TYPES, NATURE OF CONFLICTS, AGENT COSTS AND RESOLUTION IN AGENT RELATIONSHIP IN AN ORGANIZATION
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
Conclusion
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.
Interesting topic for a blog!A very good and informative article,thanks for sharing. Top recruitment agencies in Nepal
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