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AGENTS WITH PRINCIPLES: REDUCING RISK THROUGH ETHICS EDUCATION Christopher M.

Brockman, University of Tennessee at Chattanooga, USA Robert Brooks, University of Alabama, USA D. Michael Long, University of Tennessee at Chattanooga, USA

ABSTRACT The typical principal-agent relationship is, in theory, based on a foundation of mutual trust. But typical agency theory is based on the belief that the agent cannot be trusted. Agency costs, such as monitoring, must be incurred to increase the agents incentive for work effort and moral conduct. We contend that a firms agency costs and cost of capital can be lowered, increasing firm value, if managers who have been taught the importance of proper ethical convictions through their collegiate studies and/or through earning a professional designation are employed by the firm. Keywords: Business Ethics, Agency Theory, AACSB 1. INTRODUCTION The first assumption that is usually made in an introductory corporate finance course is that managements primary goal is to maximize shareholder wealth, which generally translates into maximizing share price. DeAngelo (1981) shows that if the decisions of a firm affect its owners consumption opportunities only through the impact on initial wealth, then maximization of firm value should be unanimously supported by shareholders because it maximizes every owners wealth, and thus, their utility. But in the real world, we know that managers may not always act in the best interest of the shareholders. It is sometimes difficult to tell whether managers are trying to maximize shareholders wealth, or simply trying to keep the shareholders appeased while pursuing their own personal goals, which may actually compete with the goals of the shareholders. This conflict of interest between the managers, acting as agents for the shareholders, and the shareholders themselves has been examined extensively in the literature under the concept of agency theory. The seminal work by Jensen and Meckling (1976) shows that whenever a manager owns less than 100% of the common equity of the firm an agency conflict will exist. The manager will seek to increase his nonpecuinary benefits since he would only incur a portion of the costs and may have less incentive to pursue projects that would maximize shareholder wealth since he would only receive a portion of the benefits. This moral hazard problem arises because managers may take unobservable actions to increase their own utility at the expense of the shareholders. For example, Narayanan (1985) states that managers may have an incentive to make decisions that yield short-term profits at the expense of the long-term interests of the shareholders. A manager may pursue this path if he feels that it will enhance his reputation early and therefore increase his future compensation. The essence of the principal-agent relationship is based on a foundation of trust between the parties involved, but it is the lack of trust between these parties that is the major downfall of the relationship. It is common knowledge to agents and to principals that both increased income and increased leisure (or other nonpecuinary benefits) enter into ones utility function. Income provides utility benefits while the work effort put forth to earn this income provides disutility. Because of this disutility of effort, individuals will have an incentive to shirk in their work effort (Alchian and Demsetz 1972). Thus, a person will combine his personal pursuits with his work pursuits in a way that will maximize his total or net utility. Agency theory assumes that shareholders are imperfectly informed as to the work effort put forth by their managers. Because it is impossible for shareholders to personally observe all actions of the manager,

