hariRaj

McCool and Company is a consulting firm that provides research reports on corporate governance at large corporations and whether corporate governance systems are consistent with global best practices. McCool recently completed an evaluation of ARC Industries and listed the following observations:

• 2 of the 10 directors for ARC Industries are former employees and 4 of the 10 have large personal stock holdings in the company.
• The Chief Executive Officer for ARC has regular meetings with the Chairman of the Board.
• Each board member is up for reelection to the board on an annual basis.
• The nominating committee consists of 3 independent directors and the CEO of ARC Industries.
• The compensation committee consists of 5 independent directors.
• ARC has a requirement that all board members serving on the audit committee must be independent and must have a background in finance or accounting.

McCool and Company gives each company they evaluate a score based on how many of the following four items are consistent with global best practice:

Item 1: Board Independence.
Item 2: How the board is elected.
Item 3: Makeup of the nominating committee.
Item 4: Makeup of the audit committee.

Based on the observations of ARC Industries, what was ARC’s most likely score on the McCool report?

A) 25%.

B) 50%.

C) 75%.

---

Based on the observations, ARC Industries is in accordance with global corporate governance best practices with respect to 3 of the 4 items, resulting in a score of 75%.
With respect to Board independence, global best practice states that 75% of the directors should be independent. McCool observes that 2 of the 10 directors are former employees, but assuming no other conflicts, this would still result in 80% of the board being independent. Note that personal stock holdings among board members should be encouraged as it puts the board members in the same position as investors and can help align board member and investor interests.
Global corporate governance best practice supports annual elections of each board member rather than staggered elections – based on the observations, ARC is consistent with this practice.
The nominating committee should be made up entirely of independent directors. Having the company CEO on this committee means that ARC is not consistent with corporate governance best practice with respect to this item.
The audit committee should be made up entirely of independent directors and at least two members of the committee should have relevant accounting or auditing experience. It appears from the observations that ARC received a positive score for their requirements for serving on the audit committee.

hariRaj

Kathryn Rutherford recently joined the Board of Directors for Orvis Asset Management Company (Orvis) and will participate in its annual Board of Directors meeting. Rutherford is an Executive Vice President with Signature Bank, and knows Orvis’ finances well, serving as a commercial lender to Orvis for the last five years. Besides Rutherford, OAMC’s board consists of the following seven members:

• Dane Corser, CFO for Orvis who also serves on the board for Spencer Pharmaceuticals
• Tricia DeLucia, a granddaughter of Orvis’ founder, Michael Orvis
• Wendy Kepling, a former Executive Vice President with Orvis
• Troy Montgomery, the retired CEO of Forner Capital Management, another asset management firm
• Mike Shute, President of Spencer Pharmaceuticals
• Robert Stuart, an attorney with Bricker and Palmer, Orvis’ outside counsel
• Jason Winterfeld, Chairman and CEO of Orvis

Orvis is a publicly traded firm that specializes in managing equity portfolios for both institutional and individual clients. The firm’s investment philosophy is to focus on companies with a history of not changing their dividend payments in order to achieve stable returns. The firm’s marketing approach focuses on tax-exempt pension funds and endowments as well as individuals who depend on dividend payments to meet living expenses. Historically, Orvis has been a successful manager, but recently performance has declined relative to the firm’s benchmark. The primary focus at this board meeting is defining the long-term strategic objectives for the company and making sure the assets of the company, specifically its proprietary investment process, are being used in the best interests of the firm’s shareholders.

Winterfeld states that Item 1 on the Board’s agenda is to discuss the impact of dividends on shareholder value. Kepling begins the discussion by questioning whether Orvis’ investment process should focus on dividends at all. Kepling states, “According to work by Modigliani and Miller, dividends are irrelevant. If an investor holds a non-dividend paying stock, but wants the benefits of a dividend, all they have to do is sell a portion of the stock to get the cash flow they want. Whether the individual receives a cash dividend or sells a portion of their stock, the combination of the investment in the firm and the cash in hand is the same.” Montgomery replies, “I disagree with the theory that dividends are irrelevant. According to work by Gordon and Lintner, dividend payments matter because they are less risky than capital gains. Since investors perceive dividends as being less risky, a firm that starts paying a dividend is likely to see an increase in their P/E ratio.”

