Business Finance Assignment 1

Describe the nature of the Agency Problem and the related corporate governance issues. Explain some of the actions that shareholders can take in order to deal with the problem with specific reference to the Companies Act. Describe the various ways in which the shareholders’ interests have also been protected.

Introduction

This paper reviews and analyzes the agency problem as applicable to incorporated

companies. An attempt will be made to get an insight into the literature dealing with this

interesting subject. As aptly summed up by Jassim (1988), finance theory posits that the

goal of economic organizations is to maximize stockholders' wealth. Attainment of this

goal was not an issue when owners were also managers. However, in the present day,

corporate ownership has become increasingly diffused, with very few companies still

being owned by their managers. The separation of ownership and management raises the

issue of the relationships between owners and managers. In such a set up, directors and

managers have a leeway to substitute their own interests in place of those of shareholders.

This is possible because of information asymmetry between shareholders and managers;

which tend to give managers a leverage to act at cross-purposes with advancement of

shareholder needs. Such a phenomenon, commonly referred to as “agency problem” is

prevalent in modern day corporates. The writer will look at the corporate governance

implications of the agency problem as well as the statutory and non-statutory remedies

that the shareholders may resort to in order to minimise their vulnerability.

Definition of terms

Agency Problem

Jensen and Meckling (1976) define the agency relationship as a contract under which one

party (the principal) engages another party (the agent) to perform some service on their

behalf. As part of this, the principal will delegate some decision-making authority to the

agent. Applied to finance theory, the agency problem refers to the conflict of interest

arising between creditors, shareholders and management because of differing goals

(www.investopedia.com, 30/09/08). The agency problem emanates from the arrangement

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where the interests of the agent differ substantially from those of the principal because of

the impossibility of perfectly contracting for every possible action of an agent whose

decisions affect both his own welfare and the welfare of the principal (Brennan, 1994).

Emanating from this problem is how to induce the agent to act in the best interests of the

principal.

The agency problem arises due to the separation of ownership and control of business

firms. In theory the shareholders, being the owners of the firm, control its activities. In

practice, however, due to a diffuse and fragmented set of shareholders, the latter appoints

a board of directors to direct the affairs of the company. The board would similarly

delegate the duty of day to day running of the organisation to managers. In terms of this

arrangement therefore, managers are the agents of the board whereas board members are

also agents of the shareholders. As the discussion that follows will show, an agency

problem exists when shareholders, directors and managers have conflicting ideas on how

the company should be run.

Corporate Governance

Corporate governance can be defined as the system by which corporations are directed

and controlled in line with stakeholder expectations (King II Report, July 2001). Such

task is placed upon the shoulders of directors and senior management. Corporate

governance facilitates the attainment of common sense business objectives like effective

business and risk management, establishing and maintaining good relations with

shareowners, ensuring reasonable and sustainable returns, compliance with applicable

laws and regulations among others.

The Institute of Directors (IOD) in South Africa (2002) identifies seven (7)

characteristics of good corporate governance that must be exhibited by individuals who

make decisions on behalf of a company. These are discipline; transparency;

independence; accountability; responsibility; fairness and social responsibility. The

various characteristics listed above will be fully explored with reference to how they have

been incorporated in the Zimbabwe’s Companies Act. In light of the agency problem,

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corporate governance principles assist in lessening the worry among investors about the

“professional manager” who wields excessive power. From this understanding, it can be

argued therefore, that corporate governance practices basically sets parameters which

attempts to regulate instances giving rise to agency problems.

Nature of the Agency Problem and Corporate Governance Implications

Nature of the Agency Problem

Inherent in any principal-agent relationship is the understanding that the agent will act for

and on behalf of the principal. The agent assumes an obligation of loyalty to the principal

that he will follow the principal’s instructions and will neither intentionally nor

negligently act improperly in the performance of the act. An agent cannot take personal

advantage of the business opportunities the agency position uncovers. A principal, in

turn, reposes trust and confidence in the agent. These obligations bring forth a fiduciary

relationship of trust and confidence between principal and agent.

