(Ch1- part.

2)

Agency Problems between Managers

and Shareholders
The two main types of agency problems are

1- Perquisites

2- Empire building

1- Perquisites or perks consist of on-the-job consumption by

the managers , While the benefits from the perks accrue to
the managers, their costs are borne by the shareholders

Examples of perks are CEO mansions financed by the firm

and personal usage of corporate jets

Another example The former CEO of Tyco International had

his company fund his wife’s 40th birthday party on Sardinia at
a cost of US$1 million

Another example Former Merrill CEO John Thain spent $1.2

million to renovate his offices, including installation of a
$35,000 toilet.”

While perks can cause public outrage, especially when they

are combined with lacklustre performance, they tend to be
modest compared to empire building

2- Empire building consists of managers pursuing growth

rather than shareholder-value maximization

1
  While there is a link between the two, growth does not
necessarily generate shareholder value and vice-versa

 Empire building is also referred to as Jensen’s free cash

flow problem , The free cash flow problem consists of
managers investing beyond the point where investment
projects earn an adequate return given their risk

So why would managers be tempted by empire building?

1- Managers derive benefits from increasing the size of their

firm

2- Such benefits include increased power and social status

3- Managerial remuneration has also been shown to depend

on firm size

Agency Problems of Debt and Equity

So far, we have focused on the agency problem of equity,
the agency problem between the managers and the
shareholders , However, there also exists an agency
problem of debt

When there is very little equity left (i.e. when the firm is in
financial distress), the shareholders may be tempted to
gamble with the debtholders’ money

 They may do so by investing the firm’s funds into high-

risk projects

 If the project fails, the major part of the costs will be

borne by the debtholders

2
  If the project is successful, most of its payoff will go to
the shareholders given that the debtholders’ claims
have a limited upside

 Jensen and Meckling argue that, given that there are

agency costs from both debt and equity, there is an
optimal mix of debt and equity which minimizes the sum
of the agency costs of debt and equity

The Expropriation of Minority

Shareholders
The principal-agent model is based on the Berle-Means
premise that, as firms grow, ownership eventually separates
from control ,However, this is only an accurate description
of the Anglo-American system of corporate governance

In the rest of the world, most stock-exchange listed firms

have large shareholders exerting significant control over the
firm

Hence, the main conflict of interests is between the large

shareholder and the minority shareholders

Minority shareholders may face the danger of being

expropriated by the large shareholder via e.g.

1- Tunnelling

2- Transfer pricing

3-Nepotism

3
 4-Infighting

Tunnelling consists of the large shareholder transferring the

firm’s assets or profits into his own pockets

 The large shareholder may also expropriate the minority

shareholders via transfer pricing, i.e. by overcharging
the firm for services or assets provided

Tunnelling and transfer pricing involving the large

shareholder are also sometimes referred to as related-party
transactions , Large shareholders may be even more
tempted to engage in related-party transactions in the
presence of ownership pyramids

Nepotism consists of the large family shareholder appointing

family members to top management positions rather than
the most suitable candidates on the job market

Infighting may not necessarily be a wilful form of

expropriating the firm’s minority shareholders, but
nevertheless is likely to deflect management time as well as
other firm resources

4
Alternative Forms of Organisation and
Ownership
The main alternative to the stock corporation is the mutual
organization

A mutual organization is owned by and run on behalf of its

members

For example, a mutual bank is owned by its savers and

borrowers

Both stock corporations and mutual organizations are likely

to suffer from the principal-agent problem

However, this problem may be more severe in mutual

organisations given that stock corporations benefit from a
range of mechanisms that mitigate agency problems

 These include

1- the threat of a hostile takeover

2- monitoring by large shareholders

3- ownership of stock options and stocks by

managers and employees

4- a market price for the stocks

As each member of a mutual organisation has only one vote,

this prevents the emergence of powerful owners

Through the 1980s/90s, a number of UK mutual building

societies went through a demutualization

5
They changed their legal status to a stock corporation and
applied for a stock exchange listing

At the time, it was thought that this would result in a major

improvement in the efficiency of these organizations

Overall, it is still unclear which of the two organisational

forms is superior

 One of the potential benefits of the mutual form is that

it avoids conflicts of interests between owners and
customers

 These conflicts tend to be severe for long-term

products and services as the owners may be tempted to
expropriate the customers ,For these products and
services, the mutual form is superior as it merges the
functions of owner and customer

 While mutual organisations are not subject to the

disciplining role of the stock market, they have their
own disciplinary mechanism

 The members of a mutual organisation are allowed to

withdraw their funds at any time ,Such withdrawals
reduce the financial basis of the mutual organisation

 In contrast, stock corporations do not see their funds

shrink when shareholders sell their shares

 Some commercial organizations are in the form of

partnerships and owned by their employees

– Goldman Sachs

6
 – John Lewis Partnership

– Sanford Grossman, Oliver Hart and John Moore’s

theory of property rights predicts when employees
should have ownership of their firm

 Employees should be given property rights if they have

to make investments in their human capital which are
highly specific (idiosyncratic) to the firm

Defining Ownership and Control

 Ownership is defined as cash flow rights

 Cash flow rights give the holder a pro rata right to the
firm’s assets and earnings

 Control is defined as control rights

 Control typically stems from voting rights

 However, there are other channels for control

1- The firm’s articles of association

2- A so-called golden share

3- The management may have de facto control in the

absence of a large shareholder