Corporate Finance, 3e (Berk/DeMarzo)
Chapter 29 Corporate Governance
29.1 Corporate Governance and Agency Costs
1) Corporate governance is best defined as:
A) the system of laws and regulations that control corporations.
B) the system of controls, regulations, and incentives designed to prevent fraud and minimize
conflicts of interest.
C) the system that determines who controls and runs a corporation.
D) the system that minimizes agency costs between bondholders and stockholders.
2) Agency costs are best defined as:
A) the costs imposed on a corporation through the laws and regulations that control corporations.
B) the costs a corporation incurs as the result of fraud.
C) the costs that arise when there are conflicts of interest between a firm’s stakeholders.
D) the costs associated with compensating managers when ownership and control are separated
in a firm.
3) Which of the following statements is FALSE?
A) The conflict of interest between managers and investors derives from the separation of
ownership and control in a corporation.
B) Any discussion of corporate controls—the system of controls, regulations, and incentives
designed to prevent fraud—is a story of conflicts of interest and attempts to minimize them.
C) Once control and ownership are separated a conflict of interest arises between the owners and
the people in control of a corporation.
D) The separation of ownership and control is perhaps the most important reason for the success
of the corporate organizational form. Because any investor can hold an ownership stake in a
corporation, investors are able to diversify and thus, with no costs, reduce their risk exposures.
4) Which of the following statements is FALSE?
A) The incentives come from owning stock in the company and from compensation that is
sensitive to performance.
B) The role of the corporate governance system is to mitigate the conflict of interest that results
from the combination of ownership and control without unduly burdening managers with the risk
of the firm.
C) Punishment comes when a board fires a manager for poor performance or fraud, or when,
upon failure of the board to act, shareholders or raiders launch control contests to replace the
board and management.
D) The corporate governance system attempts to align interests by providing incentives for
taking the right action and punishments for taking the wrong action.
5) What is corporate governance?
29.2 Monitoring by the Board of Directors and Others
1) Which of the following is/are NOT corporate monitors?
A) Security analysts
B) Lenders
C) Securities and Exchange Commission
D) All of the above are monitors.
2) Which of the following is NOT a direct action that can be taken by shareholders?
A) Submitting shareholder resolutions directing the board to take specific actions
B) Withholding votes for the board of directors candidates
C) Initiating a proxy contest
D) Voting to remove the management team
3) A board of directors is said to be captured when:
A) a majority of the directors are independent directors.
B) a majority of the directors are outside directors.
C) its monitoring duties have been compromised by connections or perceived loyalties to
management.
D) when the CEO also serves as chairman of the board of directors.
4) Regarding board size, researchers have found that:
A) smaller boards are associated with greater firm value and performance, since small groups
make better decisions than larger groups.
B) smaller boards are associated with lower firm value and performance, since small groups are
more likely to be compromised by connections to management.
C) larger boards are associated with greater firm value and performance, since larger boards tend
to have directors with a more diverse range of backgrounds and talents.
D) larger boards are associated with lower firm value and performance, since larger groups are
more likely to be compromised by connections to management.
5) Directors who are employees, former employees, or family members of employees are called:
A) managing directors.
B) independent directors.
C) inside directors.
D) gray directors.
6) Directors who are not as directly connected to the firm but who have existing or potential
business relationships with the firm are called:
A) gray directors.
B) independent directors.
C) advising directors.
D) inside directors.
7) Directors who are not employees, former employees, or family members of employees and
who do not have existing or potential business relationships with the firm are called:
A) monitoring directors.
B) independent directors.
C) gray directors.
D) inside directors.
8) Which of the following statements is FALSE?
A) The shareholders as a group elect a board of directors to monitor managers. The directors
themselves, however, have the same conflict of interest–monitoring is costly and in many cases
directors do not get significantly greater benefits than other shareholders from monitoring the
managers closely.
B) In principle, the board of directors hires the executive team, sets its compensation, approves
major investments and acquisitions, and dismisses executives if necessary.
C) In the United States, the board of directors has a clear fiduciary duty to protect the interests of
both the owners of the firm (the shareholders) and the interests of other stakeholders in the firm
(such as the employees).
D) When the ownership of a corporation is widely held, no one shareholder has an incentive to
bear the cost of monitoring, because she bears the full cost of monitoring but the benefit is
divided among all shareholders.
9) Which of the following statements is FALSE?
A) Researchers have hypothesized that boards with a majority of outside directors are better
monitors of managerial effort and actions.
B) Studies have found that firms with independent boards make fewer value-creating
acquisitions but are more likely to act in shareholders’ interests if targeted in an acquisition.
C) One early study showed that a board was more likely to fire the firm’s CEO for poor
performance if the board had a majority of outside directors.
