Principal-Agent Problem and Regulatory Frameworks - Literature review Example

PRINCIPAL-AGENT PROBLEM AND REGULATORY FRAMEWORKS and Contents Contents 2 0 Introduction 3 2. 0 The principal-agency theory 3 3.0 Corporate governance 5 3.1 The role of the board of directors 5 3.1.1 Size: 6 3.1.2 Expertise 7 3.1.3 Independence 8 3.2 Commitment of the board members 9 3.3 Incentive schemes 10 3.4 Information asymmetry 11 4. 0 Mitigating the agent-principal problem 12 4.1 The Financial Services Act 12 4.2 Sarbanes-Oxley Act 13 4.2.1 Increasing the independence of the board 14 4.3 Dodd-Frank Act 14 4.3.1 Executive compensation 15 4.4 Other reforms 15 5.0 Conclusion 15 Reference List 17 PRINCIPAL-AGENT PROBLEM AND REGULATORY FRAMEWORKS 1.0 Introduction In the article titled, the principal-agent problem in economics and in politics, Ribstein (2002) extrapolates the concept of agency relationship to politics. In this article, Ribstein (2002) argues that since principals do not directly participate in the daily decision-making process, they lose the ability to influence the practice on how decisions are made. Likewise, once the voters delegate their duties to the politicians, the politicians could opt to follow their interests rather than those of the agents. In addition, in such a relationship, the voters become the hostage of the politicians. The principal-agency problem can further be extrapolated to the health sector, where the health providers can act as imperfect agents of patients by prescribing unnecessary drugs. This paper assesses the principal-agency problems in explaining failures of corporate governance. The paper further examines how the recent regulatory framework has been used to mitigate the principal- agent problem. 2. 0 The principal-agency theory In the article, Theory of the firm: managerial behavior, agency costs and ownership structure, Jensen and Meckling, suggest managers as being the agents of the shareholders (Huber, 2002). The principal model guides agency relationships where the shareholders, otherwise known as the principals, delegates duties to the agents to act on their behalf. The model is defined by a number of features, which are defined in the following section. Firstly, as suggested by Bodie, Alex and Alan, agents undertake actions, which determine the payoff to the principal (2002). In other words, the effort of the agent determines the profits realized by the principal. Secondly, within a principal-agent relationship, the concept of information symmetry arises. In this regard, the principals can be able to observe the outcomes of agents’ actions but monitoring the agents’ actions is almost impossible. In instances where an imperfect contract exists, the agents could be encouraged to act to carry out actions that benefit their interests, and the possibility of a moral hazard happening becomes even more real if there is a large information asymmetry. To address the problem of information asymmetry, the principals could put in place monitoring mechanisms and initiate incentive contracts. The board of directors remains one of the common used weapons, in reduction of information symmetry by monitoring and ratifying the most important decisions carried out by the management. Beside acting on the behalf of the shareholders, the board of directors is also supposed to control resource allocation and accompanying risks. Thirdly, the agent-principal relationships assume that agent’s preferences differ from the principals. When the agents and the principals have differing risk preferences a conflict of interest occurs. Just to illustrate further, the shareholders may be risk-averse while the management is risk-neutral, which means the management is incentivized to make risky decisions against the will of their principals. If such a situation happens, the board of directors is mandated to ensure the interest of the management, and the shareholders are aligned. To deal with the challenges that are associated with the principal-agent relationships, the principals may result to outcome-based incentives. This strategy as suggested by Jickling (2002) addresses the possibility of moral hazard occurring by transferring risk to the risk-averse agent 3.0 Corporate governance 3.1 The role of the board of directors As suggested earlier the board of directors acts on the behalf of the management and plays an important role in the remuneration of the management and enhancing the control and monitoring mechanisms in an organization. From this description, the board of directors plays an important role in risk management. The role of the board members in corporate governance can be understood using the Enron’s case study. Enron’s origin dates back to 1985 and was a joint venture between Houston Natural Gas and Omaha-based InterNorth. Enron’s demise occurred after its activities were deregulated by the government (Stiroh, 2004). Following the deregulation, the executives were allowed to maintain agency over the earnings report. Following the de-regulation, the executive failed to provide the principals with accurate information about the financial position of the company. In addition, the executive embezzled funds meant for company use in lieu of personal use. Such criminal activity meant that the shareholder value was greatly diminished by their activities. The collapse of Enron surprised many people, among being shareholders and sent shockwaves across the financial markets. The Enron’s case led to huge