CHAPTER 3: CORPORATE GOVEERNANCE: CONFLICTS, MECHANISMS, RISKS & BENEFITS

Question 1

Stakeholder Conflicts and Management

Answer 1

Principal-Agent Conflict: Principal hires an agent for tasks/services.

Obligation: Agent acts in the best interest of the principal.

Conflict Example: Information asymmetry.

Question 2

Information Asymmetry

Answer 2

Managers have more information than shareholders/creditors.

Impact: Harder for shareholders to assess managers. Higher risk premiums/returns demanded.

• Managers have more info than shareholders/creditors
• Reduces ability to assess performance
• Investors demand higher risk premiums

Question 3

Shareholder-Manager Conflicts:

Answer 3

1. Insufficient effort: Managers neglect duties, inadequate employee monitoring
2. Entrenchment: Managers avoid risks to protect high compensation
3. Empire building: Pursuing growth at expense of shareholder value. Growth for growth sake.
4. Excessive risk-taking: Over-reliance on stock options encourages risky decisions
5. Self-dealing: Misuse of company resources for personal benefit (e.g., private jets)

Question 4

Agency Costs:

Answer 4

Result from conflicts between agent (manager) and principal (shareholder)

Include:
a) Monitoring costs (e.g., annual reports, board expenses)
b) Bonding costs (e.g., performance guarantees)
Better corporate governance reduces agency costs

Question 5

Controlling vs Minority Shareholders:

Answer 5

1. Dispersed ownership: Many shareholders, none with individual control
2. Concentrated ownership: Individual/group has control

Conflicts:
a) Company diversification vs core business focus
b) Long-term vs short-term goals

Question 6

Ownership Types:

Answer 6

Majority shareholders: Own >50% shares
Minority shareholders: Own <50% shares

Controlling shareholders can exert control without majority ownership

Question 7

2.2 Controlling and Minority Shareholder Relationships

Answer 7

Dual-Share Classes:

• Multiple share classes with different voting rights
• Superior voting powers assigned to one class, limited rights to others

Benefits for controlling shareholders:

1. Avoid voting power dilution when new shares are issued
2. Retain control of board elections and strategic decisions
3. Maintain control even if ownership falls below 50%

Question 8

2.3 Shareholder vs. Creditor (Debtholder) Interests

Answer 8

Conflicts arise in:

1. Dividend distribution: Creditors concerned about excess dividends impairing debt service ability
2. Risk tolerance:
   Shareholders: Higher risk tolerance, prefer more risk for higher returns
   Creditors: Conservative, prefer stable operating cash flow
3. Increased borrowing:

• Raises default risk for creditors if company can’t service debt

4. Corporate Governance Mechanisms:

Arrangement of checks, balances, and incentives managing conflicting interests among stakeholders (management, board, shareholders, creditors, others)

Purpose: Ensure adherence to external rules and regulations. Meet internal stakeholders’ needs.

Question 9

Types of Mechanisms:

Answer 9

3.1. Shareholder Mechanisms
3.2. Creditor Mechanisms
3.3. Board of Director and Management Mechanisms
3.4. Employee Mechanisms
3.5. Customer and Supplier Mechanisms
3.6. Government Mechanisms

Question 10

3.1 Shareholder Mechanisms

Answer 10

Types of mechanisms to mitigate shareholder risks:

1. Corporate Reporting and Transparency
2. Shareholder Meetings
3. Investor Activism
4. Shareholder Derivative Lawsuits
5. Corporate Takeovers

Question 10

3.1.1 Corporate Reporting and Transparency

Answer 10

Sources of information:

1. Annual reports
2. Proxy statements
3. Company website disclosures
4. Investor relations department
5. Other channels

Question 11

3.1.2 Shareholder Meetings

Types of general meetings:

Answer 11

1. Annual General Meetings (AGMs):

Held once a year
Present and discuss annual performance
Answer shareholders’ questions

2. Extraordinary General Meetings:

Called anytime during the year
Initiated by company or shareholders
For major resolutions (e.g., bylaw amendments, mergers, acquisitions, business sales)

Question 11

Benefits of information:

Answer 11

1. Reduces information asymmetry between shareholders and managers
2. Allows assessment of company and management performance
3. Aids in company valuation and share trading decisions
4. Enables informed voting on key corporate matters

