THE AGENCY THEORY AND PROBLEM

An agency relationship arises where one or more parties called the principal contracts/hires another called an agent to perform on his behalf some services and then delegates decision making authority to that hired party (Agent) In the field of finance shareholders are the owners of the firm. However, they cannot manage the firm because:

Shareholders therefore employ managers who will act on their behalf. The managers are therefore agents while shareholders are principal.
Shareholders contribute capital which is given to the directors which they utilize and at the end of each accounting year render an explanation at the annual general meeting of how the financial resources were utilized. This is called stewardship accounting.

  • In the light of the above shareholders are the principal while the management are the agents.
  • Agency problem arises due to the divergence or divorce of interest between the principal and the agent. The conflict of interest between management and shareholders is called agency problem in finance.
  • There are various types of agency relationship in finance exemplified as follows:

1. Shareholders and Management
2. Shareholders and Creditors
3. Shareholders and the Government
4. Shareholders and Auditors
5. Headquarter office and the Branch/subsidiary.

1. Shareholders and Management
There is near separation of ownership and management of the firm. Owners employ professionals (managers) who have technical skills. Managers might take actions, which are not in the best interest of shareholders. This is usually so when managers are not owners of the firm i.e. they don’t have any shareholding. The actions of the managers will be in conflict with the interest of the owners. The actions of the managers are in conflict with the interest of shareholders will be caused by:

i) Incentive Problem
Managers may have fixed salary and they may have no incentive to work hard and maximize shareholders wealth. This is because irrespective of the profits they make, their reward is fixed. They will therefore maximize leisure and work less which is against the interest of the shareholders.

ii) Consumption of “Perquisites”
Prerequisites refer to the high salaries and generous fringe benefits which the directors might award themselves. This will constitute directors remuneration which will reduce the dividends paid to the ordinary shareholders. Therefore the consumption of perquisites is against the interest of shareholders since it reduces their wealth.

iii) Different Risk-profile

Shareholders will usually prefer high-risk-high return investments since they are diversified i.e they have many investments and the collapse of one firm may have insignificant effects on their overall wealth.
Managers on the other hand, will prefer low risk-low return investment since they have a personal fear of losing their jobs if the projects collapse. (Human capital is not diversifiable). This difference in risk profile is a source of conflict of interest since shareholders will forego some profits when low-return projects are undertaken.

iv) Different Evaluation Horizons
Managers might undertake projects which are profitable in short-run. Shareholders on the other hand evaluate investments in long-run horizon which is consistent with the going concern aspect of the firm. The conflict will therefore occur where management pursue short-term profitability while shareholders prefer long term profitability.

v) Management Buy Out (MBO)
The board of directors may attempt to acquire the business of the principal. This is equivalent to the agent buying the firm which belongs to the shareholders. This is inconsistent with the agency relationship and contract between the shareholders and the managers.

vi) Pursuing power and self esteem goals
This is called “empire building” to enlarge the firm through mergers and acquisitions hence increase in the rewards of managers.

vii) Creative Accounting
This involves the use of accounting policies to report high profits e.g stock valuation methods, depreciation methods recognizing profits immediately in long term construction contracts etc.

Solutions to Shareholders and Management Conflict of Interest
Conflicts between shareholders and management may be resolved as follows:

1. Pegging/attaching managerial compensation to performance
This will involve restructuring the remuneration scheme of the firm in order to enhance the alignments/harmonization of the interest of the shareholders with those of the management e.g. managers may be given commissions, bonus etc. for superior performance of the firm.

2. Threat of firing
This is where there is a possibility of firing the entire management team the shareholders due to poor performance. Management of companies have been fired the shareholders who have the right to hire and fire the top executive officers e.g the entire management team of Unga Group, IBM, G.M. have been fired shareholders.

3. The Threat of Hostile Takeover
If the shares of the firm are undervalued due to poor performance and mismanagement. Shareholders can threatened to sell their shares to competitors. In this case the management team is fired and those who stay on can loose their control and influence in the new firm. This threat is adequate to give incentive to management to avoid conflict of interest.

4. Direct Intervention the Shareholders
Shareholders may intervene as follows:

  • Insist on a more independent board of directors.
  • By sponsoring a proposal to be voted at the AGM
  • Making recommendations to the management on how the firm should be run.

5. Managers should have voluntary code of practice, which would guide them in the performance of their duties.

6. Executive Share Options Plans
In a share option scheme, selected employees can be given a number of share options, each of which gives the holder the right after a certain date to subscribe for shares in the company at a fixed price.
The value of an option will increase if the company is successful and its share price goes up. The theory is that this will encourage managers to pursue high NPV strategies and investments, since they as shareholders will benefit personally from the increase in the share price that results from such investments.
However, although share option schemes can contribute to the achievement of goal congruence, there are a number of reasons why the benefits may not be as great as might be expected, as follows:
Managers are protected from the downside risk that is faced shareholders. If the share price falls, they do not have to take up the shares and will still receive their standard remuneration, while shareholders will lose money.
Many other factors as well as the quality of the company’s performance influence share price movements. If the market is rising strongly, managers will still benefit from share options, even though the company may have been very successful. If the share price falls, there is a downward stock market adjustment and the managers will not be rewarded for their efforts in the way that was planned.
The scheme may encourage management to adopt ‘creative accounting’ methods that will distort the reported performance of the company in the service of the managers’ own ends.

