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Principle-agent Problem in Shareholders and Managers

Paper Type: Free Essay Subject: Accounting
Wordcount: 3531 words Published: 24th Apr 2018

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This essay identifies the principle-agent problem between shareholders and managers. It also overlooks UK’s corporate governance compared to Germany and Japan. Furthermore effectiveness of UK’s system will be analyzed amid recommendations to reduce the vulnerability.

Economic theory speculates that a firm’s goal is to capitalize on shareholders wealth; achievable with entrepreneurial firm since owners are managers. However, ownership nowadays is significantly diluted, with companies owned by large shareholder groups. This causes the separation of ownership and management which hinders the relationship between shareholders and managers; where managers replace shareholders interest with their own. This may be due to information asymmetry [1] where managers have the power to act in accordance to shareholder needs. This is known as the “agency problem” and is common in modern corporate.

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Under this theory the relationship is formed through a binding contract whereby principal’s (shareholders) appoint the agents (managers) to execute services with authority to make decisions. However such “contracts” are imperfect as the impracticality to include every action of the agent whose decisions has an impact on their and the principal’s benefits. Thus, self interested behaviour arises in organisations as the interest of both parties diverges, i.e. principal’s interest regards maximisation of shareholders wealth (profit maximisation) whereas agent’s interest lies in own utility maximisation (bonuses/promotion). Shareholders permit managers to run the firm’s assets; resulting in a conflict of interest. The fundamental problem therefore is to align the interests of both parties.

Furthermore, principals expect board of directors to base their decisions on maximising equity value. However the board of directors expect managers to follow strategies that support their goals. This situation illustrates that shareholders have no direct input into the operation and therefore have no power to tell managers what to do. This issue arises because of the separation of ownership and control and therefore managers are able to pursue goals beneficial to them and unfavourable to shareholders. Overall, detachment between the two parties increases lack of goal congruence.

The question arises as to why shareholders do not monitor management? There are three reasons why taking control causes difficulties. (1) Expensive to monitor managerial activities as obtaining information is difficult (2) disgruntled shareholders are unable to pose threats in order to reduce undesirable managerial behaviour i.e. hiring an outside member and (3) dispersed shareholders have an incentive to “free ride”. Keasy et al 1997 regards the above as economic costs to monitoring.

These limitations pose problems for shareholder wealth since undesirable managerial actions takes place in the absence of control. Shareholders may introduce incentive packages which include profit related bonuses, performance, promotion incentives and encourage employees to buy shares which increase their wages, to encourage agents to make “optimal effort”. Due to the above problems, nations have developed systems which carry out independent monitoring and control of the firm in order to align the overall goal.

OECD 1999 stated that “corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.”

In UK capital markets play a vital role where share prices advocates performance levels. Management’s focus is to maximize shareholders wealth through the use of independent board of directors. The fear of takeover bids forces management to undergo effective actions. Approximately 50% of shares are held by institutional investors indicating dominant ownership. Cadbury Report 1992 states large proportion of shareholder ownership influence company’s actions.

In 2008 the Financial Reporting council developed the ‘Combined Code’ i.e. various reports/codes pertaining ‘good’ corporate governance. The most influential is Cadbury Report 1992 [2] , was produced as the lack of monitoring management activities caused several scandals whereby executives acted in their interest. Initially, Polly Peck [3] went into liquidation after years of false accounting leading to scrutinizing of the financial aspects and accountability. However after the scams of BCCI and Robert Maxwell, they revised the relationship between boards, auditors and shareholders. The final report states CEO’s and Chairman’s of companies should be separated. Jenson 1993 [4] states that if roles were mutual, conflict of interest would arise. Furthermore, 3 non-executive directors, two of whom should be independent [5] and an audit committee involving non-executives should be included.

Companies were encouraged to follow these practises alongside “the code of best practise” which outlines other areas of concern. However the “one size fits all” problem was recognised by Cadbury causing all companies registered in UK to follow the “comply or explain” system. Companies should comply with corporate best practise or have legitimate reasons for non-compliance. Furthermore, the board must offer a full explanation to shareholders and explicate how their practises are consistent with shareholders. It’s acceptable only when shareholders believe good governance has been achieved.

Greenbury committee, formed to evaluate director’s remuneration packages and the lack of disclosure of payments in the annual reports, commenced over public’s anger regarding increases in executive pay. The report added to the Cadbury Code and advised (1) each board include a remuneration committee involving independent non-executives briefing shareholders annually and (2) directors should have LT [6] performance related pay, all disclosed in the annual accounts. Moreover, progress should be reviewed every 3 years to ensure companies are operating effectively.

