Reading 27: Introduction to Corporate Governance

Compared to civil law systems, common law systems most likely provide stronger protections for the interests of: A. both shareholders and creditors. B. shareholders and weaker protections for the interests of creditors. C. creditors and weaker protections for the interests of shareholders.

A. The interests of shareholders typically receive stronger protections in countries with legal systems based on the common law tradition. In such jurisdictions, judges have a greater ability to interpret laws in a manner that is beneficial to providers of all types of capital. By contrast, civil law systems require judges to strictly apply laws, allowing management to take any action that is not specifically prohibited by legislation.

A credit committee formed in the aftermath of a bankruptcy most likely represents the interests of: A. borrowers. B. employees. C. unsecured creditors.

C. In certain jurisdictions, credit committees are formed to represent the interests of lenders, particularly unsecured creditors, during the bankruptcy process.

Which of the following is least likely to be included among the core objectives of corporate governance? A. Managing incentives B. Creating checks and balances C. Minimizing conflict between shareholders and directors

C. The core of corporate governance is managing incentives and creating a system of checks and balances for the purpose of minimizing and managing conflicts and potential conflicts between insiders and shareholders. Directors are the elected representatives of shareholders. In theory, their interests should be aligned.

Universal owners are most accurately described as: A. activist investors. B. thematic investors. C. long-term investors.

C. Universal owners (e.g., pension funds) have large, globally diversified portfolios. They have sustainable growth and the long-term health of the overall economy.

A company has consistently and significantly increased its cash balance over the past three years. The least likely explanation for the increase in cash is a: A. forthcoming issue of new equity. B. potential acquisition. C. planned increase in the dividend.

A. A is correct. A new equity issue will provide additional cash, so it does not explain an increase in cash holdings prior to the issue. B is incorrect. A company might increase its cash to build a "war chest" in order to make an acquisition. C is incorrect. A company might increase its cash to pay a larger dividend.

Under the stakeholder theory, corporate governance is most consistent with a system of: A. internal controls and procedures by which individual companies are managed. B. defined roles for management and the majority shareowner(s). C. checks and balances to minimize the conflicting interests among shareowners.

A. A is correct. Corporate governance is the system of internal controls and procedures by which individual companies are managed. B is incorrect. The majority shareholder doesn't necessarily have a specific role that is defined through corporate governance. Instead, the majority shareholder exercises influence and/or control through voting mechanisms tied to their shareholdings. C is incorrect. Corporate governance is primarily aimed at managing the conflicting interests between management and external shareholders, not amongst shareholders.

Green finance is most likely an example of which ESG-related investment approach? A. Impact investing B. Negative screening C. Values-based investing

A. A is correct. Green finance is an example of impact investing, which seeks to achieve targeted social or environmental objectives by direct investment in projects or companies. Values-based investing is used to express the moral or ethical beliefs of the investor. Negative screening refers to the practice of excluding certain sectors or companies that deviate from acceptable standards. B is incorrect. Negative screening refers to the practice of excluding certain sectors or companies that deviate from acceptable standards. C is incorrect. Values-based investing is used to express the moral or ethical beliefs of the investor.

Which is least likely an example of a principal-agency conflict? A. Management agreeing to a takeover by a third party at a premium B. Management entering a related-party transaction with a key supplier C. Impact on minority shareholders of a company adopting straight voting

A. A is correct. Management agreeing to a takeover by a third party at a significant premium is not likely an indication of a principal-agency conflict. Because the takeover is by a third party at a significant premium, this is a benefit to shareholders. Although management may also benefit, it is not an example of an agency conflict. Straight voting means one share, one vote, which leaves minority shareholders with much less representation and can be an example of an agency conflict. Management entering into a related-party transaction is an example of a conflict; because of the nature of the relationship with the supplier, it may not be in the best interests of shareholders. B is incorrect. Management entering into a related-party transaction is an example of a conflict; because of the nature of the relationship with the supplier, it may not be in the best interests of shareholders.

Which of the following statements regarding ESG investment approaches is most accurate? A. Negative screening is the most commonly applied method. B. Thematic investing considers multiple factors. C. Positive screening excludes industries with unfavorable ESG aspects.

A. A is correct. Negative screening, which refers to the practice of excluding certain sectors, companies, or practices that violate accepted standards in such areas as human rights or environmental concerns, is the most common ESG investment approach.

Which of the following statements about non-market factors in corporate governance is most accurate? A. Stakeholders can spread information quickly and shape public opinion. B. A civil law system offers better protection of shareholder interests than does a common law system. C. Vendors providing corporate governance services have limited influence on corporate governance practices.

