The Agency Relationship
Relation between agent and principal is known as agency relation. Principal delegates the authority to the agent to do the work on her/his behalf. But sometimes, an agent may not work in the best interest of the principal. There may be a conflict of interest between agent and principal. Such conflict is known as the agency problem. More precisely, the agency problem is the conflict of interests between the principal and the agent.
In financial management agency problem refers to the conflict of interest between the shareholders and managers who can appropriately be viewed as the principals. and agents, respectively. There is agency problem also between shareholders through managers as agents and creditors as principals in a company. Thus, there are two types of agency problems: (i) agency problem between shareholders and managers, and (ii) agency problem between shareholders and creditors. Michael C. Jensen and William H. Meckling at first in 1976 explained the nature of agency problems in a firm.
Agency Problem: Shareholders versus Managers
The agency relationship exists between shareholders and managers in a company. Shareholders are the passive principals and managers are active agents. Shareholders are the real owners of a company. However, they cannot actively manage the company themselves since they are in large numbers and dispersed in various geographical locations. Besides, all of them may not have the necessary interests, skills, expertise, and experiences to manage the company. So shareholders elect a board of directors from among themselves for managing the firm in the shareholders’ best interest. BOD delegates its authority to the CEO who is responsible for the management of a company. A number of functional managers assist the CEO. Thus, the ownership and management of a company are separate from each other as the principals and agents.
As we know, the goal of a financial manager is to maximize the wealth of the owners of the firm. In theory, no financial manager would disagree with the goal of owners’ wealth maximization. In practice, however, managers are concerned with their personal wealth, prestige, salary, job security, lifestyle, fringe benefits, etc. So, it is doubtful that managers would necessarily act in the best interest of owners. Instead, they may pursue their own goals at the owners’ expense.
Managers may tend to compromise between their own satisfaction and maximization of shareholder wealth. They may play safe and create a satisfactory level of wealth for the shareholders instead of maximizing it. It might result in the potential loss of wealth for the shareholders.
Similarly, the management may be interested in maximizing the size of firms but for its own benefit. Growth in size of a firm reduces the chance of any hostile takeover and also increases managers’ power, status, and salaries. It also creates more opportunities for lower and middle-level management. It is also contended that the managers tend to give away corporate earnings to their favorite charitable institutions for their glory and personal satisfaction. However, such actions of managers do not necessarily maximize the shareholder wealth.
Mechanism to Resolve the Conflict of Interests between Shareholders and Managers
The agency problem has become a significant problem of modern corporations. It must be dealt with properly to achieve the goal of a corporation. Conflict of interest between shareholders and managers can be resolved through different ways which are described below.
MANAGERIAL COMPENSATION.
Managerial compensation refers to the incentive mechanism for the good performance of the management. Its objective is to attract and retain able managers and to harmonize managerial actions with the interest of shareholders. It is the most popular, and powerful, but an expensive method for aligning managerial interest to shareholders’ interest. To implement this scheme, first, the performance of management is evaluated through earning per share, return on assets and return on equity relative to other firms in the industry. If the performance meets the set standard, the managers are compensated through performance shares and executive stock options.
Performance share is given on the basis of the company’s actual performance and the continued service of management. An executive stock option is an option to buy the stock at a stated price within a specified period. It is granted to the managers to motivate them to increase the stock price greater than the stated price.
DIRECT INTERVENTION BY SHAREHOLDERS.
Shareholders may directly intervene to resolve the conflict in a number of ways. First, they may intervene by passing a resolution against the interest of the management in the annual general meeting. Next, any shareholders holding a significant share (minimum 5 percent of the total votes in Nepal) may ask to include a proposal for discussion and decision in the meeting. This form of direct intervention by shareholders has become more convenient due to the corporate bodies (institutional investors) being shareholders. They can suggest about the way of running a business. Ignoring their suggestions may be costly for management because the other shareholders and the public have the faith in the expertise of the institution. investors. Finally, shareholders holding significant shares (at least 10 percent of the total paid-up capital of the company or 25 percent of the total number of shareholders in Nepal) may ask for convening an extraordinary general meeting to discuss and decide on direct intervention.
THE THREAT OF FIRING.
Not working in the best interest of shareholders creates the threat of firing to the management. Getting fired is not good for the career and prestige of managers. So, to avoid the threats of firing, management is supposed to act in the best interest of shareholders.
THE THREAT OF HOSTILE TAKEOVER.
Hostile takeover refers to the acquisition of a company over the opposition of its management. A hostile takeover may likely take place if the company’s share price is undervalued relative to its potential due to poor management. If a hostile takeover takes place, the management of the acquired firm is generally fired. Though the management may practice poison pills and greenmail to avoid hostile takeovers, the threats still exist. So management tries to maximize share price to avoid the hostile takeover of the company. Thus, managers try to increase the share price to increase their job security and prestige.
Agency Problem: Shareholders versus Creditors
There is also a conflict of interests between shareholders and creditors. Conflict of interest between shareholders and creditors arises when the managers make decisions for shareholders’ value maximization by ignoring the interest of creditors. Creditors are viewed as principal and the shareholders as the agent in their agency relaüonship. Creditors, in general, provide their capital to the firm at a fixed rate of interest for a specified period, and the firm is authorized to use it for a given time period according to the agreed terms and conditions. Creditors do not have any say in the firm’s management and decision-making.
Both shareholders and creditors have claims on the assets and earnings of the company. Creditors get priority for receiving their interest. and principal repayment. However, creditors invest their capital to earn a fixed rate of interest and to get the principal paid back upon maturity. Shareholders invest their capital to maximize the market price of their shares. Creditors are concerned to see the earnings sufficient to cover their fixed interest payment and principal repayment in time. Creditors do not entitle to the extra return from additional risk, but they have to bear the additional risk taken by the company. So, they oppose the high risk. For example, the managers may decide to invest in a highly risky project. If such a risky project becomes successful, all the benefits go to the shareholders because the creditor will receive only the already fixed rate of return. However, if the project is unsuccessful, creditors may have to sustain the losses.
The managers may repurchase the firm’s outstanding stock by borrowing additional funds to increase the leverage situation. In such a situation also all the benefits go to the stockholders at the cost of increased risk to the creditors. Thus there is a conflict of interests between shareholders and creditors.
Mechanism to Resolve the Conflict of Interest between Shareholders and Creditors
Some of the specific mechanisms to resolve the conflict of interests between shareholders and creditors can be explained below.
PROTECTIVE TERMS AND CONDITIONS FOR CREDITORS.
Creditors may keep themselves safe by putting restrictive terms and conditions in loan contracts. These conditions are set to keep up the debt servicing capacity of the firm. Restrictive terms and conditions may include the restriction on the repurchase of shares, restructure of capital structure, dividend policy decisions, etc. In addition, it may make management mandatory to maintain a certain level of working capital. Such terms and conditions compel shareholders through managers to act in the fairway with the creditors.
COMPENSATE CREDITORS FOR INCREASED RISK.
Shareholders/managers are not entitled to expropriate wealth from creditors, as the business is an ethical game. If the creditors perceive that the shareholders are trying to take advantage of them, the creditors either refuse to deal further with the firm or they will charge a high rate of interest to compensate for the increased risk. The problem between shareholders through managers and creditors is solved by providing higher risk premiums to creditors for hi her level of risk.