However, the principal-agent relationship that subsists between the shareholder and the

directors on one hand and between the directors and managers on the other is fraught

with some problems. The agency problem is compounded by the conditions of

incomplete and asymmetric information as between the principal and the agent.

Shareholders (as principals), expect directors/board members (as agents), to make

decisions that will lead to the maximization of the value of their equity. In the same vein,

directors (as principals) expects management (as agents) to pursue strategies and

operations that contributes to the bottom-line and are in tune with the board’s

expectations. This scenario means that the shareholders who should stand to benefit from

the profitability of the company do not have direct control over what management (who

generate that profitability) does. This dilemma, which is a consequence of the separation

of ownership and control, raises worries that the management team may pursue

objectives attractive to them, but which are not necessarily beneficial to the shareholders.

The distance that is created between the shareholder and management team therefore

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breeds the problem of a serious lack of goal-congruence – where there is no alignment of

the actions of senior management with the interests of shareholders.

Corporate Governance Implications

Alleviation of discrepancies between shareholder and manager interests calls for strong

corporate governance measures if shareholders are to be protected from financial losses

resulting from corporate and market financial scandals.

Role of the Board

Corporate governance bestows a variety of duties on directors. Bonazzi L., Islam (2007)

defines the function of the board as a collective responsibility to determine the

company’s purpose and “ethics”; to decide the direction, i.e. the strategy; to plan; to

monitor and control managers and CEO; and to report and make recommendations to

shareholders. To ensure that directors diligently discharge these duties, personal liability

attaches to individual directors if the company can be shown to have been trading

“wrongfully” or illegally carrying out activities contrary to laws and regulations. This

personal liability will help lessen the agency problem caused by directors pursuing their

own personal interests.

Board Structures

One mechanism of corporate governance that may be used to ensure that checks and

balances are in place to minimise the agency problem would be to appoint independent

non-executive directors to the board of directors (Webb, 2006). Existence of independent

non-executive directors onto the board will ensure that management is monitored for

operational performance. For example, in terms of the RBZ Guidelines on Corporate

Governance (2004), all banking institutions’ boards should have a minimum of five (5)

directors, the majority of whom should be non-executive. Further, in terms of those RBZ

guidelines, the Chief Executive Officer (CEO) or the Managing Director (MD) of a bank

may not be a chairman of the board; a position which may only be filled by an

independent non-executive director. This position was also supported by Jensen (1993),

who suggests that ‘‘duality’’ reduces the monitoring power of the board of directors.

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Thus, a board more likely to protect shareholders from agency problems would be one

with separate individuals controlling the firm and the board (Bonazzi, 2007). Such a

board composition is important in ensuring that interests of minority shareholders are

protected and given due consideration in the decision-making process.

Related to this issue, firms whose CEOs are also part of the firm’s founding family tend

to have higher agency costs and monitoring needs than firms with unrelated CEOs. For

example, Morck et al. (2000) find that family management is inferior to professional

management. They show that these CEOs have less control over the agency problem than

CEOs who are not founders (or founder’s heirs) of the firm. Research has focused on the

theory that a strong board of directors is one that is able to effectively monitor

management and alleviate agency problems. Effective directors are typically those that

make the board more independent from the internal workings and individuals of the firm.

However, there are some boards which do not conform to codes of corporate governance

like the Cadbury (1992) Report, hence are susceptible to manipulation by management to

the detriment of the shareholders. Core et al. (1999) examine a wide range of board

characteristics and find that firms with weaker governance structures have more agency

problems, and that these firms tend to perform worse than strongly governed firms.

Specifically, they find an inverse relationship between board strength and a number of

board characteristics. Among these are the proportion of inside directors, board size, gray

directors (those directors who are not employees of the firm but receive payment from the

firm for services other than directorial duties), and when the CEO is also the board chair.

