Corporate Governance and Agency Theory

Corporate Governance and Agency Theory:

“Agency relationship is a contract under which one or more persons (the principals) engage another person (agent) to perform some service on their behalf that involves delegating some decision-making authority to the agent.” Jensen & Meckling

In corporate governance we are interested in shareholder-auditor agency relationship as well as the shareholder-manager relationship. The auditor acts as the shareholder’s agent when carrying out an audit, and thus the shareholders wish them to maintain their independence of the management of the company being audited.

Agency - Agency theory identifies the agency relationship where one party, the principal, delegates work to another party, the agent. In the context of a corporate, the owners are the principal and the directors are the agent.

Directors/managers act as agents for the owners. Therefore, corporate governance frameworks aim to ensure that directors/managers fulfil their responsibilities as agents by requiring disclosure and suggesting they be rewarded for on the basis of performance.

Other than agency theory highlighted above, the following is a summary of the various theories affecting corporate governance development:

1. Transaction cost economics- Transactions cost economics views the firm itself a governance structure. The choice of an appropriate governance structure can help align the interest of directors and shareholders.
2. Stakeholder - Stakeholder theory takes account of a wider group of constituents rather than focusing on shareholders. Where there is an emphasis on stakeholders, then the governance structure of the company may provide for some direct representation of the stakeholder groups.
3. Stewardship -Directors are regarded as the stewards of the company’s assets and will be predisposed to act in the best interest of the shareholders.
4. Class hegemony - Directors view themselves as elite at the top of the company and will recruit /promote to new director appointments taking into account how well new appointments might fit into that elite.
5. Managerial hegemony- Management of a company, with its knowledge of day-day operations, may effectively dominate the directors and hence weaken the influence of the directors.

Accountability and fiduciary responsibilities

Accountability - means that the agent is answerable under the contract to his principal. He must account for resources of his principal and the money he has gained in working for his principal’s behalf. In as much as he has been involved in generating the money, he is not at liberty to use the money as he pleases because the money belongs to the principal.

In order to make the agents accountable, corporate governance principles have been developed to monitor the behaviour of directors. This principle helps the principal to enforce the required accountability.

However, there is always a challenge when the agent is accountable to more parties than the principal. Stakeholder view is there to address these conflicting duties.

Fiduciary duty – is a duty of care and trust which one person or entity owes to another. It can be a legal or ethical obligation.

In law it is a duty imposed upon certain persons because of the position of trust and confidence in which they stand in relation to another. This duty requires full disclosure of information held by the fiduciary, a strict duty to account for any profits received as a result of the relationship, and a duty to avoid conflict of interest.

Under English law company directors owe a fiduciary duty to the company to exercise their powers bona fide in what they honestly believe to be in the best interests of the company. This duty of care is owed to the company and NOT to individual shareholders. Directors must at all times use their powers for a proper purpose and these powers are restricted for the purpose for which they were given.

Fiduciary relationship with stakeholders

In as much as management owes a duty of care to the company, it also has a fiduciary relationship to stake holders. It must act in the interests of the stakeholders as their agent, and it must act in the interest of the corporation to ensure to ensure going concern of the firm, safeguarding the long-term stakes of each group.

Performance – all agents have a contractual obligation to perform the agreed tasks that they are rewarded for. However, the activities of agents must be within the law. Hence, agents must not accept to perform an illegal act regardless of the reward associated with such an illegal act.

Obedience – the agent must act strictly in accordance with his principal’s instructions provided these are lawful (as highlighted above) and reasonable. Only lawful instructions must be obeyed.

Skill – agents must keep their skills up to date and they must ensure that they maintain standards of skill and care as would be expected of persons in their profession.

Personal performance – the agent owes the duty to perform his task himself/herself and not to delegate to another because he is selected of his personal qualities. Where delegation is necessary, the agent is still held responsible for the work delegated to a third party. In certain situations, the agent may delegate such as a solicitor acting for a client would be obliged to instruct a stockbroker to buy or sell listed securities on a stock exchange.

No conflict of interest – the agent must at all times not put himself in a situation where his own interest conflict with those of the principal even if the sale is at a fair price. e.g he cannot sell a company property to himself or vice versa.

Confidentiality - the agent must keep in confidence what he knows of his principal’s affairs even after agency relationship has ceased.

