THE AGENCY ISSUE

Shareholders VS Managers
Earlier it was stated that the decisions and actions of all managers, including the financial manager,
should be directed towards the goal of shareholder wealth maximization. Is this the case in practice? Do
company directors and managers, who are in effect agents of the owners, consistently act in the best
interests of the owners (the shareholders), or do they tend to act in their own best interests?

The shareholder-manager relationship, or the separation of ownership and control, gives rise to a
potential conflict between the objectives of the individual managers and the objectives of the shareholders
on whose behalf the managers operate the firm. This is known as the agency problem—that the
managers may place their personal goals and objectives above those of the firm’s owners and act
accordingly. The agency problem is the potential for conflict in objectives which exists in any principal-
agent relationship. In the corporate finance world, the principals are the shareholders who own the firm
and managers act as their agents.

For the shareholders of a firm where ownership is separate from managerial control, the agency problem
is that managers, who are in day-to-day control of the firm, may tend to act in their own personal best
interests, rather than those of the shareholders, the firm’s owners. It should be mentioned at this stage
that the agency problem only really arises in the context of large enterprises, small and medium-sized
enterprises (SMEs) tend to be managed and controlled by the owners, who are frequently the founding
members. In the case of larger companies while it is common practice for directors to own shares in their
companies, their holdings normally—certainly in the case of companies listed on the stock market—are
relatively small.

Managers may be more concerned with maximizing their personal wealth through generous salaries,
pension and remuneration packages, their status, job security and perquisites (executive cars, luxurious
offices and exclusive golf club memberships) than they are with the interests of non-director shareholders.
As a result of pursuing such personal goals, the decisions and actions of managers will be ‘satisficing’,
(a compromise between satisfying and maximizing behavior), rather than maximizing. This will lead to a
less than a maximum return for the firm and thus less wealth for its shareholders.

For a fuller discussion of the agency relationship see Jensen and Meckling (1976). They assert, for
example, that a manager as agent and not owning 100 per cent of the share capital is likely to maximize
his/her own welfare at the expense of the owners’ welfare.
Each time managers, as agents, give precedence to their own personal best interests over those of their
principals, the shareholders, this result in agency costs which have the effect of reducing owners’ wealth.
Agency costs are the additional costs incurred by a principal when acting through an agent rather than
dealing directly with another party.

Specifically, for a firm’s owners, the shareholders, agency costs arise as a consequence of:

1. Managerial rewards
Managers, despite the Cadbury, Greenbury and other reports, still have a considerable degree of
discretion and freedom when it comes to determining their own rewards, financial and non-financial. They
can typically vote themselves huge pay increases, bonuses, pension and other benefits and often these
are not even related to the firm’s actual performance. The costs of excessive and unjustified managerial
rewards are clearly borne by the shareholders.

2. Information asymmetry
Managers will possess intimate inside knowledge of the firm’s operations. As insiders they will have
access to more information about the firm than the shareholders. They can share this information with
shareholders and other stakeholders, for example lenders, or withhold it if they believe that it is in their
best interests to do so. This unequal access to, and distribution of, information between managers and
owners is known as information asymmetry, and it is a cost borne by the shareholders.

3. Managers’ risk preferences

The risk preferences of managers may be in contrast to those of their principals, the shareholders.
Managers may maintain a very low risk preference and only invest the firm’s funds in low-risk, low-return
projects. Alternatively, owner’s may have a high-risk preference.

4. Managers’ short-termism
Managers may make decisions which maximize returns in the short term at the expense of the firm’s
longer-term wealth, particularly if their rewards are related to short-term performance. For example,
important expenditures on repairs and maintenance, and investments in new fixed assets, may be
deferred so as not to depress short-term performance measures such as return on investment (ROI).
These decisions and actions would not be in the best interests of shareholders’ who are seeking to
improve the firm’s longer-term value.

HOW CAN SHAREHOLDERS DEAL WITH THE AGENCY PROBLEM?

There are a number of strategies which shareholders can adopt to deal with the agency problem, all of
which increase the firm’s operating costs but should reduce agency costs.
1. Monitoring and control arrangements.
Shareholders can introduce systems and procedures (e.g. management audit and internal control
systems) to limit the satisficing and minimal risk behavior of managers.

2. Insurance arrangements. This is similar to insurance contracts in which a third party (e.g. a bonding
or insurance company) will, in return for a premium, underwrite the risk of loss to the firm of, for example,
defalcation or dishonesty by managers.

3. Incentive arrangements for managers. The objective here is to secure better goal harmony between
owners and managers, through directly linking the rewards of managers to their performance; which is
usually measured by the achievement of specific objectives and targets as set by the owners.

 Executive share option schemes

 Performance incentive plans (PIPs)

These are two of the more common and popular examples of incentive arrangements. Executive share
option schemes allow managers the option to purchase the company’s shares at an agreed price and if
the share price rises managers can realize very substantial capital gains by exercising their options.

Share option schemes introduce better goal congruence (i.e. harmony) between managers and non-
executive shareholders. Managerial performance measures linked to long-term improvements in share
price are more consistent with shareholder wealth maximization.

Performance incentive plans may include performance shares—equity shares granted to managers as a
result of their performance—and/or cash bonuses related to the realization of specific targets. These
targets are likely to include measures of financial performance such as earnings per share (EPS), return
on investment (ROI) and other key financial ratios.

None of these arrangements provide prefect solutions to the agency problem; the temptation always
exists for managers to act in their own best interests rather than those of shareholders.

EXTERNAL INFLUENCE AND CONSTRAINT ON MANAGEMENT BEHAVIOR

In addition to the internal measures which the shareholders of an individual firm can take to alleviate the
agency problem, there are also certain external influences and constraints on managerial behavior. These
mainly take the form of market constraints and legal constraints.
1. Market constraints
The external threat of a hostile takeover (that is one which is not welcomed or supported by the
management of the takeover target company) is always present, particularly where the predator (the
acquiring company) considers the target company to be badly managed and undervalued. If a hostile
takeover is successful the existing management of the newly acquired company, which was seen as
inefficient, will be replaced. This threat of job-loss should influence managers to be more attentive and
alert to their shareholder and market expectations concerning value creation. This threat is frequently
referred to as the market for corporate control.

2. Legal constraints
Shareholders elect the board of directors of a company in a general meeting. A private company must
have at least one director while a public company must have at least two. Under UK company law
directors must: act bona fide in the best interests of the company as a whole; exercise reasonable care
and skill in the management of the company; and not allow their personal interests to conflict with their
duties to the company (Thomas 1992).

Directors’ and managers’ actions may also be constrained by the company’s articles of association
(AOA).

While strictly speaking not a legal requirement, listed companies must nonetheless comply with the Stock
Exchange rules and regulations if they wish to remain listed on the Exchange.

Creditors versus Shareholders

Conflicts between creditor and shareholders develop if:

(1) managers, acting in the interest of shareholders, take on projects with greater risk than creditors
anticipated and
(2) raise the debt level higher than was expected.

Legal agreements between the company and providers of debt finance (i.e. lenders) may contain
restrictive covenants, such as limits on dividend payments and other borrowing restrictions.