READING 22 CORPORATE GOVERNANCES: CONFLICTS, MECHANISMS, RISKS, AND BENEFITS

Question 1

Which of the following best describes a principal-agent relationship?
A. A shareholder managing the daily operations of the company
B. A board of directors supervising external auditors
C. A client hiring a portfolio manager to invest on their behalf

Answer 1

Correct Answer: C

Explanation:

C is correct: A principal-agent relationship arises when one party (the principal) hires another (the agent) to perform a task on their behalf — like a client hiring a portfolio manager.

A is incorrect: This is not a principal-agent situation because the shareholder is not delegating.

B is incorrect: The board-auditor relationship is more supervisory and not a classic principal-agent dynamic.

Question 2

Which of the following is most likely an agency cost?
A. A company pays dividends to shareholders.
B. A firm hires an external consultant to monitor executive decisions.
C. A company issues new shares to finance expansion.

Answer 2

Correct Answer: B

Explanation:

B is correct: This is a direct agency cost — paying to monitor management (agents) on behalf of shareholders (principals).

A is incorrect: Paying dividends is a capital allocation decision, not an agency cost.

C is incorrect: Issuing shares isn’t inherently a cost from agency conflict.

Question 3

Which of the following best describes information asymmetry in the context of corporate governance?
A. Shareholders have access to internal company reports.
B. Managers possess more and better information than shareholders.
C. All shareholders receive the same financial statements.

Answer 3

Correct Answer: B

Explanation:

B is correct: Managers typically know more about internal operations and strategy — a classic information asymmetry.

A is incorrect: Shareholders typically lack access to internal reports.

C is incorrect: While true, it doesn’t describe asymmetry between insiders and outsiders.

Question 4

hich of the following scenarios best illustrates a conflict between creditors and shareholders?
A. A company reduces executive bonuses to improve liquidity.
B. A firm increases dividends despite weak financials.
C. A company delays launching a risky new product.

Answer 4

Correct Answer: B

Explanation:

B is correct: Paying high dividends reduces company assets, increases default risk — bad for creditors, even if shareholders benefit.

A is incorrect: This benefits both creditors and shareholders.

C is incorrect: Avoiding risk is typically aligned with creditor interests.

Question 5

Which of the following actions is most consistent with empire-building behavior?
A. Issuing debt to fund share repurchases
B. Acquiring unrelated businesses with weak synergies
C. Increasing R&D spending in core business lines

Answer 5

Correct Answer: B

Explanation:

B is correct: Empire-building often involves poor or unnecessary acquisitions to increase firm size and management power.

A is incorrect: This often returns value to shareholders, not empire-building.

C is incorrect: Investing in core R&D suggests focus, not empire-building.

Question 6

Which of the following is most likely an indirect agency cost?
A. Losses from managers failing to act in shareholders’ best interest
B. Fees paid to lawyers to draft board policies
C. Costs incurred from auditing internal controls

Answer 6

Correct Answer: A

Explanation:

A is correct: Lost opportunities or poor performance due to misaligned incentives is an indirect agency cost.

B and C are incorrect: These are direct agency costs (paid to enforce monitoring).

Question 7

Which action by management is most likely to entrench them in their position?
A. Cutting unprofitable projects
B. Mimicking competitors to avoid blame
C. Paying down debt to lower risk

Answer 7

Correct Answer: B

Explanation:

B is correct: Copying competitors may reduce scrutiny, helping managers entrench themselves.

A is incorrect: Cutting poor projects is positive behavior.

C is incorrect: Reducing debt helps financial health but doesn’t entrench managers.

Question 7

Managers compensated primarily with stock options are most likely to:
A. Avoid all risky projects
B. Take on higher-risk projects
C. Focus only on short-term profits

Answer 7

Correct Answer: B

Explanation:

B is correct: Stock options offer upside but no downside — encouraging risk-seeking behavior.

A is incorrect: Avoiding risk is more common with fixed salaries.

C is incorrect: While possible, the key incentive is toward risk, not necessarily short-termism.

