1. Corporate Performance 3 2. Corporate Governance Mergers and Acquisitions Key Formulas 51

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1 1. Corporate Performance 3 2. Corporate Governance Mergers and Acquisitions Key Formulas Allen Resources, Inc. All rights reserved. Warning: Copyright violations will be prosecuted. Any use of these materials without the express written consent of the publisher is a violation of federal and/or international copyright laws. 9-1

2 Corporate Governance 2. Corporate Governance Learning Objectives This summary includes a review and an analysis of the principles set forth by CFA Institute. Upon review of this summary, you should be able to: Explain corporate governance and its importance...pg. 16 Describe the objectives of effective corporate governance systems...pg. 17 Explain the primary attributes of an effective corporate governance system...pg. 17 Understand whether a company s corporate governance system has the core attributes of an effective system...pg. 17 Understand the similarities and differences between the three main business forms..pg. 17 Know the potential conflicts of interest inherent in each business form...pg. 19 Know the similarities and differences of agency relationships between managers and shareholders and between directors and shareholders and discuss potential conflicts...pg. 20 Know the responsibilities of the board of directors...pg. 21 Define and explain what board attributes and investor or analyst must assess...pg. 21 Describe effective corporate governance practices as these relate to the attributes of the board of directors...pg. 21 Understand the strengths and weaknesses of a firm s corporate governance practice...pg. 22 List the elements of a firm s statement of corporate governance policies that should be assessed by investors and analysts...pg. 22 Detail the implications of environmental, social, and governance risk for valuing firms...pg Allen Resources, Inc. 9-15

3 Study Session 9 Overview This reading defines corporate governance and explains the importance of an effective corporate governance system to investment analysts. This reading also discusses the agency conflicts that can arise between managers and shareholders and between the board of directors and shareholders, and considers the implications of corporate governance on firm valuation. Corporate Governance and Its Importance Learning Objective: Explain corporate governance and its importance. The corporate form of business dominates because of: 1. ease and efficiency in raising capital. 2. ability to obtain resources. 3. producing products and services. In a small business where there is a single owner/manager, by definition, the firm makes value maximizing decisions; the manager has only him or herself to please, not a large body of shareholders. In a larger corporation, the owners are not necessarily the same individuals who operate the firm s assets. In large corporations, stockholders are diverse, usually holding only a very small percentage of the firm s equity. Professionals manage the company and they may not have a substantial ownership stake in the firm. In this situation, there may be conflicts between owners and managers. This is not the only possible agency conflict; other combinations of stakeholders (any parties with an interest in the firm) may also experience conflicts. Potential agency problems could arise between a manager and an employee, a stockholder and a bondholder, a manager and a supplier, a stockholder and government, a manager and a community, or a director and a shareholder. Corporate governance is a set of principles, policies, and procedures that outline responsibilities which make managers accountable to stakeholders, and minimize conflicts of interest within the corporation. Failure of a corporate governance system could have serious negative consequences for the firm. The business press has been filled recently with corporate misdeeds resulting in executives receiving substantial jail time, and bankruptcy filings for some of the firms involved. The scandals of the early 2000s have led to increased regulation, for example, the Sarbanes-Oxley Act, which spells out many responsibilities of managers and boards Study Guide for the Level II 2015 CFA Exam - Reading Highlights

4 Corporate Governance Objectives of Corporate Governance Systems Learning Objective: Describe the objectives of effective corporate governance systems. Learning Objective: Explain the primary attributes of an effective corporate governance system. Learning Objective: Understand whether a company s corporate governance system has the core attributes of an effective system. The objectives of an effective corporate governance system are: 1. reduce or eliminate conflicts, in particular, manager-shareholder conflicts. 2. make sure that the firm s assets are used effectively in the best interest of its shareholders and other stakeholders. While corporate governance systems differ, depending on the needs of the firm and local government regulations, an effective system should: define the rights of shareholders and other stakeholders. explain what responsibilities managers and directors have toward shareholders. explain how managers and directors will be accountable for their performances. treat managers, shareholders, and directors fairly. be transparent and accurate concerning operations, risk, financial statements, and managerial performance. Investors need to examine a firm s corporate governance system for the above attributes and evaluate its effectiveness. The Three Business Forms Learning Objective: Understand the similarities and differences between the three main business forms. Business can be organized as sole proprietorships, partnerships, or corporations. A sole proprietorship is a business owned and operated by a single individual. In a partnership two or more individuals reach an agreement to own and operate a business and divide its profits. A partnership may be a general partnership in which all partners are owner/operators of the business, or a limited partnership (typically organized for real estate or oil and gas exploration business) in which general partner(s) manage the company and limited partners contribute capital. A corporation is a legal entity created by a state and is separate from its owners and managers Allen Resources, Inc. 9-17