The Hampel committee [7] formed in 1998 suggested all previous principles should be collaborated into a “Combined Code”. Furthermore, the chairman of the boards should act as the ‘leader’, investors should consider voting the share and all remunerations information including pensions should be disclosed.

The Turnbull Committee, created the next year, advised that directors should be held accountable for internal financial and auditing controls. Several reports have contributed to the Combined Code namely the Higgs review outlining the actions of non-executives. More recently, after the collapse of Northern Rock and the financial crisis that followed, the Walker Review formed a report concerning banking sectors. The Financial Reporting Council produced a new Stewardship Code in 2010.

Germany’s corporate system is mainly stakeholder oriented and diffuses away from shareholders interests. The objective is maximising stakeholder value thereby revealing several distinctive differences.

Firstly, the banking sector is a major stakeholder. Charkham (1994) stated that banks hold a dominate position in financing and supervising companies for numerous reasons. (1) During 1870 companies were heavily reliant on credit. Banks began offering LT loans to LT clients who tied the companies, obtaining ownership and acting as ‘shareholders’ within industrial firms. (2) Banks hold 25% of voting capital in large corporations and 28% of seats on the supervisory boards. (3) Banks are shareholder representatives, authorised to vote for their shares plus proxy shares [8] , giving further control. Consequently companies are unlikely to face takeovers, since banks will support them through financial hardships unlike in the UK.

Secondly, “co-operative” culture is articulated under the Co-determination Act 1976 whereby workers obtain significant roles in the management process; known as work councils. Work council staff influence business actions and partake in decision making processes. Employees (elected by work councils) sit on the supervisory board when a firm has more than 2000 employees alongside shareholder representatives. This system reduces workforce conflicts by improving communication channels, increase bargaining power of workers through legislations and finally correct market failures. Overall productivity levels increase, with low levels of strikes as better pay and conditions entailing “good industrial relations”.

Finally, Germany involves a two – tier board compared to UK’s one – tier board. It includes a management board (Vorstand) where managers monitor daily operation and conduct of the firm. Plus a supervisory board (Aufsichtsrat) involving only non-executives [9] who monitor the management board responsibilities and approving decisions. Separation of the two increases the awareness of individual responsibilities and helps prevent management abuse. The downfall is having worker representatives on the supervisory board as they will opt for decisions beneficial for employees rather than company. For example closing down a factory may deem good for the company however problematic for redundant employees, making it is difficult to work in the best interest of the company.

Germany’s corporate system lies heavily on good industrial relations which considers it’s company, employees and public. It shows corporations are a social institution rather than an economic one as it “does not put financial value for shareholders at the top of the list of policy objectives” [10] . Shareholders are seen as one of many stakeholders and not just a privileged constituency.

The Japanese corporate governance revolves around banking relations like Germany along with life time employment. There are prominent features including the intervention of government and close alliances between government and companies. Business and industrial activities are monitored by the Japanese Ministry of Finance, involving them in the management and decision process.

Japanese corporate rely on main banks [11] which are all interlinked with firms, forming a concentrated ownership (shareholders). Prowse 1992 states that individuals hold 26.7% of a firm’s equity while corporations hold 67.3%. Unlike western countries, Japanese banks can hold equities up to 5%. The argument is by acting as lenders and shareholders, conflict of interests of debt providers and equity will be eradicated. Moreover banks hold these equities for long periods, building a LT “banking relationship” unlike UK’s “transactional banking”. Furthermore, they are involved with the internal management by obtaining seats on the board of directors. They actively contribute in the decision process and act as insurers for companies entering financial difficulties i.e. bankruptcy or takeovers. Like Germany, banks form LT contracts with companies based on financial services and supervision and act as representatives for other shareholders through proxy votes.

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One major distinction in Japan is the Keiretsu system. Companies form close alliances mainly between banks, businesses and the government, by working towards each other success. The role of the government became important when they intervened in 1990s as Japan suffered a recession. The government wanted to restore the economy through its policies and regulations by improving the corporate governance to stimulate growth and investment.

Germany and Japan both work toward the interest of the company and workers as a collective. However Japan’s board structure is different as all members consist of former employees excluding “outside” directors apart from bank officials. The boards have more members than UK and Germany as some companies have over 60 directors. This proves very effective as no domination of directors occur.

According to Allen and Gale (2000), focusing on stakeholders rather than solely on shareholders, societies resources are being used efficiently as employees, suppliers and customers are taken into account. This enhances productivity, thus generating higher profits, benefiting the firm and shareholders.

