2. INTRODUCTION
•In the previous lectures the agency theory has
been mentioned many times. This is because it is
at the heart of corporate governance.
•This lecture is devoted to delving into this agency
theory and its counterpart stewardship theory
which is central to corporate governance.
3. Introduction CONT’D
• At the end of the discussion, the student should be able to able to:
• Explain agency theory
• Identify the factors that contribute to agency problem in companies
• Explain how agency problem manifests in companies
• Explain how to manage agency conflict in companies
• Appreciate the difference between agency and stewardship theories
4. DEFINITION OF AGENCY THEORY
•Agency theory is the branch of financial economics that looks at
conflicts of interest between people with different interests in the
same assets. Specifically, the theory is concerned with the
conflicts: The conflicts between:
•Shareholders and managers of companies
•Shareholders and bond holders
•Insiders or controlling shareholders and outsiders or non-
controlling shareholders.
5. DEFINITION OF AGENCY THEORY CONT’D
•Jensen and Meckling (1976) define the agency
relationship as...."explicit or implicit contracts in which
one or more persons (the principal(s)) engage another
person (the agent) to take actions on behalf of the
principal(s). The contract involves the delegation of
some decision-making authority to the agent."
•
6. DEFINITION OF AGENCY THEORY CONT’D
•When the manager is the sole equity owner of a firm,
there is no separation of ownership and control, and thus
no agency problem exists between the manager and the
owner. However, when ordinary shares of a company are
diffused among many outside investors, the separation of
ownership and control leads to potential divergence
between the interests of owners and managers
•
7. DEFINITION OF AGENCY THEORY CONT’D
•Unlike other types of profit-making organizations
in which ownership and control are combined, in
pubic limited liability companies ownership and
control are separated; the owners of public
limited companies are usually not managers. This
creates an agency relationship in which the non-
owners (managers) act as agents of the owners
(principals).
8. DEFINITION OF AGENCY THEORY CONT’D
The agents are expected to make decisions that are
consistent with primary objective of the firm:
Shareholder wealth maximization. Unfortunately, in
practice, the agents do not do this. Instead, they
seem to be interested in decisions that are in line
with their interests; thus, creating the agency
problem.
9. DEFINTION OF AGENCY THEORY CONT’D
• In summary, three factors explain the agency problem:
•Divergence of ownership and control: Those who own
the company are not the managers.
•Conflict of goals between owners and managers where
the goals of the owners are different from the goals of
managers.
10. DEFINITION OF AGENCY THEORYCONT’D
•Possible management goals include: growth or maximizing the
size of the firm; increasing managerial power; creating job
security; increasing managerial pay and rewards and pursuing
their own social objectives or pet projects (Watson and Head,
2007).
•Information asymmetry between owners (principals) and
managers (agents) where the latter have better information about
the company than the former.
11. CLASSIFICATION OF THE AGENCY PROBLEM
•John and Senbet (1998) identify four types of
agency problem: Managerial agency, debt
agency, social agency and political agency.
However, in this course we are interested in the
first two.
•Managerial Agency or Managerialism: The
conflict between shareholders and managers is
called managerial agency or managerialism
which refers to self-serving behavior by
managers.
12. CLASSIFICATION OF THE AGENCY PROBLEM CONT’D
This conflict results from managerial propensity for expanding
their span of control in the form of “empire building” at the
expense of shareholders and for unduly conservative investments
in the form of seeking safe (but inferior) projects to maintain the
safety of wage compensation and their own tenure (John and
Senbet, 1998).
13. CLASSIFICATION OF THE AGENCY PROBLEM CONT’D
•Debt Agency: This is the conflict between debt holders and
managers. This arises when managers invest in risky
investments as part of the shareholder value maximization
drive. When such risky investments succeed, the debt-
holders receive only the fixed debt income under the debt
contract whilst equity-holders take the rest.
14. CLASSIFICATION OF THE AGENCY PROBLEM CONT’D
However, if the investments fail, equity holders are
insulated while the value of collateral is reduced with the
resultant reduction in the value of outstanding debt.
Indeed, if the business collapses, equity-holders lose only
the value of their shares whilst the rest of the loss is shifted
to creditors
15. CLASSIFICATION OF THE AGENCY PROBLEM CONT’D
• Social Agency: The conflict between the private
sector (the agent) and the public sector (principal)
Political agency: This is the conflict that occurs
between the agents of the public sector (e.g.
regulators) and the rest of the society or
taxpayers.