losses, especially after its shares were delisted from the NASDAQ. In total, the loss as a result of this scandal, the shareholders sustained a loss of $70 billion while the employees and trustees lost about $2 billion (Morrison & White, 2005). Although the management is primarily responsible for the Enron’s scandals, the board of directors too played a role in several ways. Firstly, the board failed to conduct the oversight role and encourage conflict of interests with Enron’s partnerships. Just to illustrate, some of the employees working in the company were equity holders of entities with Enron. At the time, Enron’s code of conduct prohibited such employees from acting on the behalf of the company, unless the top management confirmed their actions would not affect the interests of the company. In order to avoid such an eventuality the board should have performed its fiduciary responsibility of independently monitoring such partnerships. At the same time, the board was unaware of other some of the activities that were being conducted by the management and which negatively impacted on shareholder value. Secondly, the board did not receive information that would allow it to maximize the shareholders benefits. In some instances, the board failed to investigate some of the accounting techniques employed by the auditors hence exposing the principals to undue risk. To avoid such an eventuality, the board should have taken due diligence to make sure the company’s financial statements were performed according to the GACC. Thirdly, the Board members did not understand about SPEs and so could not independently be able to questions the management’s decisions. Fourthly, the independence of the board was hampered as the board members maintained close relationships with the management. As a result of lack of independence, the board failed in its oversight responsibility. As a result of board’s actions, significant costs were transferred to shareholders. Given the importance of the board of directors, the composition of its members becomes crucial for effective monitoring. The effectiveness of the board of directors in safeguarding the integrity of agency-principal relationship can be enhanced by addressing the following elements: composition, size, independence and expertise. 3.1.1 Size: The available literature has examined the impact of the size of the BOD on the agency relationship. An effective BOD should be able to safeguard the interests of the principals and the available literature offers as an insight on the optimal size of the BOD. According to Morrison (2007), the optimal size of the BOD is influenced by two factors: communication capacity and the expertise of its members. In this regard, a large BOD could provide the better safeguard the interests of the principals than a small BOD. On the other hand, a small BOD are more effective in monitoring firm as they are less susceptible to free-riding and managerial influence. In his view, Robert (2002) argues that an efficient BOD should be composed of 7-8 members, and principals should opt for a small BOD rather than large one. According to Robert (2002), a small BOD is effective because communication between the members it easier and such they are able to control the agency problem. In addition, the small size of a BOD allows it to employ effective working methods. Robert’s sentiments are supported by a study whose sample was drawn from Americas bank holding companies (Laeven & Levine, 2009). This study concluded that there is positive correlation between smaller boards and risk-taking tendencies. The study further established that large BODs were more likely to be controlled by risk-averse agents and less aligned with shareholders’ interests. 3.1.2 Expertise It is well acknowledged that BOD members should have the right background knowledge in order to effectively manage principal-agent relationships. From an agency theory perspective, agents have an informational upper-hand, and so it follows that principals should employ equally-knowledgeable emissaries. Employing knowledge, BOD members address the problem of information asymmetry while reducing agency costs. The need of having knowledgeable board members became apparent during the 2008 financial crisis. According to a report released by the Senior Supervisors Group, some of the board members working in financial institutions did not have enough knowledge about the use financial instruments and such did not independently assess the risk posed by these derivatives. The importance of having knowledgeable board members in order is further discussed below. A study conducted in the United States, prior to the 2008 financial crisis indicated that at eight of the major financial institutions, two-thirds of board members of the financial experience (Gabaix & Lanider, 2008). The study further found out that some of these members sat on highly technical committees such as those covering audit and risk. Because they lack the necessary financial expertise, these members could not properly advise their principals and manage the actions of the management. In principle, lack of the necessary expertise negatively impacted on the ability of the board members to ensure the integrity of the essential reporting and monitoring systems. The consequences of the boards’ lack of expertise can be illustrated using real examples. For long, Landesbanken, a state-owned corporation used a business model based on AAA credit ratings. However, starting from 2005, the institution decided to invest in the derivatives market. At the time, the board members did not have the experience about the new model proposed by the management, and so they could not independently assess the inherent risks associated with it. In a similar case, the Northern rock board members could not adequately grasp the implications in investing in derivatives market. 