05/08/2023

CORPORATE ISSUERS
• READING 1: ORGANIZATIONAL FORMS, CORPORATE ISSUER FEATURES, AND OWNERSHIP
• READING 2: INVESTORS AND OTHER STAKEHOLDERS
• READING 3: CORPORATE GOVERNANCE: CONFLICTS, MECHANISMS, RISKS AND BENEFITS
• READING 4: WORKING CAPITAL AND LIQUIDITY
• READING 5: CAPITAL INVESTMENTS AND CAPITAL ALLOCATION
• READING 6: CAPITAL STRUCTURE
• READING 7: BUSINESS MODELS

READING 3
CORPORATE GOVERNANCE: CONFLICTS, MECHANISMS,
RISKS AND BENEFITS
• MODULE 3.1: STAKEHOLDER CONFLICTS AND MANAGEMENT
• MODULE 3.2: CORPORATE GOVERNANCE MECHANISMS
• MODULE 3.3: CORPORATE GOVERNANCE RISKS AND BENEFITS

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MODULE 3.1: STAKEHOLDER CONFLICTS AND MANAGEMENT

• Principal-agent conflict: arises because an agent is hired to act in the interests of the principal, but an agent’s interests may not coincide
exactly with those of the principal.
o Agency costs: the costs of hiring monitoring agents or indirect, like the forgone profits and economic benefits of lost opportunities.
• Conflicts of Interest Between Shareholders and Managers or Directors:
o Information asymmetry: managers have more and better information about the functioning of the firm and its strategic direction
than shareholders do.
This decreases the ability of shareholders or non-executive directors to monitor and evaluate whether managers are acting in the
best interests of shareholders.
o Compensation is the principal tool used to align the interests of management and shareholders.
o Manager and shareholder interests may diverge in the following common ways:
 Insufficient effort: Managers may be unable or unwilling to make investments, manage costs appropriately or allocate too little
time to their role.
 Inappropriate risk appetite: the risk of company managers and directors is more dependent of firm performance compared to
the risk of shareholders, who hold diversified portfolios of stocks and are not dependent on the firm for employment.
 Empire building: Management compensation and status are typically tied to business size, which can incentivize managers to
seek “growth for growth’s sake” (acquisitions).
 Entrenchment: Tactics to do so include copying competitors and peers, avoiding risks, and pursuing complicated transactions and
restructurings that they are uniquely suited to manage.
 Self-dealing: Managers may exploit firm resources to maximize personal benefits.
The smaller a manager’s stake in the company, the less they bear these costs themselves, reducing their desire to maximize firm
value.

MODULE 3.1: STAKEHOLDER CONFLICTS AND MANAGEMENT

• Conflicts Between Groups of Shareholders:
o A group of shareholders may hold a majority of the votes and act against the interests of the minority shareholders.
o Some firms have different classes of common stock outstanding.
o A group of shareholders may have effective control of the company although they have a claim to less than 50% of the earnings and
assets of the company.
o In the event of an acquisition of the company, controlling shareholders may be in a position to get better terms for themselves.
o Related party transactions: agreements or specific transactions that benefit entities in which they have a financial interest, to the
detriment of minority shareholders.
• Conflicts of Interest Between Creditors and Shareholders:
o Equity owners could issue new debt or pay greater dividends to equity holders, thereby increasing creditors’ risk of default.
o Long-term creditors are more likely to impose contractual limits on leverage and shareholder distributions.
• Conflicts of Interest Between Shareholders and Other Stakeholders:
o Company may decide to raise prices or reduce product quality in order to increase profits to the detriment of customers.
o Company may employ strategies that significantly reduce the taxes they pay to the government.

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MODULE 3.2: CORPORATE GOVERNANCE MECHANISMS

• Corporate governance:
o The system of internal controls and procedures by which individual companies are managed.
o It provides a framework that defines the rights, roles, and responsibilities of various groups.
o The arrangement of checks, balances, and incentives a company needs in order to minimize and manage the conflicting interests
between insiders and external shareowners.
• Corporate Reporting and Transparency:
o Without them, external stakeholders would be unaware of the company’s performance and position, and thus their ability to
advocate for their interests would be severely weakened.
o Investors have access to a public company’s financial and non-financial information through annual reports, proxy statements,
company disclosures, investor relations resources, and other sources.
o Private companies will disclose information confidentially to their investors.

MODULE 3.2: CORPORATE GOVERNANCE MECHANISMS

• Shareholder Mechanisms:
o Annual general meeting: after the end of the firm’s fiscal year.
 Company management provides shareholders with the audited financial statements for the year, addresses the company’s
performance and significant actions over the period, and answers shareholder questions.
 Corporate laws dictate when the annual general meeting may occur and how the meeting must be communicated to
shareholders.
 Anyone owning shares is permitted to attend the annual general meeting, to speak or ask questions, and to vote their shares.
 Proxy: a shareholder assigns right to vote to another who will attend the meeting.
 Ordinary resolutions (approval of auditor and the election of directors): require a simple majority of the votes cast.
 Special resolutions (merger or takeover, capital increases): require a supermajority vote for passage.
 Extraordinary general meetings: address special resolutions and can be called anytime there is a resolution about a matter
that requires a vote of the shareholders.
 When there are multiple board member elections at one meeting, some companies use majority voting and some use
cumulative voting.
 Majority voting: the candidate with the most votes for each single board position is elected.
 Cumulative voting: shareholders can cast all their votes for a single board candidate or divide them among board candidates.
Cumulative voting can result in greater minority shareholder representation on the board compared to majority voting.