Kepling is also aware that Modigliani and Miller have done a great deal of work regarding capital structure theory. She asks Corser if Modigiani and Miller’s theory on capital structure has any implications for the percentage of debt and equity that Orvis has in its capital structure. Corser replies with two statements:

(1) Since Orvis has to pay taxes on its earnings, according to Modigliani and Miller, the optimal capital structure would be 100% debt.

(2) If bankruptcy costs are included in Modigliani and Miller’s capital structure theory, the value of a firm will be maximized when a firm’s cost of debt is minimized.

Which of the following questions about board independence is most accurate?

A) Montgomery qualifies as an independent director, but Stuart does not.

B) Stuart qualifies as an independent director, but Kepling does not.

C) Shute qualifies as an independent director, but DeLucia does not.

---

Montgomery may have prior ties to the asset management business, but there appears to be no prior relationship with Orvis. Stuart, as an attorney with Orvis’ outside counsel, cannot be classified as independent due to his firm’s relationship with Orvis.
DeLucia, as a family member, and Kepling as a former employee cannot be classified as independent. Also, due to interlocking directorships, Shute cannot be classified as an independent director (Corser serves on the board for Spencer Pharmaceuticals, where Shute is the President and Shute serves on the board for Orvis, where Corser is the CFO). (Study Session 9, LOS 31.d)

---

Jason Winterfeld is the Chairman of the Board of Directors at Orvis, as well as the firm’s CEO. Which of the following best describes Winterfeld’s position according to corporate governance best practices? Having the CEO also serve as Chairman of the Board is:

A) not in the best interest of shareholders because the Chairman/CEO could influence the culture of the board room and diminish the role of independent board members.

B) in the best interest of shareholders because the CEO has the knowledge and experience to provide information to the board about company strategy and operations.

C) not in the best interest of shareholders because only an independent Chairman insures the proper functioning of the Board.

---

Corporate governance experts believe that having a CEO also serve in the role of Chairman of the Board can negatively influence boardroom culture and diminish the role of independent board members. It is for this reason that corporate governance best practice supports having the Chairman and CEO as separate positions. Note that while the CEO does have the knowledge and experience to provide information to the board about company strategy and operations, if management is doing their job, it will provide the board with all necessary information, while it is the board’s responsibility to see that they get the information. Having the CEO as a knowledge base is not a valid justification for the dual role. (Study Session 9, LOS 31.e)

---

Given that Orvis does not meet the global corporate governance best practice that 75 percent of directors are independent, which of the following would be the best recommendation for a more effective system of corporate governance?

A) Reduce the potential for conflicts of interest between principals and agents of the firm.

B) Determine board member responsibilities and how the board will be held accountable.

C) Create long-term strategic objectives for the company that are consistent with shareholders’ best interests.

---

Since one of the two primary objectives of corporate governance is to eliminate or reduce conflicts of interest in a firm, and Orvis obviously has many potential conflicts of interest on their board, reducing the potential conflicts of interest between principals and agents of the firm is the best answer. In a corporation, principal-agent relationships exist between shareholders and management, and directors and shareholders. A principal agent problem occurs when managers or directors (the agent) act in their own best interests rather than those of the owners of the firm (the shareholders/principals). Both remaining answer choices are all good things, but do not get to the core principals of corporate governance which are reducing or eliminating conflicts of interest, and using company assets productively and in the best interests of shareholders. (Study Session 9, LOS 31.e)

---

Which of the following statements best reflects Orvis’ investment philosophy and marketing approach? Orvis’ investment philosophy is:

A) not consistent with a stable dividend policy, and the marketing approach depends on the clientele effect.

