The Nexus between agency theory and corporate governance - Essay Example

The Nexus between Agency theory and Corporate Governance Thesis ment This essay tries to explain the agency theory and corporate governance in the present day environment. Economists recently are more diverted to the phenomenon of organisation. The recently formulated organisation theory agency theory is different from the ones which existed in the past. This paper attempts to explain the problem which exists between the agents and corporation within the link of contracts. Introduction According to Jensen and Meckling's (1972) organisations are to be viewed as only a set of implied and open contracts with connected rights. Fama (1980) focused at the possible managerial labour market to restrain and guide individual decision-making expedience. In essence all these various statements are construed based on a few simple assumptions. These assumptions according to Donaldson (1990) are construed as a 'theory of interest, motivation and compliance'. According to Eisenhardt agency theory is: "Specifically, agency theory is directed at the ubiquitous relationship, in which one party (the principal) delegates work to another (the agent), who performs that work. Agency theory attempts to describe this relationship using the metaphor of a contract" (Eisenhardt, 1989: p58). The neoclassical school analyses the individual who tries to maximise or in the least to satisfy their utility between work and time off. This combination of assumed independence and selfish enthusiasm that is problematic within the relationship of agent and principal. In terms of corporate governance the shareholder is the principal. The problem arises due to the separation of ownership and control. Corporate Governance failure According to Jill Solomon (2007) the failure to corporate governance and corporate crumple can take place in the firmest company. It is possible to seduce the Investors, creditors and employees through a company's repute and achievement. This can even throw caution to the wind. If the agents of economic accountability were intellectuals, as it is a must based on the economic and finance theory, this form of sightlessness could never occur. But the problem is that it does happen, investors behave rationally not always, and the factors of human behaviour and psychology are tricky to fit in a finance framework or an economic hypothesis. Cases of irrational behaviour in the UK during the 1980s were that of Polly Peck and Coloroll. This was a case when the capitalist found very important information relating to contingent liabilities were missing from the accounts of these companies (Smith et all, 1992). Differences between managers and shareowners Agency theory brings up a basic problem in organizations and that is self-interested conduct. The managers of a corporation normally have their own goals which often cross roads with the proprietor's goal of maximising shareholder wealth. As it is the shareholders who give power to the managers to manage the firm's wealth, a prospective difference of opinion arises between the two groups. Agency Cost How does the agent that is the company directors serve the principal that is the shareholders is the question. The solution lies in accepting certain agency costs. These costs involve either in producing incentives or approve which adjust executive egoism with the concerns of shareholders. Or else they may be involved in supervising executive behaviour in order to restrain their self-interest. This led to the development of the number of non-executives on the company boards. Also it resulted in augmented arrangement of their function and considerations of freedom, leading to reforms all over the world. The separation of the part played by the chief executive and that played by the non-executive has been made a part of this reform. The establishment of audit, compensation, and recommendations committees is actually independent non-executives appointed to assure the proper use of the incentives and also to check the performance of the executives. These internal controls are then assisted with external controls. According to Zadek (2001) leading focus is on enhanced revelation and the lucidity allows predominantly the financial performance but in recent times also of social and environmental performance. Corporations in order to implement the device for its governance and to oversee its management have adopted agency theory which is the foundation of corporate governance. The theory actually helps to focus on the reduction of agency problems, which arises due to the severance of principals and agents in contemporary corporations. The device of agency theory is monitoring and bonding through which agency problems can be reduced. But the disagreement of the two fundamental issues are one, how far are these mechanisms successful in curbing the problem and two, what is the true relationship between both the mechanisms(Kaplan, 2008a; Locke, 2008; Walsh, 2008). Fama & Jensen, (1983) state that based on agency theory it is vital that the risks and responsibilities are allocated to parties who perform best so that the decision of the corporation can be controlled. This specialty can be preserved by the boards managing shareholder-manager relationships. The relationship thus controlled will also check the unjustifiable shift of remaining risks onto the managers. A very important activity of the board is to maintain a proper risk-reward balance for both parties (Fama & Jensen, 1983). Even though boards are considered as a unit to look after shareholder wealth, an extra significant function of the board is to supervise the contract with managers. This will help in compensating the managers adequately based on the market. Since the concentration of supervising grows, the job security of the managers becomes uncertain as they may have to take on the additional risk. Due to this additional risk taking, the managers over time demand for more pay. Prices of shareholder-management differences Agency costs are those expenses borne by shareholders to support managers to increase shareholder wealth and not act in their own self-interests. The