D) Although the firm’s stock price increases on the announcement of its addition of an
independent board member, the increased firm value appears to come from the potential for the
board to make better decisions on acquisitions and CEO turnover rather than from improvements
in the firm’s operating performance.
10) Which of the following statements is FALSE?
A) A board is said to be classified when its monitoring duties have been compromised by
connections or perceived loyalties to management.
B) Even the most active independent directors spend only one or two days per month on firm
business, and many independent directors sit on multiple boards, further dividing their attention.
C) On a board composed of insider, gray, and independent directors, the role of the independent
director is really that of a watchdog.
D) Because independent directors’ personal wealth is likely to be less sensitive to performance
than that of insider and gray directors, they have less incentive to closely monitor the firm.
11) Which of the following statements is FALSE?
A) When the CEO is also chairman of the board, the nominating letter offering a seat to a new
director comes from her. This process merely serves to reinforce the sense that the outside
directors owe their positions to the CEO and work for the CEO rather than for the shareholders.
B) Over time, most of the independent directors will have been nominated by the CEO. Even
though they have no business ties to the firm, they are still likely to be friends or at least
acquaintances of the CEO.
C) Researchers have found the surprisingly robust result that larger boards are associated with
greater firm value and performance.
D) The CEO can be expected to stack the board with directors who are less likely to challenge
her.
12) Which of the following statements is FALSE?
A) In addition to the evidence that board independence matters for major activities such as firing
CEOs and making corporate acquisitions, researchers have found a strong connection between
board structure and firm performance.
B) Theoretical and empirical research support the notion that the longer a CEO has served,
especially when that person is also chairman of the board, the more likely the board is to become
captured.
C) Most firms that have just gone public either as young companies or as older firms returning to
public status after a leveraged buyout (LBO) choose to start with smaller boards.
D) Boards tend to grow over time as members are added for various reasons. For example,
boards are often expanded by one or two seats after an acquisition to accommodate the target
CEO and perhaps one other target director.
13) What is the difference between Inside, gray, and outside directors?
29.3 Compensation Policies
1) Backdating refers to:
A) choosing the strike price of a stock option retroactively.
B) choosing the exercise date of the stock option retroactively.
C) choosing the share conversion ratio retroactively.
D) choosing the grant date of a stock option retroactively.
2) Which of the following statements is FALSE?
A) Increasing the pay-for-performance sensitivity comes with the added benefit of reducing
manager’s risk.
B) Stock and option grants give managers a direct incentive to increase the stock price to make
their stock or options as valuable as possible.
C) By tying compensation to performance, the shareholders effectively give the manager an
ownership stake in the firm.
D) During the 1990s, most companies adopted compensation policies that more directly gave
managers an ownership stake by including grants of stock or stock options to executives.
3) Which of the following statements is FALSE?
A) The substantial use of stock and option grants in the 1990s greatly increased managers’ pay-
for-performance sensitivity.
B) The optimal level of sensitivity of managers’ compensation to the performance of their firms
depends on the managers’ level of risk aversion, which is hard to measure.
C) While decreasing managers’ risk exposure, increasing the sensitivity of managerial pay and
wealth to firm performance does have some negative effects.
D) In the absence of monitoring, the other way the conflict of interest between managers and
owners can be mitigated is by closely aligning their interests through the managers’
compensation policy.
4) Which of the following statements is FALSE?
A) Backdating refers to the practice of choosing the grant date of a stock option retroactively, so
that the date of the grant would coincide with a date when the stock price was at its low for the
quarter or for the year.
B) Unless it is reported in a timely manner to the IRS and to shareholders, and reflected in the
firm’s financial statements, backdating is illegal.
C) The use of backdating suggests that some executive stock option compensation may not truly
have been earned as the result of good future performance of the firm.
D) By backdating the option the executive receives a stock option that is already out-of-the-
money, with a strike price equal to the higher price on the supposed grant date.
5) Which of the following statements is FALSE?
A) New SEC rules require firms to report option grants within two days of the grant date, which
may help prevent further abuses.
B) Studies have found evidence that the practice of timing the release of information to
maximize the value of CEO stock options is widespread.
C) Managers have an incentive to manipulate the release of financial forecasts so that good news
comes out before options are granted and bad news is delayed until after the options are granted.
D) The factor contributing most to the climb in CEO total compensation for the 1990s was the
sharp increase in the value of stock and options granted each year.
6) What are some of the negative effects of increasing the sensitivity of managerial pay to firm
performance?
29.4 Managing Agency Conflict
1) Which of the following statements is FALSE?
A) The relationship between managerial ownership and firm value is unlikely to be the same for
every firm, or even for different executives of the same firm.
B) Even with the risk benefits of separating ownership and control, there are still examples of
corporations in which the top managers have substantial ownership interests.
C) Academic studies do not support the notion that greater managerial ownership is associated
with fewer value-reducing actions by managers.