Note
The choice of an appropriate remuneration policy a company will depend, among other things, on:

  • Cost: the extent to which the package provides value for money
  • Motivation: the extent to which the package motivates employees both to stay with the company and to work to their full potential.
  • Fiscal effects: government tax incentives may promote different types of pay. At times of wage control and high taxation this can act as an incentive to make the ‘perks’ a more significant part of the package.
  • Goal congruence: the extent to which the package encourages employees to work in such a way as to achieve the objectives of the firm – perhaps to maximize rather than to satisfy.

7. Incurring Agency Costs
Agency costs are incurred the shareholders in order to monitor the activities of their agent.
The agency costs are broadly classified into 4.

a) The contracting cost.

These are costs incurred in devising the contract between the managers and shareholders.
The contract is drawn to ensure management act in the best interest of shareholders and the shareholders on the other hand undertake to compensate the management for their effort.
Examples of the costs are:

  • Negotiation fees
  • The legal costs of drawing the contracts fees.
  • The costs of setting the performance standard,

b) Monitoring Costs

This is incurred to prevent undesirable managerial actions. They are meant to ensure that both parties live to the spirit of agency contract. They ensure that management utilize the financial resources of the shareholders without undue transfer to themselves.
Examples are:

  • External audit fees
  • Legal compliance expenses e.g. Preparation of Financial statement according to international accounting standards, company law, capital market authority requirement, stock exchange regulations etc.
  • Financial reporting and disclosure expenses
  • Investigation fees especially where the investigation is instituted the shareholders.
  • Cost of instituting a tight internal control system (ICS).

c) Opportunity Cost/Residual Loss

This is the cost due to the failure of both parties to act optimally e.g.

  • Lost opportunities due to inability to make fast decision due to tight internal control system
  • Failure to undertake high risk high return projects the manager leads to lost profits when they undertake low risk, low return projects.

d) Restructuring Costs – e.g. new I.C.S., business process reengineering etc.

2. SHAREHOLDERS AND CREDITORS/bond/debenture holders
Bondholders are providers or lenders of long term debt capital. They will usually give debt capital to the firm on the strength of the following factors:

  • The existing asset structure of the firm
  • The expected asset structure of the firm
  • The existing capital structure or gearing level of the firm
  • The expected capital structure of gearing after borrowing the new debt.

Note

  • In raising capital, the borrowing firm will always issue the financial securities in form of debentures, ordinary shares, preference shares, bond etc.
  • In case of shareholders and bondholders the agent is the shareholder who should ensure that the debt capital borrowed is effectively utilized without reduction in the wealth of the bondholders. The bondholders are the principal whose wealth is influenced the value of the bond and the number of bonds held.
    Wealth of bondholders = Market value of bonds x No. of bonds /debentures held.
  • An agency problem or conflict of interest between the bondholders (principal) and the shareholders (agents) will arise when shareholders take action which will reduce the market value of the bond and extension, the wealth of the bondholders. These actions include:

a) Disposal of assets used as collateral for the debt in this.
In this case the bondholder is exposed to more risk because he may not recover the loan extended in case of liquidation of the firm.

b) Assets/investment substitution
In this case, the shareholders and bond holders will agree on a specific low risk project.
However, this project may be substituted with a high risk project whose cash flows have high standard deviation. This exposes the bondholders because should the project collapse, they may not recover all the amount of money advanced.

c) Payment of High Dividends
Dividends may be paid from current net profit and the existing retained earnings. Retained earnings are an internal source of finance. The payment of high dividends will lead to low level of capital and investment thus reduction in the market value of the shares and the bonds.
A firm may also borrow debt capital to finance the payment of dividends from which no returns are expected. This will reduce the value of the firm and bond.

d) Under investment
This is where the firm fails to undertake a particular project or fails to invest money/capital in the entire project if there is expectation that most of the returns from the project will benefit the bondholders. This will lead to reduction in the value of the firm and subsequently the value of the bonds.

e) Borrowing more debt capital
A firm may borrow more debt using the same asset as a collateral for the new debt. The value of the old bond or debt will be reduced if the new debt takes a priority on the collateral in case the firm is liquidated. This exposes the first bondholders/lenders to more risk.
Solutions to agency problem
The bondholders might take the following actions to protect themselves from the actions of the shareholders which might dilute the value of the bond. These actions include:

1. Restrictive Bond/Debt Covenant
In this case the debenture holders will impose strict terms and conditions on the borrower.
These restrictions may involve:

  • No disposal of assets without the permission of the lender.
  • No payment of dividends from retained earnings
  • Maintenance of a given level of liquidity indicated the amount of current assets in relation to current liabilities.
  • Restrictions on mergers and organisations
  • No borrowing of additional debt, before the current debt is fully serviced/paid.
  • The bondholders may recommend the type of project to be undertaken in relation to the riskness of the project.

