AGENCY THEORY

Agency refers to the relationship which submits between two parties, one party called the principal engages another one called agent and gives agent authority and mandate to act on the principal’s benefit.

The actions of agent are binding on the principal. In finance, stockholders are owners of the firm and are therefore the principal. However, they are not involved on the management of running of the firm for a number of reasons.

  1. They may not have the necessary skills and expenditure of managing the firm.
  2. They may not have them to run the firm.
  3. They may be geographically dispersed to manage the firm.
  4. They may be too many to manage a single firm.

Therefore enjoy management directors who ask on their behalf the directors are the Agents. They are given capital authority and other resources for use or that they can generate profits on behalf of principle stakeholders. The concept of entrusting resources with individuals where they are expected to give an account of how the resources are used is called stewardship. The directors/top
management are required to combine the where they have utilized he resources entrusted. Usually a conflict of interest arises when the agents pursue their own interest at the expense of the stockholders.

Types of Agency relationships

  1.  Shareholders versus Management
  2. Shareholders versus Long-term Creditors
  3. Shareholders versus Auditors
  4. Shareholders versus Government
  5. Shareholders versus Branches

1.Shareholders versus Management
The management of a firm take some actions which are inconsistent with the goal of shareholders of wealth maximization and this will cause a conflict of interest. The various causes of this conflict include the following:

  • Incentive Problem
    Top managers have a fixed salary and may not have the incentive/motivation to work harder in order to maximize the shareholders wealth. This is because, irrespective of the benefit they make, their records is fixed they will therefore maximize on leisure’s and work less. This will be against the interest of the shareholders hence the conflict.
  • Consumption of perks/perquisites
    Perquisites refer to the high salaries and generous fringe benefits which directors’ award themselves. This will take the form of directors’ remuneration, expensive cars, expensive holidays, expensive assistance, post office etc. all these will constitute an
    expense to the company and will therefore reduce the amount of dividend paid to ordinary shareholders and who are the true owners of the company. Therefore, the consumption of perks by directors is against the interest of shareholders as it reduces their wealth.
  • Differences in Risk Profile
    Shareholders prefer high risk; high return projects since they have diversified investments that is, if one firm or project one collapses it will have an insignificant effect on their overall wealth. Managers on the other hand, will prefer low return investment since they have a personal fear of losing their jobs in case of a given project/company collapsing. This is because managers do not have multiple jobs and can therefore not be diversified. This forces them to strive for returns for shareholders and not necessarily the maximum. This difference is risk profile is therefore a source of conflict.
  • Difference in Investment/Evaluation Horizon
    Managers prefer to undertake profit which are profitable in the short-term so that they can take credit when they are still in the company shareholders. On the other hand, prefer long-term investment which is consistent with the going concern concept of the firm. A conflict will therefore occur since directors will undertake short term investment against shareholders’ desire for long term investment projects.
  • Management Buyout
    The management may attempt to acquire the business of the principal (shareholders). They would do this by forming nominees companies who buy the shares of the company at the stock exchange. Once they get a majority shareholding. This is equivalent of staging a coup and taking over the business of the shareholders. This causes conflict between agency and principal.

Solutions to the preceding type of agency problem

  • Compensation plans
  • Board of Directors
  • Takeovers
  • Specialist Monitoring
  • Auditors

2. Shareholders versus Long-term Creditors
The shareholders who are the owners of the firm have the responsibility to raise capital for the business. Where they are unable to rise, they go to long-term creditors. These creditors will extend loans to the firm with hopes that, they will get interest of the principal amount. In such a situation a debt holder becomes the principal while shareholder the agent. The interest charged will depend on the riskiness of the borrower, the existing capital structure, asset backing as well as the expected capital structure and
the future asset structure of the firm.

Debenture traders may require security for their loan either having a specific charge or a general charge on all the assets of the business. Shareholders may prejudice the position of creditors hence conflict of interest in the following ways.

  • Disposal of assets used as collateral for the debt
    In this case, the bond holder (creditor) is exposed to more risk because he/she may not receive the loan given in case of liquidation of the firm.
  • Assets/investment situation
    In this case, the shareholder and the bondholder will agree on a specific low risk project. However, this project may be substituted for a high risk project whose flows have a high standard deviation. This exposes the bond holders because should the project collapse they may not recover all the amounts lend.
  • Payment of high dividends
    Dividends may be paid from the current net profit and the existing retained earnings. Retained earnings are an internal source of finance. The payment of high dividends will lead to a low level of capital investment and this will reduce the market value of the shares and the bond. Also the firm may borrow debt to finance the payment of the bonds, from which no returns are expected this will also reduce the value of the firms and the bond.
  • Borrowing more debt capital
    A firm may borrow more debt using the same assets as collateral for the new debts. The value of the old debt will therefore be reduced if the new debt takes priority on the collateral incase of the firm is liquidate. This exposes the first bond holders/lenders to more risk.
  • Under investment
    This is where the firm fails to undertake a particular project or fails to invest money or capital in the entire project if there is an expectation that, most of the returns from the project will benefit the bond holders. This will lead to the reduction in the value
    of the firm and subsequently in the value of the bond.

