M3: Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

What is a principal-agent relationship?

A relationship where one party (the principal) delegates decision-making authority to another party (the agent) to act on the principal's behalf.

Who is the principal and who is the agent?

The principal delegates authority; the agent receives authority and makes decisions on the principal's behalf.

Why does a principal-agent relationship create potential conflict?

The agent's interests may not perfectly align with the principal's interests, and the agent often has more information than the principal.

What is information asymmetry?

A situation where one party, typically the agent, possesses more relevant information than another party, typically the principal.

★ EXAM: A board appoints managers who make decisions on shareholders' behalf. What relationship is described?

Principal-agent. Authority is delegated to managers, who have more information and may have interests that do not perfectly align with shareholders.

What is the principal-agent problem?

The risk that an agent uses delegated authority in ways that do not maximise the principal's interests because of incentive misalignment and information asymmetry.

★ EXAM: What is the root problem that corporate governance mechanisms are designed to address?

The principal-agent problem: misalignment of interests + information asymmetry can generate agency costs.

What are agency costs?

Direct and indirect costs arising from conflicts of interest between principals and agents.

What is a direct agency cost?

A direct monitoring/control expense, such as the cost of hiring an independent auditor.

What is an indirect agency cost?

Economic value lost because of agency conflicts, such as forgone profits from missed investment opportunities.

★ EXAM: How does greater information asymmetry affect investors' required returns?

Information asymmetry ↑ → potential agency costs/conflicts ↑ → investors demand a higher required return/risk premium.

What is the principal-agent chain in a corporation?

Shareholders → board of directors → managers. Shareholders delegate to directors, who appoint and oversee managers.

What are the three broad types of stakeholder relationships?

Principal-agent relationships, contractual relationships, and other/indirect relationships.

Which stakeholder relationships are principal-agent relationships?

Shareholders-board, board-managers, and indirectly shareholders-managers.

Which stakeholders primarily have contractual relationships with the firm?

Customers, suppliers, creditors, employees, and governments through explicit or implicit contracts.

Why can shareholders have difficulty monitoring managers?

Managers and directors generally possess more information about company performance, risks, and investment opportunities.

When can corporate information asymmetry be especially severe?

When firms have multiple businesses/jurisdictions, technically opaque products, or relatively little monitoring by professional investors.

What is the primary tool for aligning manager and shareholder interests?

Compensation, particularly when appropriately linked to long-term company performance.

What are the five common shareholder-manager conflicts?

Insufficient effort, inappropriate risk appetite, empire building, entrenchment, and self-dealing.

What is insufficient effort?

Managers fail to devote enough time, effort, monitoring, investment, or cost discipline to maximising firm value.

★ EXAM: A manager avoids difficult decisions, inadequately monitors employees, or spends excessive time on outside activities. What conflict is this?

Insufficient effort.

What is inappropriate risk appetite?

Managers take either too much or too little risk relative to what is appropriate for shareholders.

Why may managers naturally be more risk-averse than diversified shareholders?

Managers may have their career, reputation, compensation, and human capital concentrated in one firm, while shareholders can diversify across firms.

How can option-heavy compensation affect managerial risk-taking?

It can encourage excessive risk-taking because options give managers significant exposure to upside share-price movements.

How can cash-heavy compensation affect managerial risk-taking?

It can encourage excessive caution because managers have less participation in equity upside and may focus on protecting their compensation/job.

⚠ WATCH FOR: What determines whether compensation encourages too much or too little risk?

The pay mix. Option-heavy → excessive risk-taking; cash-heavy → potentially excessive caution. Diagnose the compensation structure, not just the amount.

What is empire building?

Managers increase company size for growth, prestige, status, or power even when the expansion does not increase shareholder value.

★ EXAM: What trigger words indicate empire building?

"Increases company size but reduces shareholder value" or "growth for growth's sake."

What is the difference between empire building and self-dealing?

Empire building seeks size/status/power without requiring direct extraction of company resources; self-dealing gives the manager direct personal benefit.

What is entrenchment?

Actions by managers or directors designed to preserve their positions and make themselves harder to replace.

★ EXAM: What is the key motivation behind entrenchment?

Job preservation.

What governance features can contribute to management entrenchment?

Staggered boards and poison pills can make management more difficult to remove.

What is self-dealing?

Managers exploit company resources for direct personal benefit, such as excessive perks or misappropriation of assets.

★ EXAM: What distinguishes self-dealing from empire building?

