Chapter 4 Flashcards

1
Q

It can be defined as the economic, legal, and institutional framework in which corporate control and cash flow rights are distributed among shareholders, managers, and other stakeholders of the company.

A

Corporate governance.

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2
Q

What are the stakeholders of a company?

A

Shareholders, managers, workers, creditors, banks, institutional investors, and even the government.

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3
Q

Corporation which is jointly owned by a multitude of shareholders protected by limited liability, is a major organizational innovation with powerful economic consequences.

A

The public corporation.

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4
Q

Name some of the issues with public corporations.

A

The conflicts of interest between managers and shareholders. The separation of the company’s ownership and control.

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5
Q

In the United States, managers are legally bound by the _________ to shareholders.

A

“Duty of loyalty”.

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6
Q

What happens with diffused ownership of the company in countries other than U.S. and U.K.?

A

These large shareholders (often including founding families of the company) effectively control managers and may run the company for their own interests, expropriating outside shareholders in one way or another.

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7
Q

On what does the degree of legal protection of investors depends on?

A

On the “legal origin” of countries.

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8
Q

They provide the strongest protection for investors.

A

English common law countries.

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9
Q

Name examples of English common law countries.

A

Canada, the United States, and the United Kingdom.

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10
Q

These countries rovide the weakest protection for investors.

A

French civil law countries.

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11
Q

Name examples of French civil law countries.

A

Belgium, Italy, and Mexico.

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12
Q

What is Residual control right?

A

When the manager and the investors will have to allocate the rights (control) to make decisions under those contingencies that are not specifically covered by the contract.

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13
Q

They represent a firm’s internally generated funds in excess of the amount needed to undertake all profitable investment projects, that is, those with positive net present values (NPVs).

A

Free cash flows.

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14
Q

What are some incentives of managers to retain cash flow?

A
  1. Cash reserves provide corporate managers with a measure of independence from the capital markets
  2. Growing the size of the company via retention of cash tends to have the effect of raising managerial compensation.
  3. Senior executives can boost their social and political power and prestige by increasing the size of their company.
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15
Q

What is the heart of the agency problem?

A

The conflicts of interest between managers and the outside investors over the disposition of free cash flows.

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16
Q

What are the mechanisms that exists in order to control the agency problem?

A
  1. Board of directors
  2. Incentive contracts
  3. Concentrated ownership
  4. Accounting transparency
  5. Debt
  6. Overseas stock listings
  7. Market for corporate control.
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17
Q

It is legally charged with representing the interests of shareholders.

A

Board of directors.

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18
Q

How does the board of directors differs in Germany and U.S.?

A

In Germany, for instance, the corporate board is not legally charged with representing the interests of shareholders. Rather, it is charged with looking after the interests of stake- holders (e.g., workers, creditors, etc.) in general, not just shareholders.

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19
Q

Considering that managers may not be very interested in the maximization of shareholder wealth, many companies provide managers with…

A

Incentive contracts.

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20
Q

What benefits do incentive contracts have for managers?

A

Stocks and stock options.

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21
Q

Explain concentrated ownership.

A

If one or a few large investors own significant portions of the company, they will have a strong incentive to monitor management.

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22
Q

Give examples of concentrated ownership around the world.

A

In Gennany, for example, commercial banks, insurance companies, other companies, and families often own significant blocks of company stock.
Also in France, cross-holdings and “core” investors are common.
In Asia and Latin America, many companies are controlled by founders or their family members.
In China, the government is often the controlling shareholder for public companies.

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23
Q

It can be an effective way of alleviating the agency problem.

A

Strengthening accounting standards.

24
Q

It will reduce the information asymmetry between corporate insiders and the public and discourage managerial self-dealings.

A

A greater accounting transparency.

25
Q

What are some measures to achieve a greater transparency.

A

(1) Countries to reform the accounting rules.

(2) Companies to have an active and qualified audit committee.

26
Q

Explain the effect of managerial equity holdings.

A

As the managerial ownership share increases, firm value may initially increase, since the interests of managers and outside investors become better aligned (thus reducing agency costs). But if the managerial ownership share exceeds a certain point, firm value may actually start to decline as managers become more entrenched. With larger shareholdings, for example, managers may be able to more effectively resist takeover bids and extract larger private benefits at the expense of outside investors.

27
Q

What would happen if managers fail to pay interest and principal to creditors?

A

The company an be forced into bankruptcy and its managers may lose their jobs.

28
Q

What would be the scenario of debt vs stockholders?

A

In turbulent economic conditions, equities can buffer the company against adversity. Managers can pare down or skip dividend payments until the situation improves. With debt, however, managers do not have such flexibility and the company’s survival can be threatened.

29
Q

Countries with weak investor protection.

A

Italy, Korea, and Russia.

30
Q

Countries with strong investor protection.

A

United States and United Kingdom.

