Management: Agency Problem - Essay Example

? Management: Agency Problem MANAGEMENT An Agency Problem within a Firm and the Causes of the Problem Agency Problem is aterm used to refer to the conflict of interest which exists between the management of a company and the stockholders of the company. Managers are always put in charge of operations of a company in order to act on their behalf; they are supposed to be the agents of the shareholders, or the principals on behalf of the shareholders; the decisions they make should always be aimed at maximizing the wealth of the shareholders of the business. However, if the managers fail to do this and instead satisfy their appetites of making themselves their own wealth, then we have an agency problem. The ‘agency problem’ has been in existence as long as capitalism has been. Ferguson (2004) gives a very good account of the how long the problem has been in existence. In the eighteenth century, East India Company one of the world’s first corporations, did business in India while its major shareholders lived far away in London. In as much as the shareholders tried to exercise their control of the business, they could not because of the limitations associated with communication systems. Messages were carried by ships to and from the destination. More often than not, it would take half a year to get messages from Calcutta to London and the same period of time to get replies from London to Calcutta. The expatriate agents; the managers the shareholders put in place to run the business for them out rightly ran their own businesses not taking into consideration the interests of the shareholders and of the company as an entity. The businesses were often in competition with the shareholders. The managers became staggeringly rich and even remitted diamond boxes to England that was for their own private estates. Soon enough, the East India Company experienced a fall in the prices of its shares as a result of the war and famine in India at the time; the year was 1767. This was among the first instances of the agency problem. There are ways of ensuring that the agency problem does not find its way into a company or if it already exists, it can be dealt with accordingly. In this paper, I would like to give a description of one of the companies I have had a pleasure of working with and then give an example of the agency problem and the areas it affected in the company. Description of the Company Boeing is by far one of the most successful plane manufacturers in the world. However, it has had its fair share of problems. In organizations where the matrix management structure it utilized, it is important that communication be prioritized as the key that leads to success. At Boeing, communication lines flow, often more freely with the matrix structure hence allowing for an increase in accountability from both the project teams as well as the project managers. The matrix structure the company uses ensures that each and every one of the companies departments has a vice-president. The departments are as follows: Communications department Business development and strategy Operations, engineering, and technology Internal governance Finance International Public policy Law department Human Resources and administration The company uses specialization. This means that there are different individuals who are in different units and who perform very specific tasks in their areas of work. There is an executive council; there is the commercial airplanes department, a capital corporation department, shared services group, integrated defense systems department, and lastly the Engineering, Operations, and Technology department. The company also relies on Corporate Governance; the executive staff as well as the board of directors oversees the firm and its operations. The board of directors and the executive staff use integration in running the organization. The Agency Problem and Boeing Boeing’s agency problem is one of the examples of the form the problem has taken in modern day capital market. Boeing had in the neighborhood of 130,000 shareholders at the turn of the millennium. However, a paltry 2 percent of them were institutional intermediaries who held about 2 thirds of the rights to vote and also controlled the company. The number of people who were actually entitled to beneficial interests in the company is not known. This is because at the time, there were no accurate reports of the indirect interests via the mutual funds, as well as the pension plans. Estimates put the number of the shareholders having such interests at about 20 million, and possibly above the value. Also, close to above 10 million of the shareholders; the beneficial owners, had 401(k) retirement plans which were sponsored by organizations and companies they worked for. Quite possibly, the majority of these Boeing shareholders had representation through indirect investments which were held through the 401(k) as well as the retirement plans. The agency problem was caused by the large number of the interlopers which were between the investors in 401(k) plans, as well as the executives of the company; Boeing. In trying to trace the ownership path of the company, it is evident that the distance that that was between the investors of the company and their corporate managers is much greater than the distance that was between the shareholders of the East India Company and their managers in the eighteenth century. This is despite the fact that we are in the 20th century where there are much better means of communication, better systems of management and so forth. Public company shareholders often pay lip service to their shareholders’ interests. However, they are always referring to the fund managers and the fiduciaries who are voting for the shares and not the people who are actual company owners. The walls which separate the numerous beneficial owners of the company from their corporate executives are full of many layers; and this is soundly created out of the ignorance, the misinformation, and the failed fiduciary responsibility. Also, this multi-layer separation is caused by delays in accountability, as well as the legal disclaimers between the company and its shareholders. The fact that the people who run the companies; the managers