Corporate Governance

Question 1

Define Corporate Governance

Answer 1

Mechanisms used to manage relationships among a firm and its stakeholders.

Question 2

List the mechanism of Corporate Governance

Answer 2

1. Ownership concentration
2. Shareholder Activism
3. Boards of Directors
4. Executive Compensation
5. Market for Corporate Control

Question 3

List the advantages of corporate governance

Answer 3

1. Determines and monitors the strategic direction and performance of the firm.
2. Improve the quality of strategic decisions.
3. Establishes congruence between the goals of management and those of other stakeholders.
4. Divides firm value among stakeholders.

Question 4

List Relevant stakeholder groups

Answer 4

1. Capital Market
2. Product Market
3. Organizational

Question 5

How is separation of ownership and managerial control implemented?

Answer 5

The shareholders are principals who hire managers as agents to make decisions that direct the organization.

Question 6

List the roles of ownership and managers in the modern corporation

Answer 6

Shareholders purchase stock, becoming residual claimants of the firm’s assets and earnings.

Managers are supposed to act in the interests of shareholders

Question 7

List ways separation of control can lead to efficient specialization of tasks

Answer 7

1. As a firm grows, founders may be incapable of meeting all of the firms’ needs.
2. Risk bearing by shareholders who provide capital and reduce their risk by holding diversified portfolios.
3. Wages secure specialized labor and decision-making by professional workers and managers.

Question 8

List Agency Relationship Problems

Answer 8

1. Principals (shareholders) and Agents (managers) have divergent interests and goals.
2. Dispersed shareholding makes is difficult and inefficient to monitor management’s behavior.
3. Principals establish governance mechanisms to prevent agent opportunism.

Question 9

Define Opportunism

Answer 9

The seeking of self-interest with guile (e.g., deceit) and/or malicious intent.

1. Principals do not know beforehand who will act opportunistically
2. Monitoring and its negative side effects destroy value
3. Principals may try to achieve alignment between their interests and those of agents.

Question 10

Define Ownership Concentration

Answer 10

Fewer entities own larger portions of firms.
Large Block Shareholders (beneficial owners) own at least 5% of the firm (institutional owners or individuals).

Question 11

How can ownership concentration impact corporate governance of the firm?

Answer 11

Can improve corporate governance because entities that own more shares have more incentives to monitor management closely, and have more influence and ability to enforce their demands (voting rights, sales of large amount of shares hurt share price).

Question 12

Some owners focus on their own interests rather than the interests of shareholders at large.

Answer 12

True

Question 13

Define Shareholder Activism

Answer 13

Owners organize to force changes in firm behavior or policies (lawsuits, proxy fights, formal proposals for managers and the board to consider). Can include replacement or addition of board members, and focus on interests of stakeholders as well as shareholders.

Question 14

List Barriers to Effective Shareholder Activism

Answer 14

1. Some shareholders lack incentives to monitor firms.
2. Shareholders may disagree with one another.
3. It can be difficult to organize shareholders.
4. A single block shareholder may have more votes than many smaller shareholders.
5. Staggered boards: some firms have rules that can limit the portion of board members that can be replaced each year.

Question 15

What is the board of directors?

Answer 15

Individuals chosen to act as agents for the shareholders. Offer counsel, legitimacy, resources, and monitoring. May have subcommittees that determine executive compensation, audit the firm’s finances, etc.

Question 16

List the 3 types of board members

Answer 16

1. Insiders (high level managers)
2. Related Outsiders (non-employees with relationships with the firm)
3. Outsiders (entities lacking direct ties to the firm)

Question 17

List ways to enhance board effectiveness

Answer 17

1. More diversity among members
2. Control systems and board performance evaluation
3. Tying director compensation to firm performance
4. Balancing types of board members: outsiders (insiders) might be more (less) independent but might have less (more) knowledge of the firm.
5. Lead directors: duties include organizing the board, collecting needed information, promoting accountability, and convening meetings without the CEO present; not the same as the Chair of the Board.

Question 18

Define Executive Compensation

Answer 18

Salary, bonuses, stock, stock options, and non-monetary compensation.

Question 19

Define incentive pay

Answer 19

Meant to tie executive compensation to outcomes that are valued by the shareholders (like stock options). The bulk of compensation in most publicly- traded firms.

Question 20

List factors complicating executive compensation

Answer 20

1. Executive decisions are complex, affect firms over an extended period, and are not the only factors that affect firm performance.
2. Executives may demand more fixed compensation (e.g., salaries) to offset more at-risk compensation (e.g., incentive pay).

Question 21

List Limits on the effectiveness of executive compensation

Answer 21

1. Unintended consequences (e.g., risk aversion vs. risk seeking, short-term vs. long-term focus, unethical conduct, etc.).
2. Re-pricing and re-issuing compensation over time.
   Firm size, not firm performance, is the best predictor of executive compensation.
3. Incentive pay can produce large payouts, even when firm performance was not due to executives’ decisions (e.g., was due to economic factors).

Question 22

Define Market for Corporate Control

Answer 22

External organizations purchase control of undervalued corporations (Poor performance can make a firm an acquisition target,
Executives in the acquired firms often are replaced.)

Question 23

The threat of takeover may encourage firms to operate more effectively and efficiently.

Answer 23

True

Question 24

Regulations can thwart the market for corporate control by prohibiting certain acquisitions or making them more difficult.

Answer 24

True

Question 25

What are managerial defense mechanisms?

Answer 25

Actions or policies that reduce firms’ attractiveness as hostile takeover targets.

Question 26

List some managerial defense mechanisms

Answer 26

1. Gold parachutes (contractual severance pay for dismissed executives).
2. Poison pills (e.g., repeatedly issuing additional shares, effectively preventing the acquiror from purchasing a majority of the shares).
3. Acquiring other firms or taking on debt to reduce the firm’s attractiveness as a takeover target.

Question 27

Generally, the market for corporate control lacks the precision of the other governance mechanisms.

Answer 27

True