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they must incur agency costs that are designed to discourage the manager from shirking or otherwise acting in his own self-interest. These costs are most often associated with monitoring, bonding, and the design of managerial incentive contracts, all of which impose a cost. The theory holds that management is motivated by the shareholders, the board of directors, or the CEO through monitoring in the form of performance-contingent pay, or the threat of dismissal if performance is inadequate (Jensen and Meckling 1976; Fama and Jensen 1983). However, it is argued that the performance pay criteria does not provide adequate incentive to be consistent with agency theory (Jensen and Murphy 1990) and that the threat of dismissal is so seldom carried out, that it too, is ineffective. We contend that a portion of the principal-agent problem and the associated moral hazard and adverse selection problems can be diminished with no direct cost to the firm. We believe that agency costs can be decreased if the agent has distinguished himself as a person with high moral character and uncompromising work ethics. Attending a school that emphasizes ethics in its curriculum, such as an AACSB accredited institution, and/or obtaining a professional designation can provide an individual with instant recognition as someone who has learned the importance of strong ethical standards and the value of a reliable reputation. 2. ETHICS EDUCATION Stiglitz (1975) states that determining the quality of a commodity or factor is perhaps one of the most important informational aspects that one can obtain. This work by Stiglitz and other studies, such as Spence (1973), describe how an individuals competence and quality can be identified by means of screening and signaling, mainly through educational attainment. The proper education can separate a person from the ordinary and signal to the job market that he is of exceptional quality. This process begins with the college or university that one attends. AACSB The International Association for Management Education is an organization concerned with the promotion and improvement of higher education and is the foremost accrediting agency for bachelors, masters and doctoral degree programs in business administration and accounting. AACSB accreditation is widely considered as an important measure of the quality of a schools education program. Kim, Rhim, Henderson, Bizal, and Pitman (1996) show the importance of AACSB accreditation in a study dealing with accounting graduates. The results of the study indicate that average starting salaries at CPA firms for recent accounting graduates was significantly higher for those students who earned their accounting degrees from an AACSB accredited school. The authors suggest that AACSB accreditation can not only serve as a signal of a quality educational program, but also as a signal to the job market of the quality of a potential employee. To earn accredited status by the AACSB, a college or university must meet certain requirements pertaining to the content of its curriculum. One such standard as listed in the AACSB Curriculum Content and Evaluation requirements states that (b)oth undergraduate and MBA curricula should provide an understanding of perspectives that form the context for business. Coverage should include: ethical and global issues (AASCB p17). The AACSB interprets this standard as meaning that (t)he perspectives indicated above might be addressed via individual coursesor by interweaving them throughout other required curricula elements (AACSB p17). Thus, we can see the importance that the AACSB places on the teaching of ethics and ethics related topics in our colleges and universities. It is this teaching of ethical standards early in ones business education that helps to influence future ethical beliefs and actions in the business world. Ones education does not end after graduation, as continued professional training should be a part of a business professionals life throughout his career. One of the most highly regarded means of continuing ones education and training is through the attainment of a professional designation. The business executive with a professional designation such as the Chartered Financial Analyst (CFA), the Certified Public Accountant (CPA), or the Chartered Financial Consultant (ChFC) is recognized worldwide as someone who has established himself as a person with superior professional competence, high moral character, and dedication to his profession. Studies concerning professional designations suggest that there are numerous benefits in obtaining a designation to both the certified professional and the people

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that he serves (Lahey, Ott and Lahey 1993; Brockman and Brooks 1998). Obtaining a professional designation provides the holder with instant recognition as someone with a reliable reputation earned through his attainment of the designation and through his adherence to its code of ethics and standards of professional conduct. We believe that the screening and signaling aspects that the proper college ethics curriculum and that obtaining a professional designation bring through their indication of high moral standards and strong professional quality can alleviate both the moral hazard and the adverse selection problems of the principle-agent relationship. We contend that a firms agency costs and cost of capital can be lowered, increasing firm value, if the firm employs managers who have been properly taught the importance of ethical convictions through their collegiate studies and/or through earning a professional designation. 3. PRINCIPALS AND AGENTS AGENTS AND PRINCIPLES As previously noted, finance theory states that the primary goal of the firm should be to maximize shareholder wealth. However, there is convincing evidence that investors are motivated significantly by ethical considerations and not exclusively by share price maximization (Rivoli 1995). We believe that unethical behavior by firms inevitably has an adverse effect on the investment psychology of investors, diminishing the confidence level that they place in the financial markets and obscuring their perception of the risks that the market holds. A study by Perry (1994) indicates that investor attitude is a notable general market risk and investors moods and attitudes toward a particular investment have significant influence on their willingness to buy and own the stock, which in turn impacts the stocks price. A study by Rao and Hamilton (1996) examines the effects of published reports of unethical behavior by publicly traded U.S. and multinational firms on the performance of the firms stock. The study, covering the years 1989 to 1993, indicates that stock performance for those firms was lower than the expected market adjusted returns. The authors state that unethical conduct, which is publicly disclosed, does have an impact on shareholders in that the value of their stock is lowered for a substantial period of time. They conclude that there is a significant link between unethical behavior by firms or by the firms managers and the market value of a firms stock. Quinn and Jones (1995) note that the long-term benefits from a reputation for ethical behavior typically outweigh the short-term gains from unethical actions and that most companies would benefit from at least the perception that their managers are ethical. The agent morality view of business policy as posited by Quinn and Jones (1995) proposes that the principal-agent model entails two differing views about what should guide managements decision making. The first view holds that managers are agents of the shareholders and that maximizing shareholder wealth is the appropriate motivating factor for management. The second view holds that management has certain moral duties and that moral reasoning should motivate managers decision making. We know that in a perfect world, these two views would not be mutually exclusive - doing what is morally right should maximize the value of the firm. In our imperfect world though, should the agent be guided by his moral obligation to the general public or by his obligation that he has to his shareholders? Or, is he guided by neither one, but instead is guided by his own self-interests? As implied earlier, agents will choose their level of work effort based on maximizing their net utility. The utility derived is based in part, on both the level of effort put forth by the agent and the amount of monitoring undertaken by the principal. As the agent increases his work effort, his work benefits in the form of monetary and nonmonetary compensation are likely to increase as well, but at a marginally decreasing rate. This can be expressed mathematically as:

