Introduction This paper reviews and analyzes the agency problem as applicable t

o incorporated companies. An attempt will be made to get an insight into the lit
erature dealing with this interesting subject. As aptly summed up by Jassim (198
8), finance theory posits that the goal of economic organizations is to maximize
stockholders' wealth. Attainment of this goal was not an issue when owners were
also managers. However, in the present day, corporate ownership has become incr
easingly diffused, with very few companies still being owned by their managers.
The separation of ownership and management raises the issue of the relationships
between owners and managers. In such a set up, directors and managers have a le
eway to substitute their own interests in place of those of shareholders. This i
s possible because of information asymmetry between shareholders and managers; w
hich tend to give managers a leverage to act at cross-purposes with advancement
of shareholder needs. Such a phenomenon, commonly referred to as “agency problem” is
prevalent in modern day corporates. The writer will look at the corporate gover
nance implications of the agency problem as well as the statutory and non-statut
ory remedies that the shareholders may resort to in order to minimise their vuln
erability.
Definition of terms Agency Problem Jensen and Meckling (1976) define the agency
relationship as a contract under which one party (the principal) engages another
party (the agent) to perform some service on their behalf. As part of this, the
principal will delegate some decision-making authority to the agent. Applied to
finance theory, the agency problem refers to the conflict of interest arising b
etween creditors, shareholders and management because of differing goals (www.in
vestopedia.com, 30/09/08). The agency problem emanates from the arrangement
Business Finance Assignment 1 Describe the nature of the Agency Problem and the
related corporate governance issues. Explain some of the actions that shareholde
rs can take in order to deal with the problem with specific reference to the Com
panies Act. Describe the various ways in which the shareholders’ interests have al
so been protected.
1
where the interests of the agent differ substantially from those of the principa
l because of the impossibility of perfectly contracting for every possible actio
n of an agent whose decisions affect both his own welfare and the welfare of the
principal (Brennan, 1994). Emanating from this problem is how to induce the age
nt to act in the best interests of the principal.
The agency problem arises due to the separation of ownership and control of busi
ness firms. In theory the shareholders, being the owners of the firm, control it
s activities. In practice, however, due to a diffuse and fragmented set of share
holders, the latter appoints a board of directors to direct the affairs of the c
ompany. The board would similarly delegate the duty of day to day running of the
organisation to managers. In terms of this arrangement therefore, managers are
the agents of the board whereas board members are also agents of the shareholder
s. As the discussion that follows will show, an agency problem exists when share
holders, directors and managers have conflicting ideas on how the company should
be run.
Corporate Governance Corporate governance can be defined as the system by which
corporations are directed and controlled in line with stakeholder expectations (
King II Report, July 2001). Such task is placed upon the shoulders of directors
and senior management. Corporate governance facilitates the attainment of common
sense business objectives like effective business and risk management, establis
hing and maintaining good relations with shareowners, ensuring reasonable and su
stainable returns, compliance with applicable laws and regulations among others.
The Institute of Directors (IOD) in South Africa (2002) identifies seven (7) cha
racteristics of good corporate governance that must be exhibited by individuals
who make decisions on behalf of a company. These are discipline; transparency; i
ndependence; accountability; responsibility; fairness and social responsibility.
The various characteristics listed above will be fully explored with reference
to how they have been incorporated in the Zimbabwe’s Companies Act. In light of th
e agency problem, corporate governance
2 principles assist in lessening the worry among investors about the “professional
manager” who wields excessive power. From this understanding, it can be argued th
erefore, that corporate governance practices basically sets parameters which att
empts to regulate instances giving rise to agency problems.
Nature of the Agency Problem and Corporate Governance Implications Nature of the
Agency Problem Inherent in any principal-agent relationship is the understandin
g that the agent will act for and on behalf of the principal. The agent assumes
an obligation of loyalty to the principal that he will follow the principal’s inst
ructions and will neither intentionally nor negligently act improperly in the pe
rformance of the act. An agent cannot take personal advantage of the business op
portunities the agency position uncovers. A principal, in turn, reposes trust an
d confidence in the agent. These obligations bring forth a fiduciary relationshi
p of trust and confidence between principal and agent.
