Corporate Governance and ACE- Q3

Question 1

Give a neutral definition of corporate governance

Answer 1

corporate governance deals with conflicts of interests
between: the providers of finance and the managers; different types of shareholders (mainly the large shareholder and the minority shareholders); the shareholders and the stakeholders;
and the prevention or mitigation of these conflicts of
interests

Question 2

Detail the principle agent problem

Answer 2

The agent has been asked by the principal to carry out a
specific duty. However, the agent may not act in the best interest of the principal once the contract has been signed.
The agent may rather prefer to act in his own interest, Economists call this moral hazard
One way of addressing principal–agent problems is via so
called complete contracts

Question 3

what factors contribute to agency costs in the principle - agent problem

Answer 3

the monitoring expenses incurred by the principal;
the bonding (alignment) costs accruing to the agents;
any residual loss, loss in value for the principal

Question 4

What are the Agency costs of equity (in general)

Answer 4

conflicts between shareholders (principal) and
managers (agent).
conflicts between large shareholders ( agent) and
minority shareholders ( principal)

Question 5

What are the Agency costs of debt

Answer 5

conflicts between shareholders (i.e., agent) and a specific
stakeholder, bondholders (i.e., principal)

Question 6

The three main types of agency problems in the conflicts
between shareholders and managers are
Agency cost of equity

Answer 6

perquisites
empire building
managerial entrenchment and risk-aversion

Question 7

What are perquisites
ACE

Answer 7

Perquisites or perks consist of on-the-job consumption by the managers
E.g. The chairman using the private jet for £1 per month

Question 8

What is empire building and the problems associated with it
ACE

Answer 8

Empire building consists of managers pursuing growth
rather than shareholder-value maximisation.
While there is a link between the two, growth does not
necessarily generate shareholder value and vice-versa.
Empire building is also referred to as Jensen’s free cash
flow problem (1986): managers investing beyond the positive Net Present Value threshold

Question 9

Why do Managers empire build
ACE

Answer 9

Benefits from increasing the size of the firm are: increased power and social status, larger remuneration, more visibility

Question 10

What is Managerial entrenchment
ACE

Answer 10

Managers shield themselves from hostile takeovers and
internal disciplinary actions (e.g. poison pills, staggered boards,
golden parachutes).

Question 11

What is Managerial risk aversion
ACE

Answer 11

They tend to prefer the quite life.
Managers tend to make inefficient investment decisions: reject positive NPV projects with high risk.
Well-diversified shareholders’ interests: invest in risky
projects so long as they increase the equity value.
Invest in all positive NPV projects.

Question 12

The main types of agency problems in the conflicts
between large shareholders and minority shareholders are
related to expropriation through:
ACE

Answer 12

tunnelling;
transfer pricing;
nepotism;
infighting

Question 13

What is tunnelling
ACE

Answer 13

Tunnelling consists of the large shareholder transferring
the firm’s assets or profits into his own pockets

Question 14

What is Nepotism
ACE

Answer 14

Nepotism consists of the large family shareholder
appointing family members to top management positions
rather than the most suitable candidates on the job market

Question 15

What is Infighting
ACE

Answer 15

Infighting may not necessarily be a wilful form of
expropriating the firm’s minority shareholders, but
nevertheless is likely to deflect management time as well
as other firm resources

Question 16

Describe Transfer pricing
ACE

Answer 16

Moving money out of one firm to another

Question 17

5 solutions to agency cost of equity

Answer 17

Bonding solutions
Monitoring solutions
Alignment solutions & compensation policies
Regulation
The market for corporate control

Question 18

Solutions to agency cost of equity:
What is Bonding

Answer 18

Managers sign complete contracts indicating that they will
always take actions to maximise shareholder’s wealth.
Such contracts must specify:
What managers must do in each state of the world
How profits are distributed in each state

Question 19

Solutions to agency cost of equity:
Limitations of Bonding

Answer 19

Difficult to write a complete contract
Impossible to know all possible states in advance
(unobservable or costly observable outcome)
Difficult for shareholders to verify managers’ action or
know whether the action will be value-maximising
Impossible to reinforce by outsiders such as a court of law

Question 20

Solutions to agency cost of equity:
What is Monitoring

Answer 20

Shareholder activism: effective mechanisms must be
in place to represent credible threats to the management
In a company with very diluted shares there is very little monitoring incentive (free rider problem due to passive investors)

Question 21

Solutions to agency cost of equity:
Limitations of Monitoring

Answer 21

Limitations to being effective monitors in the “outsider”
system:
High (fixed) costs of monitoring.
Lack of expertise.
Lack of incentives due to portfolio diversification.
The free-rider problem.

