The agency theory attempts to explain the conflicts of interest among corporate constituencies, including those between corporate ‘insiders,’ such as controlling shareholders and top managers, and ‘outsiders,’ such as minority shareholders or creditors. These conflicts all have the character of what economists refer to as ‘agency problems’ or ‘principal-agent’ problems. ‘Agency problem’—in the most general sense of the term—arises whenever the welfare of one party, termed the ‘principal’, depends upon actions taken by another party, termed the ‘agent.’ The problem lies in motivating the agent to act in the principal’s interest rather than simply in the agent’s own interest.

In particular, almost any contractual relationship, in which one party (the ‘agent’) promises performance to another (the ‘principal’), is potentially subject to an agency problem. The core of the difficulty is that, because the agent commonly has better information than does the principal about the relevant facts, the principal cannot easily assure himself that the agent’s performance is precisely what was promised. As a consequence, the agent has an incentive to act opportunistically, skimping on the quality of his performance, or even diverting to himself some of what was promised to the principal. This means, in turn, that the value of the agent’s performance to the principal will be reduced, either directly or because, to assure the quality of the agent’s performance, the principal must engage in costly monitoring of the agent. The greater the complexity of the tasks undertaken by the agent, and the greater the discretion the agent must be given, the larger these ‘agency costs’ are likely to be.

Three generic agency problems arise in business firms.

1.       The first involves the conflict between the firm’s owners and its hired managers. Here the owners are the principals and the managers are the agents. The problem lies in assuring that the managers are responsive to the owners’ interests rather than pursuing their own personal interests.

Causes of conflict:
a)       Remuneration: Most managers are paid fixed salaries irrespective of profit made during the year.
b)      Risk profile differences: Shareholders prefer high risk high return investments since they may have diversified investment portfolios. The managers prefer low risk investments which have low returns. This, the profit generated by the company reflects the managers performance. High risk investment gone bad can lead to managers loss of job hence preference to low risk low returns investments.
c)       Difference in valuation horizon: managers prefer projects with profits in the short run so that they can get credit for their work. On the other, shareholders  prefer long term investment which are consistent with going concern accounting concept.
d)      Unnecessary perks: these are incurred by management in high salary perks and fringe benefits that the management award themselves
e)       Creative accounting system: This involves manipulation of accounting policies in order to report high profits e.g. by changing stock valuation and depreciation methods.
f)        Pursuing power and self esteem  goals: It may be referred as empire building through so as to enlarge the company through mergers and acquisitions thus increasing rewards to managers. This might be beneficial to managers at the expense of shareholders.

Solutions to these problems:
a)       Threat of firing: If managers are not performing, they can be threatened with firing during the annual general meeting or even appointing other managers.
b)      Threat of hostile takeovers: Shareholders can threaten to sell the company to another company.
c)       Performance based remuneration: this is where a bonus is paid to managers depending with performance of the company. The managers can  also have an option of acquiring part of the company at specified stock prices.
d)      Having a voluntary code of ethics: this will guide the managers in their duties so that they act in the best interest of the shareholders.
e)       Incur agency costs: these can be legal costs for drafting employment letters and contracts for managers, cost of setting performance  standards and negotiation fees paid to employment agencies and monitoring costs paid to external auditors, setting up internal control system.

2.       The second agency problem involves the conflict between, on one hand, owners who possess the majority or controlling interest in the firm and, on the other hand, the minority or non-controlling owners. Here the non-controlling owners can be thought of as the principals and the controlling owners as the agents, and the difficulty lies in assuring that the former are not expropriated by the latter. While this problem is most conspicuous in tensions between majority and minority shareholders, it appears whenever some subset of a firm’s owners can control decisions affecting the class of owners as a whole. Thus if minority shareholders enjoy veto rights in relation to particular decisions, it can give rise to a species of this second agency problem. Similar problems can arise between ordinary and preference shareholders, and between senior and junior creditors in bankruptcy (when creditors are the effective owners of the firm).