Dealing with benefits – all benefits must be handed to the principal unless the principal agrees that the agent may retain them. The agent will however be paid his remuneration. He also must account for all the benefits to the principal. The agent must not offer commission or reward to other parties to induce them to make contracts with him. Such acts would be regarded as a bribe and the contract would be fraudulent.

AGENCY THEORY

Agency in relation to Director-Shareholder relationship

Agency has become of great import due to the dominance of the joint-stock company, the company limited by shares as a business organisation. For larger companies, this has led to separation of ownership of the company and itsmanagement. The owners are principals and the management are agents.

In this relationship, the shareholders are despite being the owners of the company have no right to inspect the books of accounts. In short, there powers are restricted even though directors have to account to them. There forecast of company future prospects are gleaned from the annual report and accounts, journals, and daily tabloids.

How then does conflict of interest arise in this principal-agent relationship? The day-to-day running of the company is the responsibility of the directors and other managers to whom the directors delegate, not the shareholders. Hence, the conflict of between management and shareholders.

The agency problem

Shareholders as already noted are not involved in day to day management of the organisation and their rights are limited in some way. This results in the agency problem especially in joint stock companies – shareholders (principals) not running the company but depending on agents (directors) to do it for them. Usually, this separation of ownership from management can result in breach of trust by directors by intentional action, omission, neglect or incompetence. This is common where the directors are pursuing their own interest rather than those of shareholders. Sometimes, it could be that the directors and shareholders have different risk appetites.

Sometimes, agents would concentrate on achieving short-term organisational objectives, such as maximising profits, inorder to maximise their own bonuses at the expense of future prospects. They will by all means reduce capital expenditure in the short term to get maximum profit. Hence, the organisation will be profitable in the short term and non-profit table in the long-term.

To help address this problem, shareholders have the power to remove directors from office.

Agency costs

For shareholders to verify what the agent is doing due to limited information they have and also for them to introduce mechanisms to control the activities of the agent, there is a cost involved. The shareholders (principals) as a result of wanting to exercise control and monitoring incur agency cost. Agency cost are costs of monitoring and control that is required due to separation of ownership and management.

Examples of common agency costs include:

• External auditors’ fees;
• Time spent in attending company meetings;
• Cost of studying and analysing company data;
• Transaction cost of shareholding;
• Purchase of expert analysis;
• Costs of devising and enforcing directors’ contracts;

The best way to minimise agency costs is by aligning interest of shareholders and directors.

In public companies, shareholder agency cost may increase due to the following factors among others:

• Concerns over strategies and risk;
• Lack of or inadequate communication by company;
• Conflicts with other shareholders;
• Inadequacy of governance arrangements.

Alignment of Interests

In order to better achieve organisational objectives and solve the agency problem, there is need to align objectives of individual employees and department objectives. Once these objectives are align, there will also be alignment of interest.

The objectives of agents and the objectives of the organisation as a whole must be aligned.

For instance, inorder to align interest and solve the agency problem, managers can be given some profit related pay or other incentives that are related to profit or share price. However, it must be noted that this approach may not be the best as profit related incentives may lead to creative accounting methods which distort the reported performance of the company.

Profit related incentives may include:

• Profit related/economic value added pay – pay salaries or bonuses related to the size of profit or economic value added.
• Rewarding managers with pay – managers may be invited to subscribe for share in the company at a good/attractive price when the company ‘goes public.’ In a management buyout for instance, where existing managers purchase the business, managers become joint owners. Hence, they will act in the best interest of the organisation.
• Executive share option plans (ESOPs) – here, selected employees are given a number of share, each of which gives the holder the right after a certain date to subscribe for shares in the company at a fixed price. The values of the option will increase if the company is successful and its share price goes up, therefore giving managers incentives to take decisions to increase value of the company. That way, managers will act in the best interest of the organisation as a whole. Hence, there interests will be aligning to those of the shareholders.

Inorder to safeguard against creative accounting that comes as a result of the above options, shareholders may monitor managers’ activities/behaviours by, for instance, establishing ‘management audit’ procedures, to introduce additional reporting requirements. However, this move would result in increased agency costs as this may require significant shareholder engagement with the company.

Other agency relationships

Shareholder-auditor relationship – this focuses on shareholders as principals and auditors as agents to audit the activities of the agent inorder to give an opinion as to whether the reports show a true and fair view of activities for the period. In addition, there are also to give an opinion as to whether management’s statement on going concern is reasonable. The audit report is the key method of communication.