However, the principal-agent relationship that subsists between the shareholder
and the directors on one hand and between the directors and managers on the othe
r is fraught with some problems. The agency problem is compounded by the conditi
ons of incomplete and asymmetric information as between the principal and the ag
ent. Shareholders (as principals), expect directors/board members (as agents), t
o make decisions that will lead to the maximization of the value of their equity
. In the same vein, directors (as principals) expects management (as agents) to
pursue strategies and operations that contributes to the bottom-line and are in
tune with the board’s expectations. This scenario means that the shareholders who
should stand to benefit from the profitability of the company do not have direct
control over what management (who generate that profitability) does. This dilem
ma, which is a consequence of the separation of ownership and control, raises wo
rries that the management team may pursue objectives attractive to them, but whi
ch are not necessarily beneficial to the shareholders. The distance that is crea
ted between the shareholder and management team therefore
3 breeds the problem of a serious lack of goal-congruence – where there is no ali
gnment of the actions of senior management with the interests of shareholders. C
orporate Governance Implications Alleviation of discrepancies between shareholde
r and manager interests calls for strong corporate governance measures if shareh
olders are to be protected from financial losses resulting from corporate and ma
rket financial scandals.
Role of the Board Corporate governance bestows a variety of duties on directors.
Bonazzi L., Islam (2007) defines the function of the board as a collective resp
onsibility to determine the company’s purpose and “ethics”; to decide the direction, i
.e. the strategy; to plan; to monitor and control managers and CEO; and to repor
t and make recommendations to shareholders. To ensure that directors diligently
discharge these duties, personal liability attaches to individual directors if t
he company can be shown to have been trading “wrongfully” or illegally carrying out
activities contrary to laws and regulations. This personal liability will help l
essen the agency problem caused by directors pursuing their own personal interes
ts.
Board Structures One mechanism of corporate governance that may be used to ensur
e that checks and balances are in place to minimise the agency problem would be
to appoint independent non-executive directors to the board of directors (Webb,
2006). Existence of independent non-executive directors onto the board will ensu
re that management is monitored for operational performance. For example, in ter
ms of the RBZ Guidelines on Corporate Governance (2004), all banking institution
s’ boards should have a minimum of five (5) directors, the majority of whom should
be non-executive. Further, in terms of those RBZ guidelines, the Chief Executiv
e Officer (CEO) or the Managing Director (MD) of a bank may not be a chairman of
the board; a position which may only be filled by an independent non-executive
director. This position was also supported by Jensen (1993), who suggests that ‘‘dua
lity’’ reduces the monitoring power of the board of directors.
4 Thus, a board more likely to protect shareholders from agency problems would b
e one with separate individuals controlling the firm and the board (Bonazzi, 200
7). Such a board composition is important in ensuring that interests of minority
shareholders are protected and given due consideration in the decision-making p
rocess.
Related to this issue, firms whose CEOs are also part of the firm’s founding famil
y tend to have higher agency costs and monitoring needs than firms with unrelate
d CEOs. For example, Morck et al. (2000) find that family management is inferior
to professional management. They show that these CEOs have less control over th
e agency problem than CEOs who are not founders (or founder’s heirs) of the firm.
Research has focused on the theory that a strong board of directors is one that
is able to effectively monitor management and alleviate agency problems. Effecti
ve directors are typically those that make the board more independent from the i
nternal workings and individuals of the firm.
