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Free Essays - Management Essays

Corporate Governance
Response to Business Finance Week
The primary engines driving agency situations are conflicts of interest. The issues are not new. Adam
Smith(1723-1790) noted (1776) that managers could not be expected to manage other people's money
with ''the same anxious vigilance with which the partners in a private copartnery frequently watch over
their own'', and that ''negligence and profusion, therefore, must always prevail''. Smith was writing
about manager-shareholder conflicts – considered in more details below.
In this paper I argue that maintaining good corporate governance – itself not a costless endeavour - is
important as it may help reduce manager-shareholder conflicts but its effect is limited when it comes to
reducing the agency costs that may be incurred by a firm through borrowing. These costs would not be
present if there were no borrowing. These agency costs are primarily those of the inefficiencies in
operating and investing assets caused by actual or potential default upon a debt contract, by the
restrictive covenants which appear in those contracts to protect the interest of creditors, and by the
reasonable assumption made by creditors that, given the chance, managers will take decisions in the
interests of shareholders (and adversely to those of bondholders if necessary). All such costs are priced
into interest rates or other terms in bond contracts.
In this paper I shall also look at the corporate governance model in the UK. But first, let's define what
constitutes an agency situation.
Agency situations
First, to be a problem in agency, there must be an an 'agent'. An agent is an individual, group or
organization to whom a principal has designated decision-making authority. Consider the option
characteristics of geared equity. Equity is actually a call option: if interest and principal are paid to
creditors, shareholders own the underlying assets of the firm; if interest and principal are defaulted,
creditors will end up with the assets. Financial managers can shift wealth from bondholders to
shareholders by causing the firm to undertake unanticipatedly risky asset investments. Obviously, this
is a situation where shareholder and bondholder interest diverge. In this potential shareholder-
bondholder conflict of interest, shareholders (or their proxies, the financial managers of the firm) are
the agents, and the bondholders are the 'principals'. Principals are those who feel the ultimate effects of
the decisions taken by agents.
Another instance of agency conflict occurs when a company is financial distress(where its bond values
have declined due to poor expectations) is unwilling to undertake a profitable investment because the
resulting effect would be to help bondholders and not shareholders.
Agency problems and agency costs
In order for an agency situation to a 'problem', it must contain the potential for a conflict of interest
between the agent and the principal. The shareholder-bondholder conflict of interest is an important
one, but by no means the only agency problem experienced in corporate finance.
Other important agency problems arise in the relationship between a firm's managers and its
shareholders (Jensen and Meckling, 1976; Watts and Zimmerman,1983). Consider that managers can
be assumed to maximise their personal wealth as a function of the decisions that they undertake for the
firm. Depending on the type of remuneration paid to managers, the efficiencies of the 'market for
managerial talent' and the corporate 'takeover' market, managers may find instances of decision making
where their personal best interests conflict with those of shareholders. Managers may consume
company resources by spending on 'perks' such thick carpets, private jets and attractive/handsome
secretaries, all of which return less in improved company performance than they provide as
consumption to managers. Managers can also 'consume' company-paid time by shirking duties. The
resulting lower value is the 'agency cost'.
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For managers to discontinue such activities, their personal interests must be melded with those of
shareholders. To accomplish this, it is not generally enough to give some shares to managers. As long
as managers own less than 100 per cent of the firm's shares, managers will gain ￡1 in personal benefit
from consuming ￡1 of company resources, while losing only ￡1 multiplied by their percentage holding
of all company shares due to the resulting lower value of shares.
If managers are discovered undertaking such company consumption, an efficient market in managerial
talent could drive down their salaries. But it is not clear, in a firm with widely dispersed shareholdings,
that this kind of compensation pressure can be brought to bear upon managers (who probably control
the board of directors). Thus many economists think that an efficient market for company takeovers is
an important solution to the agency problem of manager–shareholder conflict.
There are some important general lessons about agency problems in the above discussion. First, note
that there is an incentive to solve the agency problem. The overall incentive is that the increase in the
value of the company if managers perform without unproductive personal consumption exceeds the
value to the managers of their personal consumption. So, in general, managers would lose less than the
company would gain if such activities were curtailed. But unless managers are provided personal
incentives to change their behaviour, this value is permanently lost (an agency cost). The 'solutions'
illustrated above include buyouts by outside management groups.
There are other possible solutions to this agency problem, from complex management employment
contracts, to managerial stock options, to auditing by independent directors, and many more. No matter
what solution is adopted, there is a cost involved.
Agency problems can also arise when ‘information asymmetries’ exist (Haugen, 1979; Hellwig,1989).
An information asymmetry occurs when a buyer and seller in a transaction may have different amounts
or quality of information about the decision at hand.
Consider the situation of a company attempting to sell bonds so as to undertake a positive NPV project.
Suppose that the managers inside the firm have specific information as to the NPV of the project, but
that the potential bondholders have only a general notion of its NPV (as is often the case, due to legal
and competitive constraints upon information release).
If there is a range of possible NPVs, bondholders likely assume that NPVs lower than those known by
the firm are possible. Therefore the firm will not be able to sell bonds at prices commensurate with the
actual higher NPVs of the project. The lower bond prices are the agency cost of this situation.
