Agency Theory

An agency relationship is created when one party (principal) appoints another party (agent) to act on their (principals) behalf. The principal delegates decision making authority to the agent. In a firm agency relationship exists between;

1 Shareholders and management
2 Shareholders and creditors
3 Shareholders and the government
4 Shareholders and auditors

Shareholders and management
The separation of ownership and control in most modern corporations’ causes a conflict of interest between the personal interest of appointed managers (agent) and the interests of the owners of the firms (principals).this conflict is known as the agency conflict.
The following are some decisions by managers which would result in a conflict with shareholders:

1. Managers may use corporate resources for personal use.
2. Managers may award themselves hefty pay rises
3. Managers may organize mergers which are intended for their benefit only and not for the benefit of shareholders.
4. Managers may take holidays and spend huge sums of company money.
5. Managers may use confidential information for their benefit(insider trading)

Resolution of conflict
1. Performance based remuneration
This will involve remunerating managers for actions they take that maximize shareholders wealth. The remuneration scheme should be restructured in order to enhance the harmonization of the interest of shareholders with those of management. Managers could be given bonuses, commissions for superior performance in certain periods.
2. Incurring agency costs
Agency costs refer to costs incurred by shareholders in trying to control management behavior and actions and therefore minimize agency conflicts.

These costs include:

  • Monitoring costs: They arise as a result of mechanisms put in place to ensure interests of shareholders are met. They include cost of hiring external auditors, bonding assurance which is insurance taken out where the firm is compensated if manager commits an infringement, internal control system implementation.
  • Opportunity costs: which are incurred either because of the benefit foregone from not investing in a riskier but more profitable investment or in the due to the delay in decision making as procedures have to be followed(hence, a timely decision will not be made)
  • Restructuring costs: are those costs incurred in changing or altering an organizations structure so as to prevent undesirable management activities.
  • Board of directors:- a properly constituted board plays the oversight role on management for the shareholders.

3. Threat of corporate takeover
When management of a firm under performs this result in the shares of that firm being undervalued there is the threat of a hostile takeover. This threat acts to force managers to perform since should the firm be taken over they will be replaced.
4. Shareholders intervention
The shareholders as owners of the company have a right to vote. Hence, during the company’s AGM the shareholders can unite to form a bloc that will vote as one for or against decisions by managers that hurt the company. This voting power can be exercised even when voting for directors. Shareholders could demand for an independent board of directors.
5. Legal protection
The companies act and bodies such as the capital markets authority have played their role in ensuring trying to minimize the agency conflict. Under the companies act, management and board of directors owe a duty of care to shareholders and as such can face legal liability for their acts of omission or commission that are in conflict with shareholders’ interests. The capital market authority also has corporate governance guidelines.
6. Use of corporate governance principles which specify the manner in which organizations are controlled and managed. The duties and rights of all stakeholders are outlined.
7. Stock option schemes for managers could be introduced. These entitle a manager to purchase from the company a specified number of common shares at a price below market price over duration. The incentive for managers to look at shareholders’ interests and not their own is that, if they deliver and the company’s share price appreciates in the stock market then they will make aprofit from the sale.
8. Labour market actions such as hiring tried and tested professional managers and firing poor performers could be used. The concept of ‘head hunting’ is fast catching on in Kenya as a way of getting the best professional managers and executives in the market but at a fee of course.

Shareholders vs. creditors
In this relationship the shareholders (agent) are expected to manage the credit funds provided by the creditors (principal). The shareholders manage these funds through management. Debt providers/creditors are those who provide loan and credit facilities to the firm. They do this after gauging the riskiness of the firm.

The following actions by shareholders through management could lead to a conflict between them and creditors
1. Shareholders could invest in very risky project
The management under the directive of the shareholders may undertake highly risky investments than those anticipated by the providers of long term debt finance. The creditors would not be interested in highly risky projects because they stand to lose their funds when the investments collapse. Even if the risky projects succeed they would not benefit because they only get a fixed
rate of return.
2. The dividend payments to shareholders could be very high
An increase in the dividend rate in most cases is financed by a decrease in investments. This in turn reduces the value of bonds. If the firm is liquidating and it pays a liquidating dividend to its shareholders, the providers of capital could be left with worthless claims.
3. Default on interest payments to bondholders
4. Shareholders could organize mergers which are not beneficial to creditors
5. Shareholders could acquire additional debt that increases the financial risk of the firm
6. Manipulation of financial statements so as to mislead creditors
7. Shareholders could dispose of assets which are security for the credit given
8. Under investments
The shareholders may invest in projects with a negative net present value.
9. The shareholders may adopt an aggressive management of working capital. This may bring
conflicts in liquidity position of the firm and would not be in the interest of the debt holders

Resolution of this conflict
1. Restrictive covenants- these are agreements entered into between the firm and the creditors to protect the creditor’s interests.

These covenants may provide restrictions/control over:

  • Asset based covenants- These states that the minimum asset base to be maintained by the firm.
  • Liability based covenant- This limits the firm’s ability to incur more debt.
  • Cashflow based covenant- States minimum working capital to be held by the firm. This may restrict the amount of dividends to be paid in future.
  • Control based covenant – Limits management ability to make various decisions e.g. providers of debt fund may require to be represented in the BOD meetings.

2. Creditors could also offer loans but at above normal interest rates so as to encourage prompt
3. Having a callability clause to the effect that a loan could be re-called if the conflict of interest is severe
4. Legal action could also be taken against a company
5. Incurring agency costs such as hiring external auditors
6. Use of corporate governance principles so as to minimize the conflict.

3. Shareholders and the government
The shareholders operate in an environment using the license given by the government. The government expects the shareholders to conduct their business in a manner which is beneficial to the government and the society at large. The government in this agency relationship is the principal and the company is the agent. The company has to collect and remit the taxes to the government. The government on the other hand creates a conducive investment environment for the company and then shares in the profits of the
company in form of taxes. The shareholders may take some actions which may conflict the interest of the government as the principal. These may include;

  • The company may involve itself in illegal business activities
  • The shareholders may not create a clear picture of the earnings or the profits it generates in order to minimize its tax liability.(tax evasion)
  • The business may not response to social responsibility activities initiated by the government
  • The company fails to ensure the safety of its employees. It may also produce substandard products and services that may cause health concerns to their consumers.
  • The shareholders may avoid certain types of investment that the government covets.

Solutions to this agency problem

  • The government may incur costs associated with statutory audit, it may also order investigations under the company’s act, the government may also issue VAT refund audits and back duty investigation costs to recover taxes evaded in the past.
  • The government may insure incentives in the form of capital allowances in some given areas and locations.
  • Legislations: the government issues a regulatory framework that governs the operations of the company and provides protection to employees and customers and the society at laws regarding environmental protection, employee safety and minimum wages and salaries for workers.
  • The government encourages the spirit of social responsibility on the activities of the company.
  • The government may also lobby for the directorship in the companies that it may have interest in. i.e. directorship in companies such as KPLC, Kenya Re. etc.

4. Shareholders and auditors
Auditors are appointed by shareholders to monitor the performance of management. They are expected to give an opinion as to the true and fair view of the company’s financial position as reflected in the financial statements that managers prepare. The agency conflict arises if auditors collude with management to give an unqualified opinion (claim that the financial statements show a true and fair view of the financial position of the firm) when in fact they should have given a qualified opinion (that the financial statements do not show a true and fair view). The resolution of this conflict could be through legal action, removal from office, use of disciplinary
actions provided for by regulatory bodies such as ICPAK.

(Visited 128 times, 1 visits today)
Share this:

Written by