D) While increasing managerial ownership may reduce perquisite consumption, it also makes
managers harder to fire—thus reducing the incentive effect of the threat of dismissal.
2) Which of the following statements is FALSE?
A) If managers have large ownership stakes, then shareholders are more likely to use
compensation policies or a stronger board to create the desired incentives.
B) If all else fails, the shareholders’ last line of defense against expropriation by self-interested
managers is direct action.
C) A shareholder resolution could direct the board to take a specific action, such as discontinue
investing in a particular line of business or country, or remove a poison pill.
D) Any shareholder can submit a resolution that is put to a vote at the annual meeting.
3) Which of the following statements is FALSE?
A) Recently, shareholders have started organizing “no” votes. That is, when they are dissatisfied
with a board, they simply refuse to vote to approve the slate of nominees for the board.
B) One early study of proxy contests found that the announcement of a contest increased firm
stock price by 8% on average, even if the challenge was eventually unsuccessful and the
incumbents won reelection.
C) Shareholders’ only real role in governance is in electing the directors of the company.
D) Perhaps the most extreme form of direct action that disgruntled shareholders can take is to
hold a proxy contest and introduce a rival slate of directors for election to the board.
4) Which of the following statements is FALSE?
A) One study found that firms with fewer restrictions on shareholder power performed worse
than firms with more restrictions during the 1990s.
B) Some large public pension funds, such as CalPERS (the California Public Employees
Retirement System), take an activist role in corporate governance.
C) In 2004 with the Walt Disney Company, major shareholders were dissatisfied with the recent
performance of Disney under long-time CEO and Chairman, Michael Eisner. They began an
organized campaign to convince the majority of Disney shareholders to withhold their approval
of the reelection of Eisner as director and chairman of the board.
D) Given the importance of shareholder action in corporate governance, researchers and large
investors alike have become increasingly interested in measuring the balance of power between
shareholders and managers in a firm.
5) Which of the following statements is FALSE?
A) An active takeover market is part of the system through which the threat of dismissal is
maintained.
B) When internal governance systems such as ownership, compensation, board oversight, and
shareholder activism fail, the one remaining way to remove poorly performing managers is by
mounting a hostile takeover.
C) Likely because hostile takeovers and internal governance systems are substitute mechanisms,
researchers have found that boards are less likely to fire managers for poor performance during
active takeover markets than they are during lulls in takeover activity.
D) The effectiveness of the corporate governance structure of a firm depends on how well
protected its managers are from removal in a hostile takeover.
6) What is the role of takeovers in corporate governance?
29.5 Regulation
1) The Sarbanes-Oxley Act:
A) prohibits insiders with a fiduciary duty to their shareholders from trading on material non-
public information in that stock.
B) prohibits anyone with nonpublic information about a pending or ongoing tender offer from
trading on that information.
C) overhauls incentive and independence in the auditing process.
D) requires corporations to consider all stakeholders in corporate governance decisions.
2) Insider trading is best described as:
A) when a member of the management team makes a trade based upon privileged information.
B) when a member of the management team makes a trade based upon public information.
C) when any investor makes a trade based upon public information.
D) when any investor makes a trade based upon privileged information.
3) Which of the following was NOT a finding of the Cadbury Commission?
A) Audit and compensation committees should be made up entirely of independent directors or,
at least, have a majority of them.
B) Auditors should be rotated, and there should be fuller disclosure of non-audit work.
C) The CEO should not be chairman of the board, and at the very least there should be a lead
independent director with similar agenda-setting powers.
D) The CEO and the CFO should personally attest to the accuracy of the financial statements
presented to shareholders.
4) The Sarbanes-Oxley Act requires all of the following EXCEPT:
A) that audit partners rotate every five years to limit the likelihood that auditing relationships
become too cozy over long periods of time.
B) strict limits on the amount of non-audit fees (consulting or otherwise) that an accounting firm
can earn from the same firm that it audits.
C) that senior management and the boards of public companies to be comfortable enough with
the process through which funds are allocated and controlled, and outcomes monitored
throughout the firm, to be willing to attest to their effectiveness and validity.
D) the auditor must personally attest to the accuracy of the financial statements presented to
shareholders and to sign a statement to that effect.
5) While the Sarbanes-Oxley Act (SOX) contains many provisions, the overall intent of the
legislation was to improve the accuracy of information given to both boards and to shareholders.
SOX attempted to achieve this goal in all of the following ways EXCEPT:
A) overhauling incentives and independence in the auditing process.
B) mandating the separation of the positions of CEO and Chairman of the Board.
C) stiffening penalties for providing false information.
D) forcing companies to validate their internal financial control processes.
6) Which of the following statements is FALSE?
A) The Cadbury Commission stiffened the criminal penalties for providing false information to
shareholders.
