Law of Business Organisations - Essay Example

?Agency Theory INTRODUCTION Agency theory is a concept which examines the governance of corporate bodies, particularly when the owners of such entities hand over the management tasks to third parties – agents. The owners who are the principals delegate the running of their business to the agents. Basically, the owners are the shareholders and the agents are the managers. The agents are given the duties to run a corporate body because of the professional skills they possess. The members of the management may not necessarily own shares in the corporate organization. The principals hand over the running of the corporate body to the management with the aim of benefiting from professional management of such corporate body. The agency theory offers many views of this relationship, as well as prepositions on how this relationship can be nursed in order to benefit the principals. The subject of this essay is to examine the ways in which agency cost theory has influenced company law and corporate governance reform. AGENCY THEORY The Problem to be Uprooted The concerns that the agency theory raises were first raised by Adam Smith. Smith noted that when a business unit grows into a level at which its management is handed over to other members who are not owners, the running of such a business will not be optimized. The new people who are responsible for managing the business lack an equivalent commitment as the owners. This particularly rises because of conflict of interests. Conflict of interests comes up because the agents will want to maximise their benefits at the lowest efforts while the principals will want to incur the least expenses but with maximum input from the agents to that the principals’ benefits are maximized.1 These concerns were revisited by other scholars, for instance, Berle and Means, but were fortified by the efforts of Jensen and Meckling.2 Jensen and Meckling clearly explained the conflict of interest that often comes up in the delegation of duties by the principals to the agents. They called it the agency problem. They observed that because agents do not own the business unit they are running, there are likely chances that they will commit ‘moral hazards’. Moral hazards in this context are actions that benefit the agents but at the expense of the business unit or rather the business unit owners. Such actions as shirking duties to attend to personal matters arise when non owners of a business start running it. Such actions are clearly not in the best interest of the principals.3 In order to solve the agency problem, two suggestions were made. One was that the delegation of duties and that the relationship between principal and agent must be designed in a manner that will uphold efficiency. The second suggestion made was that there has to be an effective means of monitoring the agents. Jensen clarified that in the first suggestion, there has to be consensus on the amount of rights that the principals will transfer to the agents. The agents have to be allowed enough rights to allow them execute their duties as pertains to those rights but they should not be too much to the extent of undermining the principals’ rights. And in the second suggestion a mechanism is created that will monitor the agents to ensure that what is agreed in the first suggestion is being adhered to – that is, the agents do not overstep their mandate. Thus from the very outset, the agency theory is all about corporate governance and company law. Putting up structures to enable agents manage a corporate body in a certain way that the principals wants is actually influencing how corporate governance is undertaken.4 It is clear that even though principals invite agents to run their business for efficiency purpose due to the professional skills that these agents have, the agents to some extent are not likely to work as hard as the principals would have worked if they had the skills that the agents possess. It therefore becomes inevitable that the corporate body will lose some value due to the change in management staff and also due to the costs involved in bringing the management staff on board and ensuring that the management team operates as it ought to. These costs are referred to as agency costs.5 In further explaining about agency costs, Jensen and Meckling add that monitoring costs will include using tools such as budget restrictions and operating rules. They also observe that the total agency costs can be categorized into three: monitoring costs, bonding costs and residual loss.6 The residual costs are the ones that the principals significantly seek to reduce. Residual losses are incurred due to the kind of decisions that the agents make. The agents may make some decisions that will at the end not maximise the value that the principals have in the company. For instance, the agents may make decisions to expand the company not necessarily to increase profits but so that their stature increases as they will be managing a bigger portfolio – such expansion may lead to costs such as diseconomies of large scale operations. This may not add value to the principals but will be valuable to the agents. The agency problem therefore seems to be deep and hard to uproot. Somehow the owners will have to be actively engaged in the running of the company from a passive perspective.7 This is what Fama suggested. AGENCY THEORY AND CORPORATE GOVERNANCE AND COMPANY LAW The concepts brought about by agency theory and agency costs have a direct effect on the corporate governance and thus indeed on company law. According to Fama, a large firm can control the challenge created by the issue of agency by using internal devices. These devices will ensure that the agents only engage in activities that will benefit the principals.8 In further discussing these internal devices, Fama and Jensen argued that decision management is separated from decision control at all the levels in the hierarchy of a corporate but with a special interest in the top level. A clarification is made whereby decision management is explained as activities relating to undertaking of a company’s function. On the other hand, decision control involves managing the activities of the decision management function. Decision management is carried out by the board of directors in conjunction with the managers while decision control is carried out by the managers and the workers.9 Decision management is involved in initiation and execution duties. Initiation in this context refers to the generation of proposals for a firm to make investment and structuring of contracts. Execution refers to actual undertaking of the proposal made in the initiation stage. These two functions as already pointed out above are practiced by the board of directors and managers. This is a kind of an oversight docket that specifically guards the interests of the principals as will be explained later. The decision control tasks are approval and evaluation. Approval relates to the choosing of a proposal and the contract while evaluation deals with undertaking of oversight duties in reference to the execution process and making an assessment on how the process progresses. There is a need to note that the decision management and decision control duties dovetail each other and none can work without the other. The separation of decision management from decision control is a safeguard measure taken by the principals to ensure that agency problems specifically the challenge of residual loss is controlled. Residual control as already mentioned above results