Shivdasani and Yermack (1999) find that gray directors have a conflict of interest and

can enhance management entrenchment by their presence on the board. All these

characteristics do not auger well with tenets of good corporate governance as they reduce

independence and therefore lead to poorer monitoring by the boards. A board which is

dominated by directors who are also members of the executive employees of the

company are not independent. Such a set up would mean that managers and board

members may pursue goals which do not necessarily lead to the maximization of the

value of the share holder's equity. As Webb (2006) observes, such a board would

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encourage “entrenchment” and “managerialism”. By entrenchment, management would

be protecting themselves through reducing the monitoring power of the board.

Where executive directors seek to entrench their positions in this manner, the board

would have diverted from performing its “stewardship” role which advances shareholder

interests. Since the board may not be fully independent from management and there is a

large gap between the management and the board, the managers and the board may be

tempted to have goals that compete with shareholder wealth maximization. Simon

Herbert (quoted in Baysinger and Hoskisson, 1990) proclaimed that managers might be

“satisfiers” rather than “maximisers”, i.e. they tend to act in a risk-averse manner and

seek an acceptable level of growth because they are more concerned with perpetuating

their own existence than with maximising the value of the firm to its shareholders.

The following are some of the specific conflict areas which are exacerbated by poor

corporate governance practices, namely:

Earnings retention conflicts

Managers may increase retained earnings in order to finance some projects which would

not necessarily enhance shareholder wealth. Such grandiose managerial investment

policies (Easterbrook, 1984), may not produce results that are clearly apparent to the

shareholders as it may be to management. The resultant growth grants to management a

larger power base, job security, greater prestige/status, and an ability to dominate the

board and award themselves higher levels of remuneration, (Jensen, 1986). On the other

hand, shareholders would prefer higher levels of cash distributions, especially where the

company has few internal positive Net Present Value (NPV) investment opportunities,

hence producing a clash of interests between principal and agent.

Time Horizon Agency Conflicts

McColgan (1991) observes that conflicts of interest may also arise between shareholders

and managers with respect to the timing of cash flows. Shareholders will be concerned

with all future cash flows of the company into the indefinite future. However,

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management may only be concerned with company cash flows for their term of

employment, leading to a bias in favour of short term high accounting returns projects at

the expense of long-term positive NPV projects. For example, research and development

(R&D) expenditures would tend to decline as top executives approach retirement

(Dechow and Sloan, 1991). This is because R&D expenditures reduce executive

compensation in the short-term, yet the retiring executives won’t be around to reap the

benefits of such investments. Healy (1985) also posits that time horizon agency conflict

may also lead to management using subjective accounting practices to manipulate

earnings prior to leaving their office in an attempt to maximise performance-based

bonuses.

To mitigate against negative consequences of the agency problem outlined above, various

statutory and non-statutory mechanisms may be employed as analysed below.

Statutory Protection available to Shareholders: The Companies Act [Chapter 24:03]

Legislation in the form of the Companies Act (hereafter to be referred to as “the Act”)

has been promulgated to afford shareholders some protection in the face of challenges

caused by the agency problem. Such protection is critical given the vast powers that

directors have. As noted by Volpe (1979) (citing Tett and Chadwick: Zimbabwe

Company Law), directors may act individually or corporately as a board, or in

committees or by appointing one or more managing directors or managers responsible to

them. As a board, the directors may concern themselves with anything between the

extremes of day to day management and overall policy and responsibilities.

Qualifications and Appointment of Directors

Section 173 of the Act proscribes who may become a director. For example, a person

with any legal disability, an unrehabilitated insolvent and a person convicted of certain

classes of economic crimes are not eligible for appointment as director. The objective for

placing such restrictions as noted by Christie (1998) is to keep directorship and

management of the company under responsible hands. This screening process will give

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solace to the shareholder who would know that his investments are under the stewardship

of directors who can be trusted.

