Agency Theory and Corporate Governance Problem - Essay Example

AGENCY THEORY AND CORPORATE GOVERNANCE PROBLEM The concept of corporate governance problem evolved as soon as formal organizational structures evolved. There exists conflict of interest between the shareholders of a company and the management within an organization. While the company managers aim at increasing the size of the company and intend to benefit optimally from the growth of the firm, the company owners wish that the company share value would increase and the amount of benefits would increase (Childs et al., 2005: Eoltn & Gruber, 1997). Therefore, a conflict of interest arises due to misalignment of the two groups of people. The Agency theory conceptualizes the relationship between the firm managers and shareholders as a “nexus of contract” that is bound to result to conflict due to the different interests of each group. The proposal of this theory is that firms should have independent board structures and that the equity-based compensation for top executives should be applied to curb the aggressive behaviour of the management (Markowitz, 1991). While this theory suffers a number of weaknesses by assuming perfect organizational structures, it provides a possible approach to solution of the corporate governance problem. On this ground, agency theory, to a great extent provides workable solutions that can harmonise the interests of both the managers and company stakeholders. Corporate structures are characterised by a separation between the owners and the management of an organization (Demsetz and Lehn, 2011). The owners of an organization appoint managers who are better versed with management knowledge to run their business for payment. The expectation of the shareholders is that the managers run the organizations to the best interests of the shareholders at all times (Bhagat and Black, 1999). However, there is the risk that the management may put their goals first before those of the firm, which would be contradictory to their duties. As expected, the managers are the information bearers and haveFbr the power to influence the firm performance and profit through their strategic initiatives. From a different angle, the shareholders have little information and hence act in good faith expecting that the management will pursue the firm interests (Cadbury, 2011). However, it is hard for them to establish whether the management influenced the outcomes of their firms through economic manipulation (Brennan, 2009). Ultimately, the shareholders wish to submit the business risks to the experts with the sole aim of maximising the share values for their own benefits. Contrally, the manager’s goals may be against the shareholders interest as they seek to maximise the benefits they accrue from the organization. Nordberg (2011) points out to the conflicting interests of their shareholders and that of managers. The shareholders interest is to increase earnings per share, share prices and hence the dividends. Therefore, shareholders aim at optimizing the share returns to ensure that their investments are worth and that they generate more wealth. Differently, the managers’ interest may be to increase their personal wealth by paying themselves higher pays to ensure that they optimize their benefits from the organization (Arnold & Hatzopoulos, 2000). From this perspective, the two parties have their goals misaligned and hence they have high chances of being embroiled in a conflict. For instance, when the managers increase their salaries, the compare share value is bound to go down and hence company owners interpret this as a failure (Franks and Mayer, 1996). On the other hand, managers will underperform if the firm owners underpay them (Fama & French, 2004). Therefore, misalignment of the interests of shareholders and managers underpins the corporate governance problem. The agency theory is among the firm theories that have conceptualized the corporate governance problem as an inevitable issue of the firm. The agency theory perceives the corporate structure as a “nexus of contract” which comprises of the principal and the agent. In this contract, the principal is the owner of the company while the agent is the managers who carry out the organizational operations (Faccio and Lasfer, 2000). The principal hires the agent so as to averse business risks and to ensure that the company interests are safeguarded. On the other hand, the agent performs for the company at a pay and is given the power to push the shareholder’s interests (Harris and Raviv, 2006). The proponents of the agent theory points out that such contracts suffer from imperfection due to the fact that both the principal and the agency pursue personal interest while working within the limits of the contract. The agency theory perceives individuals as selfish in nature and that they are obsessed with self-interest and hence conflicts are inevitable within the organizations. The agency theory provides a number of propositions to check the conflict between shareholders and the manager. To begin with, this theory suggests that setting an independence executive would be crucial in ensuring that the organizations control is effective. Evidently, the board of directors comprises of both executive and non-executive directors (Burkart et al., 2012). One of the propositions of the theory is that organizations that have independent Chief Executive Officer (CEO) and a higher proportion of non-executive members will perform better than those that have an alternative structure (Conyon and Murphy, 2000: Denis and Kruse, 2000). This argument implies that the independent CEO is not affiliated to the organizations and hence is better in understanding the management decisions (Hermalin and Weisbach, 2011). Since their interests are neutral within the organization, they have a stricter control of the organization (Eisenberg et al., 1998). Such a measure ensures that the managers work with the interests of the shareholders at heart and that they benefit from their optimal performance. The proponents of this theory support it on the basis that strict control would reduce the agency costs that result from misaligned interests. The second proposal of the agency theory is that compensation packages can be used to align the interests of the principal and