when agents make decisions which may not benefit the principals but rather the agents in a direct or an indirect manner. The separation of decision management and decision control therefore makes it hard for an agent to make decisions which take care of the interest of the principals’ interests. The board of directors can be said to be a watchdog for the principals – actually they are usually appointed by the principals. In any firm, the board of directors has the authority to control decisions while the senior managers have the right to manage the decisions. It has been argued above that the board of directors is appointed by the principals to act as a watchdog. But again, the agency problem may arise in this case whereby the board of directors instead of safeguarding the interests of the principals will instead choose to safeguard its own interests. This is often dealt with by the owners offering share-based incentives. Such offering will align the interests of the board of directors with those of the principals because in actual sense when the board is offered share-based stocks it becomes part of the principals – they form part of the principal pool and thus the agency problem is eliminated in the case of the board of directors. Managerial ownership has been considered as one way in which agency challenges may be dealt with. Jensen and Meckling made the suggestion that if the managers acquire part of the ownership the agency costs will be reduced proportionally. They posed that agency costs will reduce to zero as the full ownership is transferred gradually to the managers.10 This is true simply because the managers would have turned into the principals. But this is just theoretical; in practice transfer of ownership often does not take this trend. Managerial ownership can only be to an extent. Several studies have been conducted to examine how governance is affected with this partial managerial ownership in place.11 It has been shown that at low levels of managerial ownerships, the agency costs are drastically reduced thus governance is aligned to the interests of the principals. However, the reverse starts to take place as the managerial ownership increases. Therefore, the need for trade-off arises to balance the managerial ownership at a level that will optimally ensure governance is to be in the best interests of the principals. CRITICAL ANALYSIS From the above review of literature, there is no doubt that agency theory and agency costs have a great influence on the governance of a corporate body and indeed on company laws. The board of directors which is set up to ensure that agency costs are reduced particularly plays a very critical role in the governance of a firm and composition of company laws. The management team especially the top management is the subject of agency costs and depending on which measures are taken to handle agency costs with respect to the management team, the influence on the governance will be great. Board of Directors Board of directors is brought about as a result of the need to reduce agency costs. Many studies have recognized the significant role that this board plays in shaping the governance mechanism of a firm.12 It has also been pointed out that powerful boards are very influential in matters pertaining to corporate identity creation and corporate social responsibilities.13 Some other studies have however pointed out that boards can make governance a hard task to undertake. This has been pointed to be the case especially where such boards are large. Large boards have been said to make decision making process long and cumbersome.14 Whether a board of directors has a positive or a negative influence on the governance has been tied down to the composition of a board. When the board has more of the non-executive membership, it has been observed that the managerial discretion is severely influenced from the outside. Whether this will have a positive or a negative impact on the governance of a firm will depend on individual cases.15 However, some studies have pointed out that when the board has non-executive as the major component, there arises the risk of bad governance. This has been tied down to the lack of professional skills in the outsiders as far as running some corporate bodies is concerned.16 Therefore a board of directors has an influence on the governance of a firm. This influence may be positive as is in the case of a powerful board of directors but it can has well be negative as it the case for a large board of directors which make decision making a cumbersome process. A board of directors also has a direct influence on the kind of company laws which are in existence as this is an area it controls. Management Team The agency theory points out that the senior management team needs to be handled in a manner that will ensure their interests do not override the interests of the owners. The manner in which this is handled will determine how a management team goes about handling the governance of a firm. It has been suggested that compensation will play a part in ensuring that the management team concentrates on meeting the interests of the principals. It has been logically assumed that if managers are compensated well, then they will in turn execute their duties in ways that will yield maximum benefit to the firm. They are likely to do this to avoid losing their jobs on grounds that they are unproductive. Indeed studies have shown that there is direct correlation between good compensation and performance. 17 However, it has been observed that some level of compensation packages may create conflicts with the principals. This is the case when such packages are costly to the firm – this may be the case for packages which include such allowances as apartment purchases, use of private jets among others.18 Suggestions have been made that there be a ‘best practices’ as far as compensation packages to top executives is in question.19 Therefore managerial compensation in as much as it increases the probability of better performance there is a level of trade-off that needs to be identified in order to protect the interests of the principals. This was observed to be the same case for the managerial ownership. CONCLUSION Agency theory proposes that when a firm is run by separate entities other than the owners, then the management of such a firm is confronted with conflicts of interests. The agents who are authorized to run a firm on behalf of the owners are likely to engage in activities which may not benefit the owners of the firm but instead benefit the agents. To eliminate this challenge, the agency theory proposes that the owners have to find ways of eliminating the conflict of interests and monitoring the actions of the agents. In order to eliminate conflict of interests, good compensation packages and proposals such as managerial ownership are suggested. In order to ensure that agents are monitored, a board of directors is appointed. A board of directors has been shown to affect the governance of a firm in various ways. The compensation made to the managerial team in order to eliminate conflict of interest between the agents and the owners has also been shown to have an effect on the performance of the agents. Therefore agency theory has indeed influenced in a great way corporate governance and company law. Bibliography Agrawal A and Knoeber CR, ‘Firm Performance and Mechanisms to Control Agency Problems Between Managers and Shareholders’ (1996) 31 Journal of Financial and Quantitative Analysis 377. 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