Question 12

3.1.3 Shareholder Activism

Answer 12

Strategies used by shareholders to compel company action

Primary motivation: Increase shareholder value
Predominant activists: Hedge funds

Question 13

Voting requirements:

Answer 13

Simple majority: For simple decisions
Supermajority (75%): For material decisions

Question 14

3.1.5 Corporate Takeovers

Answer 14

Methods:

1. Proxy contest: Group seeks board control by influencing shareholder votes
2. Tender offer: Offer to purchase shareholders’ shares to gain control
3. Hostile takeover: Bypassing management, directly approaching shareholders

Question 14

Special voting methods:

Answer 14

1. Proxy voting: Shareholders authorize others to vote on their behalf
2. Cumulative voting: Shareholders accumulate votes for one candidate in multi-director elections

Question 15

3.1.4 Shareholder Derivative Lawsuits

Answer 15

Legal proceedings initiated by shareholders against board directors, management, or controlling shareholders

Note: Prohibited in many countries

Question 16

3.2 Creditor Mechanisms

Types

Answer 16

1. Bond Indenture(s)
2. Corporate Reporting and Transparency
3. Creditor Committees

Question 17

3.2.1 Bond Indenture

Answer 17

1. Legal contract describing bond structure, company obligations, bondholder rights

Covenants: Terms specifying issuer actions

a) Affirmative covenants: Required actions (e.g., maintaining insurance levels)

b) Restrictive covenants: Prohibited actions (e.g., minimum liquidity requirements)

Collaterals: Pledged assets/guarantees for repayment in case of default

Question 18

3.2.2 Corporate Reporting and Transparency

Answer 18

Periodic financial information required to monitor risk and covenant compliance

Question 19

3.2.3 Creditor Committees

Answer 19

Formed during bankruptcy proceedings

Represent bondholders and protect interests in restructuring/liquidation

Question 20

3.3 Board of Director and Management Mechanisms

Answer 20

Common board committees:

1. Audit Committee
   - Monitor financial reporting process
   - Supervise internal audit function
   - Appoint and interact with external auditor
2. Governance Committee
3. Remuneration or Compensation Committee
4. Nomination Committee
5. Risk Committee
6. Investment Committee

Question 21

3.3.2 Governance Committee

Answer 21

Key functions:

1. Develop and monitor corporate governance policies and practices
2. Ensure organizational compliance with laws and regulations
3. Align organizational structure with governance principles

Question 22

3.3.3 Remuneration or Compensation Committee
Key functions:

Answer 22

1. Develop director and executive remuneration policies
2. Oversee performance policy management and evaluation
3. Set HR policies for employee compensation

Question 23

3.3.4 Nomination Committee
Key functions:

Answer 23

1. Oversee director nomination and board election process
2. Identify senior leadership candidates
3. Maintain board composition and independence

Question 23

3.3.6 Investment Committee
Key functions:

Answer 23

1. Assess major investment opportunities
2. Evaluate board investment recommendations

Question 24

3.3.5 Risk Committee
Key functions:

Answer 24

1. Determine company risk profile
2. Ensure appropriate enterprise risk management
3. Align corporate activities with risk appetite

Question 25

3.4 Employee Mechanisms
Types:

Answer 25

1. Labor Laws:
   - Define standard employee rights (work hours, pension, vacation, etc.)
   - Allow for union formation in many countries
2. Employment Contracts
   - Define individual employee rights, responsibilities, remuneration, and benefits (e.g., ESOPs)

Question 26

3.5 Customer and Supplier Mechanisms

Answer 26

1. Contracts defining products, services, guarantees, after-sales support, payment terms
2. Define actions in case of contract violation

Question 27

3.6.2 Corporate Governance Codes

Answer 27

Guiding principles for publicly traded companies

Adopted by regulatory authorities

Require companies to:
a) Disclose implementation of recommended practices
b) Explain reasons for non-implementation

Question 27

3.6 Government Mechanisms
Types:

Answer 27

1. Regulations:
   - Laws protecting consumer/stakeholder interests
   - Rigorous regulatory frameworks for sensitive industries (e.g., banking, healthcare, food manufacturing)
2. Corporate Governance Codes