Further, the Act requires directors (the agents) to be appointed by shareholders (the

principals). Section 174 of the Act gives members/shareholders an opportunity to

consider merits of each director individually. In terms thereof, no appointment of two (2)

or more directors may be made by the same resolution at a general meeting. Thus, the

qualifications required of directors as well as the appointment procedure to be followed

ensure that incidents of adverse selection and moral hazard are minimised.

Removal of Directors by Shareholders

To ensure that some checks and balances exist, the Act has a procedure for the removal

of directors by shareholders. In terms of section 175 of the Act (read with section 135),

shareholders can utilize their power from the democratic process of voting by which

means they can elect or dismiss directors. When appropriately used, the power to remove

directors from office would effectively afford shareholders protection against errant

directors who tend to pursue practices that work at cross-purposes with interests of

shareholders.

Fiduciary Duties of Directors: No Conflict of Interest

As noted by Christie (1998), the relationship between the director and the company is a

unique one. A director stands in a fiduciary relationship to the company. As such, a

director is statutorily bound by the Act to discharge his duties and exercise his powers for

the benefit of the company, not his own. This should be reflected in two major ways;

firstly, that directors should act with skill and care and secondly, that they should act in

good faith. Thus, to protect the interests of shareholders of the company, a director is

required to exhibit that degree of skill which can reasonably be expected of a person of

his knowledge and experience and avoid any conflict of interests. Table “A” Articles as

read with section 186 of the Act therefore places a special procedure to be followed

where directors are required to declare any possible conflicts of interests that may

compromise their objectivity when discharging company business. Such a procedure

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helps preclude incidents of abuse by directors and managers who stand to benefit from

inside information they may have gained by virtue of their positions in the company.

Convening of Members’ Meetings

In terms of section 124 of the Act, every public listed company is obliged to convene a

statutory meeting where directors should present a statutory report. Further, every

company (both private and public) should convene an annual general meeting (section

125), where specific business to do with the affairs of the company is discharged.

Additionally, members have the power to call for or requisition an extra-ordinary general

meeting. These various meetings are significant in advancing corporate governance and

reducing the agency conflict as they assist in bridging the information asymmetry

existing between shareholders and managers. How this is achieved is discussed below:

Annual Reports and other Disclosures

Section 146 requires management to lay the company’s accounts (i.e. the balance sheet

and the profit and loss account signed by two directors) at an annual general meeting of

members. An external auditor’s report should also be annexed to such accounts. Further,

and in terms of section 147 of the Act, there should be attached to these accounts a

directors’ report outlining the state of the company’s affairs.

Significant issues of corporate governance arise here. Effective corporate governance by

company boards requires both good information and the will to act on negative

information. The requirement to distribute the company’s accounts and other reports to

members forms the hallmark of transparency and accountability by the agents to their

principals. As pointed out earlier in this paper, such disclosures are critical for the

advancement of corporate governance and for ensuring that information asymmetry is

reduced as between agent and principal. Further, it is agreed that the publicity which

comes with such disclosures places management under compulsion to take shareholder-

value maximising decisions as managerial labor markets tend to discipline poorly

performing managers (Kaplan and Reishus, 1990).

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Thus, the platform afforded by statutory and other meetings and the reports that are

presented at those meetings gives shareholders an opportunity to assess not only “what” a

company reports but also “why” particular actions were taken.

Personal Liability of Officers and Auditors

Managers and company auditors may not afford to conduct the affairs of the company

recklessly as doing so would result in personal liability attaching to their actions (see

section 190 of the Act). Further, in terms of section 189, directors are encouraged to have

regard to the interests of the company’s members, principally to do with profit

maximization. However, the weakness of this provision is that it is merely directory and

not peremptory/compulsory.

Limits on Power of Directors

As a way of averting corporate scandals where directors would end up prejudicing the

shareholders, section 183 (1) (b) of the Act prohibits directors from disposing of the

undertaking of the company or of the whole part of such company’s assets without the

approval of the company in a general meeting. This limits the powers of directors to

unilaterally do as they wish with the company’s assets, hence preventing the possibility

of ripping-off shareholders. This way, shareholders are protected from overzealous

directors and management.