A. A is correct. Social media has become a powerful tool for stakeholders to instantly broadcast information with little cost or effort and to compete with company management in influencing public sentiment.

Which of the following is least likely to be of concern to value-based ESG investors? A. Avoidance of companies that conflict with moral values B. Reduction in risks associated with increased litigation costs C. Increase in risk-adjusted returns through ESG factor ranking

A. A is correct. The objective of a value-based ESG approach is to mitigate risks and identify opportunities by analyzing ESG considerations in addition to traditional finance metrics. Avoidance of companies that conflict with moral or ethical values reflects a value-based approach. B and C are incorrect. The objective of a value-based ESG approach is to mitigate risks and identify opportunities by analyzing ESG considerations in addition to traditional finance metrics.

The primary motivation of activist shareholders is to promote: A. improved shareholder value. B. environmentally sustainable business practices. C. consideration of human rights in employee relations.

A. A is correct. The primary motivation of activist shareholders is to increase shareholder value. If they feel management or the board has failed to act in the best interests of shareholders, they may attempt to force changes by gaining control of the board. B is incorrect. This is more likely to be a goal of ESG investors with an investment mandate focused on environmental factors. C is incorrect. This is more likely to be a goal of ESG investors with an investing mandate focused on social factors.

Based on best practices in corporate governance procedures, it is most appropriate for a company's compensation committee to: A. link compensation with long-term objectives. B. include a retired executive from the firm. C. include a representative from the firm's external auditor.

A. A is correct. Under appropriate corporate governance procedures, the compensation committee should link compensation with long-term objectives. B is incorrect because the committee should be composed of independent members only. Good corporate governance procedures would require that executive (internal) directors not rule on matters underlying conflicts of interest or on matters requiring an unbiased judgment (such as audit, remuneration, or related-party transaction matters). Retired executives and external auditors are not independent and should not be a part of the compensation committee. C is incorrect because the committee should be composed of independent board members only. Good corporate governance procedures would require that executive (internal) directors not rule on matters underlying conflicts of interest or on matters requiring an unbiased judgment (such as audit, remuneration, or related-party transaction matters). Retired executives and external auditors are not independent and should not be a part of the compensation committee.

Based on good corporate governance practices, it is most appropriate for a company's compensation committee to: A. develop director remuneration policies. B. recommend remuneration for the external auditors. C. include some external directors.

A. A is correct. Under good corporate governance practices the compensation committee develops remuneration policies for directors as well as key executives. The audit committee, not the compensation committee, would be involved in the remuneration of the external auditors. C is incorrect. The committee should be composed of independent (non-executive) members only. B is incorrect. The audit committee is responsible for proposing the external auditor's remuneration.

Which of the following scenarios can best be described as offering superior protection of shareholder interests? A. When common law is practiced B. When CEO duality is common C. When stakeholder theory prevails

A. A is correct. Unlike civil law systems, common law systems provide judges with the ability to create law by setting precedents that are followed in subsequent cases. Shareholders are viewed as better protected under common law because judges may rule against management actions in situations that are not specifically addressed by statutes. B is incorrect. Under CEO duality, the CEO also serves as chairperson of the board. All else equal, this decreases the protection of shareholder interests in favor of those of management. C is incorrect. Stakeholder theory incorporates the interests of non-shareholders such as customers, suppliers, and employees. This inevitably dilutes the focus on shareholders.

A board of directors that includes significant numbers of both executive and non-executive members is most accurately described as having a: A. one-tier structure. B. supervisory board. C. dual-class structure.

A. A one-tier board is likely to include significant representation of both executive (internal) and non-executive (external) directors. By contrast, the supervisory board in a two-tier structure includes few, if any, executive directors. A dual-class structure refers to a capital structure with more than one class of equity shares. In such a structure, certain classes of shares have greater voting rights.

Which of the following statements about two-tier boards is most accurate? A. A two-tier board structure is actually two separate boards B. A two-tier board structure includes equal numbers of executive and non-executive directors C. In a two-tier board, one tier of directors is elected by shareholders and the other tier is appointed by management

A. A one-tier structure has both executive and non-executive directors. "Non-executive" typically means external directors. A two-tier structure has a supervisory board, which contains mostly non-executive directors, and a management board, which contains executive directors.

Which of the following statements is most accurate? The OECD's Principles of Corporate Governance framework: A. is consistent with stakeholder theory. B. provided the foundation for the Cadbury Report. C. defines corporate governance more narrowly than the Cadbury Report.

A. The 1991 Cadbury Report defined corporate governance as a system of rules used to manage the relationships between directors, shareholders, and managers. This interpretation of corporate governance is more consistent with shareholder theory. The OECD's Principles of Corporate Governance, written in 1999, broadened the definition of corporate governance to include the interests of other stakeholders, such as employees, creditors, and suppliers.