and the executives, perceive their shareholders as very little people, and they are remote and also distant strangers to them, they are very removed and indifferent from their ultimate owners. The executives are very unconcerned about their shareholders’ needs yet they profess to being at their service. Controlling the Agency Problem Most of the beneficial owners of the Boeing company did not know that they held stocks of the company through the mutual funds that they held with the company. As a result, they did not stand a chance of claiming any form of ownership with their lack of knowledge. It is, therefore, advisable that in order to see a better run company, the shareholders need to be told of their roles to the company and the amount of shares they own in the company. This will make them understand how much voice they have in the matters of the company. Also, given that most of the shareholders were just high-school graduates in their early 40’s, they did not understand anything about financial issues. It would be prudent that they be trained on financial management so that they understand where their money has been invested in and also be able to hold the managers and executives accountable for their activities and decisions they make on behalf of the shareholders. Accountability is important, and therefore if the executives can be held accountable by measures put in place towards that purpose, there will be less of the agency problem; none of them would dare make decisions that are in contrary to the interests of the company and its shareholders. Apart from accountability, the shareholders should be informed on the kind of the investment funds they would like to be included in their plans with the company. It is not enough to only provide a person with the risks associated with a given fund, or the description of the performance, or the investment aims of the fund; a person should know which one among the available funds is best for them. If this happens, the investor can be able to choose from the multiple choices available with adequate information such as; the different returns of the funds over a given period of time. For instance, a certain fund A could have a 20% return for a 5 year period. On the other hand, a different fund, say a value fund B, could be having a 15% return over the same period. Lastly, a balanced fund, say fund C, could be having 10% returns. From then onwards, the investor could be able to make a choice that is backed by information and not simply by guess work and heresy. Previously, it was very difficult for the investors to have access to information of the extent to which the funds they invested in could give them returns. They did not know of the amount of dividends their funds accrued and even how much profits were unrealized in the market by their investments. This was mainly as a result of the burst that came to be known as the Great Bubble. Investors had no idea of the average ratio of the price-earnings or even of the underlying yields accrued in the form of dividends from the fund components. As a matter of fact, most of the shareholders cannot be able to make anything out of the information even if they were allowed access to it in the first place. Most of these investors are very trusting; so stupidly trusting that they expected the Investment Committee planning their investment packages to give them alternatives into the kind of the investments available, and which were more appropriate towards safeguarding their life savings. This is not the case, as many of the people on the committees are not concerned about the interests of the shareholders and simply on ensuring their security as executives. The fact that the prospectus to the plans were loaded of caveats, full of warnings, as well as admonitions which absolved the fund managers, the employers, and even the plan trustees of any kind of responsibility, nobody would be held responsible if by any chance, or misfortune, an investor lost his or her entire retirement fund. These are some of the changes which would need to made in order for the company to be compliant with the needs of the shareholders. While the executives of the company made informed investments for themselves, the other investments simply relied upon their own ‘uniformed judgment’, the advice from their relatives, advice from commercials on television from commentators, popular magazines, and even the advice from their co-workers, and those from their friends. About three quarters of the 401(k) investors admit to having no understanding of the investments they make, and those who may know have very little comprehension of the same. As a result, most of them do not show any form of diversification when it comes to making plans for their retirement benefits. Most of them made investments in to the investments of their employers. The administrators of the plans were in total disregard to the interests of the employees’ interests and this is very wrong. Information should be made available to investors on the kind of benefits are appropriate for them and their plans to retire. If this happens, they will be able to make informed choices. Also, employers should show accountability by letting their employees know about diversification and not just show total disregard for their interests. Job Dimensions of the Firm The Plan Administrator Under the department of the stocks and financial retirement benefits, there are a lot of layers. In the first layer is the plan administrator. This is the employer who sets up the 401(k) plan and also administers it, going to the extent of determining which investments participants may choose, which vesting provisions are available, as well as the conditions which are available for matching the funds, and of the other details. All the investment risks are vested entirely on the employee; the plan administrator. The 401(k) plan gives no provision whatsoever, of supporting the investor in his or her old age. Plan Trustees They come after the plan administrators. The plan trustees hold the funds which have been authorized for payment by a worker into the 401(k) plan. They are mutual fund groups or money center banks. The Fund Directors Next in line are the fund directors who are on the second layer of the management of