Reading 34- LOS c ～ Q1－5

1.Corporate governance systems are primarily concerned with potential principal-agent problems between:

A)   managers and directors.

B)   directors and shareholders.

C)   directors and employees.

D)   managers and creditors.

The correct answer was B)

Corporate governance systems attempt to minimize or eliminate any potential agent problems that may arise between two groups: (1) directors and shareholders and (2) managers and shareholders.

2.A principal-agent problem may exist between:

A)   managers and directors.

B)   regulators and managers.

C)   shareholders and directors.

D)   regulators and directors.

The correct answer was C)

An agency relationship exists when an individual (the agent) acts on behalf of another individual (the principal). Such a relationship creates the potential for a principal-agent problem where the agent may act for his own well being rather than that of a principal. The key test of whether a principal-agent problem may exist is if one party is responsible for acting in the best interest of the other. Of the answer choices given, directors are responsible for acting in the best interests of shareholders.

3.The purpose of the board of directors is to act as an intermediary between shareholders and management to assure that management is acting in shareholders’ best interest. Which of the following is NOT a factor that may cause directors to align more closely with managers than shareholders?

A)   Directors receive excessive compensation.

B)   Directors are responsible for CEO succession planning.

C)   Directors are employed by financial institutions that lend money to the firm.

D)   Members of senior management serve as directors for companies run by board members.

The correct answer was B)

Succession planning for the CEO is one of the duties of the board of directors, and should not cause directors to align with management over shareholders. Factors that could cause directors to align more closely with management include:

§ Lack of independence (i.e. family relationships, prior employment, or existing business relationships).

§ Interlinked boards.

§ Directors are overcompensated.

4.Jill Tangeman and Lawrence Winkelman are shareholders for Hilliard Electric Components, Inc. (HECI). Tangeman and Winkelman are concerned about potential conflicts of interest that may affect them as shareholders of HECI and decide to draft a letter to various HECI decision makers to ask them what they are doing to eliminate or reduce potential conflicts of interest.

The basic premise of Tangeman and Winkelman’s letter is that corporate governance systems should focus on two potential areas where decision makers may not act in shareholders best interests: conflicts between managers and shareholders, and conflicts between directors and shareholders.

Winkelman states in the letter than he is concerned about executive compensation. “Having too much executive wealth concentrated in employee stock options can lead to managers avoiding potentially risky projects that would actually maximize wealth for shareholders.” Tangeman adds her own comment: “The primary responsibility of the board of directors is to assure that shareholders’ interests are balanced with those of management when negotiating on issues such as compensation.” When the letter is complete, both sign it as shareholders in the company and mail out 12 copies.

The assertion made by Tangeman and Winkelman about the focus of corporate governance systems is:

A)   valid, and neither Winkelman or Tangeman make a correct statement in the letter.

B)   valid, and only Winkelman makes a correct statement in the letter.

C)   invalid, and only Tangeman makes a correct statement in the letter.

D)   valid, and both Winkelman and Tangeman make a correct statement in the letter.

The correct answer was A)

The assertion made by Tangeman and Winkelman is valid – one of the two main objectives of corporate governance is to eliminate or reduce conflicts of interest. The two primary areas for potential conflicts of interest in a corporation are conflicts between shareholders and management and conflicts between directors and shareholders.

Winkelman’s statement is incorrect. Executive compensation in the form of large amounts of stock options can cause managers to take on too much risk as the asymmetric payoff of those options means that managers can reap huge rewards if the risks pay off, but will not share in the losses if the risky projects fail. Note that managers taking too little risk is also a concern, but taking too little risk is a symptom of managers holding too much stock – not stock options. If the manager has the bulk of their wealth tied to company stock, the manager may want to avoid risky projects to protect the value of the stock even though the risky projects may do a better job of maximizing value for the firm’s shareholders.

Tangeman’s statement is incorrect in two respects. The most important roles for the board of directors is to institute long-term strategic objectives for the company and institute corporate values that will insure that business is conducted in an ethical and fair manner. Also – the board should not “balance shareholder and management needs” when negotiating with management in areas such as compensation. The board needs to determine management compensation with shareholders’ best interest as their sole consideration.

5.The principal-agent problem can best be described as:

A)   the agent may act for the well being of management rather than that of the stakeholders.

B)   the agent may act for his own well being rather than that of the principal.

C)   the agent may act for the well being of stakeholders rather than that of the principal.

D)   the agent may act for the well being of the principal rather than that of the stakeholders.

The correct answer was B)

In a principal-agent relationship, one party (the agent) acts on behalf of another party (the principal). A principal-agent problem arises when the agent places his own interests ahead of the principal.