Page 42 - FINAL CFA II SLIDES JUNE 2019 DAY 6

LOS 24.f: Describe elements of a company’s statement of
corporate governance policies that investment analysts should READING 24: CORPORATE GOVERNANCE
assess.

• Codes of ethics. A corporate code of ethics articulates the values, responsibilities, and ethical conduct of an organization.
• Directors’ oversight, monitoring, and review responsibilities. These include statements regarding internal controls, risk management, audit and
accounting disclosure policies, regulatory compliance, nominations, and compensation.
• Management’s responsibility to the board. These include management’s responsibility to provide complete and timely information to board
members, and to provide directors with direct access to the company’s control and compliance functions.
• Reports of directors’ oversight and review of management.
• Board self assessments.
• Management performance assessments.
• Director training. Includes training that is provided to directors before they join the board as well as ongoing training.
LOS 24.g: Describe environmental, social, and governance risk exposures –ESG risk can be:. LOS 24.h: Explain the valuation implications of corporate governance.
Legislative and Regulatory Risk
It is important to consider legislative and regulatory risk when analyzing investments since a • The best governed companies generated a return on equity
company that has invested in cleaner or safer technologies is less likely to suffer from new (ROE) that was 23.8% higher than firms with poor corporate
legislation than their competitors. governance.

Legal Risk • Portfolios of companies with strong shareholder-rights protections
To evaluate the level of legal risk that a specific company is exposed to, an analyst should outperform portfolios of companies with weaker protections by
examine the company’s regulatory filings, such as form 10-K, which requires companies to 8.5% annually.
disclose possible legal risk exposures. Additionally, an analyst should consider the industry
in which the firm operates, as well as its specific operations, in order to evaluate the • Weak or ineffective corporate governance system increases the
magnitude of legal risk exposure. risk to an investor, thus reducing the value of the company.

Reputational Risk • Financial disclosure risk. Information and disclosures
Companies with management that has been seen in the past to show insufficient regard for that investors use as a basis for financial decisions are
environmental, social, and corporate governance issues will be valued at a lower market incomplete, misleading, or materially misstated.
value compared to companies that manage these risk exposures suitably. • Asset risk. Managers and directors may use company
assets inappropriately. Examples include excessive
Operating Risk compensation and “perks.”
Operating risk refers to the possibility that a firm will be forced to modify an operation, or • Liability risk. Management may enter into off-balance-
shut it down altogether, due to impact of ESG factors. sheet obligations that reduce the value of the
shareholders’ stake in the company.
Financial Risk • Strategic policy risk. Management may enter into
Financial risk is simply the risk that the ESG risk factors will result in a monetary cost to the transactions that may not be in the best interests of
firm or shareholders. Because of this potential financial cost, analysts should be sure to shareholders, but will provide benefits for management.
examine all possible sources of ESG risk when analyzing a company and include these Examples include acquisitions that may increase the
potential risk impacts in the valuation. size of the firm and improve management’s prestige and
perhaps its pay, but ultimately destroy shareholder
value.