the investments of the company. The mutual funds which are open ended are organized in form of corporation in the United States. Duly so, they have very ceremonial but rather legally potent directors of the board who are nominated company management. The directors and the executives of the company are employees of the manager of the funds. The directors of the mutual funds are well paid; and the remunerations are not exorbitant. These directors are responsible for approving the portfolio performance reports, as well as passing on the recommendation s they make to the trustees of the funds concerning appointments such as of investment managers, auditors, and finally of the changes stipulated by the charter of the funds. On certain occasions, the trustees and the plan administrators pass annual reports to the investors who are the beneficial owners of the company. Fund Managers These are the next executives in charge of management of the mutual funds. These are the people who make the decision of whether or not an investor should be allowed to hold Boeing stock. The Company Directors Corporate law allows shareholders to vest certain adequate powers to the company directors. The directors are responsible for appointing the executives, authorizing the dividends, and also buying back of stocks, setting management remunerations, approving mergers, as well as acquisitions, and finally the determination of the business policies. The previous design of the job implementations made it very difficult for the investors to be able to reach the executives in terms of communication. As a result, it was necessary to ensure that a better design of organization structure be put in place of the previous one. Job Design The company has implemented the matrix management structure as earlier on mentioned in this document. As a result, communication has been made a key factor in ensuring success of the company as well as the shareholders. Communication lines have been made to be more free flowing along the company structures hence allowing for an increase in accountability in all the people who are in charge of the management of the mutual funds. The project managers and the project teams are now more accountable in their duties and capacities as agents of the shareholders. In addition to accountability, the project managers and the project teams are now more specialized as well as the other employees of the company. Corporate governance has also been made better too. The matrix organizational structure the company has implemented is a hybrid of the functional and the divisional structures of organization. The benefits of the functional structure of organizations as well as the divisional benefits have been incorporated into the company and exist together seamlessly. While it is thought that there may be problems with this dispensation, it is not that much of a hassle. Every person has his duties well defined and spelt out for them. The company’s clients and the staff know what they need to do in their capacities of employment. Therefore, the investors know who to approach in any case there is a problem. The organizations functions are well defined using the functional organizational structure and then enhanced using the divisional organizational dispensation which caters for the different locations of the company’s branches. Consequently here is the organizational structure of the company: 1 Figure 1: Boeing Organizational Structure Compensation Packages for Employees and Executives as a Solution to the Agency Problem Compensation Packages given to executives are meant to keep them and retain their services to the company and to ensure they remain faithful to the company’s interests during the period of their employment by the company. A compensation package refers to the combination of all the benefits that employers may offer to their employees such insurance, wages, days of vacation, guaranteed raises among other perks. In order to maintain the company values, as well as the interests of the shareholders among the employees and the executives of the company. Among the compensation packages the executives could be offered are contractual agreements. The managers could be offered contracts in which they are also part of the negotiators to kind of salaries they would like to be paid among other benefits. Once the contract agreements have been signed with the employees and the managers as well as the executives, they are bound by them to ensure that they keep the interests of the shareholders in mind in every decision they make. There are also equity based compensation plans that the owners of the company could offer the executives and the managers. They can be allowed a certain percentage of the equity share of the company so that they treat every decision they make as part of the group of owners as their shareholders would like them to be. Dequity contracts could also be put in place to ensure that executives are faithful to the demands and interests of the owners of a company. This is a hybrid of the debt contracts as well as the equity compensation plans and offers a superior solution to the agency problems in companies. The debt features in debt contracts and the equity features are combined together and put in place for the investors and the executives of the company. The thinking behind this is that when the executive fails to honor the agreements of the contract, he or she is given a period of time to plan repayment of a certain amount of money. References Blasius, A., & Cabados, J. (2008). Organizational Structure. Capital Flow Analysis. (2012). The Agency Problem and Business Ethics. Retrieved June 16, 2012, from Capital Flow Analysis: http://www.capital-flow-analysis.com/investment-essays/agency_problem.html Cogmap.com. (2012). Boeing Company Structure. Retrieved June 17, 2012, from Cogmap: http://www.cogmap.com/chart/boeing-company Ferguson, N. (2004). Empire: The Rise and Demise of the British World Order and the Lessons for Global Power. New York: Basic Books. Investopedia ULC. (2012). Agency Problem. Retrieved June 16, 2012, from Investopedia: http://www.investopedia.com/terms/a/agencyproblem.asp#axzz1xwN51sjg Sepe, S. M. (2012). Corporate Agency Problems and Dequity Contracts. Tucson: University of Arizona. Read More