5 Study Session 9 The advantages and disadvantages of a sole proprietorship include: Advantages Easy and low cost formation Faces few government regulations No corporate income taxes Disadvantages Hard to obtain large amounts of capital Unlimited personal liability for the owner/manager, in other words, creditors can seize personal assets as well as business assets if the business becomes financially distressed Limited life - the business ends when the owner retires, dies, or decides to abandon the business The advantages and disadvantages of a partnership include: Advantages Easy and low cost formation No corporate income taxes Disadvantages Varying degrees of formality: informal, oral agreements; or formal legal documents outlining the conditions of the partnership Unlimited liability for all general partners. Capital contributors in a limited partnership have limited liability Limited life - the death or retirement of a partner will necessitate dissolving the business or reaching a new partnership agreement Difficulty in transferring ownership Hard to raise large amounts of capital. Raising capital may be easier than in a sole proprietorship since there are more individuals contributing capital 9-18 Study Guide for the Level II 2015 CFA Exam - Reading Highlights

6 Corporate Governance The advantages and disadvantages of a corporation include: Unlimited life Advantages Disadvantages More rules and regulation and expense in setting up Easy transferability - ownership typically is in the form of shares of stock which can be sold if the original owner no longer wishes to keep an ownership interest. Limited liability - owners can only lose the amount invested in the firm in the event of bankruptcy. Creditors cannot seize their personal assets. Double taxation - firm earnings are taxed at the corporate level and then again at the personal level as dividends or realized capital gains. It s harder for owners to monitor the actions of managers, particularly in a large corporation with many shareholders. Specialization - a corporation can have many employees, each expert in a specific area of the business, but not expert in all aspects of operations and financing. Legal entity - the corporation is a separate entity. It can enter into contracts, sue or be sued, purchase land and assets, borrow money, etc. Greater ability to raise capital and grow the firm While there are more sole proprietorships than any other business form, revenue from corporations accounts for 90% of total revenues among U.S. businesses. Conflicts of Interest Learning Objective: Know the potential conflicts of interest inherent in each business form. A sole proprietorship will have no conflicts between managers and shareholders. The manager is the sole owner and will make decisions that benefit him/her. A sole proprietorship could experience other conflicts of interest; for example, between creditors and the sole proprietor. A partnership could experience conflicts among the owners and operators, with the potential for conflict rising as partners are added. A corporation has the most potential for conflict. Managers who may not even own shares in the corporation make the day-to-day operating decisions for the firm, which may or may not be in the best interest of shareholders. It is harder for shareholders, particularly those who own only a small percentage of the firm, to monitor the actions of managers and ensure that the managers are acting in the shareholders best interest Allen Resources, Inc. 9-19

7 Study Session 9 The Principal-Agent Relationship Learning Objective: Know the similarities and differences of agency relationships between managers and shareholders and between directors and shareholders and discuss potential conflicts. The objective of the firm is maximizing shareholder wealth. The firm accomplishes this by maximizing stock price, which is achieved by accepting all possible positive net present value projects. Managers may have personal goals other than shareholder wealth maximization. An agency relationship occurs when the principals (shareholders) hire agents (managers) to operate the firm. Agency theory addresses the conflicts of interest that can arise when agents have decision-making power and perform services for the principals. In particular, agency theory addresses agency costs or agency problems resulting from these conflicts of interest. Corporate governance is primarily concerned with manager/shareholder and director/shareholder agency conflicts. Manager/Shareholder Agency Conflict Possible manager/shareholders conflicts include: excessive perquisite consumption. The manager may want a corporate jet or an office stocked with works of art, which benefit the manager but not necessarily the shareholders. decisions which benefit the manager at the expense of the shareholder. For example, finance theory states that non-diversifiable risk, not total risk, is relevant. In other words, the market will only compensate an investor for taking on non-diversifiable risk, as measured by beta. While it is bad news for an investor if a firm he owns stock in declares bankruptcy, it is not disastrous news if he has a diversified portfolio. A manager is more concerned with total risk, which includes both non-diversifiable risk and firm-specific, or diversifiable, risk. It is disastrous for a manager if his firm declares bankruptcy since there is an extremely reduced job market for former CEOs of bankrupt firms. As another example, the manager may prefer to head a large, rapidly growing firm. The larger the firm, the more difficult a hostile takeover of the firm (and the possible loss of employment accompanying a takeover). Generally, there is more status and salary for a CEO of a large firm versus a small business. On the other hand, managers compensated heavily with stock options might take on very risky ventures (risk increases the value of options) that could benefit managers more than shareholders. fraud. In recent years, major corporate scandals have rocked the financial markets. In World Com s case, managers falsified the firm s accounting statements, making the company look more profitable than it was. In his plea agreement, convicted Enron Chief Financial Officer, Andrew Fastow, stated that Enron s financial statements were designed to materially mislead investors. An effective corporate governance system must be transparent, with accurate financial statements Study Guide for the Level II 2015 CFA Exam - Reading Highlights

