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Birmingham Business School

Student ID Number: 1971322

Programme Of Study: MscIB

Module: Corporate governance

Assignment Title: Principal-agent theory and mechanisms to mitigate them

Date and Time of Submission: 18/10/18 ;12.05 am; (SGT)

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INTRODUCTION:
Corporate Governance defines the methods, structure and the processes of a company in
which the business and affairs of the company managed and directed (Khan, 2011). It works
to achieve the goal of the organization and manages the relationship among the stakeholders
including the board of directors and the shareholders. Fine corporate governance is an
essential standard for establishing the striking investment environment which is needed by
competitive companies to gain a strong position in efficient financial markets. Good
corporate governance is fundamental to the economies with extensive business background
and also facilitates the success for entrepreneurship (Berle A & Means, 1932).
The success of the company lies in balancing the rights and relationships among principal and
the agents. The principal is the shareholders of the company. The agents are the managers
employed by the shareholders to manage the company on behalf of the shareholders. The
agents are accountable to the shareholders. The main aim of corporate governance is to
maintain the relationships between internal and external stakeholders as well as help the
corporation to achieve its goals. The prime importance of the corporate governance is to
reduce the principal-agent problem (Baker & Anderson, 2010). Corporate governance as a
term refers to the private and public institutions that include laws, regulations and the
business practices which governs the relationship between the corporate managers and the
stakeholders (Oman, 2001).
ROLE OF PRINCIPAL (SHARE HOLDERS):
Share holders can be an individual or institution who owns shares in a limited company.
Good corporate governance practices entail active participation of shareholders in the direct
and indirect control of the company through the board of directors and an arrangement of
effective checks and balances among shareholders, the board and management (Crowther &
Jatana, 2004).
Rights of principal:
Share holders have the right to appoint, nominate and to remove the directors. The share
holders have the right to approve the major corporate decisions. The basic shareholder rights
include the rights to transfer the shares, right to obtain relevant information about the
company, right to vote and participate in the shareholder meetings and right to share in the
profits of the company, right to know about the financial matters in the company, right to
know about the performance of the company (Waring, 2006).The directors and the share
holders are the backbones of the company. They are responsible for the proper functioning of
the company. Though certain matters can’t be decided by the directors independently they
require permission from the share holders, like selling of corporate assets, changing the
corporation’s share capital, increasing or decreasing the number of directors, confirming by-
laws, putting restrictions on any issues or removal of the restrictions, transfer of shares,
ownership of shares. The decisions regarding all this cannot be taken by the directors it
requires approval from the shareholders. If the shareholders are dissatisfied with the
performance of the directors who are in control of the management of the corporation they
would either remove the directors or refuse to put vote for them again. This might be a
difficult decision particularly when shares of the company are widely held. According to the
corporate law if a shareholder request to change the director the corporation will provide a
list of shareholder to him/her, thereby making the shareholders to mount a proxy battle for the
election of directors. Many shareholders do not have the time or resource to take action in
order to stop or oppose the management proposal. The exceptions are large institutions. They
have huge shares in the company, hence they can make their voice to hear in the annual
meetings or in private meetings to the representatives before the shareholder meeting is held.
Their suggestion can make a change in the board. Proxy battle may also result in the
replacement of the board of the directors, but it is a random one (Osler & LLP, 2009).

ROLE OF AGENTS (DIRECTORS):

A director is defined as a person having control over the direction, conduct, management or
superintendence of the affairs of a company. Again, any person in accordance with whose
directions or instructions, the board of directors of a company is accustomed to act is deemed
to be a director of the company (Jan & Sangmi, 2016).The duty of the directors is to manage
the company on behalf of the shareholders of the company. The directors are required to
perform the duties to the best interests of the company, shareholders and the stakeholders.
The directors are responsible for the management and execution of the company. The board
of directors play a vital role in corporate governance. The decision of whom to be whole time
directors whom to be managing directors whom to be executive directors must be approved
by the shareholders of the company. The quality of the governance depends upon the strength
of the relationship between the board of directors and the shareholders. These directors are in
charge of attaining a perfect balance between the interests of the shareholders, customers,
lenders and promoters. The board of directors is the heart beat of a company. Their decision,
their performance decides the success of the company. They are in the position to satisfy the
shareholder and stakeholders of the company (Biswas, 2008). “Corporate Governance
addresses the issues facing Boards of Directors”. According to him, the main responsibility of
governing a company is in the hands of the board of directors, hence attention should be
given to their role and responsibility (Tricker, 2009).

Right of agent:

As an individual, he /she has the right to inspect book of accounts, right to receive notices of
board meetings, right to participate in proceedings and cast vote in favour or against the
resolution. As collective, the directors have the right to refuse to transfer the shares, right to
elect a chairman, right to appoint a managing director, right to recommend dividend (Jan &
Sangmi, 2016).