conception of agency costs is linked to a seminal appearing in the 1976 Journal of Finance paper by Michael Jensen and William Meckling. They recommended that corporate liability levels and administration equity levels are both determined by agency costs. Michael Jensen and William Meckling state that "there are three chief types of agency costs: (1) expenditures to monitor managerial activities, such as audit costs; (2) expenditures to structure the organization in a way that will limit undesirable managerial behaviour, such as appointing outside members to the board of directors or restructuring the company's business units and management hierarchy; and (3) opportunity costs which are incurred when shareholder-imposed restrictions, such as requirements for shareholder votes on specific issues, limit the ability of managers to take actions that advance shareholder wealth" (Simon Deakin, 2005). Concentration of Ownership In these present days ownership of the firms have become more and more strenuous. Empirically, both the number of shareholders and the total percentage of shares held by them are defined as the ownership concentration. In theory, once the ownership concentration starts to increase monitoring should be made more effective (Shleifer & Vishny, 1986). This will most likely result in the increase of shareholder value with the managers' decisions. In the United Kingdom uninteresting proprietors have become the leading ownership group (Monks & Minow, 2004). When organisations feel it difficult to simply sell the stock they use alternative tactics by becoming active, when it comes to governance and they take the initiative to hold managers accountable for their planned actions. Sometimes when the top level managers display undue self-interest then the shareholders pressurize the board to amend the management team. If the board is reluctant to change the managers, the shareholders alter the members of the board by proxy votes. According to Monks & Minow, (2004) during the 90's the owners started to shift their concentration away from CEOs and tried to attend more on the responsibilities of the board to forestall the problems by rendering autonomous oversight and watchfulness. As Dale Hanson the CEO of CalPERS stated, "We are no longer into CEO bashing but we are now into director bashing" (Monks & Minow, 2004, p. 197). The centering on boards has given greater board freedom from the firm's CEO and higher management, and modified the board's power to supervise managers more strongly. Self-centred conduct Agency theory proposes that managers will try to maximise their own efficacy at the cost of corporate shareholders. Since the manager's know better as to whether the goals of the firms can be achieved or not the agents act on their own self-interest and not on the best interests of the firm. Proof of self-centred managerial conduct includes the utilisation of some corporate resources as perquisites and avoiding optimal risk situations. This results in some managers bypassing profitable chances so that the shareholders invest. Whereas outside investors realise that the firm will take contrary decisions to their best interests. Therefore, investors will reduce the costs of the firm's securities (Simon Deakin, 2005). In corporations, agency differences are potentially quite important as the firm's managers normally own only a small percentage of shares. Consequently, shareholder wealth maximisation becomes secondary to a collection of other managerial goals. For example, managers may basically think of increasing the size of the firm. When the firm grows at a faster pace executives are able to increase their own position thereby creating more chances for lower- and middle-level managers. This will also increase their salaries, and augment their job safety as takeover is less likely (Simon Deakin, 2005). Managers can be bucked up to act in the stockholders' best interests by bonuses, restraints, and penalties. These methods will be effective only if shareholders are able to scrutinize all the actions adopted by managers. But it is not always possible for the shareholders to monitor all the actions taken by the managers. Thus to decreased the risk of wrong actions shareholders must incur agency costs (Simon Deakin, 2005). How to deal with shareholder-manager conflicts There are two mechanisms to deal with shareholder-manager agency differences. The firm's managers can be rewarded wholly on the basis of stock price alterations. This way the cost of agency will be low as managers get more incentives to increase shareholder wealth. But it is very difficult to hire gifted managers based on these contractual terms. The reason is that the firm's earnings may be affected by economic unpredictable economic events which cannot be controlled by the managers. The other mechanism is that the shareholders can check every managerial activity which would turn out to be very costly and incompetent. The best solution is to link executive compensation with his performance and at the same time some monitoring is also done (Simon Deakin, 2005). Apart from this the following can also be considered (Simon Deakin, 2005): (1) Declare performance-based incentive plans for managers; (2) Straight interference by shareholders; (3) Threaten of being fired; and (4) Takeover fear. The moral risk and incentives (http://mises.org/journals/scholar/Padilla3.pdf retrieved 10 November 2009) A moral risk is a problem which crops up when the principal is not able to observe the actions of the agent because (1) Cost is involved; (2) Unable to perfectly deduce the actions of the agents; This happens when the actions of the agent does not fully ascertain the outcome. Conventionally, the literature indicates that this second development may ensue from the interference of an unanticipated-haphazard incidence that has moulded the result. The consequence may have being due to some boon or calamity and due to the actions of the agent. According to Kotovitz (1987: 549) "Moral hazard may be defined as actions of economic agents in maximizing their own utility to the detriment of others, in situations where they do not bear the full consequences or, equivalently, do