Question 8

A dual-class share structure is most likely to:
A. Align voting rights with cash flow rights
B. Allow minority shareholders to control the company
C. Give certain shareholders more control than their ownership justifies

Answer 8

Correct Answer: C

Explanation:

C is correct: Dual-class structures give some shareholders more voting power per share, allowing control without proportional ownership.

A is incorrect: It misaligns voting and cash flow rights.

B is incorrect: Minority shareholders typically have less control.

Question 9

A conflict between controlling and minority shareholders is most likely when:
A. The firm avoids risky investments
B. Controlling shareholders use company resources for personal gain
C. The firm adopts strict accounting standards

Answer 9

Correct Answer: B

Explanation:

B is correct: This is a classic expropriation scenario — controlling owners using their power against minority interests.

A is incorrect: Avoiding risk can benefit all shareholders.

C is incorrect: Strict standards usually promote transparency.

Question 9

Which type of firm is most likely to face high information asymmetry?
A. A small, domestic retail company
B. A firm with high institutional ownership
C. A global firm with complex products

Answer 9

Correct Answer: C

Explanation:

C is correct: Larger, diversified, complex firms make it harder for outsiders to assess operations.

A is incorrect: Small firms are simpler and more transparent.

B is incorrect: Institutional investors typically demand higher disclosure.

Question 10

Which of the following most likely reduces principal-agent conflict?
A. Offering stock options with no restrictions
B. Separating CEO and Chair roles
C. Eliminating performance-based bonuses

Answer 10

Correct Answer: B

Explanation:

B is correct: Separating roles increases board independence, reducing conflict.

A is incorrect: Unrestricted options can increase risk-taking.

C is incorrect: Eliminating bonuses removes performance alignment.

Question 11

Which of the following best describes self-dealing by managers?
A. Pursuing riskier strategies to increase share price
B. Using company funds for personal travel
C. Retaining earnings for reinvestment

Answer 11

Correct Answer: B

Explanation:

B is correct: This is a misuse of corporate assets for personal gain — classic self-dealing.

A is incorrect: Risk-taking can be strategic, not always self-serving.

C is incorrect: Retained earnings can serve shareholder value.

Question 12

Which of the following would best align management’s interests with shareholders?
A. Paying management a fixed salary
B. Offering long-term stock options
C. Allowing management to serve on the audit committee

Answer 12

Correct Answer: B

Explanation:

B is correct: Long-term options align incentives with shareholder value.

A is incorrect: Fixed salary lacks performance motivation.

C is incorrect: Management on the audit committee creates conflicts, not alignment.

Question 13

Why might shareholders favor higher business risk than managers?
A. Shareholders are risk-averse
B. Managers want to maximize shareholder wealth
C. Shareholders can diversify, but managers’ income is tied to the firm

Answer 13

Correct Answer: C

Explanation:

C is correct: Shareholders can spread risk across firms, while managers are exposed to firm-specific risk, making them more risk-averse.

A is incorrect: Shareholders are usually less risk-averse due to diversification.

B is incorrect: Managers may not always act in shareholder interest.

Question 13

Which of the following best describes agency theory?
A. Managers and shareholders always have identical goals
B. Agents are always required to make profit-maximizing decisions
C. Conflicts arise when agents act in their own interest rather than the principal’s

Answer 13

Correct Answer: C

Explanation:

C is correct: Agency theory addresses misalignment of interests between principals and agents.

A is incorrect: Goals often diverge.

B is incorrect: Profit-maximizing is preferred, but not always followed.

Question 14

Which management decision would most likely concern long-term creditors?
A. Launching a new product line
B. Issuing new long-term debt
C. Paying large one-time dividends

Answer 14

Correct Answer: C

Explanation:

C is correct: Paying out large dividends reduces assets and increases default risk, which hurts creditors.

A is incorrect: Product expansion can benefit all stakeholders if well-managed.

B is incorrect: While adding debt does increase leverage, the dividend payout directly reduces creditor protection.