3.1.3 Independence In order to best protect the interests of the principals, some of the board members must remain independent from the company. According to Peter (2002), this requirement is necessary in order to ensure they are able to carry out fiduciary duty to shareholders. In agency theory perspective, maintaining independence of the board ensures additional conflict is not introduced in the principal-agent relationship. It is also worth noting that in any relationship, there is a possibility of having insider and outsider directors. The insider directors are more likely to be aligned with the management than the principals. In contrast, the outsider directors are more inclined to side with the principals and hence are better positioned to minimize the private benefits accrued by the management. The implications of having an independent board in order to preserve the integrity of agent-principal relationship can further be understood, by revisiting Enron’s case study. The board members had financial ties with Enron, hence their ability to make objective decisions, became clouded. A report that was released by the U.S. Senate describes how the board members received money from firms that had financial ties with Enron. For instance, Herbert Winokur received compensation from National Tank Company, which had financial ties with Enron and its subsidiaries (Fahlenbrach & Stulz, 2010). Similarly, John Urquhart and Lord Wakeham received money for their consulting services to Enron. 3.2 Commitment of the board members In the run-up to the 2008 financial crisis, Fahlenbrach and Stulz, (2010) established that the board members in some of the financial institutions did not have get enough information. Due to lack of enough information, the board members could not adequately assess the risk appetite of the organizations they worked for and identify emerging areas of risk. One of the reasons behind the situation could be because the board members had other commitments and as such did not have enough time to gather reliable information about the company. These events are supported by a study conducted by Abhay (2000) which indicates that directors holding numerous positions are in incapable of performing their duties as required. The study further concluded, holding a large number of board positions, may hinder the boards’ ability to reduce the agency costs. These sentiments are echoed by Loren (2003) who found out that busy directors are incapable of monitoring the decisions made by the management hence limiting the shareholder primacy. 3.3 Incentive schemes From above it is apparent that controlling the actions of the management by putting in place, competent and independent BODs is one way of managing agency relationships. Beyond monitoring and controlling, the interests of the principals can be protected by ensuring the compensation of the executive is aligned with the long-term interests of the company and its shareholders. According to the Basel principles, good corporate governance should offer proper incentives for management while at the same time safeguarding the interests of the shareholders. Some of the commonly components of remuneration include fixed salaries, bonuses shares and options. Using variable incentive pay; that is bonuses, share sand options; encourages the agents to maximize the value to shareholders but in the process, the agents are incentivized to engage in risky projects. The effect of remuneration schemes on the integrity of the principal-agent relationship can best be understood using the Enron’s case study. After the de-regulation of the financial market, Enron’s management saw an opportunity to generate more cash flows and profits. The company employed young talent to take advantage of the new market opportunities. To encourage the young employees the remuneration packages were rewarded with hefty bonuses. This pay-scheme encouraged the employees to trade in high-risk markets in an effort to gain disproportionately high profits. The new pay-scheme created fierce competition among the employees and in the end, this culture was appreciated in the organization. The Enron’s story highlights the problems created by earnings-based compensations schemes. In a similar case, in the run-up to the 2008 financial crisis the use of bonuses to incentivize the agents had become very popular. A study that was conducted by Nancy, Rapoprt and Bala (2009) found out that fixed salary accounted for 6% of the total compensations while stock-related pay was abnormally high. A good example can be at UBS where short-term incentives accounted for 70% of the executive compensation. Such compensation no doubt, encouraged the executive to engage in risky behavior with the purpose of reaping short-term gains. More importantly, in the run-up to the 2008 financial crisis, the executive directors did not have substantial shareholding in their companies, which means they were not incentivized to safeguard the interests of the principals. 