Reading 34: Corporate Governance- LOS b～ Q1-3

provides, executive, discuss, corporate, management

LOS b: Evaluate explicit and implicit incentives that can align management's interests with those of the firm's shareholders.

Q1. Frank Groh and Peter Holman are consultants for Pasadena Advisors. Pasadena Advisors provides advice on executive compensation and corporate governance issues to publicly held corporations.

In their discussion over lunch, Groh and Holman discuss the latest findings in the corporate governance literature. Groh states that, due to poorly designed compensation schemes, managerial compensation is often independent of management performance. He states that a remedy for this is for management to be incented by paying them a base salary that is competitive with other firms in its industry and size classification. These figures can be obtained from firms that specialize in executive compensation, he states.

Holman provides his input on executive compensation by stating that although managers are often required to hold a minimum amount of the firm’s stock to incent better performance, some managers have gotten around these restrictions through the use of derivative contracts. Furthermore, he states that because bonuses are usually tied to accounting figures which are subject to managerial manipulation, their effectiveness as an incentive is limited. Bonuses, Holman states, likely reflect an executive’s short-term success whereas stock-based compensation is more closely tied to the manager’s long-term successes.

The next week, Groh and Holman visit the headquarters of Severna Technologies to consult with its board on effective corporate governance. During their visit, Natalia Adaro, the board chairman of Severna Technologies, makes the following two comments:

Statement #1: In general, shareholder class action lawsuits have provided a strong incentive for directors to monitor management. Courts typically side with shareholders in actions against the board.

Statement #2: The cost of liability insurance for directors has become so prohibitive that directors cannot insure against litigation resulting from their poor performance. The lack of insurance has increased director responsibility and incentives for performance.

During their presentation, Groh provides an example of four hypothetical firms, whose characteristics are shown below. Groh asks the Severna Technologies executives which firm is likely to have the highest corporate governance effectiveness based on the information below.

	Percent of shares traded on a daily basis	Debt-to-equity ratio	Percent of shares owned by five largest shareholders	Board Compensation
Firm A	5.3%	51.1%	11.3%	Flat fee
Firm B	10.3%	54.8%	21.8%	Flat fee
Firm C	15.4%	30.0%	9.1%	Equity based
Firm D	1.2%	62.3%	31.2%	Equity based

Later on in the day, Groh and Holman comment on the role of active investors in a large corporation. Groh makes the following statements:

Statement #1: The problem with active investors is that they themselves are unmonitored and they do not face the same pressure they place on corporations. Their interests may not be the same as other shareholders.

Statement #2: On the plus side, the managers of active investor positions are compensated on the basis of their performance. Given the large amount of funds at stake, these managers have a strong incentive to maximize shareholder wealth.

Holman’s statements on active investors are as follows:

Statement #1: Due to the regulatory burden imposed by Sarbanes Oxley and other recent regulations, the cost of proxy contests has unfortunately increased in the U.S. This makes it more difficult for the active investor to persuade other shareholders of their position.

Statement #2: There are larger holdings of stock by pension funds and other active investors in the U.S., relative to that in France, Germany, and Japan.

Regarding Groh’s comments over lunch on executive compensation, which of the following is most accurate, as stated in the Level 3 curriculum?

A) Groh is incorrect because the base salary is not considered a management incentive.

B) Groh is incorrect because the figures for managerial compensation from outside firms are not reliable.

C) Groh is correct.

Q2. Regarding Holman’s comments over lunch on executive compensation, which of the following is most accurate, as stated in the Level 3 curriculum?

A) Holman is incorrect because stock-based compensation is more closely tied to the manager’s short-term successes.

B) Holman is correct.

C) Holman is incorrect because the SEC requires that executives hold employer stock for the duration of their employment.

Q3. Regarding Adaro’s statements about board legal liability, are the statements correct?

Statement 1 Statement 2

A) Yes No

B) No Yes