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Chapter 8

AGENCY CONFLICTS AND CORPORATE GOVERNANCE Behavioral Corporate Finance by Hersh Shefrin


Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 1

Learning Objectives
1.Explain how overconfidence prevents corporate boards from putting compensation systems in place that align the interests of managers and shareholders 2.Explain the role of prospect theory casino effects in aligning the interests of shareholders and managers

3.Describe how aversion to a sure loss can interfere with the alignment of the interests of investors and the interests of auditors engaged to monitor managers 4.Analyze how, because of aversion to a sure loss and overconfidence, stock option-based compensation can exacerbate agency conflicts

Traditional Approach 
Agency theory is used to study the structure of compensation contracts that principals offer to agents engaged to act on their behalf. In the corporate governance setting, shareholders are the principals, the board of directors is charged with representing the interests of shareholders, and the firm¶s managers are the agents.


6 . enabling him to apologize to investors for having lost their money.  He enlists a meek accountant named Leo Bloom to produce a flop that will enable him to hide his actions.  In Bialystock¶s plan.Plot  Bialystock raises a large amount of money from investors by selling more than 100% of a new show²25. which he then proceeds to keep.000% actually. the show fails.

3. 7 . where principals (the investors) entrust their money to an agent (the producer).  Only a successful show would reveal the producer¶s true action. Principal-agent relationship involved. the agent is better informed than the principals. 1. 2. Third. Inherent conflict of interest between the principals and the agent.The Point The plot of The Producers has 3 key features.

Participation: offer the agent a contract that is attractive enough. with three goals in mind.Traditional Approach Rational principals offer contracts to rational agents that combine positive rewards and penalties. 3. so called carrots and sticks. 2. 1. Incentive compatibility: Set the carrot-stick differential to induce the agent to represent the interests of the principal. Don't overpay the agent. 8 .

to the detriment of investors. 9 .  Managers who bear such risk might react by behaving in too risk averse a fashion. but do not penalize them for unfavorable outcomes.  In theory.  Options reward managers for favorable outcomes. managerial risk aversion can be countered by using stock options. especially career risk. incentive compatibility typically prevents managers from diversifying away all the unique risk of their firms.Risk and Agency Conflicts  In the traditional approach.

Paying for Performance in Practice  Most influential academic studies on executive compensation conclude that CEO pay varies far too little to be consistent with traditional theory.  These studies. bonuses. and stock options so as to provide either large rewards for superior performance or large penalties for poor performance. indicate that most corporate boards do not structure salaries. published in 1990. 10 .

11 .  The frequency with which CEOs are dismissed for poor results is low.  Corporate stock options do not appear to play a major role in aligning the interests of executives and investors. resulting in low variability in respect to corporate performance.  Some evidence points to the relative strength of shareholder rights as being key. Executive pay has featured too narrow a carrot-stick differential.

000 change in corporate value corresponded to a change of just 6.  Accounting for all monetary sources of CEO incentives²salary and bonus.000 change in corporate value corresponded to a change in CEO compensation of just $2.7 cents in salary and bonus over two years.59. a $1.Low Variability  For the median CEO in the 250 largest companies. shares owned.  A $1. and the changing likelihood of dismissal 12 . stock options.

stock options added another 58 cents worth of incentives. the value of shares owned by the median CEO changed by 66 cents for every $1.  At the median.Changing Attitudes and Perceptions About Risk  In this regard.000 increase in corporate value. 13 .

Stock Options  There is some evidence that firms offering stock options to their employees perform better. and serve as a substitute for cash compensation in cash-strapped firms. 14 .  Less clear is whether stock options serve to align the incentives of executives and employees with those of shareholders. principally because they aid in employee retention.  Options lead to increased firm value.

 The manner in which options are recorded in financial statements has been a long running subject of debate. inefficient as motivators.  He suggests that although options can be appropriate in theory. 15 . in practice their use has been capricious.Controversy  Warren Buffet has been a longtime critic of the manner in which firms use stock options. whether as footnotes or expensed. and very expensive for shareholders.