16. MANIFESTATION OF AGENCY PROBLEM
•In companies, agency problem manifests in the following
areas:
•Investment decisions: Since managerial reward schemes
are usually based on short-term performance measures,
managers tend to focus their attention on projects that
yield short-term returns at the expense of long-term
projects which can ensure the survival of the company.
17. MANIFESTATION OF AGENCY PROBLEM CONT’D
•Besides, whereas managers are interested
in low-risk projects, shareholders are
interested in higher-risk projects because
higher-risk projects yield higher returns.
18. MANIFESTATION OF AGENCY PROBLEM CONT’D
•Financing decisions: Managers usually prefer the use of
equity finance to the use of debt finance since equity
finance comes with no interest payments and lower
bankruptcy risk. However, to shareholders equity finance
is more expensive than debt finance because increasing
equity finance of a company increases the cost of capital
of the company.
19. MANIFESTATION OF AGENCY PROBLEM CONT’D
Divergence of interests of shareholders and debt holders:
The return to shareholders is unlimited whilst their loss is
limited to the value of their shares. Therefore, they prefer
higher-risk projects. Conversely, the return to debt
holders is limited to a fixed interest so they are not likely
to benefit from higher returns from riskier projects.
Therefore, they prefer lower-risk projects.
20. MANAGING THE AGENCY PROBLEM
Both external and internal mechanisms have been
identified to deal with agency problems between
managers and owners. External monitoring mechanisms
include the outside managerial labor market, monitoring
from the capital market by financial analysts, institutional
shareholders and block shareholders, and the takeover
market.
21. MANAGING THE AGENCY PROBLEM CONT’D
Internal monitoring mechanisms include a natural
process of monitoring from higher to lower levels of
management, mutual monitoring among managers, and
the board of directors (Fama, 1980; Fama and Jensen,
1983). Of all monitoring mechanisms, the board is viewed
as the “ultimate internal monitor” (Fama, 1980) and “the
common apex of the decision control systems of
organizations,
22. MANAGING THE AGENCY PROBLEM CONT’D
•large and small, in which decision agents do not
bear a major share of the wealth effects” (Fama and
Jensen, 1983) cited in He and Sommer (2010).
How is the agency problem between shareholders
and managers as well as the agency problem
between shareholders and debt holders addressed?
23. MANAGING THE AGENCY PROBLEM BETWEEN
SHAREHOLDERS AND MANAGERS
•Two main strategies have been suggested:
•Shareholders should monitor the actions of management using
monitoring devices such as independently audited financial
statements and the use of external analysts
•Incorporation of clauses into managerial contracts which
encourage goal congruence. Such clauses formalize constraints,
incentives and punishments (Watson and Head, 2007).
24. MANAGING THE AGENCY PROBLEM BETWEEN
SHAREHOLDERS AND MANAGERS CONT’D
•Two main managerial incentives that are often used
to achieve goal congruence are performance-related
pay (PRP) and executive share option schemes.
Shareholders can find an accurate measure of
managerial performance and align it with
remuneration.
25. MANAGING THE AGENCY PROBLEM BETWEEN
SHAREHOLDERS AND MANAGERS CONT’D
•Performance indicators such as profit, earnings
per share and return on capital employed are
usually linked to managerial remuneration.
Executive share option schemes allow managers
to acquire shares in the company under a special
arrangement aimed at achieving goal congruence.
26. MANAGING THE AGENCY PROBLEM BETWEEN DEBT
HOLDERS AND SHAREHOLDERS
•Debt holders have two main strategies to protect their
interests in the company:
•Securing their debt against the assets of the
Debt holders can secure their debt against the assets of
the company which will ensure that in the event of the
company going into liquidation they will have a prior
claim over assets which they can sell to recoup their
debt.
27. MANAGING THE AGENCY PROBLEM BETWEEN DEBT
HOLDERS AND SHAREHOLDERS CONT’D
•Using restrictive covenants: Debt holders can protect
their interests and limit the amount of risk they face in
the company by resorting to restrictive covenants. Thy
can incorporate these restrictive conventants into debt
agreements which may restrict the company’s decision-
making process. Such clauses may, for example, bar the
company from paying out excessive levels of dividends.
28. STEWARDSHIP THEORY
•Stewardship theory argues that managers are inherently
trustworthy and thus are not susceptible to
misappropriate the resources of the firm (Davis,
Schoorman and Donaldson 1997; Donaldson and
Davis, 1991).