Question 27

4.1 Risks of Poor Governance and Stakeholder Management

Answer 27

1. Weak Control Systems:
   Can negatively affect company performance and value

Example: Enron’s fraudulent reporting due to auditor failure

2. Ineffective Decision-Making
   Poor decisions include:
   a) Avoiding good investment opportunities to maintain low-risk profile
   b) Taking excessive risk without proper evaluation
   Not in shareholders’ interests
   Often results from information asymmetry between managers and board/shareholders
3. Legal, Regulatory, and Reputational Risks

Improper implementation and monitoring of corporate governance procedures may result in:

a) Legal risks: Stakeholders (shareholders, creditors, employees) may file lawsuits if rights violated
b) Regulatory risks: Government/regulator may take action if applicable laws violated
c) Reputational risks: Negative publicity from investors/analysts due to improperly managed conflicts of interest

4. Default and Bankruptcy Risks
5. Poor corporate governance may affect company performance
6. Can impact company’s ability to service debt. If creditors’ rights violated and legal action taken on defaulting debt, company may be forced to file for bankruptcy

Question 27

4.2 Benefits of Effective Governance and Stakeholder Management

Answer 27

1. Operational Efficiency: Clear understanding of responsibilities and reporting structures for all employees

• Improved efficiency when combined with strong internal control mechanisms

2. Improved Control: Helps manage risk efficiently at all levels

Enhanced through:
a) Good audit committee
b) Compliance with laws and regulations
c) Procedures for handling related-party transactions

3. Better Operating & Financial Performance Improvements through:
   - Proper management remuneration
   - Mitigation of lawsuits against the company
   - Enhanced decision-making for investments
4. Lower Default Risk & Cost of Debt

Achieved by:
1. Protecting creditors’ rights
2. Ensuring proper audits
3. Minimizing information gaps between company and creditors

Question 28

Which of the following statements is least accurate about agency costs?

A They include costs borne by creditors to monitor the management of the company.
B They include costs borne by management to assure owners that they are maximizing the company value.
C The better a company is governed, the lower the agency costs.

Answer 28

A is correct. Agency costs include costs borne by equity owners to monitor the management of the company, e.g., expenses of the annual report, board of director expenses, etc.

B and C are correct statements about agency costs.

Question 29

‘Growth for growth sake’ is most likely associated with which of the following:

A Empire building
B Entrenchment
C Excessive risk taking

Answer 29

A is correct. ‘Growth for growth sake’ is associated with ‘Empire Building’. This occurs when the manager/director compensation is tied to the size of the company resulting in managers pursuing acquisitions and expansions that do not increase shareholder value.

B is not correct. Entrenchment occurs if the overall level of manager/director compensation is excessive, they may try to avoid risk so as to not jeopardize the compensation they have been receiving.

C is not correct. Excessive risk taking by management is likely if the compensation package relies too heavily on stock grants/options. Similarly, a compensation package with too little or no stock grants/options can have the opposite effect.

Question 30

A controlling shareholder of Acme Corporation owns 65% of Acme’s shares, and the remaining shares are spread among a large group of shareholders. In this situation, conflicts of interest are most likely to arise between:

A the controlling shareholder and minority shareholders.
B shareholders and bondholders.
C the controlling shareholder and managers.

Answer 30

A is correct. In this shareholding structure, conflicts of interest may arise between controlling shareholders and minority shareholders.

The controlling shareholder may be able to exploit its position to the detriment of the interests of the remaining shareholders.

Question 30

LO. Describe the principal
agent relationship and conflicts that may arise between stakeholder groups

Answer 30

A principal agent relationship arises when a principal hires an agent to carry out a task or a service.

An agent is obliged to act in the best interests of the principal and should not have a conflict of interest in performing a task.

However, such relationships often lead to conflicts among stakeholders in a corporate structure.

Examples of relationships that lead to such conflicts include:
* shareholder and manager/director.
* controlling and minority shareholder.
* shareholder and creditor

Question 31

LO. Describe corporate governance and mechanisms to manage stakeholder relationships and mitigate associated risks

Answer 31

Corporate governance can be defined as the arrangement of checks, balances, and incentives that exists to manage conflicting interests among a company’s management, board, shareholders, creditors, and other stakeholders.