not enjoy the full benefits of their actions due to uncertainty and incomplete or restricted contracts which prevent the assignment of full damages (benefits) to the agent responsible." The practical relevance of agency theory It can be said without any doubt that agency theory has added to the betterment in contract theory and the acceptance of markets by guiding the ubiquity of uncertainty and presence of asymmetric information ensuing from the partition of labor and knowledge. Its share balances especially in underlining that real-world contract is different from contracts that would exist in an imaginary world. Such a world where there is no cost and no uncertainty, and also different approaches towards risk among individuals do not subsist. In a similar way, agency theory has added to the agreement of several kinds of devices to reduce agency problems (http://mises.org/journals/scholar/Padilla3.pdf retrieved 10 November 2009). The practical application of agency theory is in fact quite restricted and therefore it is not easy to deduce economic-policy significances. Two reasons linking this limit are First, as Arrows states (1985: 48-49), agency models are not dependable with what we detect in reality: "But it is perhaps more useful to consider the extent to which the principal-agent relation in actuality differs from in the models developed to date. Most importantly, the theory tends to lead to very complex fee functions." Uncertainty has to be differentiated from risk. Even though uncertainty subsists when, "the probabilities of alternative outcomes cannot be determined by a priori reasoning or statistical inference" (Casson, 1982:371), risk denotes the cognition of the likely dispersion of possible results (Alchian, 1950). Thus, risk denotes a state of future matters that is to some level even if only probably foreseeable. Uncertainty prevents the setting of target probabilities. The differentiation between indecision and risk is significant as only the existence of uncertainty contributes to the creation of entrepreneurial profits. Knight (1921) states that "The assumption of risk does not give rise to entrepreneurial profit. Rather, the compensation for risk is determined, as with any other factor of production; by the forces of supply and demand and its reward is normal rent or salary." Risk bearers get a reasonable return for their services in quantity to the amount of risk they are contracting. This position is entirely different from activities rendering true entrepreneurial profits. These are above normal returns for acting upon exclusive doubts or chances for which objective chances cannot be computed. According to Kotowitz (1987) customarily in agency patterns the nature of the reward plan is responsive to the nature of the info accessible, the residuary uncertainty and the level of risk loathing of the agent and principal. Solution to the Agency Problem (Gareth R. Jones, 1992) Many of the problems arising out agency by organisational factors can be figured out by the plan of the entrepreneurial setting to adjust interests of principals and agents. When the firm grows they require giving some motivators for agents to act as principals. This means that ways has to be found out to (a) Offer agents with the chance to take accountability for entrepreneurship, (b) Identify individual performance assistance, (c) Honour entrepreneurial performance suitably. One way to achieve this is to find organizational inventions that advance the profile of an agent's operation and increment accountability to shorten avoidance and support the bearing of uncertainty. According to Williamson, (1975) "One such innovation occurs in the form of the movement of the firm from a functional structure, to a product structure, and eventually to a multidivisional structure as its size and complexity increase." One of the major causes for the shift from the U-form to the M-form structure is that controlling and strategic conclusions become confused in the U-form, making it unmanageable for the firm to observe new strategic chances (Gareth R. Jones, 1992). Opportunities can be dissembled upon more rapidly and expeditiously in the M-form organisation since it has a corporate home office committed exclusively to detecting opportunities. Fundamentally, by separating entrepreneurship at the pinnacle of the organisation, admitting top divisional managers, the motivational and agency troubles linked with rising organizational complexness and size are decreased, and internal corporate enterprisers are more effortlessly able to be distinguished and to take rewards from their ground-breaking performance. Moreover, the survival of a corporate headquarters helps to monitor activities easily inside the functioning divisions, which cuts down the capability of divisional managers to follow their own interests. Thus a multi-divisional structure can decrease the turn down in inner corporate entrepreneurship (Gareth R. Jones, 1992). Conclusion In the present day of corporate ownership agency theory indicates shares are held extensively which makes efficient synchronization among shareholders complicated and costly. Expenditure results when the CEO is made the de facto policymaker. Thus the actions taken by CEO are more probable to head off from those mandatory to maximise shareholder repays. In the terms of agency theory this cost and lesser returns is due to an agency problem because of which profits to shareholders fall below than that if shareholders exerted direct check of the company. The shareholders therefore confront a moral hazard issue as the value of managerial planned decisions may be intricate to decide fully. These agency issues can be reduced if there is ownership concentration, particularly in the case of uninteresting investors. If institutional investors hold the maximum shares in companies, which accounts for their voting power linked to their holdings, their support or else of schemes of the CEO can be vital components in determining how a company is dealt and run (Chung et al., 2002; Mallin, 2002). Reference 1. Arrow, Kenneth J. (1985), "The Economics of Agency," in John W. 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