agent with a contract. This tenet of the agent theory suggests that the use of equity-based compensation for executives will enhance the financial performance of the firm. An equity-based compensation system is where the shareholders allow its employees to purchase company shares at predetermined prices and sell them at particular time (Hampel, 2008: Balsam et al., 2014). A number of authors have come to support this hypothesis by citing the need for organizations to have managers who have long-term visions with organizations (Himmelberg et al., 2011). By making the managers shareholders within the company, they realize that they will profit by increasing the share value (Burkart, 2007). Another group of scholars that supports the equity-based compensation systems argues that stock options make managers think like the company owners, hence align the interests of the agent and the principal (Bethel et al., 2001: Ledoit & Wolf, 2003). Apparently, managers that have long-term relationships with organizations are better versed to pursue the interests of the shareholders. Since they intend to sustain the organization in the long-term, they make decisions that ensure that the company grows and that their income increases as the company grows (Hermalin and Weisbach, 2001). Therefore, an equity-based organization system will ensure that there is a balance between managers’ and shareholder’s interest. The idea that managers pursue self-interest is an issue that has drawn a lot of controversy within the world of research. The agency theory puts forward the idea that managers act in self-interests and that an increase in the remuneration results to the reduction in the performance of the firm (Fama, 2000). However, the theory appears to believe that cutting management expenses would lead to increase in the share value and hence organizational performance. Empirical evidence shows that it is possible for a company to increase its share value by providing better pay for their executives (Alkaraan & Northcott, 2006). Notably, compensation structure is an important aspect of organization that influences the employee motivation and their willingness to pursue the shareholder interests. Research shows that companies that pay their employees higher pays have high chances of growing (Dittmann et al., 2004). Since paying the employees satisfactory salaries wins their loyalty, they become aligned with the corporate goals and will have a higher work output. Companies that underpay their employees are faced with the challenge of misalignment and will be characterized by low work output and high employee turnover (Denis and Denis, 1995). Since the employees are always looking for better paying companies, they will leave the organization as soon as they find better paying jobs. From this perspective, the idea that the management costs contribute to reduction in the share value is weak and does not lead auger with the wide accepted theories of finance control. Secondly, the agency theory assumes that the structure of the executive board and its composition is the main determinant of the company performance. The argument implies that constituting corporate board with a high proportion of non-executive members is essential in ensuring finance and operations control. While this is accepted as an important fact, there is evidence that it is not a guarantee for streamlining organizational performance (Dahya et al., 2000). Besides the composition of the corporate board, the behavior of each member of the board is crucial and plays an important role in determining the success of the organization. Evidently, the conflict of interest between the shareholders and the management may persist even when such a board composition exists (Benston, 2013). It would be essential to support the right behavior within the board as a means to foster harmony within the business environment. Behavioral theories emphasize that companies perform well only when the behavior of the board is positive and that there exists a balance between the shareholder and management power. Since each member is represented in the organization, they will feel comfortable to pursue the shareholder goals. From this perspective, the agency theory provides a suitable but not a necessary ground to resolve the corporate governance problem within business organizations. Its simplistic view on the control role of the corporate board suffers weakness and ignores the need for aligning corporate board behavior. On this ground, it is crucial for corporate to consider the worker behavior and to represent both the interests of the agent and the principal while establishing contracts. This means that companies must engage in fair contracts that ensure that both shareholder and managers goals are aligned (Baker et al., 2010: Banker, Lee and Potter, 2006). One strategy would be applying the behavioral approach that requires that shareholders work hand in hand in achieving the goals of the organization. Effective communication between the management and the shareholders would be essential in ensuring that managers pursue the shareholder interests (Agrawal and Mandelker, 2012). Therefore, the relationship between the agent and the principal should be mutual if the conflict of interests is to be neutralized. Secondly, the shareholders must focus on supporting the management through considerate remuneration to ensure that they form long-term relationships with them. In conclusion, the agency theory, besides a number of its weaknesses provides an approach through which the corporate governance problem can be solved. The theory proposes that to settle the conflicting interests of the shareholders there is need to reinforce the control systems by setting up an independent board structure and composition. This will ensure that the managers’ self-interest motives are controlled and that they work towards increasing shareholder value (Miller, 2009). Secondly, the idea that equity-based compensation systems can motivate the management to perform optimally is reasonable and in line with motivational theories. This idea seems to ignore the concept of corporate behavior and the value that this has in resolving the corporate problem, hence a source of weakness (Phylaktis & Chen, 2009). 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