B) not consistent with a stable dividend policy, and the marketing approach depends on the signaling effect.

C) consistent with a stable dividend policy, and the marketing approach depends on the clientele effect.

---

Orvis’ investment philosophy is to focus on companies with a history of not changing their dividend payments, which is NOT consistent with a stable dividend policy. A stable dividend policy aligns the company’s dividend with the firm’s long-term growth rate to achieve stability in the rate of increase for the dividend each year. If the company never changed their dividend payments, the value of the dividend would decline over time as a result of inflation. The marketing approach seems to depend on the clientele effect which refers to the varying preference for dividends among different groups of investors. Tax considerations, institutional investor requirements, and individual investor preferences to spend dividends only and not dip into principal are all rationales for the clientele effect. (Study Session 8, LOS 30.f)

---

With regard to their statements about dividend theories:

A) Kepling is correct; Montgomery is correct.

B) Kepling is correct; Montgomery is incorrect.

C) Kepling is incorrect; Montgomery is correct.

---

Kepling is correct. According to Modigliani and Miller’s dividend irrelevance theory, a stock holder can effectively create their own dividend policy by buying or selling a firm’s stock to get the combination of cash flow and ownership they want to receive. Note that Modigliani and Miller’s theory only holds in a perfect world with no taxes or brokerage costs. Montgomery is also correct. According to Gordon and Lintner’s “bird-in-the-hand theory,” a dollar of dividends is less risky than a dollar of capital gains. Since dividends are less risky, a company that pays dividends will cause its cost of equity to decrease. Since the cost of equity declines, the required return for the investor will also decline, which will result in a higher P/E ratio. (Study Session 8, LOS 30.a)

---

With regard to Corser’s statements about Modigliani and Miller’s theory on capital structure, Kepling should:

A) agree with both Statements 1 and 2.

B) disagree with Statement 1, but agree with Statement 2.

C) agree with Statement 1, but disagree with Statement 2.

---

Modgliani and Miller’s work on capital structure theory concludes that in a world with no taxes and no bankruptcy costs, capital structure is irrelevant. However, in a subsequent study, they updated their work to include the effect of taxes. Since corporations can deduct interest payments when determining taxable income, the stockholders will benefit from the use of debt. According to their theory, the optimal capital structure in a world with taxes is 100% debt – Statement 1 is correct. However, if bankruptcy costs are factored into their results, debt is useful initially for its tax savings to lower the cost of capital, but only up to the point where it increases risk and the cost of debt and equity starts to rise. In a world with taxes and bankruptcy costs, the optimal capital structure is the one that minimizes the weighted average cost of overall capital - not simply the cost of debt. (Study Session 8, LOS 29.a)

hariRaj

Jon Fisher is a junior analyst for Folker Capital Management. Jim Russell, Director of Research has asked Fisher to prepare a list of items that may be included in a company’s statement of governance practices that would help assess company governance policies concerning the operation of the board of directors. Fisher’s list includes the following items:

Item 1:	Board and committee self-assessment reports.
Item 2:	Statement of the responsibilities directors have to review and oversee management.
Item 3:	Reports of findings in directors’ oversight and review of management.
Item 4:	Statement detailing how directors are trained before they join the board.

Which items should analysts include in order to understand a company’s corporate governance practices as they relate to the board of directors?

A) All 4 items should be included.

B) Item 1 only.

C) Items 1 and 3 only.

---

All of the items on the list are elements of a company’s statement of corporate governance policies that should be assessed by investors and analysts.

hariRaj

Which of the following would be the most effective means for a manufacturing firm to communicate its corporate governance policies to shareholders?

A) Include a statement on the company website that the company is committed to global corporate governance best practices.

B) Adopt a statement of governance policies that is provided by the North American Association of Manufacturers.

C) Provide access to internal management performance assessment reports.