Other / Non-statutory protection available to Shareholders

Apart from the statutory provisions discussed above, other measures are also available to

be taken by shareholders to shield themselves from the agency problems. These will now

be considered below:

Appointing Non-Executive Directors

As stressed above, one of the reasons for the existence of the agency conflict is the

appointment of board members who are also members of the management team

(executive board members). The various reasons why this is so has also been discussed

above. To counter the negative effects of a board dominated by the management team,

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shareholders may consider shifting the board composition in favour of non-executive

directors. A non-executive board member would not normally sympathize with decisions

that are in conflict with the goal of maximising the wealth of shareholders. Fama and

Jensen (1983) argued that effective boards dominated by non-executive directors are

better able to separate the problems of decision management and decision control.

Outside directors are able to separate these functions and exercise decision control, since

reputation concerns, and perhaps any equity stakes they might have, provides them with

sufficient incentive to do so.

Managerial and Director Incentives

It is generally agreed that the structure of executive compensation contracts can have a

large influence in aligning the interest of shareholders and management (McColgan,

2001). Compensation contracts, and their revision, represent a financial incentive for

management to increase company value. It is argued that higher levels of such incentives

should be proportionate to higher company performance (Jensen and Meckling 1976).

Effective compensation contracts should therefore provide management with sufficient

incentive to make value maximising decisions at the lowest possible cost to shareholders.

The main forms of managerial and director compensation are basic salary, accounting-

based performance bonuses, performance-based share option schemes and long-term

incentive plans. The effectiveness of such incentives largely depends on the strategy

adopted. For example, companies with long-term investment opportunities should be

expected to employ compensation plans with contingencies which cause executives to

forfeit the compensation if they leave the company. Accounting-based bonus schemes

and performance-based share option schemes as modes of incentives will now be dealt

with below:

Accounting Based Bonus Schemes

Basing bonuses upon accounting measures of performance provides an improved

mechanism for aligning managers’ interests with those of the company’s shareholders

(McColgan 2001). However, Healy (1985) argue that paying executives on the basis of

accounting variables provides an incentive for management to directly manipulate the

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accounting system, and favour projects with short-term accounting returns at the expense

of long-term positive NPV investment. Bonuses related to company sales may further

encourage earnings retention and firm size growth, which doesn’t always equate with

payment of dividends hence shareholder wealth growth. Another weakness is that

accounting bonuses may also lead to a focus on the determining variables of these

compensation plans, perhaps leading managers to neglect other non-financial aspects of

performance like occupational health and safety; social investment; environmental

impact; and development and skilling of staff.

Performance Shares

The use of share options in executive compensation plans is generally seen as the one of

the most effective means of tying the interests of managers and shareholders. Under this

scheme, shares are offered to managers as a reward for performance which enhances

shareholder wealth. Such options give management the right to buy company stock at a

fixed price at given times in the future. As ownership of the company by inside managers

increases, so too does their incentive to invest in positive NPV projects and reduce

private perquisite consumption. The higher the value of the firm, the higher the value of

the options and the profit managers can make upon exercising them. Agrawal and

Mandelker (1987) report that stock options encourage management to make investment

and financing decisions which increase the variance of the firm’s assets. Additionally,

Denis et al. (1997) find that executive ownership is associated with greater corporate

focus, indicating that the severity of the managerial risk-aversion problem may be

reduced through higher equity stakes.

Closely linked to performance shares is the economic value added [EVA] mechanism

which can be used to tie managerial compensation to shareholder wealth maximization.

EVA is the performance measure most directly linked to the creation of shareholder

wealth over time. A positive EVA indicates that management is creating wealth for the

shareholders. It denotes an estimate of true "economic" profit, or the amount by which

earnings exceed the required minimum rate of return that shareholders and lenders could

get by investing in other securities of comparable risk.