B) The Exchange Acts of 1933 and 1934, among other things, established the Securities and
Exchange Commission (SEC) and prohibited trading on private information gained as an insider
of a firm.
C) Many of the problems at Enron, WorldCom, and elsewhere were kept hidden from boards and
shareholders until it was too late. In the wake of these scandals, many people felt that the
accounting statements of these companies, while often remaining true to the letter of GAAP, did
not present an accurate picture of the financial health of a company.
D) While one study found that those firms that separated the position of CEO and chairman
performed better, another found no relation between the independence of key board committees
and firm performance in the post-Cadbury era.
7) Which of the following statements regarding auditors is FALSE?
A) Most auditors have a longstanding relationship with their audit clients; this extended
relationship and the auditors’ desire to keep the lucrative auditing fees makes auditors less
willing to challenge management.
B) Most accounting firms have developed large and extremely profitable consulting divisions.
Obviously, if an audit team refuses to accommodate a request by a client’s management, that
client will be less likely to choose the accounting firm’s consulting division for its next
consulting contract.
C) Auditing firms are supposed to ensure that a company’s financial statements accurately reflect
the financial state of the firm.
D) In the post Sarbanes-Oxley world, accounting firms are no longer allowed to offer both audit
and non-audit services to the same firm.
8) Which of the following statements regarding auditors is FALSE?
A) The Sarbanes-Oxley Act called on the SEC to force companies to have audit committees that
are dominated by outside directors and required that at least one outside director have a financial
background.
B) Whether information is material has been defined in the courts as referring to whether the
information would have been a significant factor in an investor’s decision about the value of the
security.
C) CEOs and CFOs must return bonuses or profits from the sale of stock or the exercise of
options during any period covered by statements that are later restated.
D) The law is especially strict with regard to takeover announcements, prohibiting any insider
with nonpublic information about a pending or ongoing tender offer from trading on that
information or revealing it to someone who is likely to trade on it.
9) Describe the main requirements of the Sarbanes-Oxley Act of 2002.
29.6 Corporate Governance Around the World
1) Dual class shares are best defined as:
A) a process where a company issues both common and preferred stock to finance the company.
B) a scenario in which companies have more than one class of shares and one class has superior
voting rights over the other class.
C) a scenario in which 51% of the shares are held by a holding company which is part of a
pyramid structure.
D) a process where a company issues shares in two separate countries each trading on a separate
stock exchange.
2) Which of the following statements is FALSE?
A) In many other countries, the central conflict is between what are called “controlling
shareholders” and “minority shareholders.”
B) Controlling shareholders can make decisions that benefit them disproportionately relative to
the minority shareholders, such as employing family members rather than the most talented
managers or establishing contracts favorable to other family controlled firms.
C) As recent events and corporate scandals have shown, investor protection in the United States
is generally seen as substandard when compared to the developed economies in the world.
D) Much of the focus in the United States is on the agency conflict between shareholders, who
own the majority of a firm but are a dispersed group, and managers, who own little of the firm
and must be monitored.
3) Which of the following statements is FALSE?
A) The United States is somewhat of an exception, in that it focuses solely on maximizing
shareholder welfare.
B) A controlling family has many opportunities to expropriate minority shareholders in a
pyramid structure.
C) One way for families to gain control over firms even when they do not own more than half
the shares is to issue dual class shares—a scenario in which companies have more than one class
of shares and one class has superior voting rights over the other class.
D) Researchers have claimed that the degree of investor protection was largely determined by the
legal origin of the country—specifically, whether its legal system was based on British common
law (less protection) or French, German, and Scandinavian civil law (more protection).
4) Which of the following statements is FALSE?
A) Controlling shareholders pay for their control rights because the firm effectively faces a
higher cost of equity for outside capital.
B) Most countries follow what is called the stakeholder model, giving explicit consideration to
other stakeholders—in particular, rank-and-file employees.
C) In a pyramid structure, a family first creates a company in which it owns more than 50% of
the shares and therefore has a controlling interest.
D) A conflict of interest arises because the family has an incentive to try to move profits (and
hence dividends) down the pyramid—that is, toward companies in which it has few cash flow
rights and away firms in which it has more cash flow rights.
5) How does a pyramid structure work?
6) Describe the “stakeholder” model of corporate governance.
29.7 The Tradeoff of Corporate Governance
1) Which of the following statements is FALSE?
A) It is important to keep in mind that good governance is value enhancing and so, in principle,
is something investors in the firm should strive for.
B) Corporate governance is a system of checks and balances that trades off costs and benefits.
C) Because good governance is based upon a basic set of principals, like those detailed in the
Cadbury Commission’s findings, one should expect all firms to display similar governance
structures.
D) The costs and benefits of a corporate governance system also depend on cultural norms.