 The evidence indicates that firms with stronger shareholder rights are associated with      higher firm value higher profits higher sales growth lower capital expenditures. and fewer corporate acquisitions 16 .Shareholder Rights  Provisions that move away from one share one vote and put anti-takeover provisions in place contribute to weak shareholder rights.

and behavioral biases on the part of executives. Overconfident directors are inclined to think that they do a better job of addressing agency conflicts than they actually do. Overconfident directors are prone to approve compensation that feature insufficient pay for performance. and overpayment.Overconfidence Among Directors and Executives  Overconfident directors underestimate the extent of both traditional agency conflicts. 17   .

and yet the directors think they¶re doing a hell of a job.  They delude themselves.Quotes from Fortune  Compensation committee members are not malevolent.  They think things are being done right and fairly--they don¶t think they¶re being had--when actually the excesses they¶re approving are just mind-boggling« 18 .  I've seen situations that are f---d up.

in most cases. pros. It¶s really ³amateurs vs. as pros.´  I¶m classing the directors. as amateurs.  You can have a very sophisticated board--and it¶ll still be amateurs vs. together with the compensation consultants they hire. pros« 19 . and management.

20 .  A comp committee also hears a lot about external factors.  The pendulum has to swing both ways--and usually it doesn¶t.Insufficient Pay for Performance  So my view of incentive comp of any kind is that it¶s fine if it isn¶t just a giveaway program. things that couldn¶t have been anticipated when the budget was being made. And you have to answer. ³We worked our butts off´--da-dada-da. that was the deal. ³Look.  People say.

then you get dung. saying.´  CEOs will claim it¶s all deserved. You agreed to work here for a year under that deal. 21 .´  That¶s bunk in a lot of cases. and if the shareholders get dung. ³Look at the way I made my stock go up. egregiously so at companies that don¶t pay dividends.

it will rise by 74%.  And you won¶t even have had to give President Bush an option on the bond. Let me refer you to a Treasury zero bond:  If you buy one today and hold on for ten years. 22 .

where every kid is above average. 23 .  ³We want our CEO¶s compensation to be between the 50th and 75th percentile in our peer group.´  If everybody does that.Better Than Average Effect  How in the world do you stop that when every self-respecting compensation committee--I just read this once again today in a proxy-says. it¶s Lake Wobegon.

³Casino effect. 1. 2.Stock Options There are two important behavioral phenomena associated with stock options being used to compensate employees. Excessively optimistic.´ 24 . overconfident employees overvalue the stock options they are granted. especially executives.

³You can fiddle with my bonus. but don¶t cut out my options´--because they know there¶s the big casino waiting out there.Casino Effect They say. 25 .

1 Indicate which of the following two risky alternatives you would prefer to choose. 26 . A: winning $2. A or B. if you wish).000 with a 45% probability winning $0 with a 55% probability. B: winning $4. (You can also indicate indifference.000 with a 90% probability winning $0 with a 10% probability.Concept Preview Question 8.

where the probability of winning is 0. in advance.  You need to commit. whether you would prefer to play alternative A or alternative B.  If you win the lottery.002 (actually 2/900). imagine that you are registering to participate in a lottery. where you will face either alternative A or alternative B above. 27 . Next. your prize is a choice to play yet another lottery. should you win the opportunity to do so.

alternative D or indifference between C and D.999 28 D: . please indicate which one you find preferable.998 winning $4. C: winning $2.000 with probability .001 winning $0 with probability .000 with probability . alternative C.Concept Preview Question 8.2 Of the two alternatives below.002 winning $0 with probability .

2 is a reframing of the second part of the concept preview question 8.9. to obtain 0.  To see why. just multiply the probability of winning the lottery (2/900) by the probability of winning $2.002 = 2/900 x 0.000 in A (0.9). 29 .Reframing  Concept preview question 8.1.

30 . where they focus on probabilities that are much higher. they act as if they are risk seeking rather than risk averse.  However.1.The Point  The point is that when people focus directly on the low probabilities.  In choosing alternative D over alternative C. they act as if they overweight lower probabilities relative to higher probabilities. they act as if they are risk averse. in concept preview question 8.

 How do the principals monitor managers?  The conventional way is to hire the services of a professional auditor. 31 .Auditing Agency Conflicts  Managers. release financial statements in order to report the financial results of their firms to the owners. as agents.