Since 1990 the UK have implemented many policies reforming the management and governance of companies. These range from codes, reports, regulation and legislations; but how effective are they?

To ensure company interests are aligned with shareholders, UK has imposed various committees to monitor the effectiveness. For example, audit committees review audits annually and overlook financial relationships between companies and auditors. Nomination committees administer human resources and plans future directors. Compensation committees examine management actions and daily operations. Moreover the existence of institutional investors has its advantages as investing in firms they have incentive and motivation to monitor them. This leads to high performance levels which reduces agency costs. However, companies practise ST [12] profit maximisation without LT planning making companies underperform, therefore investors sell their shares and “exit” rather than “voice” their discontent (occurs mainly in Germany). Overall UK’s approach in monitoring company interest is effective as companies have majority of existing shareholders through the need of committees.

The ‘Code of best practice’ gives shareholders confidence that companies are operating with high levels of transparency during decision making processes. From this, the “comply or explain” system was created, whereby some freedom is left for companies to make effective decisions. The gains from this is that (1) managers and shareholders follow the LT interest of both the company and owners (2) distinguishes the culture barrier individual firms face since there are different levels, size and ownership of companies, whereas code of best practice instils “one size fits all” rule. Moreover, codes are more effective than regulations as companies can grow whereas enforcing strict internal controls companies are limited to procedures. Furthermore, codes tackle more ‘softer’ problems relating to best practise compared to regulations i.e. training and supporting directors in their role.

The Cadbury Report reflects the above whereby “The effectiveness with which boards discharge their responsibilities determines Britain’s competitiveness position. They must be free to drive their companies forward, but exercise that freedom within a framework of effective accountability. This is the essence of any system of good corporate governance.”

For this system to work effectively shareholders require full disclosure to facilitate them in their decisions and having rights when dissatisfied. Consequently companies must disclose information in their annual reports stating how they have applied the combined code and giving shareholders voting rights to discharge directors. All these requirements are set out under the company law making the system successful since it was adopted in EC [13] and included in the EUD [14] in 2006; outlining same principles.

Empirical evidence show that UK has drawn close to the concept of ‘good’ corporate governance. According to the FTSE ISS Corporate Governance Index and Governance Metrics International Reports, the UK has the highest average governance score out of all the countries. Moreover 94% [15] of UK pension Funds considered corporate standards in the UK has developed exceptionally.

The following reforms revolve around two primary issues (1) lack of separation of management and control and (2) dilemma faced by non-executive directors in terms of monitoring. Accordingly UK’s current reforms indicated the need for independent non-executive directors to minimise conflicts otherwise present. However, the disadvantage regarding this independence is, there is less incentive to spend a sufficient amount of time controlling company issues because they have no direct relationship with the company. In addition, doubts on how much knowledge they acquire also poses a problem.

One possible pivotal solution that could be incorporated into UK governance is increasing the frequency and duration of board meetings. Company information is very broad and complex especially relating to LT financial performances, competitive position and organisational structure. Therefore it is vital that directors assign more time to assess the information and deem upon past decisions and events. It is recommended that directors meet on a monthly basis for continual supervision and allow directors to address all areas and ask specific questions that affect the future of the company. There are issues surrounding this proposal for example, preparation, however the more frequent the meetings the less time needed to prepare as oppose to the time needed for meetings held every quarter. Moreover, meetings should not be limited to a time schedule but rather should last until all aspects are covered. This method is very flexible for example meetings could last more than one day when a company is in a difficult situation. The advantage is that opinions will be shared more openly and allows non-executive directors to be more involved; this should be carried when discussing the long term corporate strategy.

Another solution is altering the composition of the board. In the ‘Combined Code’ section A.3.2 it pronounces that “at least half the board, excluding the Chairman, should comprise non-executive directors determined by the board to be independent”. This does not specify the maximum number of seats in total. Therefore it is advisable that the fewer directors, the more likely that each director can play a dynamic and imperative role. The recommended number should consist of eight to ten directors in total. This is so that there is enough variety and sufficient array of viewpoints. When there are more than ten or twelve members on the board, there will be a “free rider” problem where some director’s will stop preparing for meetings and rely on the work of others resulting in topics not being discussed in depth.

Finally UK should consider adding a supervisory board like Germany and Japan as this will allow wider diversity among the decision making processes. Moreover it will reduce abuses from dominate directors since there is constant revision of management performance. Overall UK should cease to improve existing polices and the challenge lies in keeping UK’s corporate governance an asset rather than a liability for companies.


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