Reading 33: Corporate Governance－LOS c discuss, monitors, management, 2008

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 CFA Institute Area 8-11, 13: Asset Valuation
Session 10: Equity Portfolio Management
Reading 33: Corporate Governance
LOS c: Explain the shortcomings of boards of directors as monitors of management and state and discuss prescriptions for improving board oversight.

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In which of the following situations is the board of directors most likely to become more effective?

A) The economy is in a recession and the firms stock price has been consistently declining.

B) The firms earnings have been increasing and the stock price has been consistently increasing.

C) The firm has sustained several quarters of losses and the firms stock price has been consistently declining.

D) The economy is in an expansion and the firms stock price has been consistently increasing.

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Answer and Explanation

If the firms earnings have been consistently decreasing, the firm is likely nearing crisis. Boards become more active during periods of crisis or when the stock price declines. It is at these times when the personal relationship between managers and directors deteriorates and that boards find themselves in the public limelight.

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Which of the following would enable a Board of Directors to act in the best long-term interest of the shareholders?

A) A majority of the Board of Directors is comprised of independent members and the Chairman of the Board is also a former Chief Executive Officer of the firm.

B) There are Board members who are closely aligned with a firm supplier and the Board meets regularly outside the presence of management.

C) The Chairman of the Board is also the Chief Executive Officer of the firm and there are Board members closely aligned with the firms pension advisor.

D) A majority of the Board of Directors is comprised of independent members and the Board meets regularly outside the presence of management.

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Answer and Explanation

The Chairman of the Board, who is also the CEO or former CEO, may impair the Board members from expressing opinions contrary to management. Also, when Board members interests are closely aligned with a firm supplier, customer, pension advisor, etc., independence may be impaired.

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Suppose shareholders wish that the board directors undertook more risk. Which of the following would most likely achieve that goal?

A) The directors were paid with stock and their liability insurance was paid for.

B) The directors were paid with stock options and their liability insurance was paid for.

C) The directors were paid with stock options and their liability insurance was their responsibility.

D) The directors were paid with stock and their liability insurance was their responsibility.

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Answer and Explanation

If board directors were paid in stock options, they would be encouraged to take more risk. If their liability insurance were paid for, then they would also have an incentive to take greater risk because they would not have to face the potential consequences of their decisions.

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Which of the following prescriptions would least likely improve board of director effectiveness?

A) The board should have an independent chairman.

B) The audit nominating committee should be dominated by independent directors.

C) Directors should be subject to maximum equity positions.

D) Self-evaluations of boards should be performed.

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Answer and Explanation

Directors should be required to hold a minimum amount of equity, not limited to a maximum of how much equity they can hold.

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Which of the following statements regarding management compensation is most accurate?

A) Stock-based compensation and bonuses are complements whereas explicit and implicit incentives are most often complements.

B) Stock-based compensation and bonuses are substitutes whereas explicit and implicit incentives are most often substitutes.

C) Stock-based compensation and bonuses are substitutes whereas explicit and implicit incentives are most often complements.

D) Stock-based compensation and bonuses are complements whereas explicit and implicit incentives are most often substitutes.

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Answer and Explanation

Bonuses and stock-based compensation are complements because bonuses reflect the managers short-term success whereas stock-based compensation more reflects the managers longer-term successes. Implicit incentives are usually substitutes for explicit incentives because the stronger the implicit incentive, the lower the need is for explicit incentives.