29. STEWARDSHIP THEORY CONT’D
•It posits that there are non-financial motivators and that
corporate managers are seen as drawing motivation
from the need to achieve, to gain intrinsic satisfaction
via successful execution of intrinsically challenging work,
to exercise responsibility and authority and by it draw
recognition from peers and bosses (McClelland, 1961).
30. STEWARDSHIP THEORY CONT’D
•When corporate managers identify with the firm
(more likely if they have been with the firm for a
long time and have shaped its form and
directions), this facilitates the merging of
individual ego and the corporation, thus melding
individual self-esteem with corporate prestige.
31. STEWARDSHIP THEORY CONT’D
•The theory argues that it is possible for a corporate manager
to find a course of action personally unrewarding,
nonetheless, they are likely to pursue it from a sense of duty.
This compliance with a duty when there is no personal reward
is referred to as normally induced compliance (Etzioni, 1975).
32. STEWARDSHIP THEORY CONT’D
•When corporate managers perceive that their fortunes
are inextricably tied to their current employers through
an expectation of future employment or pension rights,
they may view their interest as aligned with that of the
firm and its owners even if they do not own shares in
the firm.
33. STEWARDSHIP THEORY CONT’D
•In essence, the stewardship theory submits that there is no inner
motivational problem among corporate managers; corporate
managers aspire to achieve good corporate performance.
Performance variations, in the view of the theory, emanates from
the structural situation in which corporate managers find
themselves. If the structural situation is convenient one should
expect good corporate performance from corporate managers.
34. STEWARDSHIP THEORY CONT’D
•The question arises as to whether or not the organizational
structure supports corporate managers to formulate and
implement plans for high corporate performance. Structures
support goals to the extent that they “provide clear, consistent
expectations and authorize and empower senior management”
(Donaldson and Davis, 1991).
35. STEWARDSHIP THEORY
•In terms of the role of the CEO, structures will support
the CEO to achieve superior performance for the
corporation to the extent that complete authority over
the corporation is vested in the CEO and that the role
of the CEO is unambiguous and unchallenged.
36. STEWARDSHIP THEORY CONT’D
• To ensure this, CEO duality (a governance practice in which the CEO is also
the chair of the board of directors) is recommended by stewardship theory.
CEO duality places power and authority in one person which leaves no room
for doubt as to who has authority or responsibility over a particular matter.
According to the theory, CEO duality has benefits such as unity of direction
as well as strong command and control.
37. STEWARDSHIP THEORY CONT’D
•In a nutshell “stewardship theory focuses not on motivation of
the CEO but rather facilitative, empowering structures, and holds
that fusion of the incumbency of the roles of chair and CEO will
enhance effectiveness and produce superior returns to
shareholders” (Donaldson and Davis, 1991, p.52)
38. AGENCY THEORY VRS STEWARDSHIP OVER
CEO GOVERNANCE
•According to the agency theory, CEO duality can only
be beneficial to shareholders if the interest of the CEO
is aligned with that of shareholders by a suitable
incentive scheme for the CEO.
•That is if the firm implements a system of long-term
compensation additional to basic salary.
39. AGENCY AND STEWARDSHIP THEORIES ON CEO
GOVERNANCE CONT’D
•Where a CEO holds the dual role of chair, the presence of long-
term compensation will align their interests with shareholders’.
•According to agency theory, any superiority in shareholder
returns observed in CEO duality is attributable to spurious effects
of financial incentives.
40. AGENCY AND STEWARDSHIP THEORIES ON CEO
GOVERNANCE CONT’D
•By contrast, stewardship theory posits that any observed
superiority in shareholder returns from CEO duality is not a
spurious effect of greater financial incentives for the bn nbbn
CEO.
•Indeed, stewardship theory argues that CEO duality promotes
shareholder-value-maximization agenda.
41. ASSIGNMENT-ONE
•“Since the board of directors is made up of human
beings with selfish tendencies, formation of board
of directors irrespective of its configuration, cannot
eliminate the agency conflict.” Fully evaluate this
assertion. Submit by 30th November, 2015. 3 pages;
double line spacing; Times New Roman, Font
Size=12
42. ASSIGNMENT-TWO
•“Being ethical as a business can be costly”
•Fully evaluate this assertion.
•Submit by 30th November, 2015.
•3 pages; double line spacing; Times New Roman,
Font Size=12
43. ASSIGNMENT-THREE
•For a firm that you know well, give an example SO Strategy,
showing how an internal strength can be matched with an
external opportunity to formulate a strategy.
•For a firm that you know well, give an example WT Strategy,
showing how an internal weakness can be matched with an
external threat to formulate a strategy.