However, there are some boards which do not conform to codes of corporate govern
ance like the Cadbury (1992) Report, hence are susceptible to manipulation by ma
nagement to the detriment of the shareholders. Core et al. (1999) examine a wide
range of board characteristics and find that firms with weaker governance struc
tures have more agency problems, and that these firms tend to perform worse than
strongly governed firms. Specifically, they find an inverse relationship betwee
n board strength and a number of board characteristics. Among these are the prop
ortion of inside directors, board size, gray directors (those directors who are
not employees of the firm but receive payment from the firm for services other t
han directorial duties), and when the CEO is also the board chair. Shivdasani an
d Yermack (1999) find that gray directors have a conflict of interest and can en
hance management entrenchment by their presence on the board. All these characte
ristics do not auger well with tenets of good corporate governance as they reduc
e independence and therefore lead to poorer monitoring by the boards. A board wh
ich is dominated by directors who are also members of the executive employees of
the company are not independent. Such a set up would mean that managers and boa
rd members may pursue goals which do not necessarily lead to the maximization of
the value of the share holder s equity. As Webb (2006) observes, such a board w
ould5
encourage “entrenchment” and “managerialism”. By entrenchment, management would be prote
cting themselves through reducing the monitoring power of the board. Where execu
tive directors seek to entrench their positions in this manner, the board would
have diverted from performing its “stewardship” role which advances shareholder inte
rests. Since the board may not be fully independent from management and there is
a large gap between the management and the board, the managers and the board ma
y be tempted to have goals that compete with shareholder wealth maximization. Si
mon Herbert (quoted in Baysinger and Hoskisson, 1990) proclaimed that managers m
ight be “satisfiers” rather than “maximisers”, i.e. they tend to act in a risk-averse ma
nner and seek an acceptable level of growth because they are more concerned with
perpetuating their own existence than with maximising the value of the firm to
its shareholders.
The following are some of the specific conflict areas which are exacerbated by p
oor corporate governance practices, namely: Earnings retention conflicts Manager
s may increase retained earnings in order to finance some projects which would n
ot necessarily enhance shareholder wealth. Such grandiose managerial investment
policies (Easterbrook, 1984), may not produce results that are clearly apparent
to the shareholders as it may be to management. The resultant growth grants to m
anagement a larger power base, job security, greater prestige/status, and an abi
lity to dominate the board and award themselves higher levels of remuneration, (
Jensen, 1986). On the other hand, shareholders would prefer higher levels of cas
h distributions, especially where the company has few internal positive Net Pres
ent Value (NPV) investment opportunities, hence producing a clash of interests b
etween principal and agent.
Time Horizon Agency Conflicts McColgan (1991) observes that conflicts of interes
t may also arise between shareholders and managers with respect to the timing of
cash flows. Shareholders will be concerned with all future cash flows of the co
mpany into the indefinite future. However,
6 management may only be concerned with company cash flows for their term of em
ployment, leading to a bias in favour of short term high accounting returns proj
ects at the expense of long-term positive NPV projects. For example, research an
d development (R&D) expenditures would tend to decline as top executives approac
h retirement (Dechow and Sloan, 1991). This is because R&D expenditures reduce e
xecutive compensation in the short-term, yet the retiring executives won’t be arou
nd to reap the benefits of such investments. Healy (1985) also posits that time
horizon agency conflict may also lead to management using subjective accounting
practices to manipulate earnings prior to leaving their office in an attempt to
maximise performance-based bonuses.
To mitigate against negative consequences of the agency problem outlined above,
various statutory and non-statutory mechanisms may be employed as analysed below
. Statutory Protection available to Shareholders: The Companies Act [Chapter 24:
03] Legislation in the form of the Companies Act (hereafter to be referred to as
“the Act”) has been promulgated to afford shareholders some protection in the face
of challenges caused by the agency problem. Such protection is critical given th
e vast powers that directors have. As noted by Volpe (1979) (citing Tett and Cha
dwick: Zimbabwe Company Law), directors may act individually or corporately as a
board, or in committees or by appointing one or more managing directors or mana
gers responsible to them. As a board, the directors may concern themselves with
anything between the extremes of day to day management and overall policy and re
sponsibilities.
Qualifications and Appointment of Directors Section 173 of the Act proscribes wh
o may become a director. For example, a person with any legal disability, an unr
ehabilitated insolvent and a person convicted of certain classes of economic cri
mes are not eligible for appointment as director. The objective for placing such
restrictions as noted by Christie (1998) is to keep directorship and management
of the company under responsible hands. This screening process will give
7 solace to the shareholder who would know that his investments are under the s
tewardship of directors who can be trusted. Further, the Act requires directors
(the agents) to be appointed by shareholders (the principals). Section 174 of th
e Act gives members/shareholders an opportunity to consider merits of each direc
tor individually. In terms thereof, no appointment of two (2) or more directors
may be made by the same resolution at a general meeting. Thus, the qualification
s required of directors as well as the appointment procedure to be followed ensu
re that incidents of adverse selection and moral hazard are minimised.