Shareholder auditor relationship in public companies – corporate governance codes have sought to address the problem of auditors not being independent of the management of the company that they audit. They may become too familiar with management or they may want to secure non-audit work from management. Hence, in the process the auditors loose independence.

The auditor-shareholder relationship in public companies is quite complex in some way. Auditors act as shareholders’ agent in monitoring the stewardship of directors. Auditors are also monitored by non-executive/independent directors on the board’s audit committee. They non-executive directors are responsible for recommending the appointment or removal of external auditors, deciding auditors’ remuneration package, and discussing the scope of the audit.

Director –ManagerRelationships – here directors act as principals and employees as agents. Directors must, however, ensure that they establish appropriate systems of performance measurement and monitoring.

Managers also act as principals and subordinates as agents.

Agency problem in public sector organisations– this involves agency relationship between the political leaders and ultimately taxpayers (principals) and executives officers (agents). It is quite difficult to interpret what is best for the principal due to differing interests and objectives. It is also difficult to know establish and monitor the achievement of strategic objectives.

Agency relationships in charities – the agents are the officers (directors/managers) responsible for spending the donations while principals are the donors and recipients of the charitable services. Controls must be put in place to avoid misappropriation of the donations or use of donations for self-enrichment.

TRANSACTION COST THEORY

The theory states that the way the company is organised or governed determines its control over transactions. Companies will try to keep as many transactions as possible in-house inorder to reduce uncertainties about dealing with suppliers, and about purchase price and quality. To achieve this, companies would seek vertical integration – purchase suppliers in the chain.

The theory assumes that managers are opportunistic – organise transactions to purchase their convenience. They are influenced by personal gain, likelihood of bad behaviour being discovered and extent to which their actions are tolerated.

TYPES OF STAKEHOLDERS

Directors have a responsibility towards various stakeholders.

Stakeholders are entities (persons, groups, non-human entities) that can affect or be affected by the achievement of organisational objectives. Each stakeholder group has different expectations about what it wants and different claims upon the organisation.

Stakeholders have different claims on an organisation; some want to influence what the organisation does while others are concerned with how the organisation affects them, of which they may wish to increase or decrease this effect.

Some stakeholders know they have a claim on the organisation but do not know what claim it is. Others do not know what that they have claims.

Some have direct while others have indirect claims.

Direct stakeholder claims – stakeholders who make direct claims do so with their own voice and are usually clear.

Indirect stakeholder claims – stakeholders who have indirect claims are usually unable to make the claims themselves because they are for some reason inarticulate or voiceless. The fact that some stakeholders have no voice does not invalidate their claims. Sometimes their claims may be the most powerful.

Knowledge of who stakeholders are and what claims they make is vital part of an organisation’s risk assessment, because the claims made may affect the achievement of objectives. Various stakeholders have various influences on the organisation. Hence it is important to recognise all stakeholder claims.

Care must be taken to avoid misinterpreting stakeholder claims. Misinterpreting the stakeholder claims may mean the organisations take the wrong actions or fail to take right actions to deal with stakeholder concerns due to focusing on the wrong ones. This may result in conflicts between the organisation and some stakeholders with some stakeholders taking action.

STOCKHOLDER THEORY

This theory is sometimes called shareholder theory. It focuses on the interests of shareholders. It states that shareholders alone have a legitimate claim to influence over the company. It uses agency theory to argue that shareholders (as principals) own the company. Hence, directors as agents have a moral duty to take account of shareholders’ interests. It assumes that shareholders main aim is to maximise profit, hence directors’ sole duty is to pursue profit maximisation.

STAKEHOLDER THEORY

Stakeholder theory proposes corporate accountability to broad range of stakeholders. It takes it that companies are so broad that their impact on society is so significant that it ca not just be responsible to shareholders. The organisation must always know how its activities are affecting both people inside and outside the organisation. Stakeholders must also not just exit but must be seen to be making legitimate demands upon the organisation.

What stakeholder will want will vary due to different interest.

Instrumental view of stakeholder – the view that organisations have mainly economic responsibilities in addition to the legal responsibilities that they have to fulfil inorder to keep trading. Hence, the fulfilment of responsibilities towards stakeholders is desirable because it contributes to companies maximising their profits or fulfilling other objectives such as gaining market share, meeting legal or stock exchange requirements. The organisations use shareholders instrumentally to pursue other objectives.