3.       The third agency problem involves the conflict between the firm itself—including, particularly, its owners—and the other parties with whom the firm contracts, such as creditors, employees, government and customers. Here the difficulty lies in assuring that the firm, as agent, does not behave opportunistically toward these various other principals—such as by expropriating creditors, exploiting workers, or misleading consumers.

i)        Creditors vs shareholders: creditors here are the principal while the shareholders are the
agents. Shareholders invest funds in high risk investments. Thiese investments can eithr succeed and get high returns or fail leading to huge loses. Conflict therefore can arise in the following instances.
a)       Under investment where funds borrowed are diverted to other business recurrent nd commitments.
b)      Investment substitution: shareholders can agree with bond holders that the funds will be invested in low risk projects only to be  substituted with high risk projects
c)       Dispoding of collateral assets: assets pledged as collateral can be disposed off by the owners without the knowledge of the bond holders.
Solutions to these problems:

a)       Threat of not granting any future credit should misuse of credit be discovered.
b)      Collateral security: creditors should demand security where necessary before granting credit
c)       Representation: creditors can demand to have representation in the management of the company in order to oversee proper utilization of the debt capital.
d)         Convertibility:  a convertibility clause can be agreed upon where the debt capital can be converted into preference shares in case the company is unable to repay the debt.
e)       Collability provision: this is where the debt holders demand early payment of the debt should they discover that the borrower is misusing the borrowed funds.

ii)      Government (principal) and owners(agent): Companies operate in the environment with mandate from the government. The owners may affect the position of the government by engaging in illegal business activities, tax, failure to take part in CSR and avoiding investment in certain areas of the economy.

Solutions to these problems:
a)       Incurring monitoring costs e.g statutory audits, investigation, back duty investigations and VAT refund audits.
b)      The government can lobby for directorship representation in the boards of strategic importance to the entire economy e.g KPLC
c)       Offering investment incentives to encourage investors invest in certain areas which can be risky.
d)      Legal legislation to govern the operations of firms.

iii)    Shareholders (principals) and auditors (agents): the auditors who are appointed by the owners of the company to satisfy that the financial position of the company reflect the true and fair view of the company state of affairs at a particular date in time. The auditors may affect the interest of the shareholders causing agency problems in the following ways:

a)       Colluding with management where independence is compromised
b)      Demanding outrageously high audit fees thus reducing company profits
c)       Failure to apply professional care and due diligence in the performance of their work

Solutions to these problems
a)       Removing auditors from office by the shareholders at the AGM
b)      Shareholders can result to legal action because of misleading financial reports resulting to losses
c)       Shareholders can also seek redress from the auditors regulatory bodies e.g. ICPAK in order to have the auditors disciplined for negligence and lack of professionalism in his work
d)      Use of audit committees and audit reviews

In each of the foregoing problems, the challenge of assuring agents’ responsiveness is greater where there are multiple principals—and especially so where they have different interests, or ‘heterogeneous preferences’. Multiple principals will face coordination costs, which will inhibit their ability to engage in collective action. These in turn will interact with agency problems in two ways. First, difficulties of coordinating between principals will lead them to delegate more of their decision-making to agents. Second, the more difficult it is for principals to coordinate on a single set of goals for the agent, the more obviously difficult it is to ensure that the agent does the ‘right’ thing. Coordination costs as between principals thereby exacerbate agency problems.

Law can play an important role in reducing agency costs. Obvious examples are rules and procedures that enhance disclosure by agents or facilitate enforcement actions brought by principals against dishonest or negligent agents. Paradoxically, mechanisms that impose constraints on agents’ ability to exploit their principals tend to benefit agents as much as—or even more than—they benefit the principals. The reason is that a principal will be willing to offer greater compensation to an agent when the principal is assured of performance that is honest and of high quality. To take a conspicuous example in the corporate context, rules of law that protect creditors from opportunistic behavior on the part of corporations should reduce the interest rate that corporations must pay for credit, thus benefiting corporations as well as creditors. Likewise, legal constraints on the ability of controlling shareholders to expropriate minority shareholders should increase the price at which shares can be sold to non-controlling shareholders, hence reducing the cost of outside equity capital for corporations. In addition, rules of law that inhibit insider trading by corporate managers should increase the compensation that shareholders are willing to offer the managers. In general, reducing agency costs is in the interests of all parties to a transaction, principals and agents alike.

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