Removal of Directors by Shareholders To ensure that some checks and balances exi
st, the Act has a procedure for the removal of directors by shareholders. In ter
ms of section 175 of the Act (read with section 135), shareholders can utilize t
heir power from the democratic process of voting by which means they can elect o
r dismiss directors. When appropriately used, the power to remove directors from
office would effectively afford shareholders protection against errant director
s who tend to pursue practices that work at cross-purposes with interests of sha
reholders.
Fiduciary Duties of Directors: No Conflict of Interest As noted by Christie (199
8), the relationship between the director and the company is a unique one. A dir
ector stands in a fiduciary relationship to the company. As such, a director is
statutorily bound by the Act to discharge his duties and exercise his powers for
the benefit of the company, not his own. This should be reflected in two major
ways; firstly, that directors should act with skill and care and secondly, that
they should act in good faith. Thus, to protect the interests of shareholders of
the company, a director is required to exhibit that degree of skill which can r
easonably be expected of a person of his knowledge and experience and avoid any
conflict of interests. Table “A” Articles as read with section 186 of the Act theref
ore places a special procedure to be followed where directors are required to de
clare any possible conflicts of interests that may compromise their objectivity
when discharging company business. Such a procedure
8 helps preclude incidents of abuse by directors and managers who stand to bene
fit from inside information they may have gained by virtue of their positions in
the company. Convening of Members’ Meetings In terms of section 124 of the Act, e
very public listed company is obliged to convene a statutory meeting where direc
tors should present a statutory report. Further, every company (both private and
public) should convene an annual general meeting (section 125), where specific
business to do with the affairs of the company is discharged. Additionally, memb
ers have the power to call for or requisition an extra-ordinary general
meeting. These various meetings are significant in advancing corporate governanc
e and reducing the agency conflict as they assist in bridging the information as
ymmetry existing between shareholders and managers. How this is achieved is disc
ussed below: Annual Reports and other Disclosures Section 146 requires managemen
t to lay the company’s accounts (i.e. the balance sheet and the profit and loss ac
count signed by two directors) at an annual general meeting of members. An exter
nal auditor’s report should also be annexed to such accounts. Further, and in term
s of section 147 of the Act, there should be attached to these accounts a direct
ors’ report outlining the state of the company’s affairs.
Significant issues of corporate governance arise here. Effective corporate gover
nance by company boards requires both good information and the will to act on ne
gative information. The requirement to distribute the company’s accounts and other
reports to members forms the hallmark of transparency and accountability by the
agents to their principals. As pointed out earlier in this paper, such disclosu
res are critical for the advancement of corporate governance and for ensuring th
at information asymmetry is reduced as between agent and principal. Further, it
is agreed that the publicity which comes with such disclosures places management
under compulsion to take shareholder- value maximising decisions as managerial
labor markets tend to discipline poorly performing managers (Kaplan and Reishus,
1990).
9 Thus, the platform afforded by statutory and other meetings and the reports t
hat are presented at those meetings gives shareholders an opportunity to assess
not only “what” a company reports but also “why” particular actions were taken.
Personal Liability of Officers and Auditors Managers and company auditors may no
t afford to conduct the affairs of the company recklessly as doing so would resu
lt in personal liability attaching to their actions (see section 190 of the Act)
. Further, in terms of section 189, directors are encouraged to have regard to t
he interests of the company’s members, principally to do with profit maximization.
However, the weakness of this provision is that it is merely directory and not
peremptory/compulsory.
Limits on Power of Directors As a way of averting corporate scandals where direc
tors would end up prejudicing the shareholders, section 183 (1) (b) of the Act p
rohibits directors from disposing of the undertaking of the company or of the wh
ole part of such company’s assets without the approval of the company in a general
meeting. This limits the powers of directors to unilaterally do as they wish wi
th the company’s assets, hence preventing the possibility of ripping-off sharehold
ers. This way, shareholders are protected from overzealous directors and managem
ent.