Question 15

Which of the following best describes the main objective of corporate governance?
A. To maximize short-term profits for shareholders
B. To manage and minimize conflicts of interest among stakeholders
C. To ensure a company’s legal compliance

Answer 15

Correct Answer: B
Explanation:

Correct: Corporate governance aims to manage and minimize conflicts of interest between stakeholders.

A is incorrect because maximizing short-term profits does not consider long-term stakeholder interests.

C is incorrect because legal compliance is a part of governance but not its main objective.

Question 16

Which of the following best describes stakeholder management?
A. Focusing solely on shareholders’ returns
B. Managing the board of directors’ incentives
C. Maintaining effective communication with stakeholders

Answer 16

Correct Answer: C
Explanation:

Correct: Stakeholder management involves understanding stakeholder interests and maintaining effective communication.

A is incorrect because stakeholder management includes all stakeholders, not just shareholders.

B is incorrect as it focuses only on internal governance.

Question 17

Which of the following reports is most likely to contain information about executive compensation and governance structure?
A. Quarterly earnings call transcript
B. Public company’s proxy statement
C. Internal audit report

Answer 17

Correct Answer: B
Explanation:

Correct: Proxy statements disclose executive compensation and governance details.

A is incorrect as earnings calls focus on financial performance.

C is incorrect as internal audit reports are not public.

Question 18

A company’s transparency in reporting primarily helps stakeholders by:
A. Reducing tax liabilities
B. Reducing information asymmetry
C. Increasing profit margins

Answer 18

Correct Answer: B
Explanation:

Correct: Transparent reporting reduces information asymmetry between management and stakeholders.

A and C are incorrect as they are outcomes not directly related to transparency.

Question 19

At an annual general meeting, a shareholder who cannot attend may vote by:
A. Electronic ballot
B. Tender offer
C. Proxy

Answer 19

Correct Answer: C
Explanation:

Correct: A proxy allows a shareholder to assign their voting rights to another person.

A is incorrect as not all jurisdictions use electronic ballots.

B is incorrect as tender offers relate to acquisitions, not voting.

Question 20

Which of the following resolutions requires more than a simple majority of shareholder votes and is typically addressed at an extraordinary general meeting?
A. Election of directors
B. Appointment of auditors
C. Merger or takeover

Answer 20

Correct Answer: C
Explanation:

Correct: Extraordinary matters like mergers require a supermajority and are handled at extraordinary general meetings.

A and B are incorrect as they are ordinary resolutions.

Question 21

A hedge fund pressures a company to replace its CEO due to poor performance. This is an example of:
A. Proxy solicitation
B. Shareholder activism
C. Management entrenchment

Answer 21

Correct Answer: B
Explanation:

Correct: The hedge fund is engaging in shareholder activism to influence management.

A is incorrect unless they are collecting votes via proxies.

C is incorrect as entrenchment refers to management resisting change.

Question 22

Which of the following best describes a poison pill strategy? A. A shareholder resolution requiring immediate management action B. Issuance of additional low-price shares to deter takeovers C. A legal document outlining bondholder rights

Answer 22

Correct Answer: B Explanation: Correct: A poison pill involves issuing low-price shares to existing shareholders to make takeovers more difficult. A is incorrect as it refers to shareholder activism. C is incorrect as it describes a bond indenture.

Question 23

Which document legally specifies the covenants associated with a bond? A. Proxy statement B. Bond indenture C. Prospectus

Answer 23

Correct Answer: B Explanation: Correct: The bond indenture outlines covenants and bondholder rights. A is incorrect as it relates to shareholder voting. C is incorrect as it contains general offering details.

Question 24

What role does a trustee typically perform in the context of a bond issuance? A. Appoint directors to the board B. Monitor compliance with bond covenants C. Negotiate shareholder dividends

Answer 24

Correct Answer: B Explanation: Correct: Trustees ensure companies meet their obligations under bond covenants. A and C are incorrect as they are unrelated to the trustee’s role.

Question 25

Which of the following best describes the role of a creditor committee? A. To vote on shareholder resolutions B. To represent bondholders during financial distress C. To manage internal audits

Answer 25

Correct Answer: B Explanation: Correct: Creditor committees act on behalf of bondholders in distress situations. A is incorrect as it refers to shareholders. C is incorrect as it is the role of the audit committee.