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MODULE 3.2: CORPORATE GOVERNANCE MECHANISMS

• Shareholder Mechanisms:
o Activist shareholders: pressure companies in which they hold a significant number of shares for changes to increase shareholder
value.
o Shareholder derivative lawsuits: which are legal proceedings initiated against the board of directors, management, and/or
controlling shareholders by a shareholder deemed to be acting on behalf of the company in place of its directors and officers, who
have failed to adequately act for the benefit of the company.
o Corporate Takeovers:
 Proxy fight (proxy contest): A group seeks the proxies of shareholders to vote in favor of their alternative proposals.
 An activist group may make a tender offer for a specific number of shares of a company to gain enough votes to control the
company.
 Hostile takeover: an attempt to acquire a company without the consent of the company’s management.
 Poison pill: the company adopts anti-takeover measures.

MODULE 3.2: CORPORATE GOVERNANCE MECHANISMS

• Creditor Mechanisms:
o Bond indenture: specifies the rights of bondholders and the company’s obligations in a legal document.
o Covenants: require the company to take certain actions or restrict it from taking certain actions.
o Collateral: a specific asset against which the bondholders will have a claim if the company defaults on the bond.
o Creditor committees: form among bondholders to protect their interests when an issuer experiences financial distress.
o Ad hoc committee: When a company is struggling to meet its obligations under an indenture, it may be formed by a group of
bondholders to approach the company with potential options to restructure their bonds.
• Board of Directors and Management Mechanisms:
o A board of directors typically has committees made up of board members with particular expertise.
o Audit committee:
 Oversight of the financial reporting function and implementation of accounting policies.
 Effectiveness of the company’s internal controls and the internal audit function.
 Recommending an external auditor and its compensation.
 Proposing remedies based on their review of internal and external audits.

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MODULE 3.2: CORPORATE GOVERNANCE MECHANISMS

• Board of Directors and Management Mechanisms:
o Nominating/Governance committee:
 Oversight of the company’s corporate governance code.
 Implementing the company’s code of ethics and policies regarding conflicts of interest.
 Monitoring changes in relevant laws and regulations.
 Ensuring that the company is in compliance with all applicable laws and regulations, as well as with the company’s governance
policies.
 Proposes qualified candidates for election to the board.
 Attempts to align the board’s composition with the company’s corporate governance policies.
o Compensation committee (remuneration committee):
 Recommends to the board the amounts and types of compensation to be paid to directors and senior managers.
 May also be responsible for oversight of employee benefit plans and evaluation of
senior managers.
o Risk committee:
 Informs the board about appropriate risk policy and risk tolerance of the organization.
 Oversees the enterprise-wide risk management processes of the organization.
o Investment committee:
 Reviews and reports to the board on management proposals for large acquisitions or projects, sale or other disposal of company
assets or segments, and the performance of acquired assets and other large capital expenditures.

MODULE 3.2: CORPORATE GOVERNANCE MECHANISMS

• Employee, Customer, and Supplier Mechanisms:
o Labor laws, employment contracts, and the right to form unions are the primary mechanisms for employees to manage relationships
with employers.
 Employee stock ownership plan (ESOP): help retain employees and further align their interests with those of the company.
o Contracts tend to be the mechanism through which they manage their relationships with companies.
• Government Mechanisms:
o Government often establish agencies to regulate industries or sectors.
o Common-law system: judges’ rulings become law in some instances and Shareholders’ and creditors’ interests are considered to be
better protected.
o Civil law system: judges are bound to rule based only on specifically enacted laws.

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MODULE 3.2: CORPORATE GOVERNANCE MECHANISMS

Question 1: Which of the following stakeholders are most likely to demand higher returns and risk premiums when faced with greater
information asymmetry due to the greater potential conflicts of interest?
A. Directors and managers.
B. Suppliers and customers.
C. Shareholders and lenders.

Question 2: An analyst is examining the governance of several companies in her coverage area and learns that one of the CEOs is highly
involved in political and charitable activities. These activities may result in which one of the following misalignments of interests between
management and shareholders?
A. Self-dealing.
B. Entrenchment.
C. Insufficient effort.

Question 3: Which of the following is typically used to represent creditors’ interests?

A. Ad hoc committee.
B. Poison pill.
C. Tender offer.

Question 4: A primary responsibility of a board’s audit committee does not include:

A. oversight of accounting policies.
B. adoption of proper corporate governance.
C. recommending remuneration for the external auditor.

MODULE 3.3: CORPORATE GOVERNANCE RISKS AND BENEFITS

• Risks of Poor Governance and Stakeholder Management:
o When corporate governance is weak, the control functions of audits and board oversight may be weak. Accounting fraud, or
simply poor recordkeeping, will have negative implications for company performance and value.
o Poor compliance procedures with respect to regulation and reporting can easily lead to legal and reputational risks.
o Failure to manage creditors’ rights well can lead to debt default and bankruptcy.
• Benefits of Effective Governance and Stakeholder Management:
o Effective corporate governance can improve operational efficiency by ensuring that management and board member incentives
align their interests well with those of shareholders.
o A strong system of controls and compliance with laws and regulations can avoid many legal and regulatory risks.
o Proper governance with respect to the interests of creditors can reduce the risk of debt default or bankruptcy, thereby reducing
the cost of debt financing.
o Alignment of management interests with those of shareholders leads to better financial performance and greater company value.

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MODULE 3.3: CORPORATE GOVERNANCE RISKS AND BENEFITS

Question 1: Which of the following is not a benefit of an effective corporate governance structure?
A. Operating performance can be improved.
B. A corporation’s cost of debt can be reduced.
C. Corporate decisions and activities require less control.