Other / Non-statutory protection available to Shareholders Apart from the statut
ory provisions discussed above, other measures are also available to be taken by
shareholders to shield themselves from the agency problems. These will now be c
onsidered below:
Appointing Non-Executive Directors As stressed above, one of the reasons for the
existence of the agency conflict is the appointment of board members who are al
so members of the management team (executive board members). The various reasons
why this is so has also been discussed above. To counter the negative effects o
f a board dominated by the management team,
10 shareholders may consider shifting the board composition in favour of non-exe
cutive directors. A non-executive board member would not normally sympathize wit
h decisions that are in conflict with the goal of maximising the wealth of share
holders. Fama and Jensen (1983) argued that effective boards dominated by non-ex
ecutive directors are better able to separate the problems of decision managemen
t and decision control. Outside directors are able to separate these functions a
nd exercise decision control, since reputation concerns, and perhaps any equity
stakes they might have, provides them with sufficient incentive to do so.
Managerial and Director Incentives It is generally agreed that the structure of
executive compensation contracts can have a large influence in aligning the inte
rest of shareholders and management (McColgan, 2001). Compensation contracts, an
d their revision, represent a financial incentive for management to increase com
pany value. It is argued that higher levels of such incentives should be proport
ionate to higher company performance (Jensen and Meckling 1976). Effective compe
nsation contracts should therefore provide management with sufficient incentive
to make value maximising decisions at the lowest possible cost to shareholders.
The main forms of managerial and director compensation are basic salary, account
ing- based performance bonuses, performance-based share option schemes and long-
term incentive plans. The effectiveness of such incentives largely depends on th
e strategy adopted. For example, companies with long-term investment opportuniti
es should be expected to employ compensation plans with contingencies which caus
e executives to forfeit the compensation if they leave the company. Accounting-b
ased bonus schemes and performance-based share option schemes as modes of incent
ives will now be dealt with below:
Accounting Based Bonus Schemes Basing bonuses upon accounting measures of perfor
mance provides an improved mechanism for aligning managers’ interests with those o
f the company’s shareholders (McColgan 2001). However, Healy (1985) argue that pay
ing executives on the basis of accounting variables provides an incentive for ma
nagement to directly manipulate the
11 accounting system, and favour projects with short-term accounting returns at
the expense of long-term positive NPV investment. Bonuses related to company sa
les may further encourage earnings retention and firm size growth, which doesn’t a
lways equate with payment of dividends hence shareholder wealth growth. Another
weakness is that accounting bonuses may also lead to a focus on the determining
variables of these compensation plans, perhaps leading managers to neglect other
non-financial aspects of performance like occupational health and safety; socia
l investment; environmental impact; and development and skilling of staff.
Performance Shares The use of share options in executive compensation plans is g
enerally seen as the one of the most effective means of tying the interests of m
anagers and shareholders. Under this scheme, shares are offered to managers as a
reward for performance which enhances shareholder wealth. Such options give man
agement the right to buy company stock at a fixed price at given times in the fu
ture. As ownership of the company by inside managers increases, so too does thei
r incentive to invest in positive NPV projects and reduce private perquisite con
sumption. The higher the value of the firm, the higher the value of the options
and the profit managers can make upon exercising them. Agrawal and Mandelker (19
87) report that stock options encourage management to make investment and financ
ing decisions which increase the variance of the firm’s assets. Additionally, Deni
s et al. (1997) find that executive ownership is associated with greater corpora
te focus, indicating that the severity of the managerial risk-aversion problem m
ay be reduced through higher equity stakes.
Closely linked to performance shares is the economic value added [EVA] mechanism
which can be used to tie managerial compensation to shareholder wealth maximiza
tion. EVA is the performance measure most directly linked to the creation of sha
reholder wealth over time. A positive EVA indicates that management is creating
wealth for the shareholders. It denotes an estimate of true "economic" profit, o
r the amount by which earnings exceed the required minimum rate of return that s
hareholders and lenders could get by investing in other securities of comparable
risk.