Question 26

Which of the following committees is primarily responsible for overseeing financial reporting and internal controls? A. Governance committee B. Audit committee C. Risk committee

Answer 26

Correct Answer: B Explanation: Correct: Audit committees oversee financial reporting and control systems. A is incorrect as it focuses on governance issues. C is incorrect as it deals with risk management.

Question 27

Which board committee is typically responsible for executive compensation? A. Audit committee B. Compensation committee C. Investment committee

Answer 27

Correct Answer: B Explanation: Correct: The compensation committee handles executive and director pay. A and C are incorrect as they have different oversight roles.

Question 28

What is a primary function of a nominating/governance committee? A. Determining executive bonuses B. Selecting internal audit staff C. Proposing board candidates

Answer 28

Correct Answer: C Explanation: Correct: The nominating/governance committee proposes and evaluates board members. **A and B are handled by other committees.

Question 29

Which of the following board committees should consist only of independent directors? A. Compensation committee B. Investment committee C. Risk committee

Answer 29

Correct Answer: A Explanation: Correct: Compensation committees must be independent to prevent conflicts of interest. B and C may include executives based on function.

Question 30

Employee stock ownership plans (ESOPs) primarily serve to: A. Prevent unionization B. Align employee and company interests C. Increase dividend payouts

Answer 30

Correct Answer: B Explanation: Correct: ESOPs align interests by making employees partial owners. A is incorrect and C is unrelated.

Question 31

Which mechanism best helps suppliers manage their relationship with a company? A. Proxy voting B. Board elections C. Contracts

Answer 31

Correct Answer: C Explanation: Correct: Contracts define terms between suppliers and companies. A and B are not relevant to suppliers.

Question 32

Which of the following is a recent mechanism customers use to influence company behavior? A. Government regulation B. Social media campaigns C. Tender offers

Answer 32

Correct Answer: B Explanation: Correct: Social media is an emerging tool for stakeholder influence. **A is traditional and external. **C is used by investors.

Question 33

Which entity typically enforces workplace safety standards? A. Risk committee B. Board of directors C. Government agencies

Answer 33

Correct Answer: C Explanation: Correct: Government agencies regulate workplace safety and similar issues. A and B do not enforce such standards.

Question 34

Which of the following is most likely to develop a corporate governance code in some countries? A. The board of directors B. Industry regulators C. Investment committees

Answer 34

Correct Answer: B Explanation: Correct: Regulatory agencies often issue governance codes. **A and C may adopt codes but do not develop them at a national level.

Question 35

Which of the following best describes a staggered board election? A. All directors are elected annually B. Only a portion of directors are elected each year C. Elections are held every five years

Answer 35

Correct Answer: B Explanation: Correct: Staggered boards elect only a subset of directors each cycle, making takeovers harder. A and C are not staggered formats.

Question 36

What is the purpose of an extraordinary general meeting (EGM)? A. To review annual financial statements B. To handle routine shareholder votes C. To vote on significant or urgent matters

Answer 36

Correct Answer: C Explanation: Correct: EGMs address non-routine or urgent decisions like mergers. **A is done at AGMs. **B relates to ordinary meetings.

Question 37

Which group is legally entitled to replace senior management or board members in public companies? A. Creditors B. Shareholders C. External auditors

Answer 37

Correct Answer: B Explanation: Correct: Shareholders have the right to elect and remove directors. A and C do not have that authority.

Question 38

Which of the following is an example of shareholder activism? A. Filing an annual report B. Holding a board meeting C. Proposing a resolution to change CEO compensation

Answer 38

Correct Answer: C Explanation: Correct: Activist shareholders use resolutions to influence policies or management. **A and B are routine corporate activities.