B B E > 0; E

2B B EE < 0 , E2

where, E, represents the work effort put forth by the agent and, B, represents the work benefits received by the agent. Economic theory espouses that individuals (agents) have an incentive to shirk, or decrease their work effort, if the benefits of doing so outweigh the costs. Agency theory suggests that to decrease

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this incentive to shirk, principals must incur monitoring costs, such as internal audits, to raise the level of work effort put forth by their agents. The level of work effort will theoretically increase as the level of monitoring, M, increases:

E > 0. M
This behavior is said to occur due to what is known as the disciplining effect where higher levels of monitoring raise the marginal cost of shirking and/or reduce the marginal cost of effort for the agent. However, following the framework of Frey (1993), under certain principal-agent relationships, an increase in monitoring activities may actually decrease the agents work effort. This is due to a crowding out effect that may occur where higher levels of monitoring reduce the agents marginal benefit from work effort. The benefit of effort and the cost of effort for the agent are functions of both the amount of effort that he exerts and the level of monitoring that the principal imposes. As the agent increases his work effort, the cost of the effort, C, to the agent increases at an increasing rate:

C C E > 0; E

2C C EE > 0 . E2

Rational agents will seek to maximize their net utility, which can be shown as the disutility of the cost of work effort, C(E, M), netted from the utility of the work benefits, B(E, M):

U[B(E,M) - C(E,M)] ,
by choosing their level of work effort, taking the level of monitoring to be constant. They choose an optimal level of effort, E*, at the point where the marginal benefit of effort is equal to the marginal cost of effort. Frey shows that by differentiating this optimal effort level with respect to the level of monitoring, the agents reaction to the monitoring can be seen as one of three possible alternatives:

B C EM dE * = EM dM C EE B EE

< = >

In one situation, the agent may see the monitoring as an indication of distrust by the principal, in that the agent feels that the principal does not trust him to fulfill his contractual obligation. This in turn, can be interpreted as a breach by the principal of the principal-agent contract, which was formed on a basis of trust. This perceived breakdown of trust may induce the agent to consider the contract nullified, and cause him to seek to maximize his utility by shirking, when he would otherwise feel a contractual obligation not to do so. Thus, the crowding out effect is likely to occur, where increased monitoring reduces the agents marginal benefit from work effort, which would cause him to reduce his effort. This can be shown as:

BE B EM < 0 M

E* < 0, M

given that the marginal cost of effort with monitoring, or the disciplining effect, CEM, is zero. The crowding out effect is most likely to occur when the principal-agent relationship is on a more personal basis where trust is major factor and when the agents job requires high degrees of discretion, intuition, or judgement, such as in managerial type positions.

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In the second case, there is a disciplining effect, where tighter monitoring reduces the marginal cost of effort, which increases work effort. This can be shown as:

CE C EM < 0 M

E* > 0, M

given that the marginal benefit from effort with monitoring, or the crowding out effect, BEM, is zero. The disciplining effect may occur when the relationship is less personal and involves more structured work requirements, such as in some blue-collar type jobs. The third situation is when the disciplining and the crowding out effects both have an impact (CEM<0, BEM<0). In this case, monitoring has two opposing consequences on the agents work effort, the net effect of which can only be speculated on without investigation. The above crowding out effect presents a no-win situation for shareholders. If they incur agency costs to monitor the manager, the manager may decrease his work effort, which costs the company further. But if the shareholders do not monitor the manager, they will not be confident that the manager is putting forth his best work effort for the company. To help alleviate this problem, the shareholders could hire a manager who has distinguished himself to be someone with high ethical standards and a commitment to perform his duties to the best of his ability - someone who will do this without the incentive of monitoring and who, if monitored, will feel a moral, if no longer a contractual obligation not to shirk on his duties. 3. ETHICS - ADDING VALUE TO THE FIRM According to the American Heritage Dictionary (1982), to be ethical is to be in accordance with the accepted principles of right and wrong that govern the conduct of a profession. This definition goes well beyond simply complying with stated rules, regulations, and laws - it also encompasses aspects of integrity and a sense of morality in which violations are not punishable by law, but by a remorseful feeling of wrongdoing. This exemplifies the importance of an academic curriculum that includes the teaching of business and personal ethics. As the AACSB states (AACSB p17), the teaching of ethics helps to provide an understanding of perspectives that form the context for business. Compliance with ones sense of morality can also be enforced through a code of ethics or a code of professional conduct. Most professions including law, medicine, and real estate have a number of distinct organizations that oversee the regulation of their profession and the conduct of its members. In the business profession there are many such organizations that award professional designations, such as the CPA, the CFA, and the ChFC. The holders of these designations must adhere to the organizations strict code of ethics and standards of professional conduct, violations of which can result in severe disciplinary action including suspension or revocation of the designation. The fear of disciplinary action as well as the fear of embarrassment and of losing respect among ones peers is a strong deterrent against wrongdoing. We assert that managers who have been properly taught the importance of ethical convictions through their collegiate studies and/or through earning a professional designation have shown that they have learned the value of high ethical standards and are committed to their profession and perform their duties with the utmost in moral aptitude. We contend that there is a valuable benefit to corporations that results from their managers having these qualities. Higher degrees of professionalism, competence, quality, and ethics that are exhibited by these professionals help add value to the firms for which they work. Firms that are directed by managers, such as these, are maintained with these same high ethical standards, and this has a positive impact on the value of the firm by lowering the firms agency costs and its cost of capital. Aggregating this effect over all firms, we can see that there is a positive impact on the overall market.