3.4 Information asymmetry Enron’s case study also highlights the problem of information asymmetry. The management in this case, engaged in complex trading activities which the board members could not understand. This scenario led into a situation where between the information that the management had and what was reported to the principals. The management capitalized on this asymmetry to pursue selfish ambitions, which were harmful to the agents. Just to illustrate, the implications of information asymmetry in an agency relationship, Enron’s management was aware about the untrue nature of the reports that were being presented to the investors and potential shareholders, but the principals did not have this information. Likewise, the management was aware of the risky nature of SPEs but the same information was not available to the principals (Vijay, 2002). Had the principals been provided with information about the highly structured partnerships, maybe they would have investigated the case before the firm went under. At the same time, the agents did not give the right financial information to their principals. 4. 0 Mitigating the agent-principal problem 4.1 The Financial Services Act This legislation was passed in the UK, and it replaced the Tripartite structure. The act brings on board, the Financial Services Authority, the Treasury and the Bank of England. These entities have a huge role in maintaining a proper regulatory environment to ensure the interest of persons who do not take part in the daily running of the firms. The Act creates the Financial Policy committee, the Prudential Regulation Authority and the Financial Conduct Authority. These three bodies will play the role of safeguarding the shareholders and the consumers from risky practices and maintaining the soundness of financial institutions. To improve the integrity of the executive, the Financial Services Authority has taken an active role in scrutinizing the executive appointments. The would-be-executives are vetted through formal panels, and this is a suitable step in selection of executive members who have the ability to protect principals’ wealth in the company. To further protect the principals and the customers, in 2010, the European countries passed tough restrictions, which stipulate that the management can only receive 20-30% of their bonuses in immediate cash. The guidelines further required banks to defer 40-6-% of bonuses to 3 to 4years and pay half of bonuses in shares. To discourage, the executive from engage in risky projects, the regulators established the maximum bonus level as a percentage of total compensation. The same guidelines empowered banking institutions to recover compensation to the members of the management who are deemed to have under performed. In this regard, if the executive is deemed to have failed to undertake necessary measures, to protect the shareholders’ value, their compensation can be clawed back. 4.2 Sarbanes-Oxley Act In response to the Enron scandal, the Sarabanes-Oxley act was enacted on July 30th, 2002. The act affects the management and the board members of public companies. The Act, which is also known as the Public Company Accounting Reform and Investor Protection Act, was drafted by Paul Sarbanes and Michael Oxley. The Act is composed of 11 titles and it protects the interests of the principals in several ways. Firstly, it mandates the management to provide the investors with accurate financial position of the company while prohibiting insider trading. Secondly, the acts require the management to reimburse any compensation received in the event the financial position of the company is not well stated. To further protect the principal, from shadow and complex transitions, the act requires the disclosure of off-balance sheet transactions. Such information helps address the problem of information asymmetry and thus helps the principal to make wise decisions regarding their investment in the company. Thirdly, to prevent the events that occurred at Enron, the act strengthen corporate governance and motoring systems in an organization. In particular, the act promotes the independence of the audit committees. This requirement addresses the situation whereby an auditing company provides other concurrent services beside audit services. Given that the board may lack the necessary financial background to help them make appropriate decisions in regard to the protection of principals’ interests, the act mandate organizations to form Accounting Oversight Boards. Fourthly, the act introduced punitive measures to discourage the agents from engaging in risky behaviors that are likely to negatively affect principal’s interests in company. In addition, the legislation increases liability risk on the part of the management. This move discourages the principal from investing in firms. Fifthly, to address the problem of information asymmetry, the Act requires forms to invest more resources in getting information that is beneficial to the principals. This requirement is likely to force firms to pay more in auditing costs in order to provide the principals with accurate information and to avoid the costs associated with cover-ups. The act has far-reaching implications on the daily running of the firms and the measures that are put in place to protect the investors. Some of the elements which positively impact on the shareholders include the protection of whistle-bowling mechanisms. In this regards, when employees’ complains’ touch on the firm’s financial statements, the