Question 39

Which of the following is a likely consequence of poor corporate governance? A. Lower risk of regulatory penalties B. Improved alignment between management and shareholder interests C. Increased risk of related-party transactions favoring insiders

Answer 39

Correct Answer: C Explanation: C is correct: Poor governance often means weak oversight, making it easier for management to engage in related-party transactions that benefit themselves or associates rather than shareholders. A is incorrect: Poor governance increases the risk of violating regulations, which raises the risk of regulatory penalties. B is incorrect: Poor governance typically leads to misalignment of interests between management and shareholders.

Question 40

A company fails to properly monitor its management team, allowing them to take unnecessary risks for personal benefit. This is best described as: A. Effective stakeholder alignment B. A principal-agent problem C. Risk-sharing efficiency

Answer 40

Correct Answer: B Explanation: B is correct: This describes the classic principal-agent problem, where managers (agents) pursue their own interests at the expense of shareholders (principals) due to lack of oversight. A is incorrect: Stakeholder alignment is a benefit of good governance, not a problem. C is incorrect: Risk-sharing efficiency refers to optimal risk distribution, which is not the case here.

Question 41

Which of the following is most likely to occur when a company has weak compliance procedures? A. Reduced cost of capital B. Higher operational efficiency C. Increased legal and reputational risk

Answer 41

Correct Answer: C Explanation: C is correct: Weak compliance makes the company vulnerable to breaking laws and losing public trust, both of which increase legal and reputational risks. A is incorrect: Poor compliance generally increases risk and raises the cost of capital. B is incorrect: Operational efficiency tends to decline under poor compliance and weak controls.

Question 42

Which of the following best describes a benefit of effective corporate governance? A. Reduced alignment between board and shareholder interests B. Increased cost of debt financing C. Enhanced financial performance and firm value

Answer 42

Correct Answer: C Explanation: C is correct: Strong governance aligns management’s interests with shareholders, improving decision-making and enhancing company performance and value. A is incorrect: Effective governance increases alignment, not reduces it. B is incorrect: It tends to reduce cost of debt due to lower perceived risk.

Question 43

A manager approves a contract that benefits his brother's company without proper disclosure. This situation is best described as a failure in: A. Stakeholder engagement B. Conflict-of-interest policy C. Board independence

Answer 43

Correct Answer: B Explanation: B is correct: This is a clear conflict of interest involving a related-party transaction, and good governance requires formal policies to prevent or disclose such cases. A is incorrect: This is not a stakeholder communication issue. C is incorrect: While board independence can help catch such issues, the root cause is lack of conflict-of-interest governance.

Question 44

Which of the following most likely contributes to better operational results? A. Ignoring related-party transaction risks B. Formal policies on conflicts of interest C. Giving management full discretion without oversight

Answer 44

Correct Answer: B Explanation: B is correct: When companies have clear rules on conflicts of interest and enforce them, they reduce abuse and improve operations. A is incorrect: Ignoring such risks invites mismanagement. C is incorrect: Lack of oversight leads to inefficiencies and self-serving decisions.

Question 45

Poor stakeholder management could result in all of the following except: A. Lawsuits from stakeholders B. Enhanced shareholder trust C. Reputational damage

Answer 45

Correct Answer: B Explanation: B is correct: Poor management of stakeholders damages relationships and trust; it does not enhance trust. A is incorrect: Disregarding stakeholder rights often leads to legal action. C is incorrect: Governance failures frequently damage company reputation.

Question 46

Which of the following is most likely an outcome of aligning management incentives with those of shareholders? A. Managers are encouraged to prioritize personal bonuses B. The company experiences stronger financial performance C. The likelihood of financial misstatements increases

Answer 46

Correct Answer: B Explanation: B is correct: Aligning incentives ensures managers focus on company value, which usually improves performance. A is incorrect: That is a risk when incentives are misaligned. C is incorrect: Proper alignment and oversight reduce the risk of misstatements.

Question 47

Which of the following statements about effective corporate governance is most accurate? A. It increases the likelihood of related-party abuses B. It requires minimal board involvement C. It provides strong control and monitoring mechanisms

Answer 47

Correct Answer: C Explanation: C is correct: Effective governance ensures active monitoring and internal controls that help manage risks. A is incorrect: It reduces, not increases, abuse. B is incorrect: Effective governance requires strong board involvement.