8 Corporate Governance Director/Shareholder Agency Conflicts Learning Objective: Know the responsibilities of the board of directors. The firm s board of directors is elected by shareholders. One of its functions is to monitor management and ensure that managers are acting in the shareholders best interests. Boards typically make major corporate decisions, such as hiring the chief executive officer and other top managers and setting their salaries, approving mergers and other major capital expenditures, and declaring dividends. A firm can have outside or independent directors, directors who are not employed by the firm (although they may own stock in the firm), and inside directors, directors who are also employees, usually top management such as the chief executive officer or chief financial officer. Outside directors may be more objective, for example, willing to make difficult decisions, such as firing an underperforming executive. They are not involved with the day-today operations of the firm. Inside directors have the advantage of knowing more about the firm. Conflicts between directors and shareholders can occur when the board relinquishes its monitoring and control function and is no longer independent of management. This can occur when board members have close, personal relationships with management, if they have consulting contracts that depend on the firm s goodwill, or if they simply ignore their responsibilities to shareholders because of lack of time or desire. Assessing the Effectiveness of Corporate Governance Learning Objective: Define and explain what board attributes and investor or analyst must assess. The board of directors should: be independent of firm managers. be objective. have no relationships, business or personal, which could compromise board independence. have the expertise and resources to competently perform its duties. For example, board members should be able to hire outside consultants when needed as part of their decisionmaking and to aid in their monitoring of managers. An analyst should look closely at the firm s corporate governance practices and at the composition and actions of the board of directors to determine whether the directors are providing appropriate oversight. Learning Objective: Describe effective corporate governance practices as these relate to the attributes of the board of directors. Most financial markets require information about corporate governance to be disclosed, generally as part of its regular filings. In the U.S., corporate filings with the Securities and Exchange Commission are easily available to investors Allen Resources, Inc. 9-21

9 Study Session 9 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 Study Guide for the Level II 2015 CFA Exam - Reading Highlights

10 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. Self-Assessment 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? 2014 Allen Resources, Inc. 9-23

11 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 Study Guide for the Level II 2015 CFA Exam - Reading Highlights

12 Corporate Governance 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 include: ethics code. director and management responsibilities. board self-assessments, management assessments, and reports of directors investigations and evaluations. director training Allen Resources, Inc. 9-25

13 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 Study Guide for the Level II 2015 CFA Exam - Reading Highlights

14 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. First and most important, the target s customers must care deeply about the issue (and be on the side of the boycotting group); in this case, most of the Chick-Fil-A customer base strongly supported the restaurant s position. Thus, the effort was doomed from the start. In addition, boycott efforts are helped when the cost of participation is low. Boycotting gasoline purchases because of greedy oil companies never works, as the cost to go without gas is too high for most people. However, the cost of choosing to avoid one fast-food restaurant chain is not particularly high. Boycotts are also buoyed when the issue is clear and understandable. In the case of Chick-Fil-A, it was, but many times it is not (such as boycotts over unspecified labor disputes). An action related to consumer boycotts is divestiture, which calls for investors (especially institutional investors) to sell their holdings of certain firms which engage (or fail to engage) in specified practices. One of the more widespread cases of institutional divestiture was that of university endowments divesting of firms doing business in South Africa during the 1980s. Selling a stock does not change the intrinsic value of the firm, but a successful divestiture 2014 Allen Resources, Inc. 9-27

15 Study Session 9 campaign can drive down the value of a firm s stock. In addition, a successful consumer boycott can lower demand, revenue, and profit. Governance Risk Good corporate governance should mitigate these risks substantially. If a company does not have an effective corporate governance system, investors face: accounting statement risk, the risk that the financial statements and valuations made on the basis of those statements are incorrect. asset management risk, the risk that managers will take excessive perquisites or otherwise misuse firm assets. liability risk, the risk that the firm will take on excessive liabilities and hide them through off-balance-sheet transactions. strategic risk, the risk that managers will make decisions, such as capital budgeting expenditures or acquisitions, that are not in the best interest of shareholders. Studies have found that companies with strong corporate governance systems are more profitable and have stronger earnings and other performance measures than companies with weaker systems. Thus, companies with strong corporate governance systems should enjoy comparatively higher valuations Allen Resources, Inc. All rights reserved. Warning: Copyright violations will be prosecuted. Any use of these materials without the express written consent of the publisher is a violation of federal and/or international copyright laws. Study Guide for the Level II 2015 CFA Exam - Reading Highlights