Answers - Reading 16 Environmental, Social, and Governance (ESG)

Question #1 of 15 Question ID: 1472759 Which of the following scenarios is NOT an example of a principal-agent problem? A) A board member also serves as a consultant to the company. B) A senior manager also serves as a director on the board of another company. C) Top management is awarded large amounts of executive stock options. Explanation A senior manager may serve on the board of another company so long as there are no other circumstances that may compromise objectivity. For example, problems arise if the boards of two companies are "interlinked" by way of managers of Company A serving on the board of Company B, and managers of Company B serving on the board of Company A. (Module 16.1, LOS 16.a) Maria Guadalupe Hernandez is a securities analyst with Grupo Financiero Evaluar, S.A.B. de C.V. (Evaluar). Hernández is responsible for covering eleven companies in the Consumer Staples industry. Hernandez reports to Jose Antonio Rodriguez, a senior analyst and partner with the firm. Although Rodriguez has for a long time been aware that corporate governance can have a significant impact on a firm's long-term performance, he has more recently become increasingly concerned with environmental and social factors, specifically how companies manage related resources and risk exposures. Rodriguez has noted that mismanagement of ESG factors has led to a number of widely reported corporate events that have had significant negative impacts on securities prices. In addition to focusing on corporate ownership structures and how these ownership structures may affect corporate governance outcomes, Rodriguez has asked Hernandez to also take into account ESG-related risks and opportunities that are relevant to security analysis. Rodriguez has asked Hernandez to begin incorporating environmental, social, and governance (ESG) considerations into her investment analyses, in order to provide a broader perspective on the risks and investment opportunities of the various companies' securities that she analyses. Question #2 - 5 of 15 Question ID: 1472766 Hernandez is most likely to encounter principal–agent problems when analyzing a company with an ownership structure that combines: A) dispersed ownership and concentrated voting power. B) concentrated ownership and concentrated voting power. C) dispersed ownership and dispersed voting power. Explanation The combination of dispersed ownership and dispersed voting power is generally associated with shareholders who lack the power to exercise control over managers. In this scenario, there is a significant risk that managers will seek to use a company's resources to pursue their own interests; this conflict is known as a principal–agent problem. The combination of concentrated ownership and concentrated voting power, as well as the combination of dispersed ownership and concentrated voting power, are more closely associated with the principal–principal problem. (Module 16.1, LOS 16.a) Question #3 - 5 of 15 Question ID: 1472767 Hernandez is analyzing the securities of a company that has mutual business interests with another company. Two firms have cross-holding share arrangements with each other. Hernandez could best describe this structure as: A) horizontal ownership. B) vertical ownership. C) pyramid ownership. Explanation Horizontal ownership describes a scenario where companies with mutual business interests have cross-holding share agreements with each other. Pyramid (also known as vertical) ownership is the situation where a company has a controlling interest in two or more holding companies; and these holding companies have controlling interests in several operating companies. (Module 16.1, LOS 16.a) Question #4 - 5 of 15 Question ID: 1472768 Rodriguez points out to Hernandez that CEO duality is present in one of the firms that Hernandez is analyzing. It would be most accurate for Hernandez to describe CEO duality as the scenario where the chief executive officer also serves as the firm's: A) chairperson. B) president. C) chief operating officer. Explanation CEO duality is present when the chief executive officer also serves as chairperson of the board. CEO duality raises concerns that the oversight and monitoring role of the board may be compromised, relative to having chairperson and CEO roles independent. If the chairperson is not independent, (i.e., if these roles are combined), a company is likely to appoint a lead independent director in order to safeguard investor interests. (Module 16.2, LOS 16.b) Question #5 - 5 of 15 Question ID: 1472769 When integrating corporate governance and ESG factors in investment analysis, Hernandez is least likely to face which of the following challenges? A) B) Corporate governance considerations, such as the structure of the board of directors, tend to be inconsistent across most companies. ESG information and metrics are inconsistently reported by companies, and such disclosures are voluntary. C) It is difficult to identify and obtain ESG information that is relevant and useful. Explanation Corporate governance concerns, such as the structure of the board of directors, are likely to be relatively similar across most companies. By contrast, ESG considerations often differ significantly among firms. A key challenge of incorporating ESG factors into an investment analysis is finding and obtaining information that is pertinent and useful. Not only is ESG data and metrics inconsistently reported by companies, but such disclosure is not mandatory, which provides analysts further difficulties. (Module 16.2, LOS 16.c) Question #6 of 15 Question ID: 1472756 All of the following are examples of the principal-agent relationship (PAR) problem EXCEPT: A) an employee calls in sick to use up their sick time since they cannot carry it over to the next year. B) two members of a board of directors are having an illicit relationship. C) a senior executive routinely leaves the office early claiming to work from home yet there is no accountability. Explanation The PAR problem is generally viewed as being between shareholders (principals) and company executives (agents) but any employee of the firm could be viewed as an agent and therefore contribute to the principal-agent problem if they act in their own best interests to the detriment of the firm. Examples of the PAR problem are: CEOs enjoying on-the-job consumption in the form of excessive corner offices or lavish travel that is passed off as a necessary business expense. CEOs manipulating the board of directors for excessive compensation packages which are not linked to company performance. Executives seeking status by expanding the business (empire