Recent trends in corporate governance most likely include: A. focusing on the corporate governance system's responsibility to maximize shareholder value. B. expanding the scope to consider the interests of employees, customers, and suppliers. C. increasing the diversity of corporate governance systems tailored to specific jurisdictions.

B. B is correct. A significant majority of OECD member countries have ratified the influential "Principles of Corporate Governance." Most recently updated in 2015, the principles call for an expanded scope of stakeholders to be considered as part of a prudent corporate governance system. Regulators and practitioners have responded by moving toward a more effective balance of stakeholder interests. A is incorrect. There has been a move away from the narrower focus of shareholder theory toward the broader stakeholder theory. C is incorrect. The trend is toward global convergence of corporate governance systems.

A credit analyst is most likely to place more focus on: A. operating leverage than financial leverage. B. cash flows than accrual income. C. upside potential than downside risk.

B. B is correct. Credit analysts are particularly focused on assessing debt-paying ability, which is generated from cash flows and not from accrual-based measures, such as net income. The return to debtholders is limited by contract, so upside potential is less important than concern for loss. Financial leverage is a major concern for credit analysts because it is associated with a greater chance of default. Operating leverage, which measures the volatility of operating income as a result of fixed costs, is a lesser concern. A is incorrect. Credit analysts are more concerned with financial leverage because higher financial leverage is associated with higher levels of default. C is incorrect. Debt providers are more concerned with downside risk because they are entitled only to contractual cash flows. Additional upside potential does not result in additional return.

Which of the following conditions is most likely to facilitate shareholder activism? A. Cross-shareholdings B. Cumulative voting C. Staggered boards

B. B is correct. Cumulative voting facilitates shareholder activism by allowing shareholders to accumulate and vote all their shares for a single candidate in an election involving more than one candidate. Minority shareholders, who may be activist shareholders, are more likely to successfully elect a board member in this way. A is incorrect. Cross-shareholdings inhibit shareholder activism because the management teams of the cross-held companies implicitly agree to use their votes to support each other's interests. C is incorrect. Staggered boards inhibit shareholder activism by limiting the number of board members that are elected in a given year. This makes it difficult to implement immediate change.

In countries where employee representatives commonly sit on supervisory boards, the employee representatives are most likely: A. appointed by the CEO. B. elected by employees. C. members of the management board.

B. B is correct. Employee representatives on supervisory boards are typically elected by the employees. A is incorrect. Employee representatives are typically elected by the employees. C is incorrect. Employee representatives are usually part of the supervisory board, not the management board.

Which of the following statements regarding stakeholder management is most accurate? A. Company management ensures compliance with all applicable laws and regulations. B. Directors are excluded from voting on transactions in which they hold material interest. C. The use of variable incentive plans in executive remuneration is decreasing.

B. B is correct. Often, policies on related-party transactions require that such transactions or matters be voted on by the board (or shareholders), excluding the director holding the interest.

A mining company has received government approval for the development of a mining property and has also consulted with members of the local community near the development site throughout the project assessment process. The latter action is best described as an example of: A. principal-agent conflict mitigation. B. stakeholder management. C. regulatory compliance.

B. B is correct. Stakeholder theory broadens a company's focus beyond the interests of only its shareholders to those of its customers, suppliers, employees, and others who have an interest in the company. The local community is likely a stakeholder in the company's development plans. By identifying the community and understanding its interests, the company is engaging in stakeholder management. A is incorrect. The company has not hired the local community as an agent, and the local community has not hired the company as an agent, so any conflict that arises would not be considered principal-agent conflict. C is incorrect. Regulations do not necessarily require companies to consult with local communities. In this case, the consultations were taken in addition to meeting all the government/regulatory requirements.

Based on good corporate governance practices, independent board members most likely: A. are pre-approved by management before being nominated. B. have a "lead" director when the board chair is not independent. C. hold large equity positions but have never worked at the company.

B. B is correct. Under good corporate governance practices, independent board members should have a "lead" director when the board chair is not independent. A is incorrect. The Nomination Committee identifies qualified candidates for director positions, not management. C is incorrect. Board members with a large stake in the company are not independent because they have a material ownership relationship with it.

Pension fund managers who accept lower returns in pursuit of environmental, social, and governance (ESG) objectives are most likely at risk of violating their: A. duty of care. B. fiduciary duty. C. duty of loyalty.

B. Pension fund managers have a fiduciary duty to act exclusively in the interests of plan participants and beneficiaries. Accepting lower returns in pursuit of ESG objectives may constitute a violation of this duty. The duties of care and loyalty are long-established responsibilities for company directors.