Further in this paper we will see the differences which exist between the principal and the
agents and the mechanisms that are used to mitigate it.
PRINCIPAL AGENCY THEORY:

The conflict of interests between managers and shareholders creates agency problem. These
agency problems can be resolved using contractual agreements. Some scholars have argued,
however, that the basic principal-agent model provides limited solutions to agency
problems arising with other stakeholders, and undervalues international variations (Young,
et al., 2008).The agency theory emerges when the agents pursue their own objectives
against the interest of the other shareholders. The basic principal-agent problem is
information asymmetry, which means one knows more information than the other. This
allows managers to withhold important information to maximize personal interests
(Godfrey & Mather, 2003). The main aim of the shareholders is to maximize the value of
the firm, without any regard for the value of its debt. Creditors will try to increase the
probability of getting their money back, which means that they prefer firm taking less
risky projects than the shareholders prefer to have. Managers want to engage in activities
that maximize their own return than that of outside financiers, diversion of resources for
their personal benefits, refusing to give up the job in the face of poor performance. A
company has many share holders, which means there would be many opinions. Different
shareholders have different opinions. Large share holders have a controlling effect insider
the firm which may affect the minority shareholders. This results in the problem between
principal and agent (Prowse, 1999).The agency problem inherent in the separation of
ownership and control of assets (Smith, 1776).Separation of ownership from management
had resulted in shareholdings being unable to exercise any form of effective control over
board of directors, who were theoretically appointed by them to represent their interests
(Berle A & Means, 1932).This separation has huge influence in the managing the company.
Substantial costs result from such difference of interests among the principal and agent.
Corporate governance should work effectively to reduce these costs (Biswas, 2008).

Reasons for these problems:

Several possible reasons for the principal-agent conflict are perception of risk: The agents
are expected to be a risk averter and principal risk seeker, Extent of Involvement with the
organization: their duration within the company is only for limited period, Limit of earnings:
fixed earnings, Management decision making: decisions should be in the interests of the
shareholders, Information asymmetry: one knowing more information than the other
(Chowdhury, 2004).
MECHANISMS TO MITIGATE THE PRINCIPAL-AGENT PROBLEM:

Control mechanisms are necessary to reduce the difference of interests between the
principal and agent. Corporate governance is the effective control mechanism for principal
and agent’s problem. Corporate governance and monitoring mechanisms are manifold and
generally comprise external control mechanisms as well as internal control mechanisms
(Biswas & Bhuiyan, 2008). Size of the board: It is believed that when the number of persons
on the board is more there lacks communication. It takes more time to find solution to a
problem. Limiting board size is believed to improve firm performance because the benefits of
larger boards are outweighed by the poorer communication and decision making of
larger groups (Lipton & Lorsch, 1992). Composition of the board: The number of non-
executive directors and the separated role of Chief executive officer (CEO) and chairman of
the board (COB) will characterize the independence of the board (Haron, et al., 2005).
Depending up on the experience non-executive directors are given importance in the
company. Separated roles of CEO and COB it leads to fewer conflicts (Berglof & Claessens,
2006) Auditing committee and remuneration committee also is an effective control
mechanism. The function of audit committee is to assist the board of directors in overseeing
and focus on reviewing financial risk and risk management. Audit committee helps to analyse
the problem and increase the shareholder value. Hence the problem can be mitigated.
(Bhuiyan, et al., 2007). Managerial composition: Periodic performance reviews and incentive
compensation in the form of accounting-based bonuses, stock option grants, stock
appreciation rights, or restricted stock can reduce a variety of agency problems. When
managers are paid well they won't take firms resources for their own benefits (Habib, 2004).
Managerial Labour Market: Career opportunities and potential for higher
compensation provides incentive for effective managers, as opposed to ineffective mangers,
to increase stockholder value and limit self-serving behaviour (Habib, 2004). Dividend
Payment: Dividend policy, another important corporate governance mechanism, often serves
as substitute and/or mechanism to other corporate governance instruments.Substitute means
high dividend policy offers managers to produce sufficient amount of cash flows which will
enable them to distribute to the shareholders. When large shareholders or strong board of
members are present dividend payouts can be used as a defensive mechanism againt the
hostile takeovers (Correia Da Silva & Goergen, 2004). Market for corporate control: It is an
important external corporate control mechanism. Poorly performing companies are more
likely to be targeted by big companies. Indirectly the threat of taking over the company may
increase the efficiency of the management. This makes the agent and principal to word
cordially (Correia Da Silva & Goergen, 2004).Managerial ownership: When the managers
own the shares their personal interests and the interests of the share holders matches. This
can align the interests between the two groups and can reduce the agency costs (Jensen &
Meckling, 1976)
CONCLUSION:

The principal- agent problem is a common problem in all the corporate company. The nature
of the problem is different in different countries. According to the situations, law, practices
the nature of the problem in the company differs. The size of the problems differs according
to the size of the company. From the above discussions it shows that they are mechanisms to
mitigate the conflicts between principal and agent but still now there is no solution for it. The
conflict between the principal-agent is not due to materialistic thing hence there is no perfect
mechanism to completely get rid of this problem. Though we can’t get rid of this problem the
corporate governance should use proper mechanisms to reduce these problems. Blind
adoption of corporate governance mechanisms from other countries without considering their
legal considerations, their constraints won’t help to achieve the desired solution of the
problem. Suitable mechanisms should be drawn to achieve the solution for the problem
(Biswas, 2008)
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