2. Callability Provisions
These provisions will provide that the borrower will have to pay the debt before the expiry of the maturity period if there is breach of terms and conditions of the bond covenant.

3. Transfer of Asset
The bondholder or lender may demand the transfer of asset to him on giving debt or loan to the company. However the borrowing company will retain the possession of the
asset and the right of utilization.
On completion of the repayment of the loan, the asset used as a collateral will be transferred back to the borrower.

4. Representation
The lender or bondholder may demand to have a representative in the board of directors of the
borrower who will oversee the utilization of the debt capital borrowed and safeguard the
interests of the lender or bondholder.

5. Refuse to lend
If the borrowing company has been involved in un-ethical practices associated with the debt capital borrowed, the lender may withhold the debt capital hence the borrowing firm may not meet its investments needs without adequate capital.
The alternative to this is to charge high interest on the borrower as a deterrent mechanism.
6. Convertibility: On breach of bond covenants, the lender may have the right to convert the bonds into ordinary shares.

3. Agency Relationship Between Shareholders And The Government

Shareholders and extension, the company they own operate within the environment using the charter or licence granted the government. The government will expect the company and extension its shareholders to operate the business in a manner which is beneficial to the entire economy and the society.
The government in this agency relationship is the principal while the company is the agent.
It becomes an agent when it has to collect tax on behalf of the government especially withholding tax and PAYE.
The company also carries on business on behalf of the government because the government does not have adequate capital resources. It provides a conducive investment environment for the company and share in the profits of the company in form of taxes.
The company and its shareholders as agents may take some actions that might prejudice the position or interest of the government as the principal. These actions include:

  • Tax evasion: This involves the failure to give the accurate picture of the earnings or profits of the firm to minimize tax liability.
  • Involvement in illegal business activities the firm.
  • Lukewarm response to social responsibility calls the government.
  • Lack of adequate interest in the safety of the employees and the products and services of the company including lack of environmental awareness concerns the firm.
  • Avoiding certain types and areas of investment coveted the government.

Solutions to the agency problem
The government can take the following actions to protect itself and its interests.

1. Incur monitoring costs
E.g. the government incurs costs associated with:

  • Statutory audit
  • Investigations of companies under Company Act
  • Back duty investigation costs to recover tax evaded in the past
  • VAT refund audits

2. Lobbying for directorship (representation)
The government can lobfor directorship in companies which are deemed to be of strategic nature and importance to the entire economy or society e.g directorship in KPLC, Kenya Airways, KCB etc.

3. Offering investment incentives
To encourage investment in given areas and locations, the government offers investment incentives in form of capital allowances as laid down in the Second schedule of Cap 470.

4. Legislations
The government has provided legal framework to govern the operations of the company and provide protection to certain people in the society e.g. regulation associated with disclosure of information, minimum wages and salaries, environment protection etc.
5. The government can in calculate the sense and spirit of social responsibility on the activities of the firm, which will eventually benefit the firm in future.

4. Agency Relationship between Shareholders and Auditors
Shareholders appoint auditors as per the provisions of Section 159(1)-(6) of the Companies Act.
The auditors are supposed to monitor the performance of the management on behalf of the shareholders. They act as watchdogs to ensure that the financial statements prepared the management reflect the true and fair view of the financial performance and position of the firm.
Since auditors act on behalf of shareholders they become agents while shareholders are the principal. The auditors may prejudice the interest of the shareholders thus causing agency problems in the following ways:

  • Colluding with the management in performance of their duties wheretheir independence is compromised.
  • Demanding a very high audit fee (which reduces the profits of the firm) although there is insignificant audit work due to the strong internal control system existing in
    the firm.
  • Issuing unqualified reports which might be misleading the shareholders and the public and which may lead to investment losses if investors rely on such misleading report to make investment and commercial decisions.
  • Failure to apply professional care and due diligence in performance of their audit work.

Solutions to the conflict
1. Firing: The auditors may be removed from office the shareholders at the AGM.
2. Legal action: Shareholders can institute legal proceedings against the auditors who issue misleading reports leading to investment losses.
3. Disciplinary Action – ICPAK.
Professional bodies have disciplinary procedures and measures against their members who are involved in un-ethical practices. Such disciplinary actions may involve:

  • Suspension of the auditor
  • Withdrawal of practicing certificate
  • Fines and penalties
  • Reprimand

4. Use of audit committees and audit reviews.

5. HEAD OFFICE AND SUBSIDIARY/BRANCH
MNC has diverse operations set up in different geographical locations.
The HQ acts as the principal and the subsidiary as an agent thus creating an agency relationship.
The subsidiary management may pursue its own goals at the expense of overall corporate goals.
This will lead to sub-optimisation and conflict of interest with the headquarter.
This conflict can be resolved in the following ways:

  • Frequent transfer of managers
  • Adopt global strategic planning to ensure commonality of vision
  • Having a voluntary code of ethical practices to guide the branch managers

An elaborate performance reporting system providing a 2-way feedback mechanism.
Performance contracts with managers with commensurate compensation package for the same.

 

Agency Theory notes

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