Agency Theory - Lecture notes 1 PDF

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Agency theory in Corporate Governance. ...

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Module: Corporate Finance Topic: Company Valuation

Agency Theory Signs of Agency Theory and how it Manifests itself Agency theory is the separation of ownership and control. The agency problem occurs when managers are not acting in the best interest of their shareholders. The three important characteristics that contribute to the agency problem are: 1. There exists a divergence of ownership and control. 2. There is no goal congruence between managers and shareholders. 3. Asymmetry of information exists between the two parties.  Asymmetry of information refers to the fact that managers have more primary information compared to shareholders.  Shareholders only receive company accounts, share price, dividend information and analyst reports.  Managers shape the information that shareholders receive, and they have inside management accounting data at their disposal.  Asymmetry of information makes it difficult for shareholder to determine whether their wealth is being maximised.  Hence asymmetry of information has a key role to play in the agency problem and ability for managers to draw a veil over their activities. Agency problem arises for several reasons which are: 1. 2. 3. 4. 5.

Excessive long term contract of directors Over generous high directive salaries Less than challenging incentive packages/share options Managers pursuing their own lows risk projects – ‘pet projects’ Reluctance to use debt

Reduce the Agency Problem There are several ways to ensure goal congruence and optimise managerial behaviour. One of them is for shareholders to monitor directors. There are a number of monitoring tools available, though the benefits must outweigh the costs as these consume time and money. These are: 1. 2. 3. 4.

Independently audited accounting statements Government regulation The legal system Independently appointed consultants

The difficulty with this methods is larger shareholders will abuse their powers and reap the benefits of corrected management behaviour, whereas smaller shareholders can’t afford. Alternatively shareholders can include clauses into the contracts of directors to reduce the agency problem this increasing goal congruence. Contracting can form constraints, incentives and punishments which reduce the agency problem.

Module: Corporate Finance Topic: Company Valuation Additionally, shareholders can also use incentives for goal alignment. So, in order to stop management from improper behaviour shareholders must encourage them to do other things. This often means there are financial rewards, so bonuses aligned with shareholder objectives e.g. the share price going up. Incentives include: 1. 2. 3. 4.

Share option schemes Long term incentive plans Annual bonuses with targets set by shareholders Share save scheme

The best of these is a share option scheme which is the right to buy a pre-determined number of shares at a pre-determined price at some point in the future. They are given to managers to incentivise behaviour and align their goals with those of the shareholder as they to require the share price to grow. Although there are issues around the number of shares management should be given and at what price shares should be offered since salaries of directors are extremely high it must be matched/increased to incentivise fruitful behaviour. Another issue is share options only hold value when share prices on the stock exchange are rising (bull market). In a bear market where share prices are falling, share options hold no value and hence will provide little incentive for managers to maximise shareholder wealth and could demotivate managers. There have been high profiled ‘fat cat’ cases where managers reap the rewards from share option packages whilst performance is mediocre. Institutional Investors Institutional investors hold large portfolios of shares and require regular dividends. It also means a large concentration of power is in the hands of a relatively small number of investors. This implies they could pressure companies thus reducing the agency problem. Often institutional investors pay more attention to dividend decision rather than financing and investment decisions. This pressures companies to pay dividends which they cannot afford having the opposite effect of not maximising shareholder wealth.

Module: Corporate Finance Topic: Company Valuation

Introduction “Corporate governance is the system by which companies are directed and controlled” well-defined by the constitutional version of the UK Corporate Governance Code referred to as ‘The Code’ and produced in 1992 by The Cadbury Committee. Its paragraph 2.5 still remains the model definition for Corporate Governance (CG). The UK Corporate Governance Code (formerly known as the Combined Code) sets out standards of good practice for listed companies concerning board leadership, remuneration, shareholder relations and accountability. The code is published by the Financial Reporting Council (FRC).

Why Corporate Governance is Necessary for Listed Companies CG is intended to increase the accountability of a company and to avoid massive disasters before they occur hence its compulsion. Failed energy giant Enron, and its bankrupt employees and shareholders, is a prime argument for the importance of solid CG. Enron professed bankruptcy in December 2001 after restating its profits by $600m. In pursuit followed WorldCom. CG is similar to a police department's internal affairs unit, weeding out and eliminating problems with extreme prejudice and therefore necessary. Fundamental features where CG influences include: separate chairman and CEO, this imposes segregation of roles which lessens the authority of significant board members. Committees must be a mix of executive and non-executive directors in regards to remuneration, risk, nomination and audit committees. Further requirement is in directors’ contracts which are reduced to a one year rolling contract to incentivise respectable performance year on year for job insecurity. However, the most meaningful and necessary I have concluded is CG encourages gender and race equality. The FRC proposed revisions to the UK CG code 2017 on gender diversity, and has announced changes to the code to strengthen the principle on boardroom diversity hence why its necessity.

What is a “Comply or Explain” Approach to Corporate Governance? The “comply or explain” approach is the trademark of CG in the UK. It has been in operation since the code’s beginnings and is the foundation of its flexibility as reported by the FRC. The CG Code is not precedential rulings. It comprises of 5 principles (Leadership, Effectiveness, Accountability, Remuneration and Relations with Shareholders) and 50 plus provisions with reference to what boards, directors and other should do. A principles-based code requires companies to state that it has complied with the requirements of the code or to explain why it could not do so in the entities annual report. This permits shareholders to draw their own conclusions regarding the governance of the entity. In the UK all entities listed on the London Stock Exchange have to comply with the FSA listing rules and these include a requirement that all entities include in their annual report: a statement of how the entity has applied the main principles set out in the code, and whether the entity has complied with all relevant provisions set out in the code.

Module: Corporate Finance Topic: Company Valuation An entity choosing not to embrace a provision can be justified if it achieves worthy governance and is transparent in their disclosure. Ultimately, the code recognises that this is about the people, their behaviour and a company's culture/values which cannot be legislated.

What is Sarbanes-Oxley Act 2002 to Corporate Governance? The Sarbanes-Oxley Act of 2002 (SOX) is legislation passed post Enron and WorldCom by U.S Congress to protect investors from the possibility of fraudulent accounting activities by corporations. It is a politician’s effort to be seen doing something to create liability for directors of boards to account for ‘accurate’ reporting. SOX is a rules-based attitude which instils the code into law with fitting consequences for transgression. Consequences comprise of significant fines (up to $5m) and possible imprisonment (s 906) for directors for failure of compliance. CEO and CFO must accept responsibility for and certify published financial reports. Individual accountability delivers accuracy since one would not endorse false accounts meanwhile acknowledging the potential consequences. SOX also calls for disclosures in annual report by management on internal controls and for auditors to attest accuracy which involves significant costs....