Self-dealing involves DIRECT personal benefit/extraction; empire building primarily concerns size, status, or power.

What is dispersed ownership?

Ownership spread among many shareholders such that no individual shareholder or group exercises control.

What is concentrated ownership?

Ownership where an individual or group, such as a family, government, or another company, can exercise control.

★ EXAM: Which conflict tends to dominate under dispersed ownership?

The principal-agent conflict between shareholders and managers.

★ EXAM: Which conflict tends to dominate under concentrated ownership?

The conflict between controlling and minority shareholders.

★ EXAM: What should you do first when an MCQ gives a large shareholder ownership percentage?

Determine whether ownership is concentrated or dispersed; a controlling shareholder can change which conflict is dominant.

Why can controlling and minority shareholders have conflicting interests?

They may have different risk preferences, time horizons, diversification needs, and strategic objectives.

Why might a founding family want the company itself to diversify?

A founding family may have much of its wealth concentrated in the company and therefore value firm-level diversification and stability.

Why might minority shareholders oppose unnecessary corporate diversification?

Diversified investors can diversify cheaply themselves and may prefer management to focus on maximising company value.

★ EXAM: If a controlling shareholder exists, what conflict should you consider first?

Controlling shareholder vs minority shareholders, not automatically shareholders vs managers.

Why does ownership percentage alone not necessarily determine control?

Different share classes and voting rights can give some shareholders disproportionate voting power.

What is a dual-class share structure?

A structure where different share classes carry different voting rights, often allowing insiders/founders to retain control with less than majority economic ownership.

What is the key relationship between economic ownership and voting control under dual-class shares?

Economic ownership ≠ voting control.

Why can dual-class shares disadvantage minority shareholders?

They allow insiders to exercise disproportionate voting power and potentially override the preferences of other shareholders.

What is CFA Institute's position on dual-class share structures in the curriculum?

CFA Institute has advocated against them because they permit disproportionate control; where legal, their structure and implications should be clearly disclosed.

What is the fundamental shareholder-creditor conflict?

Shareholders are residual claimants who benefit from upside risk, while creditors have fixed claims and prefer protection against downside/default risk.

What financing policies do creditors generally prefer?

Lower leverage, more equity financing, sufficient cash flow for debt service, and limits on shareholder distributions.

What financing policies may shareholders prefer?

Greater leverage and shareholder distributions rather than dilutive equity issuance.

Why can debt-funded dividends or share repurchases harm creditors?

They increase leverage and/or remove assets from the firm, increasing default risk while creditors' upside remains capped.

Why is the shareholder-creditor conflict generally greater for long-term debt?

Long-term creditors are exposed for longer to changes in business conditions, strategy, leverage, distributions, and management behaviour.

How do long-term creditors protect against shareholder-creditor conflicts?

Through contractual restrictions such as covenants limiting leverage and shareholder distributions.

What conflicts can arise between the firm and suppliers?

Suppliers want timely payment and agreed prices, while management/shareholders may pursue actions that increase financial distress or squeeze supplier terms.

What conflicts can arise between the firm and employees?

Employees want reasonable compensation and stable employment, while corporate actions such as leveraged restructurings can increase job-loss risk.

What conflicts can arise between the firm and customers?

Customers want quality and after-sale support, which may conflict with aggressive cost reductions or other shareholder-focused decisions.

What conflicts can arise between the firm and governments?

Governments require compliance with laws and regulations, which may conflict with actions intended to maximise short-term corporate profits.

What is the purpose of corporate governance mechanisms?

To balance stakeholder rights, responsibilities, and powers; facilitate compliance; manage conflicts; and help the company achieve its objectives.

Why are corporate reporting and transparency important governance mechanisms?

They reduce information asymmetry and allow stakeholders to assess company performance, management, governance, risks, and financial position.

What information can corporate reporting include?

Operations, strategy, audited financial statements, governance and ownership structures, remuneration, related-party transactions, and risk factors.

How do public and private company disclosures generally differ?

Public-company reporting is more standardised and regulated; private-company disclosure is more limited publicly and often negotiated with investors.

Are public-company financial statements generally audited?

Yes. Most jurisdictions/exchanges require listed companies' annual financial statements to be independently audited.

Are private-company disclosures generally required to be audited?

Usually not, although private firms may voluntarily obtain audits, potentially improving financing terms.

What can investors use corporate reports for?

Assess performance, value securities, vote on corporate matters, and monitor compliance with debt agreements.

