THE AGENCY THEORY & CONFLICT/PROBLEM

An agency relationship exists whenever one party known as the principal appoints another party known as agent and delegates decision making authority to them (agent). Therefore in this relationship the agent acts on behalf of the principal

In finance, there are various types of agency relationships depending on the interactions between the various stakeholders in a company as follows:

  1. Shareholders (A) versus Creditors (P)
  2. Management (A) versus Shareholders (A)
  3. Shareholders (P) versus Auditors (A)
  4. Head office (P) versus Branches (A)
  5. Government (P) versus Shareholders (A)

 

Agency Problem between shareholders (P) and management (A)

Whenever ownership is divorced from control, a conflict of interest arises.

Management may take some actions that are inconsistent with the shareholders wealth maximization goal and this will cause a conflict of interest.

 

The major causes of conflict between shareholders and management includes:-

  • The incentive problem: Most managers have a fixed salary and may need motivation in order to work hard so as to maximize the wealth of the shareholders.  This is because irrespective of the profit they generate, they will be paid a fixed salary. Therefore managers will maximize leisure and work less which is against the interest of the shareholders.
  • Consumption of perks or perquisites  : Perquisites refers to high salaries and other fringe benefits which the directors might award themselves.
  • Differences in risk profile:  Shareholders normally prefer high risk high return projects while managers prefer low risk low return projects.  This is because the managers have a personal fear of losing their jobs.
  • Management buyouts : Management may attempt to acquire the business of the shareholder (principal) where this can be done forming a nominee company which will buy the shares of the company which they are managing.  Once they obtain majority shareholding they can then take control of the company.  This will also bring a conflict of interest between the two parties.
  • The evaluation horizon : Managers prefer to undertake projects which are profitable in the short-term but shareholders prefer long term investments which is consistent with the going concern concept of the firm.

   Solutions to the agency problem

  1. Threat of firing – shareholders appoint managers during the annual general meeting and if the managers are not delivering the shareholders can threaten to fire them.
  2. Threat of hostile takeover – If the shares of the firm are undervalued due to poor performance and mismanagement, shareholders can threaten to sell the company to a competitor firm. In this case the managers will lose their jobs.
  3. Performance based compensation – In this case the compensation of management will be tied to the company’s performance that can be done as follows:-
    1. Pay management fixed annual salary meant to cover the managers living expenses
    2. Pay them a salary at the end of the year depending on the performance of the company.
    3. Give them a stock option plan which is the right given to management to acquire a specified number of the company’s shares at a specified price in the future.

the junior staff in the finance department.  They include:

Implementing the internal controls in the finance department.

4. Incur agency cost – Agency cost are costs incurred the firm as a result of an agency relationship. They are normally sub-divided into three groups namely:-

The contractual cost – These are the costs incurred shareholders in designing the contract or employment letter between management and the company. The contract letter will include various issues meant to govern the behaviour of managers.  These costs also include:-

  • The legal cost of drawing up the contract letter.
  • Costs of setting up performance standards.
  • The negotiation or interview fee paid to the employment agents.

 

The monitoring cost – These are costs incurred to prevent undesirable behaviour on the part of management. They include external audit fee, legal compliance expense cost, the cost of setting up an internal control system and the investigation fee paid the company.

The opportunity cost / residual cost – These are costs which occur as a result of the restrictions on management so that they may not be able to make up a timely decision which may have been profitable to the company. These costs will include:-

  • The opportunity cost of the managers undertaking low risk low return projects instead of undertaking high risk high return projects.
  • The expenses incurred the firm as a result of the behaviour of management as agents.

 

Direct intervention shareholders

Shareholders can intervene directly and dictate to management how the business should be run.  They can intervene in the following ways:-

  • By insisting on a more independent Board of directors.
  • By making recommendations on how the company should be run.
  • By setting rules and regulations which will govern the operations of the firm
  • By sponsoring a proposal to be voted on during an annual general meeting even if the management will be against the proposal.

 

(B)  Agency Problem between Creditors (P) and shareholders (A)

Creditors lend money to the company at a particular rate of interest depending on the riskiness of the firm as perceived the creditors.  However, shareholders may influence how these funds are to be invested. Shareholders can dictate to management so that the firms invest in high risk high return projects.  Should such projects succeed, it is only the shareholders who will benefit since the creditors will only be entitled to the fixed rate of return agreed upon.  However, should those projects fail, the creditors may have to share in the loss.  Creditors will therefore view themselves to be in a lose- lose situation.

