resources by management.
Robert Johnson, Ph.D, CFA, is managing firector, CFA Programme, of CFA Institute

In addition, many investors may not have seen these collapses coming because they didn’t know what to look for in the company’s financial reports in order to be able to determine whether a company is operating to good corporate governance standards.

The importance of corporate governance for shareholders is not only in protecting their investments, but also in enhancing them.

Several recent studies have shown a direct correlation between good corporate governance practices and positive earnings results. A 2004 study of US markets by researchers at Harvard University and the University of Pennsylvania found that portfolios of companies with strong shareholders rights outperformed companies with weaker protections by 8.5 percent per year. In Germany, a 2003 study discovered that portfolios of German companies with better governance policies outperformed portfolios of those companies with weaker governance by an average of 2.33 percent per month.

In addition, a joint study by Institutional Shareholder Services (ISS) and Georgia State University found that the best governed companies –as measured by ISS’s Corporate Governance Quotient – had mean returns on investment and equity that were 18.7 percent and 23.8 percent better, respectively, than those of poorly governed companies during the year reviewed.
Of course, many countries, industry groups and constituencies have responded to the wide-ranging effects of recent corporate failures on the global market. Ireland and the UK have been to the forefront of this through the Combined Code. Recently the Higgs Report moved the Combined Code on further by promulgating the importance of issues such as the role of the independent director, the division of the role of the CEO and Chairman, and having at least half of the board made up of independent non-executive directors.

Such initiatives have proposed or created new or amended corporate governance codes to establish internal controls or set an ethical tone that focuses on investors’ interests. However, the CFA Institute, which sets voluntary, ethics-based standards for the investment industry, also believes that investors must take the initiative to evaluate the presence – or absence – of corporate governance safeguards in companies in which they invest. Investors cannot rely on issuers to do this for them.

In this regard, the CFA Centre for Financial Market Integrity, the thought-leadership and policy-setting arm of the CFA Institute, has produced The Corporate Governance of Listed Companies – a Manual for Investors, a document that speaks uniquely to investors, rather than to companies and their boards, about how they should assess a company’s corporate governance standards when making their investment decisions.
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The Manual sets out a number of corporate governance issues that investors and shareholders should investigate in relation to a company’s board, management and shareowner rights before investing their money.

In relation to the board, its members owe a duty to make decisions based on what ultimately is best for the long-term interest of shareowners. In order to do this effectively, board members need a combination of three things: independence, experience and resources.

A board should be composed of at least a majority of independent board members with the autonomy to act independently from management. Board members should bring with them a commitment to take an unbiased approach in making decisions that will benefit the company and long-term shareowners, rather than simply voting with management.

Board members should also have appropriate experience and expertise relevant to the company’s business. In addition, there need to be internal mechanisms to support the independent work of the board, including the authority to hire outside consultants without management’s intervention or approval. This mechanism alone provides the board with the ability to obtain expert help in specialised areas, to circumvent potential areas of conflict with management, and to preserve the integrity of the board’s independent oversight function.

Among the areas that investors should examine when it comes to a company’s board are:
• Whether the board has, at a minimum, a majority of independent board members
• The qualifications of board members and how they are elected
• Its policies regarding business transactions between board members and the company
• Whether there is a committee of independent board members, including those with recent and relevant experience of finance and accounting, to oversee the audit of the company’s financial reports

While the board helps set the strategic, ethical and financial course for a company in consultation with management, investors ultimately must rely on management to implement that course. Management also has the responsibility to communicate to investors and the public about the company’s performance, financial condition and any changes in strategy or corporate initiatives in an effective and timely manner.

When it comes to a company’s management, investors need to be asking the following kinds of questions:
- Has the company adopted a code of ethics?
- Does it permit insiders to use company resources for personal reasons?
- Does it have a fair and transparent remuneration policy?
- Are there any share repurchase or price stabilisation programmes?

It is important for investors to recognise what specific rights are attached to the securities they are considering and factor that information into any investment decision. Doing so may avoid situations that result in reduced valuations and poor investment performance.

In terms of shareholder rights, investors and shareholders need to examine whether:
- The company allows shareholders to vote their share by proxy regardless of whether they are able to attend the meetings in person
- Shareholders can cast confidential votes
- Shareholders can approve changes to corporate structure and policies that may alter the relationship between shareowners and the company
- Shareholders can table proposals and nominate board members
- The board and management are required to implement the proposals that shareholders approve
- The company’s ownership structure has different classes of common shares that separate the voting rights of those shares from their economic value
- The corporate governance code and other legal statutes of the jurisdiction in which the company is headquartered permit shareholders to take legal or seek regulatory action to protect and enforce their ownership rights
- The company has defences to takeover bids in place

The CFA Centre manual is different from other guides – it does not advocate specific best practices, nor does it recommend any particular corporate governance system. Instead, its purpose is to alert investors, existing shareholders, analysts and issuers of financial securities to the primary corporate governance issues and risks affecting companies, and to highlight some of the factors they should consider.

Good corporate governance leads to better results for companies and for investors. Corporate governance, therefore, cannot be ignored by investors and should be considered when seeking the best possible results for themselves or their clients.

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