Title LM03 Corporate Governance - Conflicts, Mechanisms, Risks, and Benefits IFT Notes.pdf ✅

LM03 Corporate Governance 2025 Level I Notes © IFT. All rights reserved 1 LM03 Corporate Governance - Conflicts, Mechanisms, Risks, and Benefits 1. Introduction ........................................................................................................................................................... 2 2. Stakeholder Conflicts and Management ..................................................................................................... 2 Shareholder and Manager/Director Relationships ............................................................................... 3 Controlling and Minority Shareholder Relationships .......................................................................... 3 Shareholder vs. Creditor (Debtholder) Interests ................................................................................... 4 3. Corporate Governance Mechanisms ............................................................................................................ 5 Shareholder Mechanisms ................................................................................................................................ 5 Creditor Mechanisms ........................................................................................................................................ 6 Board of Director and Management Mechanisms .................................................................................. 7 Employee Mechanisms ..................................................................................................................................... 8 Customer and Supplier Mechanisms ........................................................................................................... 8 Government Mechanisms ................................................................................................................................ 8 4. Corporate Governance Risks and Benefits ................................................................................................ 9 Risks of Poor Governance and Stakeholder Management .................................................................. 9 Benefits of Effective Governance and Stakeholder Management .................................................... 9 Summary ...................................................................................................................................................................11 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM03 Corporate Governance 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module covers:  The principal-agent and other relationships between stakeholder groups  Corporate governance mechanisms to manage stakeholder relationships  The potential risks of poor corporate governance and the benefits from effective corporate governance 2. Stakeholder Conflicts and Management A corporation has a complex ecosystem of stakeholders as illustrated in Exhibit 1 from the curriculum. A principal-agent relationship arises when a principal hires an agent to carry out a task or a service (e.g. shareholders and managers/directors). An agent is obliged to act in the best interests of the principal and should not have a conflict of interest in performing a task. However, in reality, there are several conflicts of interest that arise in a principal-agent relationship, for example: information asymmetry. Information asymmetry: Managers have greater access to information about a company’s performance and prospects as compared to outsiders such as shareholders and creditors. This information asymmetry reduces shareholders' ability to assess managers' true performance and vote out poor performers. Investors demand higher risk premiums and returns from companies that have greater information asymmetry. In this section we will discuss a few examples of conflicts between principal-agents and
LM03 Corporate Governance 2025 Level I Notes © IFT. All rights reserved 3 other relationships. Shareholder and Manager/Director Relationships In this relationship, shareholders are the principals and managers/directors are the agents. Compensation is the main tool used to align the interest of managers/directors with those of the shareholders. In theory, stock grants/options offered as part of management compensation are intended to motivate managers to maximize shareholder value. However, in practice, the alignment of interests is rarely perfect. Common examples of conflict of interests are:  Insufficient effort: Managers may devote insufficient time to their duties. They may conduct too little monitoring of employees or assert too little control.  Entrenchment: If the overall level of manager/director compensation is excessive, they may try to avoid risk so as to not jeopardize the compensation they have been receiving.  Empire building: If manager/director compensation is tied to the size of the company, it can lead to ‘growth for growth’s sake’; managers may pursue acquisitions and expansions that do not increase shareholder value.  Excessive risk taking: Because option holders only participate in stock up moves, a compensation package that relies too heavily on stock grants/options may encourage excessive risk taking by management. Similarly, a compensation package with too little or no stock grants/options can have the opposite effect.  Self-dealing: Managers may misuse firm resources to maximize personal benefits (e.g., private planes, club memberships, and personal security), or they may defraud investors by misappropriating assets. Agency costs: Agency costs arise due to conflicts of interest when an agent makes decisions for a principal. All public companies and large private companies are usually managed by non-owners. Therefore, an agency cost in the context of a corporation is a consequence of a conflict of interest between managers and owners. Since outside shareholders are aware of this conflict, they will take steps that incur costs such as:  Costs borne by owners to monitor the management of the company, e.g., expenses of the annual report, board of director expenses, etc.  Costs borne by management to assure owners that they are maximizing the company value, e.g., the implicit cost of noncompete employment contracts and the explicit cost of insurance to guarantee performance. The better a company is governed, the lower the agency costs. Controlling and Minority Shareholder Relationships Corporate ownership structures can be classified as:
LM03 Corporate Governance 2025 Level I Notes © IFT. All rights reserved 4  Dispersed: Many shareholders exist and none of them have the ability to individually exercise control over the company.  Concentrated: An individual shareholder or a group has the ability to exercise control over the company (known as controlling shareholders) Conflicts of interest may arise between controlling shareholders and minority shareholders. For example:  Controlling shareholders may have a large percentage of their wealth tied up in company stock and would want management to diversify the company to achieve stability. Minority shareholders with diverse portfolios, on the other hand, would prefer management to focus on the core business because they can diversify cheaply on their own.  Controlling shareholders may have a multi-decade perspective, whereas some minority shareholders may seek quick gains from cost cutting, selling assets, or share repurchases. Share ownership alone may not necessarily reflect whether the control of a company is dispersed or concentrated. Controlling shareholders may be either majority shareholders or minority shareholders.  Majority shareholders: Own more than 50% of a company’s shares.  Minority shareholders: Own less than 50% of a company’s shares. Dual-Share Classes An equity structure with multiple share classes tends to assign superior voting powers to one class and limited voting rights to other classes. The multiple-class structure allows controlling shareholders avoid dilution of their voting power when new shares are issued and to retain control of board elections, strategic decisions, and all other significant voting matters for an extended period of time — even if their ownership level falls below 50%. Shareholder vs. Creditor (Debtholder) Interests There is a conflict of interest between the two suppliers of capital to a company under the following circumstances:  Distribution of dividends: Creditors are concerned if a company pays excess dividends to shareholders that may impair its ability to service debt.  Risk tolerance: Shareholders have a higher risk tolerance and prefer a company takes on more risk to generate higher returns. The better the performance of a company, the higher is the return shareholders can expect. Creditors are conservative and prefer a stable operating cash flow over higher returns as they do not have a claim to residual income.  Increased borrowing: When a company increases its borrowing and fails to generate returns to service the debt, then the default risk faced by the creditors increases.