 The traditional view holds that auditing firms have reputations to protect.  Notably. auditing firms are partnerships. reputations for integrity. 32 .Traditional Perspective  Auditors are vulnerable to being ³bribed´ by unscrupulous firms in order to issue clean opinions. not corporations.

Signaling  A firm that seeks to communicate that its financial statements are clean might engage the services of an auditor with a high reputation who also charges high fees.  Therefore the choice of auditor in and of itself sends a strong signal to investors. 33 .  Signaling theory stipulates that firms who face accounting problems would not use such an auditor.

2002.Images from Arthur Andersen  After Enron¶s difficulties became public. Andersen employees tampered with documents. 34 . the firm was found guilty of obstructing justice.  On June 14. and was subsequently dissolved.

and especially consultants. investment bankers.  The change in sharing rule left the auditors lagging behind those of attorneys.What Happened?  Consulting division had become much more profitable than the auditing division. the consultants managed to alter the profit-sharing rule. in their favor.  In 1989. 35 .

´  Under 2X. for every dollar of auditing work. partners were required to bring in twice the revenue in non-auditing work.2X  In 1997.  In the wake of their departure Arthur Andersen instituted a policy known as ³2X. the partners at Andersen Consulting voted to split off completely from Arthur Andersen to become Accenture. 36 .

 Among the list of Arthur Andersen¶s audit clients were: Boston Chicken. and Enron.. WorldCom. Sunbeam.  At each of these firms. a major scandal ensued.Scandals  One of Andersen¶s initiatives was to encourage clients to engage Andersen for both internal and external auditing services. 37 . Waste Management Inc.

or herself to be in the domain of losses as opposed to the domain of gains? 38 .Reference Point Issues?  Did 2X shift Andersen¶s auditors from perceiving themselves to be in the domain of gains to perceiving themselves to be in the domain of losses?  Does attitude towards risk depend upon whether a person perceives him.

Conflicts of Interest  Arthur Andersen decided to take on the roles of both internal and external auditor.  Arthur Levitt chaired the Securities and Exchange Commission (SEC) raised concerns that practices of this sort would jeopardize the quality of audits.  potential conflict of interest 39 .

Lernout & Hauspie. a succession of corporate scandals with varying degrees of fraud made clear that compensation in the form of stock and stock options could not be counted upon to align the interests of investors and managers. Sunbeam. 40  . Among the firms involved in fraudulent activities were Coca-Cola. Enron.Sarbanes-Oxley  Since 2000. Cendant. Xerox. Parmalat. IBM. WorldCom and Healthsouth.

 SEC requires that the CEO and CFO of every publicly traded firm certify.Certification  In the wake of these financial scandals. Congress passed the Sarbanes-Oxley Act of 2002. 41 . under oath. the veracity of their firm¶s financial statements.

the full panel must review those statements.  Independent directors neither work for nor do business with a corporation or its executives.  Board audit committees are required to include at least one financial expert. after the CEO and CFO have certified the firm¶s financial statements. 42 .  Every quarter.SOX and the Board  Sarbanes-Oxley increased the number of independent directors on corporate boards.

company's auditor to attest to management's assessment in accordance with Public Company Accounting Oversight Board 43 . Statement of management's responsibility for establishing and maintaining adequate internal control structure and procedures for financial reporting 2. management's assessment of the effectiveness of the company's internal control structure and procedures for financial reporting 3.Section 404 of SOX Each annual report must contain 1.

Fraud and Options  Excessive optimism and overconfidence already counteract managers¶ undue caution.  Granting of stock options might serve to induce managers to accept risky projects that feature negative net present value. 44 .

45 . stock and stock option compensation can actually amplify agency conflicts when managers find they can manipulate the market value of their firms. excessively optimistic.  Indeed. overconfident managers who are unethical will be prone to underestimate the chances that fraudulent behavior on their parts will be discovered.Amplification  Moreover.

Images from HealthSouth 46 .

 In 2002 HealthSouth was investigated for an accounting fraud that prosecutors suspect began as early as 1986.HealthSouth  HealthSouth was founded in 1984. 47 .S. diagnostic imaging and rehabilitation services. provider of outpatient surgery. HealthSouth was the largest U.  At year-end 2001.