Solutions of the above type of agency problems
The Bond holders can take the following actions to protect themselves against the actions of the shareholders:-

  • Improve restrictive debt grants
    This involves including strict terms and conditions in the loan agreement or bond covenant. These restrictions may include; No disposal of assets without permission of lenders; No payment of dividends from retained earnings; No borrowing of additional
    debts until the current debt capital is fully repaid or serviced. The bond holders may recommend the type of project to be undertaken in relation to the risk level of the project. Maintenance of a given liquidity level by the borrower as indicated by the current ratio. Restriction on merges and acquisitions especially where any merger or acquisition will change the future cash flow pattern of the borrower
  • Sinking fund provisions
    Some amounts of profits to be transferred annually into a fund for the purpose of the loan repayment.
  • Callability provision
    This is where the debt lender is given a lee way to demand early payment of the debt by the borrower. If the borrower fails to pay interest charges on the due date, the lender might demand the repayment of the due loan before the end/lapse of the repayment
    period in which case the debt is said to have been “called”.
  • Convertibility
    This will enable the lender to convert the bond into ordinary shares so that the bond holder becomes a shareholder. This is particularly so if the borrower is unable to pay on the debt and is facing liquidation.
  • Refuse to Lend
    The bond holders may refuse to provide capital to the borrower who has been involved in the misuse of debt capital in the past. Such a borrower will not be in a position to undertake viable project due to lack of investment capital.
    Alternatively, the lender can charge higher rates as deterrent mechanism.
  •  Representation
    The bond holder nay demand to have a representative in the board of directors of the borrowing company where the representative will oversee proper utilization of the debt capital
  • Transfer of Assets
    On provision of debt capital, the lender may demand that, the assets used as collateral will be transferred to the firm (legal Ownership) passes to the lender and upon repayment of the loan, the asset is transferred back to the borrower.

3. Shareholders versus Auditors
Shareholders appoint auditors to satisfy the financial statement and to establish whether they show a true and fair view of the state of as at a particular date. Auditors are supposed to monitor the performance of management on behalf of the shareholders. Since auditors act on behalf of shareholders; they become agents, while the shareholders become the principal.
Auditors may prejudice the interest of shareholders, thus causing agency problems in the following ways:

  • Colluding with the management in the performance of their duties whereby their independence is compromised.
  • Demanding very high audit fees although there is insignificant audit work due to the strong accounts in existence.
  • Issuing unqualified reports which might be misleading of which may make the public to lose upon relying on them.
  • Failure to apply professional cadre and due to diligence in the performance of the audit work

Solutions to the preceding agency problem

  • Firing
  • Auditors may be removed from office by shareholders at the Annual General Meeting (AGM).
  • Legal Action
  • Shareholders can institute legal proceedings against the auditors who issue misleading reports, hence leading to investment losses.
  • Disciplinary Action by the Profession governing Accounting Practice
  • The profession governing Accounting practice in the country in question e.g. IGPAK in Kenya can also intervene on behalf of the shareholders. Such may be through suspension of the auditors, withdrawal of the practicing certificate, fines and penalties etc.

4. Shareholders versus Government
Shareholders and by extension the company operate in the environment using license granted by the government. The government will expect the company to operate the business in a manner which is beneficial to the entire economy and society. The government is the principal and the company is the agent. The company also carries on business on behalf of the government because the conclusive investment environment for the company and benefits from the company inform of taxes. The company and its shareholders may take some actions that may prejudice the interest/position of the government as the principal.

These actions include the following:

  • Tax Evasion, this involves failure to give the accurate picture of the earning of the firm to minimize the tax liability.
  • Involvement in illegal business in the firm e.g. drug trafficking, smuggling e.t.c.
  • Lukewarm reception to social responsibility calls by the government.
  • Lack of adequate interest in the safety of employees and the products and services of the company including lack of environment awareness concerns by the firms.
  • Avoiding certain types and areas of investment as encouraged by the government through incentives so that investment can be done in such areas.

Solutions to the preceding agency problem
The government can take the following actions to protect itself and its interest.

  • Incurring monitoring costs
    For example the government will incur costs associated with statutory audits, investigation of company’s under company’s Act, back duty in the investigation cost to recover tax evaded in the past and VAT refund audits.
  • Opening investment incentives
    To encourage investments in given areas and locations, the government offers incentives in form of capital allowance laid down in the second schedule of Cap 470.
  • Legislations
    The government has provided a legal framework to govern the operations of the company and provide protection to certain people in the society e.g. regulations associated to disclosure of information, minimum wages and salaries, environmental
    protection e.t.c., guidelines on minimum disclosure in financial statements

5. Head Office versus Branch
Multi-national companies have diverse operations set up in different geographical locations. The head office will Act as the Principal and the subsidiary will act as the Agent. The subsidiary will pursue their own goals, hence creating an agency relationship.
These conflicts can be resolved in the following ways:-

  • Frequent transfer of managers
  • Adopting a global strategic planning to ensure better communication of its vision.
  • Having a voluntary code of Ethical practices to guide the brand management.
  • An elaborate performance reporting system providing a two way feedback mechanism.
  • Performance contracts for managers with commensurate compensation package for the same.
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