Sell-out rights are most likely granted to protect the interests of: A. controlling shareholders seeking to prevent a hostile takeover. B. minority shareholders of firms that have been targeted for acquisition. C. minority shareholders if the controlling shareholder is seeking to make a dilutive acquisition.

B. Sell-out rights, which are required in European Union countries, grant minority shareholders who have opposed a proposed merger the right to force a bidder to buy their shares at a fair price when the acquisition is approved.

Greater use of social media in the investment community has most likely: A. reduced the need for corporate governance reforms. B. reduced the cost of monitoring company management. C. increased management's ability to influence public opinion relative to stakeholders.

B. Social media has made it easier for stakeholders to monitor management's activities. Stakeholders also have greater power to influence public opinion in a climate where management is increasingly aware of reputational risk. Governments have become more responsive to social media when adopting new corporate governance reforms.

Galambos Corporation had an average receivables collection period of 19 days in 2003. Galambos has stated that it wants to decrease its collection period in 2004 to match the industry average of 15 days. Credit sales in 2003 were $300 million, and analysts expect credit sales to increase to $400 million in 2004. To achieve the company's goal of decreasing the collection period, the change in the average accounts receivable balance from 2003 to 2004 that must occur is closest to: A. -$420,000. B. $420,000. C. $836,000.

C. C is correct. Accounts receivable turnover is equal to 365/19 (collection period in days) = 19.2 for 2003 and needs to equal 365/15 = 24.3 in 2004 for Galambos to meet its goal. Sales/turnover equals the accounts receivable balance. For 2003, $300,000,000/19.2 = $15,625,000, and for 2004, $400,000,000/24.3 = $16,460,905. The difference of $835,905 is the increase in receivables needed for Galambos to achieve its goal.

Which of the following is most consistent with good corporate governance practices? A. All stakeholders should have the right to participate in the governance of the firm. B. An audit committee that benefits from the direct guidance of management. C. Appropriate controls and procedures to effectively manage the firm should be in place.

C. C is correct. Effective corporate governance requires a system of appropriate controls and procedures to protect financial markets and investors. A is incorrect. Only shareholders have the right (not all stakeholders) to participate in the governance of the firm. B is incorrect. The audit and compensation committees are best structured with exclusively independent directors, and no management involvement.

The least likely reason investors incorporate environmental and societal factors into their investment analysis is to: A> improve investment performance. B. have a more comprehensive understanding of a company's risks. C. limit investments to those equities that are consistent with their moral or ethical values.

C. C is correct. Environmental, social, and governance investment analysis can be implemented across all asset classes and is not limited to equity investments. It is done to provide a more comprehensive understanding of a company's risks and improve investment performance. A is incorrect. ESG is done to improve investment performance. B is incorrect. ESG is done to provide a more comprehensive understanding of a company's risks.

A cell phone manufacturer has switched to high-margin premium-priced products with the most innovative features as part of its product differentiation strategy. Which of the following other changes is most consistent with this strategy? A. An increase in inventory levels B. A decrease in research and development expenditures C. An increase in advertising expenditures

C. C is correct. Expenditures on advertising and research are required to support a product differentiation strategy. The effect on inventory is uncertain. A is incorrect because it is uncertain what the impact on inventory would be. B is incorrect because R&D expenditures would be expected to increase.

Projecting profit margins into the future on the basis of past results would be most reliable when the company: A. is in the commodities business. B. operates in a single business segment. C. is a large, diversified company operating in mature industries.

C. C is correct. For a large, diversified company, margin changes in different business segments may offset each other. Furthermore, margins are most likely to be stable in mature industries.

A credit rating agency assesses a company's corporate governance structure as favorable to creditor rights. The most likely impact of this assessment on the company is a(n): A. increase in its risk of default. B. reduction in its financial performance. C. reduction in its cost of debt.

C. C is correct. Governance arrangements that help protect creditor rights can reduce a company's cost of debt and default risk. A is incorrect. Governance arrangements that help protect creditor rights can reduce a company's cost of debt and default risk. B is incorrect. Good corporate governance usually results in better (increased) financial performance, not decreased.

A company needs to nominate an independent director for its board of directors. The following candidates are being considered: A retired senior management official of the company A representative of a pension fund that owns 10% of the company's shares A former government employee who was involved in regulating the industry Based on good corporate governance practices, which candidate is the most appropriate nominee? A. The pension fund representative B. The retired senior management official C. The former government employee

C. C is correct. Independent directors must not have material relationships with the company with regard to employment, ownership, or remuneration. The former government employee best meets these criteria. B is incorrect. The retired senior management officer has been employed by the company and likely still receives remuneration from the company in the form of a pension. He may also be reluctant to be critical of his own prior decisions or those of his co-managers. A is incorrect. The pension fund has a material ownership relationship with the company, so its representative cannot be considered independent.