12 Critique of the Performance Share scheme On the flip-side, share option schem
es may fail to provide the necessary incentive due to the existence of other fac
tors beyond the control of the managers that may affect the price of the share.
Examples are macro-economic factors like interest rates, inflation, uncompetitiv
eness of the economy etc, which lead to a dip in share value. Further, evidence
on the benefits of managerial share ownership tends to generally be mixed. While
the theoretical arguments for increased incentives are unquestionable, empirica
l evidence suggests that insider ownership may also come at the cost of entrench
ment. Many factors can influence the relationship between insider ownership and
corporate value, and as observed by McColgan (2001), recent evidence tends to su
ggest that causality may even operate in the opposite direction.
Threat of firing According to McColgan (2001), one of the most consistent empiri
cal results in the corporate governance literature is that directors are more li
kely to lose their jobs if they are poor performers. Poorest performing manageme
nt would lose their jobs at the instance of directors, moreso should such poor p
erformance be for prolonged periods. In light of this, managers may be forced to
take shareholder maximising actions simply in order to keep their jobs and in t
he process protecting the interests of shareholders hence reducing goal non-cong
ruence between shareholders and management.
Block holder or Institutional Investors The existence of large block investor(s)
in a company may overcome the problem normally encountered by small, atomistic
shareholders who may not have the time, skill, or the interest to monitor manage
rial activities. Institutional shareholders are better able to overcome this cha
llenge, as they may have more skill, more time, and a greater financial incentiv
e to overcome this free-rider problem and closely monitor management. Additional
ly, large shareholders may be able to elect themselves onto company boards, incr
easing their ability to monitor management. Denis and Sarin (1997) contend that
the purchase of large share stakes by outside investors represents a control thr
eat to company
13 management and can provide pressure for internal governance systems to operat
e more efficiently. Blockholder pressure may also deter management from non-valu
e adding diversification strategies. Since such investors already hold diversifi
ed portfolios, further risk-reductions aren’t of interest to them.
Further, institutional shareholders like pension funds, mutual funds, and insura
nce companies can afford to exert direct intervention. The managers of these ins
titutions usually have the power and take an active interest in the management o
f the companies in which they hold shares. They can lobby for the interests of a
ll shareholders and suggest ways in which the business may be run. Such direct i
ntervention by shareholder representatives will influence management into shareh
older value maximization.
Disciplinary Take-overs Disciplinary takeovers will occur in response to breakdo
wns of internal control systems in companies with large levels of free cash flow
s [Jensen (1986)]. A hostile takeover is likely to happen when the shares of the
company are undervalued relative to their potential due to poor management. Whe
re managers fear that they may lose their jobs following takeovers, they may rea
ct by investing these free cash flows in more efficient investment projects. Saf
ieddine and Titman (1999) find that targets of failed takeover attempts signific
antly increase their leverage in the period immediately following the failed bid
. These firms then tend to sell off under-performing company assets in order to
increase focus on key profitable investments, perhaps reversing previously unpro
fitable diversification policies. Thus, take-over bids may be initiated not only
for efficiency gains but also as a way of disciplining poorly performing manage
ment.
Critique of the Disciplinary Take-overs The threat of takeover alone would not b
e enough to ensure complete coherence between managerial actions and shareholder
wealth. This can be attributed largely to the costs of organising takeovers, in
particular the high bid premiums (Jensen and Ruback, 1983). However, management
may actively seek to reduce the probability of takeover since it
14 may result in loss of personal wealth and reputation. One way of achieving th
at would be to improve profitability of the firm, which in turn would be benefic
ial to shareholders. Conclusion As has been shown above, agency problems are rea
l in the business realm. The scope of each type of agency conflict will differ f
rom one firm to another, as will the effectiveness of governance mechanisms in r
educing them. However, hope is not lost for the shareholder as various mechanism
s may be employed, both statutory and non-statutory to minimise the damage to sh
areholder wealth caused by agency problems. Each type of governance and other me
chanisms discussed in this paper can be important in reducing the agency costs o
f the separation of ownership and control, and afford protection to the sharehol
der.
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