4.3 stakeholder conflicts and management

Question 1

A principal-agent relationship, or agency relationship

Answer 1

created when a principal hires an agent to act on its behalf. The principal trusts that the agent will act in its interests

Shareholders and managers have a classic agency relationship, with shareholders being principals who have hired managers as agents to act in their interests.

Question 2

corporate governance systems

Answer 2

designed and implemented to create a system of checks and balances that appropriately manage the conflicting interests in relationships between a company’s various stakeholders.

Question 3

information asymmetry

Answer 3

Managers enjoy an advantage in this agency relationship because they possess information about material matters (e.g., investment opportunities, corporate strategy) that is not available to company outsiders, including shareholders

makes it more difficult for shareholders to manage and evaluate managerial performance.

Question 4

agency costs

Answer 4

The costs incurred to reduce the potential for exploitation in an agency relationship

Companies can reduce agency costs by adopting better corporate governance practices that reduce the information advantages enjoyed by agents

Question 5

Common challenges resulting from conflicts of interest in the agency relationship between shareholders and managers include:

Answer 5

Insufficient effort

inappropriate risk appetite

Empire building

Entrenchment

Self-dealing

Question 6

Entrenchment

Answer 6

Compensation packages that are excessive, particularly with respect to base salary, create incentives to maintain the status quo.

In the case of managers, concerns over maintaining their current position can lead to the avoidance of justifiable business risks in areas where the company has a competitive advantage.

Similarly, directors may abdicate their responsibility to advocate for the interests of shareholders out of a fear of losing their position on the board.

Question 7

controlling shareholders

Answer 7

Equity owners who hold enough shares to determine the outcome of shareholder votes, board elections, etc

may be a single individual or entity, such as a company’s founder or another company or even a government. But control could also be held by a group (e.g., a family), even if none of the members of that group hold a majority position on their own

Question 8

Equity owners who are not in a position to influence corporate activities

Answer 8

minority shareholders.

Question 9

Dispersed ownership

Answer 9

defined by many minority shareholders, none of whom is in a position to exert control individually

Question 10

concentrated ownership

Answer 10

a single shareholder is able to control the outcome of votes, or at least exert significant influence. A concentrated majority shareholder owns more than 50% of a company’s shares

Concentrated minority ownership is possible if, for example, 40% of a company’s shares are owned by a single shareholder and no other owner’s position is greater than 10%.

Question 11

Dual-class share structures

Answer 11

grant disproportionately large voting power to one class of shareholders. Founders can use this structure to retain control over a company even as their economic interest is diluted

Question 12

annual general meeting (AGM)

Answer 12

managers and executives provide audited financial statements and an overview of the state of the company.

Shareholders must vote to approve the financial statements, appoint external auditors, and elect directors to represent their interests on the board.

Most shareholders take advantage of proxy voting

typically held at the end of a company’s fiscal year

Question 13

proxy voting

Answer 13

allows them to authorize another party to vote on their behalf.

Ballots are typically submitted electronically or by mail.

Question 14

extraordinary general meeting (EGM)

Answer 14

may be called by either the company or its shareholders to hold a vote on matters that require shareholder approval (e.g., merger proposals, amendments to corporate bylaws).

Companies are required to hold an extraordinary meeting if the proportion of shareholders requesting one exceeds a specified threshold.

Question 15

Shareholder Activism

Answer 15

refers to efforts by shareholders, often a single shareholder with a significant minority position, to get a company to take certain actions.

This activism may take the form of a coordinated campaign by shareholders pushing companies to achieve certain social or environmental objectives.

However, shareholder activism is typically motivated by a desire to increase the value of a company that is perceived to be performing below its potential.

Hedge funds tend to be among the most prominent activist investors because they have the flexibility to invest in illiquid and/or distressed securities and general partners are incentivized to benefit from a turnaround in a company’s fortunes.

Institutional investors that are subject to greater regulation are more limited in their ability to conduct activist campaigns, although some mutual funds use their influence to achieve positive corporate actions.

Question 16

Shareholder Litigation

Answer 16

To achieve their objectives, activist investors typically engage in proxy battles, propose shareholder resolutions, and take other actions to increase public awareness of their concerns.

Question 17

derivative lawsuits

Answer 17

suing managers and directors because they have failed to act for the benefit of shareholders.

Question 18

Corporate Takeovers
There are several means that can be used to gain control of a company:

Answer 18

A proxy contest

A tender offer

A hostile takeover

Question 19

A proxy contest

Answer 19

a campaign to persuade shareholders to vote to replace the current board of directors.

Question 20

A tender offer

Answer 20

involves shareholders selling interests directly to a group seeking to take control.

Question 21

A hostile takeover

Answer 21

effort to execute a takeover without management’s consent.

Question 22

Bond Indenture

Answer 22

a legal contract that describes the structure of a bond, obligations of the issuer, and rights of the bondholders

Question 23

Creditor Committees

Answer 23

If a company is struggling to meet its debt obligations but has not yet filed for bankruptcy protection, credit committees may be formed on an ad-hoc basis to discuss the possibility of restructuring the company’s debts.

These ad-hoc committees are not representative of all bondholders, but their interests are generally aligned with those of other creditors.

In the event of an actual bankruptcy declaration, official credit committees are formed to represent the interests of lenders, particularly unsecured bondholders, through the subsequent restructuring or liquidation process.

Question 24

The three “core” board committees

Answer 24

Audit Committee

Nominating/Governance Committee

Remuneration/Compensation Committee

Question 25

Audit Committee

Answer 25

oversees a company’s audit and control systems, including the financial reporting process

One of the audit committee’s key responsibilities is recommending an external auditor to conduct an independent audit of a company’s finances.

The resulting audit report is usually approved by the entire board before it is sent to shareholders.

Both internal and external auditors report their findings to the audit committee, which has the authority to propose measures to address any concerns that are raised. In some companies, the audit committee is also responsible for overseeing the security of information technology systems.

Question 26

Nominating/Governance Committee

Answer 26

establishes the policies and procedures for director elections and recommends candidates to be voted on by shareholders.

Members of this committee also determine the definition of director independence and monitor whether independent directors continue to meet these criteria.

Accordingly, best corporate governance practices call for this committee to be composed entirely of independent directors.

also responsible for identifying effective corporate governance practices and codifying them in documents such as the company’s code of ethics, governance code, board charters, and conflict of interest policies. Members of this committee also monitor for compliance with all existing applicable laws and regulations

Question 27

Remuneration/Compensation Committee

Answer 27

develops remuneration policies for directors and key executives and establishes the criteria to be used for evaluating managerial performance

Committee members typically design executive compensation plans to align the interests of managers with those of shareholders.

For top executives, much of their total compensation is variable and determined by metrics such as the company’s stock price.

To the extent possible, long-term value creation is incentivized and decisions based on short-term profits are discouraged.

Question 28

say-on-pay

Answer 28

allow shareholders to express their views on a company’s remuneration packages, which can limit the committee’s ability to grant compensation that is perceived to be excessive or inadequate

Question 29

Risk Committee

Answer 29

The risk committee helps directors determine the company’s risk policy, profile, and appetite.

Members of this committee oversee the establishment of enterprise risk management plans and monitor their implementation to ensure that a company’s activities remain consistent with its appetite for risk.

Question 30

Analyzing Corporate Governance

Key questions that investors and analysts should seek to answer when evaluating a company’s corporate governance are listed below. The answers to these questions can often be found in public disclosures, such as proxy statements, annual reports, and sustainability reports.

Answer 30

Ownership and voting structure

Board of Directors

Compensation

Investors

Shareholder rights

Long-term risk assessment