Question 22

Detail The efficient monitoring hypothesis and the methods of intervention

Answer 22

Institutional investors have the expertise required to effectively control managers
Successful by Chen, Harford, and Li (2007)
Methods of intervention:
Refuse to partake in rights issues when firms raise
additional equity.
Adverse public comments.
Exercise their right to vote at an AGM
Proxy contests
Threat of dumping shares

Question 23

Limitations of Institutional investors

Answer 23

Passivism
Costs outweigh benefits: especially for (well-diversified) Investors with relatively small holdings of the firm
Free-rider problem
Myopic behaviour and short-termism
Conflicts of interests (Pound, 1988):
due to current or potential relationships with the firm.
Investors are subsidiaries of investment banks who wish to act as an advisor.

Question 24

Role of the board of directors with regards to monitoring

Answer 24

Firms are generally required by law to have a board of
directors, who is charged with representing shareholders’ interests.
BoD are responsible for:
Hiring, compensating and firing top management.
Voting on major operating proposals and financial decisions.
Evaluating management and offering expert advice to
them.
Ensuring accurate corporate disclosures to outsiders. Audit
committee: overseeing financial reporting and disclosure.

Question 25

Limitations of NEDs

Answer 25

Lack of sufficient financial incentives (lack of ownership
holdings) to be concerned about firm value (Hart, 1995).
Relative lack of expertise (Jensen, 1993).
Busy, part-time NEDs: participate in several boards at the
same time, dividing their attention (multiple directorships).
Interlocked directorships

Question 26

Solutions to agency cost of equity:
What is Alignment: Managerial ownership

Answer 26

The alignment effect: an increase in manager ownership aligns
managers’ interests with those of shareholders.
BUT
The entrenchment effect: MO may lead to entrenchment:
it reduces monitoring by shareholders.
It lowers the threat of takeover and managerial discipline

Question 27

Limitations of performance based compensation

Answer 27

options vs equity
equity provides long run incentives
equity always has value whereas options must be in the money meaning
Managers may have an incentive to undertake riskier
projects which may increase the likelihood of the option
being in the money

Question 28

Explain the conflict between shareholders and managers

Answer 28

This is an agency cost of equity
Managers have the expertise to run the firm, but not the funds to finance it
Shareholders have the funds, but not the skills to run the firm.
Control lies with the managers who run the day-to-day operations of the firm whereas shareholders own the firm.
Typical when we have dispersed ownership with multitude of
atomistic shareholders ( Profit Maximisation focused)

Question 29

Explain the conflicts between large shareholders and minority
shareholders

Answer 29

This is an agency cost of equity
Large shareholders have the ownership and the control to run the company, minority shareholders don’t have a say on the day-to-day operations of the firm.
Typical when we have concentrated control and complex ownership structures

Question 30

Example of managerial entrenchment in worldcom

Answer 30

Board members serving for more than 5 years (long tenure)
Bribing directors with retention fees
Ebbers was both CEO and chairman, the chairman is meant to be the head of the non executive group and therefore monitors of managerial actions
audit and compensation committee not meeting often

Question 31

Board structure recommendations

Answer 31

Board should be made of 8-12 members that meet at least 10 times per year
Meetings should be led by the chairman
Director training required on an annual basis
appoint 1 new director per year
CEO cant work at another firm
Other board members cannot work for more than 3 companies
These are similar to Cadbury report 1992 (first corporate governance code) and Combined code 2012 (code we have now for publicly listed firms)

Question 32

When is empire building likely to occur, and in what ways to managers empire build

Answer 32

Like in the worldcom example, due to fraudulent accounting:
Excess free cash flow can lead to empire building.
possibilities are to accumulate cash, pay dividends, or to do M&A when they are not value enhancing ( growth not value) = conflict

Question 33

Pros and cons of multiple directorship

Answer 33

Stronger business relations with some other companies where the CEO is director
Learning different management styles or strategies used at other firms

inability to spend the required amount of time in ‘worldcom’
has mixed results

Question 34

Audit committee structure recommendations

Answer 34

At least 3 independent directors that meet the “financial expert requirements set by SOX 2002”
attend training annually
meet at least 8 times per year

Question 35

Compensation committee structure recommendations

Answer 35

At least 3 independent directors
proficient in HR and compensation
meet at least 4 times per year