Mechanisms to mitigate shareholder risks include company reporting and transparency, general meetings, investor activism, derivative lawsuits, and corporate takeovers.

Mechanisms to mitigate creditor risks include bond indenture(s), company reporting and transparency, and committee participation.

Mechanisms to mitigate board risks include board/management meetings and board committees.

Mechanisms to mitigate risks for other stakeholder (employees, customers, suppliers, and regulators) include policies, laws, regulations, and codes

Question 32

LO. Describe potential risks of poor corporate governance and stakeholder management and benefits of effective corporate governance and stakeholder management

Answer 32

The risks of poor corporate governance include weak control systems; ineffective decision making; legal, regulatory, and reputational risks; and default and bankruptcy risks.

Benefits include operational efficiency, improved control, better operating and financial performance, and lower default risk and cost of debt.

Question 33

Which of the statements about extraordinary general meetings (EGMs) of shareholders is true?

A These are usually held once a year.
B A resolution regarding an acquisition will most likely be passed at the EGM.
C Approval of annual financial statements takes place during an EGM.

Answer 33

B is correct. EGMs are called when a major resolution has to be passed such as an amendment to a company’s bylaws, mergers or acquisitions, or the sale of businesses.

A is not correct because EGMs can be called anytime during the year, either by the company or shareholders.

C is not correct because annual financial statements are presented for approval at the annual general meeting (AGM).

Question 34

Which of the following is least likely a tool used by creditors to protect their economic interests?

A Proxy voting
B Indenture
C Corporate reporting and transparency

Answer 34

A is correct. Proxy voting is a mechanism used by shareholders to protect their ownership interest and control in the company. It allows shareholders to authorize another individual to vote on their behalf at the AGM.

William Ackman of Pershing Square had a Proxy Voting fight w Target Corp. Can be done in conjunction with Tender Offer (offering premium to buy shares of company).

B and C are not correct because they are mechanisms used by creditors to protect their economic interest in the company.

A bond indenture is a legal contract that describes the structure of a bond, the obligations of the company, and the rights of the bondholders.

Creditors require the company to provide periodic financial information to monitor the risk exposure and to ensure covenants are not violated.

Question 35

Overseeing performance policy management and evaluation is most likely the responsibility of:

A Governance Committee
B Remuneration Committee
C Nominations Committee

Answer 35

B is correct. It is the responsibility of Remuneration Committee which is also responsible for the following:

1. developing director and executive remuneration policies,
2. overseeing performance policy management and evaluation, and
3. setting human resources (HR) policies relating to employee compensation.

A is not correct because the key functions of the governance committee include:

1. developing and monitoring corporate governance policies and practices,
2. ensuring organizational compliance and remediation with applicable laws and regulations, and
3. aligning organizational structure with governance principles.

C is not because the key functions of the nomination committee include:

1. overseeing the director nomination and board election process,
2. identifying senior leadership candidates, and maintaining board composition and independence.

Question 36

When managers have access to more information than board members/shareholders, they are most likely to make decisions that benefit:

A the shareholders.
B themselves.
C the creditors.

Answer 36

B is correct. When more information is available to managers as compared to the board/shareholders, they have an opportunity to make decisions that benefit themselves relative to the company or shareholders.

This could result in poor decision making on the part of managers including avoiding good investment opportunities to maintain a low-risk profile or taking on excessive risk without properly evaluating potential investments. Both decisions are not in the interests of shareholders.

Question 37

Which of the following is least accurate about good governance practices?

A Good governance implies improved control at senior management levels only.
B Control can be improved by introducing procedures to handle related-party transactions.
C Proper remuneration for management can help in improving the performance of a company.

Answer 37

A is correct. Good governance implies improved control at all levels to help a company manage its risk efficiently.

B and C are correct statements about good governance practices

Question 38

Poor governance structures with weak controls can affect a company’s:

A cost of debt.
B value.
C both A) and B).

Answer 38

C is correct. Weak control systems and poor monitoring can affect a company’s performance and value.

Furthermore, poor governance structures can increase the likelihood of downgrading a company’s credit rating from investment grade to speculative, resulting in a significant increase in the cost of debt.