management is mandated to act on such issues. The principals are further protected by requiring companies to document their compliance with the relevant clauses of the Act. 4.2.1 Increasing the independence of the board Given that the board acts of the behalf of the principal, it has becomes increasingly clear that its independence need to be protects. The act addressed this problem through a number of ways. Firstly, the board of directors must have a substantial number of outsiders who do not have conflicts of interests with the company and its external partners. To encourage, the independent members of the board to conduct their oversight role, they are required to hold regular schedule meetings without the presence of the management. This strategy is supposed to empower the principals while reducing the interference from the management. 4.3 Dodd-Frank Act The act was signed into law on July 21st 2010 and was proposed in response to the 2008 financial crisis. The Act planned to the actions of the management to protection principals and consumer interests. Remember, in the run up the 2008 financial market, the banking institutions engage in derivatives market hence exposing the investors to undue risk. The act protects the rights of the principal by promoting independence of the directors, disclosure to the public and the investors, improvement of the internal controls and addressing the possibility of conflicts of interests. 4.3.1 Executive compensation As discussed above, excessive compensation and variable-pay components may encourage the executive to engage in risky behaviors to the detriment of the shareholders. To address the issue of excessive executive compensation, the Act introduced the “Say on Pay” rule which gives the investors the authority to vote on executive’s compensation plans. In this regard, the principals could vote down any proposed executive pay plans to safeguard their interests. At the same time, the Act gives the principals the authority on deciding the ‘say-on-pay’ frequency. This provision no doubt gives the principals control over the daily running of the firm while allowing them to choose agents who are likely to enhance their value in the company. 4.4 Other reforms Since the Enron’s scandal happened, many organizations have undertaken a number of measures with the aim of enhancing their corporate governance capabilities. One such measure is procuring board consulting services to assess and identify any weakness in the board structures and performance. At the same time, organizations have developed rating systems whereby board members are evaluated on the basis of attendance and performance. This approach encourages, the board members to conduct their duties as expected, in essence safeguarding the interests of the principals. 5.0 Conclusion In principle, the preference of the agents and the principals differ, and where an imperfect contract exists, the agency relationship can be exacerbated by large information asymmetry. The agent-principal problem became apparent during the Enron scandal and the 2008 financial crisis. To protect the principal from the agents’ risk-taking behaviors, governments passed important regulations. These regulations discourage the management from taking excessive risk while strengthening the oversight role of the board members. On the individual level, institutions have enhanced corporate governance capabilities by procuring board consulting services to assess and identify any weakness in the board structures. Although these new control mechanisms are likely to protect shareholders’ wealthy, they are likely to increase agency costs. Reference List Abhay, M., 2000. Power Play: A Study of the Enron Project. Orient: Longman. Bodie, Z., Alex, K. and Alan, S., 2002. Investments, Fifth Edition. NewYork: McGraw-Hill Higher Education Fahlenbrach, R., and Stulz, R., 2010. Bank CEO Incentives and the Credit Crisis. Journal of Financial Economics, 99(1), pp. 11–26 Gabaix, X., and Landier, A., 2008. Why Has CEO Pay Increased So Much?" Quarterly Journal of Economics, 123 (1), pp. 49–100 Huber, K.,2002. Outline of Sarbanes-Oxley Act of 2002. Latham & Watkins, LLP. Jickling, M., 2002. The Enron Collapse: An Overview of Financial Issues.Congressional Research Service: The Library of Congress. Laeven, L,. and Levine, R., 2009. Bank Governance, Regulation, and Risk-Taking.Journal of Financial Economics, 93(2), pp. 259–75. Loren, F., 2003. Enron: The Rise and Fall. Hoboken, N.J.: Wiley Morrison, A. D., 2007. Investment Banking: Institutions,Politics, and Law. Oxford: Oxford University Press Morrison, A. D., and White, L., 2005. Crises and Capital Requirements in Banking. American Economic Review, 95(5), pp. 1548–72. Nancy, B., Rapoport, B. and Dharan, G., 2004. Enron: Corporate Fiascos and Their Implications. Foundation Press. Peter, C., 2002. What Went Wrong at Enron: Everyones Guide to the Largest Bankruptcy in U.S. History. John Willey Ribstein, L., 2002. Market vs. Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002. Journal of Corporation Law, 28(1), pp. 1-67. Robert, B., 2002. Pipe Dreams: Greed, Ego, and the Death of Enron. NewYork: McGraw-Hill Higher Education Stiroh, K. J. 2004. “Diversification in Banking: Is Noninterest Income the Answer?”Journal of Money, Credit and Banking, 36(5), pp. 853–82. Theodore, F., 2002. The Enron Scandal. Nova Science Publishers. Vijay, P., 2002. Fat Cats and Running Dogs: The Enron Stage of Capitalism. Zed Books. Read More