31
Q

How can foreign firms with weak governance mechanisms bond themselves credibly to better investor protection?

A

They can opt to outsource a superior corporate governance regime available in the United States via cross-listings.

32
Q

What happens when outside investors entrust funds to the company?

A

They receive certain rights that are legally protected.

33
Q

Examples of rights that empower investors to extract from management fair returns on their funds.

A

Among these are the rights to elect the board of directors, receive dividends on a pro-rate basis, participate in shareholders’ meetings, and sue the company for expropriation.

34
Q

What are the four legal origins?

A
  • English common law
  • French civil law
  • German civil law
  • Scandinavian civil law
35
Q

Civil laws derived from the Roman law.

A

The French and German civil laws.

36
Q

It is formed by the discrete rulings of independent judges on specific disputes and judicial precedent.

A

English common law.

37
Q

Why is the English common law system more protective of investors than the French civil law system?

A

According to the prevailing view, the state historically has played a more active role in regulating economic activities and has been less protective of property rights in civil law countries than in common law countries.

38
Q

Dominant investors may acquire control through various schemes, such as:

A
  1. Shares with superior voting rights.
  2. Pyramidal ownership structure.
  3. Interflfill cross-holdings.
39
Q

Large shareholders, who are often founders and their families, can use a ________ in which they control a holding company that owns a controlling block of another company, which in turn owns controlling interests in yet another company.

A

Pyramidal ownership structure.

40
Q

They can be used to concentrate and leverage voting rights to acquire control.

A

Equity cross-holdings.

41
Q

When do shareholders extract rivate benefits of control that are not shared by other shareholders ?

A

Once they acquire control rights exceeding cash flow rights.

42
Q

Name an example of private benefits of control.

A

Nenova (2001) computed the premium for voting shares relative to nonvoting shares in different countries. The voting premium, defined as the total vote value as a proportion of the firm’s equity market value, is only agout 2 percent in the United States and 2.8 percent in Canada. This implies that private benefits of control are not very significant in both countries. In contrast, the voting premium is 23 percent in Brazil, 9.5 percent in Germany, 29 percent in both Italy and Korea, and 36 percent in Mexico, suggesting that in these countries, dominant shareholders extract substantial private benefits of control.

43
Q

What do protection to investors promote?

A

The development of external capital markets. When investors are assured of receiving fair returns on their funds, they will be willing to pay more for securities.

44
Q

When did the world demand for a corporate governance reform?

A

In the wake of the Asian financial crisis of 1997-98 and the spectacular failure of several major companies like Daewoo, Enron, and WorldCom.

45
Q

What will failure to reform corporate governance have as consequences?

A
  • Affect investor confidence
  • Stunt the development of capital markets
  • Raise the cost of capital
  • Distort capital allocation
  • Not confidence in capitalism
46
Q

What should be an objective of the reform for corporate governance?

A

Strengthen the protection of outside investors from expropriation by managers and controlling insiders

47
Q

What does a reform in corporate governance require?

A

(1) strengthening the independence of boards of directors with more outsiders
(2) enhancing the transparency and disclosure standard of financial statements
(3) energizing the regulatory and monitoring functions of the SEC and stock exchanges

48
Q

Facing public uproar following the U.S. corporate scandals, politicians took actions to remedy the problem. The U.S. Congress passed the _______ in July 2002.

A

Sarbanes-Oxley Act.

49
Q

What are the major components of the Sarbanes-Oxley Act?

A
  • Accounting regulation
  • Audit committee
  • Internal control assessment
  • Executive responsibility
50
Q

Mention the measurements that The New York Stock Exchange (NYSE) is also currently considering to protect investors.

A

(1) listed companies to have boards of directors with a majority of independents
(2) the compensation, nominating, and audit committees to be entirely composed of independent directors
(3) the publication of corporate governance guidelines and reporting of annual evaluation of the board and CEO..

51
Q

Regarding the Sarbanes-Oxley Act, mention the section that requires public companies and their auditors to assess the effectiveness of internal control of financial record keeping and fraud prevention and file reports with the Securities and Exchange Commission (SEC).

A

Section 404

52
Q

To what was attributed the “scandalous” collapse of the prominent British companies in the 1980s and early 1990s?

A

To:

  • Their complete corporate control by a single top executive
  • Weak governance mechanisms
  • The failure of their boards of directors.
53
Q

The British government appointed the committee and issued it in 1991 with the broad mandate of addressing corporate governance problems in the United Kingdom.

A

The Cadbury Code of Best Practice

54
Q

What does the Cadbury Code of Best Practice recommends?

A

(1) Boards of directors of public companies include at least three outside (nonexecutive) directors.
(2) The positions of chief executive officer (CEO) and chairman of the board (COB) of these companies be held by two different individuals.

55
Q

Protecting the rights of investors has major economic consequences in…

A
  • Terms of corporate ownership patterns
  • The development of capital markets
  • Economic growth