Session 3: The Agency Problem

Session Learning Outcome
Learners will have knowledge of the relationship that exisst between owners and managers of the business firm.

Important Learning Terms

• Agency problem
• Agency theory
• Agency costs

Definitions
Agency problem
Conflicts of interest among stockholders, bondholders, and managers.
Agency theory
The analysis of principal-agent relationships, in which one person, an agent, acts on behalf of another person, a principal.
Agency costs
The incremental costs of having an agent make decisions for a principal.
The agency problem arises due to the separation of ownership and control of business firms.

• In theory the shareholders, being the owners of the firm, control its activities.
• In practice, however, the large modern corporation has a diffuse and fragmented set of shareholders and control often lies in the hands of directors.

It is extremely difficult to marshall thousands of shareholders, each with a small stake in the business, to push for a change. Thus in many firms there is what is called a separation, or divorce, of ownership and control.

The separation of ownership and control raises worries that the management team may pursue objectives attractive to them, but which are not necessarily beneficial to the shareholders – this is termed “managerialism”. This conflict is what is known as the principal-agent problem (Agency problem). The principals (the shareholders) have to find ways of ensuring that their agents (the managers) act in their interests.

This means incurring costs, ‘agency costs’, to (a) monitor managers’ behaviour, and (b) create incentive schemes and control for managers to pursue shareholders’ wealth maximization.

Various methods have been used to try to align the actions of senior management with the interests of shareholders, that is, to achieve ‘goal congruence’.

Linking rewards to shareholder wealth improvements:
Owners can grant directors and other senior managers share options. These permit the managers to purchase shares at some date in the future at a price, which is fixed in the present. If the share price rises significantly between the dates when the option was granted and the date when the shares can be bought the manager can make a fortune by buying at the pre-arranged price and then selling in the market place. The managers under such a scheme have a clear interest in achieving a rise in share price and thus congruence comes about to some extent. An alternative method is to allot shares to managers if they achieve certain performance targets, for example, growth in earnings per share or return on shares.

Sackings: The threat of being sacked with the accompanying humiliation and financial loss may encourage managers not to diverge too far from the shareholders’ wealth path. However this method is seldom used because it is often difficult to implement due to difficulties of making a coordinated shareholder effort.

Selling shares and the take-over threat: Most of the large shareholders (especially institutional investors) of quoted companies are not prepared to put large resources into monitoring and controlling all the firms of which they own a part. Quite often their first response, if they observe that management is not acting in what they regard as their best interest, is to sell the share rather than intervene. This will result in a lower share price, making the raising of funds more difficult. If this process continues the firm may become vulnerable to a merger bid by another group of managers, resulting in a loss of top management posts. Fear of being taken over can establish some sort of backstop position to prevent shareholder wealth considerations being totally ignored.

Corporate governance regulations: There is a considerable range of legislation and other regulatory pressures (e.g. the Companies Act) designed to encourage directors to act in shareholders’ interests. Within these regulations for example, the board of directors is not to be dominated by a single individual acting as both the chairman and chief executive. Also independently minded non-executive directors should have more power to represent shareholder interests; in particular, they should predominate in decisions connected with directors’ remuneration and auditing of firm’s accounts.

Information flow: The accounting profession, the stock exchange, the regulating agencies and the investing public are continuously conducting a battle to encourage or force firms to release more accurate, timely and detailed information concerning their operations. An improved quality of corporate accounts, annual reports and the availability of other forms of information flowing to investors and analysts such as company briefings and press announcements help to monitor firms, and identify any wealth-destroying actions by wayward managers early.

Discussion 7
Post your response in the discussions area. (See the procedure for discussions in Course Info.)

1. Taking example of one of the stock markets in the Southern Africa region (lists and links provided below) comment on the efficiency of the stock markets with support from relevant studies in that market.
The markets
• Dar es Salaam Stock Exchange (Tanzania)
• Nairobi Stock Exchange (Kenya)

2. How can adverse selection and moral hazards apply in the selection of telecommunication investments in the Southern Africa region? Give relevant example(s) to support your arguments

3. What is the application of the agency/principal in the following cases and how does it evolve?
• Regulatory body and the government
• Regulatory body and the operators
• Shareholders of a telecommunication company and management
• Public mobile company management and shareholders

4. Identify the possible agency costs between the regulatory body and the government. Articulate the return for the costs to the government as a regulator of the telecommunication sector.