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4. A PROFESSIONAL DESIGNATION ADDS VALUE TO THE FIRM The extent of agency costs, AC, expended by a firm is, in part, a function of the perceptions that the shareholders have pertaining to the integrity of the manager: AC = f (Perception of managers integrity). (1)

As we have asserted, from a corporate management perspective, obtaining a professional designation has several benefits to both the individual with the designation and to the shareholders that he serves. One of these benefits is that a professional designation shows sound professional character and a commitment to high ethical standards. These qualities lead to the individual with the designation having an overall air of professional integrity. Consequently, if a manager has a professional designation, he is perceived as having a high level of integrity:

I > 0, PD

(2)

where I represents the integrity of the manager, and PD stands for professional designation. If shareholders believe that the integrity of a manager is high, they will gain added trust, T, in the decisions and actions of the manager:

T > 0. I

(3)

As previously stated, agency costs are, in part, a function of the perceptions that the shareholders have pertaining to the integrity of the manager. As shareholders gain trust in the ethical standards of their manager, the perceived risks of agency conflicts will decrease, and shareholders will be willing to accept lower monitoring etc., to encourage the manager to act properly and in their best interest. Therefore, the increased perception of management integrity and the resulting increase in shareholder trust in management would in turn cause a decrease in agency costs:

AC < 0. T

(4)

Thus, by hiring a manager with a professional designation, the shareholders can reduce their agency costs, which will in turn increase the value of the firm. Other benefits of a professional designation are that it indicates a high level of competence and knowledge and is seen as a measure of professionalism and quality, which increases the confidence that shareholders place in the firms manager. Risk premiums, RP, are, in part, a function of the confidence level that the shareholders have in their managers ability: RP = f (Confidence in manager). As shareholders gain confidence in their managers ability, the perceived risk of the company will decrease, and shareholders will be willing to accept a lower risk premium to compensate them for the risk that they are taking. Hence, the increased confidence level, C, placed in the manager would in turn cause a lowering of the firms risk premium:

RP < 0. C

(5)

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As commonly known, the required rate of return, k, on an investment is equal to the riskless rate of return, rf, plus this risk premium: k = rf + RP. (6)

Therefore, a decrease in the firms risk premium lowers the rate of return required by shareholders to compensate them for the risk that they are bearing:

k > 0. RP

(7)

It can be shown that this lower required rate of return would result in investors increased willingness to pay a higher price for the firms stock by utilizing the well known relationship:

P=

D1 , k-g

(8)

where P represents the price of a stock; D1 is the stocks first period dividend; k is the required rate of return on the stock, and g is the expected dividend growth rate. The relationship between the change in the required rate of return and the change in the price of the stock can be found by taking the derivative of the price with respect to the required rate of return from equation (8). Assuming a zero growth rate we have:

P -P = < 0 k k

(9)

which shows that there is a negative relationship between the required rate of return and the price of a stock. So, as the stocks risk premium decreases, the required rate of return, or cost of capital decreases, which in turn will cause the price of a stock to increase:

P < 0. RP

(10)

The preceding analysis shows how hiring a manager with a professional designation can cause an increase in the price of the firms stock, and can be summarized as: P = f(k(RP(C(I(Professional Designation))))), or overall as: (11) (12)