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Critique of the Performance Share scheme

On the flip-side, share option schemes may fail to provide the necessary incentive due to

the existence of other factors beyond the control of the managers that may affect the price

of the share. Examples are macro-economic factors like interest rates, inflation,

uncompetitiveness of the economy etc, which lead to a dip in share value. Further,

evidence on the benefits of managerial share ownership tends to generally be mixed.

While the theoretical arguments for increased incentives are unquestionable, empirical

evidence suggests that insider ownership may also come at the cost of entrenchment.

Many factors can influence the relationship between insider ownership and corporate

value, and as observed by McColgan (2001), recent evidence tends to suggest that

causality may even operate in the opposite direction.

Threat of firing

According to McColgan (2001), one of the most consistent empirical results in the

corporate governance literature is that directors are more likely to lose their jobs if they

are poor performers. Poorest performing management would lose their jobs at the

instance of directors, moreso should such poor performance be for prolonged periods. In

light of this, managers may be forced to take shareholder maximising actions simply in

order to keep their jobs and in the process protecting the interests of shareholders hence

reducing goal non-congruence between shareholders and management.

Block holder or Institutional Investors

The existence of large block investor(s) in a company may overcome the problem

normally encountered by small, atomistic shareholders who may not have the time, skill,

or the interest to monitor managerial activities. Institutional shareholders are better able

to overcome this challenge, as they may have more skill, more time, and a greater

financial incentive to overcome this free-rider problem and closely monitor management.

Additionally, large shareholders may be able to elect themselves onto company boards,

increasing their ability to monitor management. Denis and Sarin (1997) contend that the

purchase of large share stakes by outside investors represents a control threat to company

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management and can provide pressure for internal governance systems to operate more

efficiently. Blockholder pressure may also deter management from non-value adding

diversification strategies. Since such investors already hold diversified portfolios, further

risk-reductions aren’t of interest to them.

Further, institutional shareholders like pension funds, mutual funds, and insurance

companies can afford to exert direct intervention. The managers of these institutions

usually have the power and take an active interest in the management of the companies in

which they hold shares. They can lobby for the interests of all shareholders and suggest

ways in which the business may be run. Such direct intervention by shareholder

representatives will influence management into shareholder value maximization.

Disciplinary Take-overs

Disciplinary takeovers will occur in response to breakdowns of internal control systems

in companies with large levels of free cash flows [Jensen (1986)]. A hostile takeover is

likely to happen when the shares of the company are undervalued relative to their

potential due to poor management. Where managers fear that they may lose their jobs

following takeovers, they may react by investing these free cash flows in more efficient

investment projects. Safieddine and Titman (1999) find that targets of failed takeover

attempts significantly increase their leverage in the period immediately following the

failed bid. These firms then tend to sell off under-performing company assets in order to

increase focus on key profitable investments, perhaps reversing previously unprofitable

diversification policies. Thus, take-over bids may be initiated not only for efficiency

gains but also as a way of disciplining poorly performing management.

Critique of the Disciplinary Take-overs

The threat of takeover alone would not be enough to ensure complete coherence between

managerial actions and shareholder wealth. This can be attributed largely to the costs of

organising takeovers, in particular the high bid premiums (Jensen and Ruback, 1983).

However, management may actively seek to reduce the probability of takeover since it

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may result in loss of personal wealth and reputation. One way of achieving that would be

to improve profitability of the firm, which in turn would be beneficial to shareholders.

Conclusion

As has been shown above, agency problems are real in the business realm. The scope of

each type of agency conflict will differ from one firm to another, as will the effectiveness

of governance mechanisms in reducing them. However, hope is not lost for the

shareholder as various mechanisms may be employed, both statutory and non-statutory to

minimise the damage to shareholder wealth caused by agency problems. Each type of

governance and other mechanisms discussed in this paper can be important in reducing

the agency costs of the separation of ownership and control, and afford protection to the

shareholder.

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