A company's management team is proposing to sell a major division because of low future growth prospects in that industry. To which committee of the board is the proposal most likely to be presented? A. Risk B. Audit C. Investment

C. C is correct. Management is most likely to present the proposed sale to the investment committee, whose main role is to review the viability of material investment opportunities proposed by management. A is incorrect. Assessing proposed investment or divestment opportunities is the primary role of the investment committee, not the risk committee. The risk committee assists the board in determining the risk policy, profile, and appetite of the company. B is incorrect. Assessing proposed investment or divestment opportunities is the primary role of the investment committee, not the audit committee.

Proponents of dual-class voting structures believe that the benefits to public shareholders most likely include: A. reducing conflicts of interest between management and those with economic interests. B. trading values that are typically at a slight premium to single-class peers. C. promoting company stability by insulating management from short-term investor pressures.

C. C is correct. Proponents of dual-class structures argue that management is better able to make long-term strategic investments that may have negative short-term implications when control is wielded by a small group of shareholders with superior voting rights. A is incorrect. Because of their reduced ability to influence management, shareholders with economic but not voting interest are more likely to view management's interests in conflict with their own. B is incorrect. Entities with multiple voting structures tend to trade at a discount to their peers, not a premium.

Which of the following is the best example of a good corporate governance practice? A. Independent board members are prior, but not current employees of the firm. B. Supervisory and management boards have overlapping membership. C. The chief executive position is separate from the chair position on the company's board.

C. C is correct. The CEO and board chair roles should be separated to prevent too much executive power. A is incorrect. Former employees are not independent board members. B is incorrect. Supervisory and management boards should be independent of each other.

Which of the following best allows a board of directors to act in the interest of the company and shareholders? A. Independent board members are selected from outside the industry. B. Internal directors provide monitoring of the firm's management. C. The board has the authority to select and terminate senior management.

C. C is correct. The board has a duty to make decisions in the best interest of the company and shareholders. It reviews management's performance in executing the strategy set by the board. In order to ensure strong execution of the strategy, the board must have the authority to select and terminate senior management. A is incorrect. At least some independent members should have industry expertise. B is incorrect. External directors should provide monitoring within the firm.

Which of the following is most likely associated with a strong corporate code of ethics? The code of ethics is: A. updated at least every 10 years. B. signed by employees on a voluntary basis. C. developed and its implementation overseen by the governance committee.

C. C is correct. The governance committee typically develops and oversees implementation of the company's code of ethics. A is incorrect. The code of ethics should be reviewed on a regular basis to incorporate relevant developments and new regulatory requirements. A review period of 10 years is too long. B is incorrect. Codes of ethics establish the company's values and standards of ethical behavior and must be followed.

Which of the following statements regarding corporate shareholders is most accurate? A. Cross-shareholdings help promote corporate mergers. B. Dual-class structures are used to align economic ownership with control. C. Affiliated shareholders can protect a company against hostile takeover bids.

C. C is correct. The presence of a sizable affiliated stockholder (such as an individual, family trust, endowment, or private equity fund) can shield a company from the effects of voting by outside shareholders.

Which of the following statements about environmental, social, and governance (ESG) in investment analysis is correct? A. ESG factors are strictly intangible in nature. B. ESG terminology is easily distinguishable among investors. C. Environmental and social factors have been adopted in investment analysis more slowly than governance factors.

C. C is correct. The risks of poor corporate governance have long been understood by analysts and shareholders. In contrast, the practice of considering environmental and social factors has been slower to take hold.

The growth of the corporate governance industry is most likely attributable to increased: A. use of related-party transactions. B. use of incentive-based compensation. C. proxy voting disclosure requirements.

C. In 2003, the US Securities and Exchange Commission began requiring US-based mutual funds to disclose their proxy voting records annually and adopt procedures to ensure that proxies were voted in the interest of their clients. These requirements spurred the growth of firms with the ability to monitor and evaluate proxy voting.

Ideally, executive remuneration packages should most likely: A. limit the volatility of total compensation. B. be aligned with the interests of creditors. C. be comparable with those offered by peer firms.

C. Remuneration plans should not provide excessive payouts compared to the packages offered by similar firms. However, limiting the volatility of total compensation will reduce the incentive for executives to deliver superior performance. Remuneration plans should create an alignment with the interests of shareholders, not creditors.