building) through acquisitions that do not benefit the existing shareholders. Company size has been strongly linked to executive compensation. (Module 16.1, LOS 16.a) Question #7 of 15 Question ID: 1472758 A principal-agent problem may exist between: A) regulators and directors. B) shareholders and directors. C) managers and directors. Explanation An agency relationship exists when an individual (the agent) acts on behalf of another individual (the principal). Such a relationship creates the potential for a principal-agent problem where the agent may act for his own well being rather than that of a principal. The key test of whether a principal-agent problem may exist is if one party is responsible for acting in the best interest of the other. Of the answer choices given, directors are responsible for acting in the best interests of shareholders. (Module 16.1, LOS 16.a) Question #8 of 15 Question ID: 1472764 Regarding the process of evaluating ESG risk exposures and investment opportunities related to a company, it is least likely that ESG integration will be used in: A) equity analysis to identify downside risk. B) fixed-income analysis to identify downside risk. C) fixed-income analysis to identify upside opportunities. Explanation In fixed-income analysis, ESG integration is generally focused on identifying downside risk. In equity analysis, ESG integration is used to both identify downside risks and potential opportunities. (Module 16.2, LOS 16.d) Question #9 of 15 Question ID: 1472755 Which of the following would be least likely to help control the principal-agent relationship (PAR) problem? A) Alter the behavior of executives through goal setting. B) Increase the asymmetry of information between the owners of the firm and the employees. C) Fire employees who misbehave. Explanation Decreasing the asymmetry of information between the owners of the firm (principals) and executives (agents) would help to control the principal-agent relationship (PAR) problem. The PAR problem arises from the agents (executives / employees) having more information about the company than the principals (owners / shareholders) and misusing that information to the advantage of the agents at the expense of the firm or principals. The other two answer choices are methods for reducing the PAR problem by affecting the behavior of agents by setting goals and principles of behavior and removing agents who misbehave and violate ethics. (Module 16.1, LOS 16.a) Question #10 of 15 Question ID: 1472760 Which of the following least accurately describes one of the nontraditional "ESG" business factors that may be critical to a company's long-term sustainability? A) security risk exposures B) environmental risk exposures C) governance risk exposures Explanation Environmental, social, and governance ("ESG") risk exposures are the nontraditional business factors that are now recognized as critical to a company's long-term sustainability. (Module 16.1, LOS 16.a) Question #11 of 15 Question ID: 1472761 CEO duality exists when the chief executive officer: A) also serves as chairperson of the board. B) also has a controlling interest in the firm. C) is simultaneously realistic and optimistic. Explanation CEO duality exists when the chief executive officer also serves as chairperson of the board. CEO duality raises concerns that (relative to independent chairperson and CEO roles) the monitoring and oversight role of the board may be compromised. (Module 16.1, LOS 16.a) Question #12 of 15 Question ID: 1472762 The boards in a two-tier board of directors are most likely to be structured as a: A) executive board and a non-executive board. B) external board and an internal board. C) supervisory board and a management board. Explanation A two-tier board of directors consists of a supervisory board that oversees a management board. A one-tier board consists of a single board of directors, composed of executive and non-executive directors (meaning, respectively, internal and external directors). (Module 16.2, LOS 16.b) Question #13 of 15 Question ID: 1472757 The principal-agent problem can best be described as: A) B) the agent may act for the well-being of the principal rather than that of the stakeholders. the agent may act for the well-being of management rather than that of the stakeholders. C) the agent may act for his own well-being rather than that of the principal. Explanation In a principal-agent relationship, one party (the agent) acts on behalf of another party (the principal). A principal-agent problem arises when the agent places his own interests ahead of the principal. (Module 16.1, LOS 16.a) Question #14 of 15 Question ID: 1472754 Which of the following best describes the principal–agent problem? An example of the principal–agent problem is when: A) a lawyer recommends protracted legal proceedings to her client. B) owners of the firm gain at the expense of the employees. C) a board of directors take advantage of their position at the expense of the shareholders. Explanation Lawyers (the agent) are incentivized to recommend protracted legal proceedings to their clients (the principal) because this will generate income for the lawyer. The principal-agent relationship (PAR) arises when one group delegates decision making or control to another group. The PAR can create problems because the group receiving the power (the agent) generally has an asymmetric information advantage over the group making the delegation (the principal). The PAR problem begins if the agent uses the information advantage for their own best interests to the detriment of the interests of the principal. It is compounded as the asymmetric information makes it difficult for the principal to know enough to detect the problem and evaluate the agent's actions. Modern corporations are built on shareholders (principals) who delegate authority to run the business to executive officers of the company (agents). The board of directors are charged with overseeing the executives of the firm. It is possible for the board of directors to align themselves too closely with the executives of the firm thus contributing to the PAR problem. (Module 16.1, LOS 16.a) Question #15 of 15 Question ID: 1472763 In the process of identifying and evaluating ESG-related risk exposures and investment opportunities, there is greatest consistency across companies in considerations related to: A) environmental. B) social. C) corporate governance. Explanation Corporate governance considerations, for example the structure of the board of directors, have a tendency to be relatively consistent across companies. In contrast, social considerations and environmental considerations often differ greatly. (Module 16.2, LOS 16.c)