Topic 2: Agency theory and problems

Content

1) Introduction to agency theory and agency problems within the business

2) Agency relation between shareholders and managers, agency problems and

solution.

3) Agency relation between shareholders and creditors, conflict of interest and

solution

4) Agency relation between shareholders and Auditors, conflict of interest and

solution

5) Agency relation between shareholders and the government, conflict of interest

and solution

6) Agency relation between head quarter office and branch/subsidiary, conflict of

interest and solution

Introduction to 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:

1. They may be too many to run a single firm.

2. They may not have technical skills and expertise to run the firm

3. They are geographically dispersed and may not have time.

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 agency problem

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.

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”

Perquisites 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 by the

shareholders due to poor performance. Management of companies have been fired by

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 by shareholders.

3. The Threat of Hostile Takeover

If the shares of the firm are undervalued due to poor performance and

mismanagement. Shareholders can threaten 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 by the Shareholders

Shareholders may intervene as follows:

1. Insist on a more independent board of directors.

 2. By sponsoring a proposal to be voted at the AGM

3. 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 by 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 by a company will depend, among

other things, on:

1. Cost: the extent to which the package provides value for money

2. Motivation: the extent to which the package motivates employees both to stay

with the company and to work to their full potential.

3. 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.

4. 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 by 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 by

the shareholders.
  Cost of instituting a tight internal control system (ICS).

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:

1. The existing asset structure of the firm

2. The expected asset structure of the firm

3. The existing capital structure or gearing level of the firm

4. The expected capital structure or 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 by 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 by 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:

a) No disposal of assets without the permission of the lender.

b) No payment of dividends from retained earnings

c) Maintenance of a given level of liquidity indicated by the

amount of current assets in relation to current liabilities.

d) Restrictions on mergers and organisations

e) No borrowing of additional debt, before the current debt is

fully serviced/paid.

f) 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 by extension, the company they own operate within the environment

using the charter or licence granted by the government. The government will expect

the company and by 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:

1. Tax evasion: This involves the failure to give the accurate picture of the

earnings or profits of the firm to minimize tax liability.

 2. Involvement in illegal business activities by the firm.

3. Lukewarm response to social responsibility calls by the government.

4. Lack of adequate interest in the safety of the employees and the products

and services of the company including lack of environmental awareness

concerns by the firm.

5. Avoiding certain types and areas of investment coveted by 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

 VAT refund audits

2.Lobbying for directorship (representation)

The government can lobby for 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 incalculate 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 by 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:

 a) Colluding with the management in performance of their duties whereby their

independence is compromised.

b) 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.

c) 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.

d) 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 by 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:

a) Frequent transfer of managers

b) Adopt global strategic planning to ensure commonality of vision

c) Having a voluntary code of ethical practices to guide the branch managers

An elaborate performance reporting system providing a 2-way feedback mechanism.