What is the basic corporate governance chain?

Shareholders elect the board → board oversees strategy/accountability and appoints management → management executes strategy and operations.

What is an annual general meeting (AGM)?

The regular annual shareholder meeting for voting and discussion on matters not delegated to the board.

What matters commonly appear at an AGM?

Director elections, auditor appointment, financial statements, dividends, compensation, equity-based compensation plans, and say-on-pay votes.

What is an extraordinary general meeting (EGM)?

A shareholder meeting outside the regular AGM used for significant matters requiring shareholder approval.

What matters commonly require an EGM?

Special board elections, bylaw/articles amendments, M&A/takeovers, asset sales, capital increases, and voluntary liquidation.

What is proxy voting?

A process where a shareholder authorises another party to vote on the shareholder's behalf.

★ EXAM: How do most shareholders who do not attend meetings participate in voting?

By proxy voting.

What is a proxy contest or proxy fight?

An attempt by a group to persuade shareholders to vote for its preferred directors or proposals, potentially changing control without buying the shares directly.

★ EXAM: What does a proxy contest seek to acquire?

VOTES.

What is majority voting for directors?

Each director position is voted on separately and a candidate generally needs more than 50% of votes cast.

What is cumulative voting?

Shareholders receive votes equal to shares owned × director seats and may concentrate those votes on one or more candidates.

What is the cumulative voting formula?

Total votes = Shares owned × Number of director seats being filled.

★ EXAM: Which voting system favours minority shareholders?

Cumulative voting because minority shareholders can concentrate their votes on a preferred candidate.

★ EXAM: Which voting system is relatively more favourable to controlling shareholders?

Majority voting because controlling shareholders can more easily prevent minority-preferred candidates from winning.

⚠ WATCH FOR: A company changes from cumulative to majority voting. What happens to minority protection?

Minority shareholder protection weakens.

What is an ordinary resolution?

A resolution requiring a simple majority, generally greater than 50% of votes cast.

What matters typically require ordinary resolutions?

Routine matters such as financial statement approval, director elections, auditor approval, and advisory say-on-pay votes.

What is a special resolution?

A resolution requiring a supermajority, typically two-thirds or three-quarters of votes cast.

What matters typically require special resolutions?

Major structural matters such as M&A, charter/bylaw amendments, voluntary liquidation, and issuance of new share classes.

★ EXAM: M&A, liquidation, or bylaw amendments usually indicate what resolution?

A special resolution requiring a supermajority.

★ EXAM: What is the quick distinction between ordinary and special resolutions?

Ordinary = simple majority/routine matters; Special = supermajority/major structural changes.

What is shareholder activism?

Investor actions intended to pressure a company into taking desired actions, usually to increase shareholder value, though ESG/social objectives may also motivate activism.

What are common shareholder activism tactics?

Proxy fights, shareholder resolutions, litigation, and public campaigns.

Why are hedge funds prominent shareholder activists?

Their fees are strongly performance-linked and they face fewer investment restrictions than regulated mutual funds, allowing concentrated and leveraged positions.

★ EXAM: Which investor type is particularly associated with shareholder activism?

Hedge funds.

What is a shareholder derivative lawsuit?

A lawsuit initiated by a shareholder on behalf of the company against directors, management, and/or controlling shareholders when company officials fail to act.

★ EXAM: Is a shareholder derivative lawsuit related to financial derivatives?

No. "Derivative" here refers to the shareholder bringing the claim on behalf of the company.

★ EXAM: What restriction may jurisdictions impose on shareholder derivative lawsuits?

A minimum shareholding threshold before a shareholder can bring the suit.

What is a tender offer?

An invitation from an acquirer to shareholders to sell their shares directly to the group seeking control.

★ EXAM: What does a tender offer seek to acquire?

SHARES.

★ EXAM: Tender offer versus proxy contest?

Tender offer → acquire shares; proxy contest → acquire votes.

What is a hostile takeover?

An attempt to acquire control of a company without management's consent.

Why can the threat of takeover improve governance?

The possibility of removal gives boards and managers an incentive to focus on shareholder wealth.

What is a staggered board as a takeover defence?

Only a fraction of directors are elected each year, making it difficult for an acquirer to replace the full board quickly.

What is a poison pill?

A shareholder rights plan allowing existing shareholders to buy additional shares at a discount after a potential acquirer crosses a specified ownership threshold, increasing takeover cost.