Corporate Finance #27 - Corporate Governance

Question 1

Describe the two major objectives of corporate governance

Answer 1

LOS 27.a

1. Eliminate or reduce conflicts of interest.
2. Use company assets in a manner consistent with the best interests of investors and other stakeholders.

Question 2

List core attributes of an effective corporate governance system

Answer 2

LOS 27.a

• Define right of shareholders and other important stakeholders
• Define and communicate to stakeholders the oversight responsibilities of managers and directors
• Provide clear and measurable accountability for managers and directorts in assuming their responsibilities
• Provide fair and equitable treatment in all dealings between managers, directors, and shareholders
• Have complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position

Question 3

Conflicts of interest associated with major business forms (structures)

Answer 3

LOS 27.b

• sole proprietorship - unlimited owner liability
  conflicts with creditors and suppliers
• partnership - unlimited but shared liability
  conflicts with creditors, suppliers, between partners (addressed through partnership contracts)
• corporations - separarate legal entity; corp shareholders have limited liability
  conflicts separation of ownership and control create principle-agent problems

Question 4

Explain the two primary principal-agent problems concerning corporate governance systems and describe examples of primcipal-agent risks.

Answer 4

LOS 27.c

• managers and shareholders - managers (agents) are trustees of capital belonging to shareholders (principals), who rely on managers to use it effectively to generate profits. Examples of risks:
  
  • using funds to expand firm size
  • granting excessive compensation and perks
  • investing in risky ventures
  • not taking enough risk
• board of directors and shareholders - BoD (agents) serve as intermediary between shareholders (principals) and management to ensure mgmt acts in shareholders’ best interests. Examples of risks:
  
  • lack of independence
  • personal relationships between BoD and managers
  • business relationships between BoD and the firm
  • cross-linked BoD between two firms
  • overcompensated BoD members

Question 5

Explain responsibilities, qualifications, and core competencies of board of directors

Answer 5

LOS 27.d

• institute corp values & governance mechanisms
• ensure compliance with all legal and regulatory requirements
• create long-term strategic objectives
• determine management’s responsibilities and how they will be held accountable
• hire, compensate, and regularly evaluate CEO
• require management to provide BoD with complete and accurate company information for decisionmaking and monitoring
• meet regularly
• ensure BoD memebers are adequately trained

Question 6

List corporate governance best practices

Answer 6

LOS 27.e

• 75% independent board members
• CEO and Chairman are separate positions
• BoD is knowledgeable/exerienced; serve only on 2 or 3 boards.
• annual, unstaggered elections
• evaluate/assess board annually
• BoD meets annually without management
• independent directors with finance experience serving on audit committee; meet auditors annually
• independent directors serving on BoD/senior management nominating committee
• most senior management’s pay tied to performance
• BoD uses independent outside (not internal) when legal counsel is required
• BoD approves all insider or related-party transactions
• Senior management responds promptly to shareholder proxy matters

Question 7

Describe elements of a company’s statement of corporate governance policies that investment analysts should assess

Answer 7

LOS 27.f

• code of ethics
• BoD oversight, monitoring, and review responsibilities
• management’s responsibilitiy to the BoD
• reports of BoD’s oversight/review of management
• BoD self-assessments
• management performance assessments
• DoB memeber training

Question 8

Describe the three additional nontraditional business long-term risk factors

Answer 8

LOS 27.g

1. environmental risk (e.g. pollution emissions)
2. social risk (e.g. labor rights, occupational safety)
3. governance risk - effectiveness of the firm’s governance structure

Question 9

List the risk categories of ESG factors

Answer 9

LOS 27.g

• legislative and regulatory (e.g. new emissions standards)
• legal (lawsuits from not dealing with ESG factors adeqautely)
• reputational (e.g. past disregard for ESG factors)
• operating (operational impact from ESG factor e.g. banning freon as refrigerant)
• financial (risk of monetary costs due to ESG factors)

Question 10

Company valuation impact of strong and weak corporate governance systems

Answer 10

LOS 27.h

Strong - increases profitability and returns to shareholders

Weak - decreases valuation by increasing risks, such as:

• financial disclosure risk - incomplete, misleading, misstated
• asset risk - inapprpriate uses of company assets (e.g. management perks, excessive compensation)
• liability risk - entering into off-balance-sheet obligations
• strategic policy risk - transactions that benefiy managers but not shareholders (e.g. “empire building”)