---

Management performance assessments as well as reports of director’s oversight and review of management are an important element of a statement of governance policies that investors and analysts should assess. Note that a statement of governance practices should be company specific (not a boilerplate statement) and that it should be detailed – simply telling investors that the company is committed to best practices is insufficient

hariRaj

John Zehetmeier, an analyst for Folker Capital Management is helping his colleague, Chris Augustine, understand elements of a company’s statement of governance policies that would be helpful in analyzing a company. Zehetmeier makes the following statements:

Statement 1:	A corporate code of ethics that conveys the values, responsibilities, and ethical conduct of an organization should be included in a statement of governance policies.
Statement 2:	A statement of director oversight responsibilities would be the best place to find information about nomination and compensation award polices.

Augustine should:

A) agree with Statement 1, but disagree with Statement 2.

B) agree with both of Zehetmaier’s statements.

C) disagree with both of Zehetmeier’s statements.

---

Augustine should agree with both statements. A corporate code of ethics should articulate the values, responsibilities, and ethical conduct of an organization and should be included in a statement of governance policies. Also, a statement of director’s oversight, monitoring, and review responsibilities should include information regarding internal controls, risk management, accounting disclosure, compliance, nominations, and compensation awards.

hariRaj

Which of the following is NOT a risk arising from having an ineffective corporate governance system?

A) Management may use company assets for personal or inappropriate purposes.

B) An otherwise profitable company may not have cash on hand to pay its bondholders.

C) Management may enter into off-balance sheet obligations that reduce the value of a company.

---

A profitable company having inadequate cash to pay its bondholders is an example of liquidity risk and would be a result of poor financial management rather than poor corporate governance. The primary risks of an ineffective corporate governance system include financial disclosure risk, asset risk, liability risk, and strategic policy risk.

hariRaj

Dan Berger, an analyst for Romulus Capital Management Inc. (RCMI), is talking with a colleague, Amy Woods, about the benefits of including corporate governance assessments in the firm’s valuation models. Berger makes the following statements:

Statement 1:	Although the results are inconclusive in emerging markets, companies in developed countries that have strong corporate governance systems have provided shareholders with higher returns than companies with weak governance system.
Statement 2:	A weak corporate governance system can cause a company to go bankrupt.

In regard to Berger’s statements, Woods should:

A) disagree with Statement 1, but agree with Statement 2.

B) agree with both Statements.

C) agree with Statement 1, but disagree with Statement 2.

---

Woods should disagree with Statement 1. Companies with strong corporate governance systems have been shown to have higher profitability and generate higher returns than companies with weaker corporate governance systems in both developed and emerging markets. Statement 2 is correct – in extreme cases, the lack of an effective corporate governance system could lead to a company’s bankruptcy such as the case of Enron in 2001

hariRaj

Studies support the conclusion that companies with effective corporate governance systems have been shown to have higher measures of profitability and generate higher returns than companies with weak corporate governance systems. Which of the following is the most critical activity that an analyst can engage in to assess the strength of a corporate governance system at a firm?

A) Note whether financial transactions between a company and its senior management are approved by the board of directors.

B) Determine whether a corporate code of ethics and statement of governance policies is easily accessible for investors and stakeholders.

C) Evaluate the quality and quantity of financial information provided to investors.

---

Over the last few years, most of the major corporate scandals (i.e. Enron, Worldcom) have involved attempts to hide or falsify financial information provided to investors. Since investors rely on information provided by management to make investment decisions, having misinformation can result in the mispricing of securities, misallocation of capital, and ultimately a lack of confidence that can reduce the efficiency and effectiveness of financial markets. As a result, one of the most critical roles an analyst can play in the corporate governance process is to evaluate the quantity (more is better) and quality of financial data that companies provide

hariRaj

Entering into a merger that would provide benefits for management, but ultimately would destroy shareholder value is an example of:

A) liability risk.

B) asset risk.

C) strategic policy risk.

---

Strategic policy risk is the risk that managers may enter into transactions or incur other business risks that would not be in the best long-term interests of shareholders, but would result in large payoffs for managers or directors