Shareholders can also prejudice creditor’s position as follows:

  • Sell the asset which was offered as a security to obtain the loan.
  • Borrow additional debt capital where the additional debt capital may take to priority over the old debt.
  •  Pay high dividends so that there are no retained earnings to repay the loan capital.

 

Setting up restrictive covenants – This refers to the restrictive terms and conditions set creditors to protect them against unethical behaviour on the part of the shareholders. This may include:-

  1. Restriction on borrowing additional debt capital
  2. Restriction on disposal of the asset used as a security
  3. Restriction on payment of dividends unless the earnings of the company exceed a given level.
  4. Restriction on the type of projects to be undertaken the company.
  5. Restriction on the liquidity ratio of the firm eg current ratio of  – 2:1  and a quick ratio  of– 1:1

 

Representation – Creditors may insist on having one of their own in the company’s board of directors who will take care of their interests.

Demanding security / collateral – The creditors can demand a security before granting credit.

Threat of not granting any future credit; Should creditors discover that the company is misusing the current credit they can threaten not to grant future credit unless the company reverts to the original agreement.

 

C) Agency problem between shareholders and auditors

Shareholders appoint auditors to monitor the performance of management and certify the financial statements issued management so as to establish if they give a true and fair view.  Auditors may however prejudice the position of shareholders by:-

  • Colluding with management during the performance of their duties and hence compromising their independence.
  • Issuing misleading reports to shareholders and the general public
  • Failure to exercise professional care and due diligence in the performance of their duties and hence failing to detect errors and frauds which they could have otherwise detected.

 

Solution to the agency problem

  • Legal action – shareholders can institute legal proceedings against auditors who issue misleading reports in order to be compensated for damages.
  • Disciplinary action professional bodies for example the institute of certified public accountants of Kenya (ICPAK). This can lead to withdrawal of their practicing certificates.
  • Shareholders can fire auditors during the annual general meeting.

 

D) Agency Problem between head office and branches

Multinational companies have diverse operations in different geographical areas all over the world.  Branches (A) are operated in order to protect the interests of the head office (P).  However, branches may pursue their goals at the expense of head office.  This leads to conflict of interest between the two parties.

 

Solutions to the agency problem

  • Having an elaborate performance reporting system which provides a two way feedback between the headquarters and the branch.
  • Frequent reshuffle of managers form one branch to another.
  • Adopting a global strategic plan for all branches thus promoting the communication of the vision and mission of the whole group.
  • Setting up performance standards and contracts for branch managers and adequately compensating them.
  • Threatening to fire those branch managers who are not working towards the achievement of the common goals of the entire group.

 

E) Agency problem between the government and shareholders

Government (P) collects taxes from shareholders (A).  However, the position of government may be prejudiced shareholders by:-

  • Tax evasion – Failing to give an accurate picture of the earnings of the company so as to minimize their tax liability.
  • Avoiding investing in certain areas or in businesses which are considered risky.
  • Not taking part in social responsibilities.

 

Solutions to the agency problems

  • The government should offer incentives to encourage investment in certain areas.
  • Government can incur monetary expenses for paying VAT audit, paying statutory audit etc.
  • Legislation – government should put in place a legal framework to govern the operations of companies.
  • The government can lobfor directorship in certain companies on the grounds that the services provided such companies are beneficial to the entire country e.g. KBC, KPLC etc.

 

Practice questions

Question one

With reference to agency theory discuss the possible areas of conflict between managers and shareholders.

Question two

  • Define the term agency relationship in the context of corporate management.
  • Discuss the methods that can be used a company to resolve the conflicts between managers and shareholders.

Question Three

Identify and briefly explain the three forms of agency relationships in a firm.

Question four

In a company an agency problem may exist between management and shareholders on one hand and the debt holders (creditors and lenders) on the other because management and shareholders who own and control the company have the incentive to enter into transactions that may transfer wealth from debt holders to shareholders.   Hence the need for agreements debt holders in lending contracts.

 

Required

  • state and explain any four actions or transactions management and shareholders that could be harmful to the interests of debt holders

(Sources of conflict)

  • Write short notes on any four restrictive covenants that debt holders may use to protect their wealth from management and shareholder raids.

Question five

  • Define agency relationship between from the context of a public limited liability company and briefly explain how this arises.
  • Highlight the various measures that would minimize agency problems between owners and management.
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