P > 0. PD

Consequently, by hiring a manager with a professional designation, the firm can reduce its cost of capital, which will in turn increase the value of the firm. 5. CONCLUSION The extent of agency costs expended by a firm is in part, a function of the perceptions that the shareholders have pertaining to the integrity of the manager running the firm. As we have asserted, from a corporate management perspective, being thoroughly educated in business ethics through ones academic studies and/or through earning a professional designation has benefits to both that individual and to the shareholders that he serves. One of the benefits to the financial professional is that such training shows sound professional character and a commitment to high ethical standards. These

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qualities lead to that individual being perceived as having a high level of integrity. If shareholders believe that the integrity of a manager is sound, they will gain added trust in the decisions and actions of that manager. As shareholders gain trust in the ethical standards of their manager, the perceived risk of agency conflicts will decrease, and shareholders will be willing to accept lower monitoring etc., to encourage the manager to act properly and in their best interest. Therefore, the increased perception of management integrity and the resulting increase in shareholder trust in management would in turn cause a decrease in agency costs. Thus, by hiring a manager who possesses strong ethical convictions learned through his collegiate endeavors and/or through his earning a professional designation, a firm can reduce its agency costs, which will in turn increase its value and thus, the value of the market as a whole. REFERENCES: AACSB The International Association for Management Education, Achieving Quality and Continuous Improvement through Self-Evaluation and Peer Review, St. Louis, 1993. Alchian, Armen A. and Harold Demsetz, Production, Information Costs, and Economic Organizations, American Economic Review, Volume 62:5, Pages 777-795, 1972. Brockman, Christopher M. and Robert Brooks, The CFA Charter: Adding Value to the Market, Financial Analysts Journal, Volume 54:6, Pages 81-85, 1998. DeAngelo, Harry, Competition and Unanimity, American Economic Review, Volume 71:1, Pages 18-27, 1981. Fama, Eugene F. and Michael C. Jensen, Separation of Ownership and Control, Journal of Law and Economics, Volume 26, Pages 301-351, 1983. Frey, Bruno S., Shirking or Work Morale?, European Economic Review, Volume 37:8, Pages 15231532, 1993. Houghton Mifflin Company, 1982, The American Heritage Dictionary, Boston, MA. Jensen, Michael C. and William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, Journal of Financial Economics, Volume 3, Pages 305-360, 1976. Jensen, Michael C. and Kevin J. Murphy, Performance pay and Top-Management Incentives, Journal of Political Economy, Volume 98:2, Pages 225-264, 1990. Kim, Kwang, Jong C. Rhim, William C. Henderson, Nancy F. Bizal and Glenn A. Pitman. AACSB Accreditation: A Positive Signal in Accounting Job Markets, The Mid-Atlantic Journal of Business, Volume 32:2, Pages 123-134, 1996. Lahey, Karen E., David M. Ott and Michael V. Lahey, Survey of the Effects of State Certification on Appraisers, Appraisal Journal, Volume 61:3, Pages 405-413, 1993. Narayanan, M.P., Managerial Incentives for Short-Term Results, Journal of Finance, Volume 40:5, Pages 1469-1484, 1985. Perry, H. Bradlee, Investor Psychology Risk, Canadian Shareowner, Volume 7:5, Pages 27-28, 1994. Quinn, Dennis P. and Thomas M. Jones, An Agent Morality View of Business Policy, Academy of Management Review, Volume 20:1, Pages 22-42, 1995.

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Rao, Spuma M. and J. Brooke Hamilton III, The Effects of Published Reports of Unethical Conduct on Stock Prices, Journal of Business Ethics, Volume 15:12, Pages 1321-1330, 1996. Rivoli, Pietra, Ethical Aspects of Investor Behavior, Journal of Business Ethics, Volume 14:4, Pages 265-277, 1995. Spence, Michael, Job Market Signaling, Quarterly Journal of Economics, Volume 87:3, Pages 355-374, 1973. Stiglitz, Joseph E, The Theory of Screening, Education, and the Distribution of Income, The American Economic Review, Volume 65:3, Pages 283-300, 1975.

AUTHOR PROFILES: Dr. Christopher M. Brockman earned his Ph.D. at the University of Alabama in 2000. He is currently an associate professor of finance at the University of Tennessee at Chattanooga and holds the UBS Professorship in Portfolio Management. Dr. Robert Brooks earned his Ph.D. at the University of Florida in 1986. He is currently a professor in finance at the University of Alabama and holds the Wallace D. Malone, Jr. Endowed Chair of Financial Management. Dr. D. Michael Long earned his Ph.D. at the University of Kentucky in 1992. He is currently a professor of finance at the University of Tennessee at Chattanooga and holds Arthur Vieth Professorship in Corporate Finance.

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