One solution to this agency problem may be to issue a security more complex than a simple bond – for
example a call-provisioned bond(see p 441-442 in Levy and Post, 2005).
But any solution to an agency problem requires that (1) there be an overall gain to solving the problem,
which is allocated in such a way that (2) the agent has an incentive to participate in the solution. This
holds, as we shall see, for bondholder–shareholder conflicts as well as shareholder–manager conflicts.
Agree with statement and link cost to value (corporation and society) – Smith and a beautiful mind.
Corporate governance in the UK
Corporate governance is about how a firm conducts its affairs and responds to stakeholders,
shareholders, creditors, and society. All of these groups have claims – in one form or another - on the
firm's cash flows (Ross, et al.,2008). Freeman et al.(2004) criticize strongly Sundaram and Inkpen's
assertion (2004) that a firm's primary goal should be to maximize shareholder wealth and at length
argue that ethics is inseparable from business. This may well be sensible in theory, but I argue that
given the practical realities of doing business today, it is reasonable to assume that all parties to a
contract will act in their own best interests.
The Financial Reporting Council (FRC) is responsible for corporate governance in the UK. According
to FRC(2006), the UK approach combines high standards of corporate governance with relatively low
costs, is proportionate, and is relatively prescriptive about how the company's board organises itself.
The corporate governance framework in the UK and elsewhere has, at least since the early nineties,
been a mixture of regulation and best practice. Much of the regulation introduced into the UK's
corporate framework, recently, has been influenced by the European Union (EU), Organisation for
Economic Cooperation and Development (OECD), and USA. Most notably, large and medium-sized
companies are required to include a business review (see the EU 8th and 4th Company Law Directives,
the EU Accounts Modernisation Directive) in the directors' report, which is part of the annual report
and accounts (Davidson,2008). The new Companies Act 2006 (BERR,2008) included further
provisions in relation to the business review and in particular includes a codification of directors'
duties. International Reporting Standards (IFRS) came into force (1 Jan 2005) for the consolidated
accounts of all listed firms in the EU.
The Code
The Financial Services Authority (FSA) administers the so-called 'Combined Code' or just 'Code'
which sets out the main guidelines (listing rules, directors' and audit remuneration, control structures,
auditing and disclosure rules, etc) for UK corporate governance. The Code operates on a principles-
based approach, (unlike ''Sarbox'' in America which is rules-based), as well as on the basis of 'comply
or explain' (Davidson,2008). If a firm takes a different approach from the Code, it must explain this to
its shareholders, who must decide whether they are happy with it, which means they must have the
right information, and the right to influence the board.
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Under the Listing Rules, firms are required to include a statement in their annual reports on how they
have applied the Code. Shareholders have significant voting rights under UK Company law, and can
call, under some circumstances, an Extraordinary General Meeting.
Has the Code been a success? Rating agencies take account of compliance when they give companies a
credit rating. So there is clearly an incentive for companies to comply. How about return on time and
money spent? According to a 2005 survey by Russell Reynolds(www.russellreynolds.com), 65 per cent
of company chairs thought the Code had little impact on performance. Most chief executives and chairs
expressed a similar sentiment in a 2005 survey by Hanson Green (www.hansongreen.co.uk).
Conclusion
Today elements of capitalism are being promoted in even in the so-called planned economies. The
reason is simple: capitalism may not be perfect but, given the apparent basic nature of mankind,
namely a 'selfish' motivation to improve his/her lot in life, the market economy currently appears to
offer the best chance of converting such a desire into reality. Agency costs will always exist, good
corporate governance is important but it should not be taken as the single tool that would solve the
agency problems.
References
 BERR, (2008) ''Companies Act 2006''[online] Available from: http://www.berr.gov.uk/bbf/co-
act-2006/index.html (Accessed: 23 August 2008)
 Davidson, A. (2008) How the City Really Works (London: Kogan Page Limited, 2008)
 FRC (Financial Reporting Council) (2006) The UK Approach to Corporate Governance,
November 2006 publication
 Freeman, R.E., Wicks,A.C., Parmar,B.(2004) 'Stakeholder Theory and “The Corporate
Objective Revisited”', Organization Science, 15(3), May–June 2004, pp. 364–369
 Jensen, M., Meckling, W. (1976) ''Theory of the firm: Managerial behavior, agency costs, and
ownership structure'', Journal of Financial Economics, 3, p305 - 360
 Haugen, R. A. (1979) ''NEW PERSPECTIVES ON INFORMATIONAL ASYMMETRY
AND AGENCY RELATIONSHIPS'', Journal of Financial & Quantitative Analysis Nov79,
Vol. 14 Issue 4, p671-694
 Hellwig, M (1989) ''Asymmetric Information, Financial Markets, and Financial Institutions'',
European Economic Review Mar1989, Vol. 33 Issue 2/3, p277-285
 Levy, H. and T. Post (2005), Investments, Prentice Hall.
 Smith, A. (1776) An Inquiry into the Nature and Causes of the Wealth of Nations
 Sundaram, A., Inkpen, A. (2004) ''The corporate objective revisited'', Organization Science
15(3) 350–363.
 Watts, R.L. L. Zimmerman., J.L. (1983) ''Agency Problems, Auditing, and the Theory of the
Firm: Some Evidence'', Journal of Law and Economics pp. 613-633
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