HealthSouth overstated its income by $1. 48 .6 million shares of HealthSouth stock.4 billion. The SEC accused HealthSouth executives of having engaged in insider trading by selling substantial amounts of HealthSouth stock while they knew that the firm¶s financial statements grossly misstated its earnings and assets.Overstated Income and Insider Trading    Between 1999 and the second quarter of 2002. HealthSouth¶s executives received options on 3. As part of their compensation.

8 million shares for proceeds in excess of $170 million.Richard Scrushy  HealthSouth¶s founder and CEO was Richard Scrushy. the SEC alleged that Scrushy induced HealthSouth executives to manipulate the firm¶s stock price until he could sell off large blocks of stock worth $25 million.  The SEC claimed that since 1991 Scrushy sold ³at least 13.  Specifically.´ 49 .

E&Y.  It also paid an additional $2.16 million in auditing fees.Ernst & Young  HealthSouth¶s auditor was a top tier accounting firm.´ 50 .  In 2001 HealthSouth paid Ernst & Young $1.  HealthSouth appears to have engaged in numerous practices that were intended to deceive their auditors.39 million in ³audit-related fees´ for what HealthSouth called ³pristine audits.

0% 10.0% 2002 HealthSouth ¦ eturn on quity 1986 .Stock Price Driven by Financials 30 25 HealthSouth 20 15 S&P 500 10 5 0 20.0% 16.2001 £ ¢ ¥ ¤ ¡ £ ££ £ £   51 . S&P 500 umulative eturns Sept 1986 .0% 2.0% 1986 1988 1990 1992 1994 Date 1996 1998 2000 Se pSe 6 pSe 7 pSe pSe 9 pSe 9 0 pSe 9 1 pSe 9 2 pSe 9 3 pSe 9 pSe 9 5 pSe 9 6 pSe 9 7 pSe 9 pSe 9 9 pSe 0 0 pSe 0 1 p02 ate Exhibit 8-1 § HealthSouth vs.0% 12.0% 6.0% 18.0% 0.0% 14.0% 4.

Signs of Disease? HealthSouth Free Cash Flow 1986 -2001 $1.000.500.00 $500.00) ate 2000 Exhibit 8-2 52 .000.00) ($1.00 1986 1988 1990 1992 1994 1996 1998 ($500.00) ($1.00 $ Millions $0.

 High leverage does not necessarily force fraudulent firms to fail in short order. 2003 did the firm announce that it would default on a $350 million bond payment and was dismissing its CEO Richard Scrushy.Borrowing  Much of HealthSouth¶s negative free cash flow in exhibit 8-2 stems from continued borrowing. 53 .  Only on April 1.

And we¶re. I just hate to go down there and just give the keys to them. we¶re seeing a healthy day right now in stock.Scrushy on CFO's Concerns About Phony Financial Statements When they get you is when you go into bankruptcy. They come in on a company that¶s screwed up. That¶s when they come in on you. 54 . They don¶t come in on a company that¶s doing good. They don¶t come in on a company that¶s paying their bank debt down. We¶re seeing that.

or make use of an explicit rule that mandates that losses be recognized beyond a prespecified level. How does it happen? High reference points. Why does it happen? High ambitions coupled with aversion to a sure loss.Debiasing for Better Decisions Errors or biases: Managers behave unethically. What can be done about it? Reset reference point. remember that most people do not beat the odds. 55 .  Also.

and excessive payment for executives. 56 . insufficient dismissal. executive compensation displays too little variability in respect to pay for performance.  Directors' tasks are made more difficult by overconfidence on the part of executives.  Directors have been overconfident in their ability to structure incentives appropriately without overpaying executives.Summary  In practice.

 In traditional theory.  Managers who behave in accordance with prospect theory might find the risk characteristics of stock options attractive because of its casino effect. employee stock options are used to align the risk attitudes of managers and shareholders.  Stock options might also induce risk seeking behavior because of the tendency to overweight low probabilities. 57 .

 In this respect. unethical managers to manipulate accounting information in order to exercise their stock options when the stock was overpriced.  Those events were the catalyst for the passage of the Sarbanes-Oxley Act. 58 . a combination of behavioral phenomena and agency conflicts affected some accounting firms. The combination of aversion to a sure loss and overconfidence can also induce ambitious.