AGENCY RELATIONSHIP

If you are the sole owner of a business, then you make the decisions that affect your own well-being. But what if you are a financial manager of a business and you are not the sole owner? In this case, you are making decisions for owners other than yourself; you, the financial manager, are an agent. An agent is a person who acts for—and exerts powers of— another person or group of persons. The person (or group of persons) the agent represents is referred to as the principal. The relationship between the agent and his or her principal is an agency relationship.

There is an agency relationship between the managers and the shareholders of corporations.

Problems with the Agency Relationship

In an agency relationship, the agent is charged with the responsibility of acting for the principal. Is it possible the agent may not act in the best interest of the principal, but instead act in his or her own self-interest?

Yes—because the agent has his or her own objective of maximizing personal wealth.

In a large corporation, for example, the managers may enjoy many fringe benefits, such as golf club memberships, access to private jets, and company cars. These benefits (also called perquisites, or “perks”) may be useful in conducting business and may help attract or retain management personnel, but there is room for abuse. What if the managers start spending more time at the golf course than at their desks? What if they use the company jets for personal travel? What if they buy company cars for their teenagers to drive? The abuse of perquisites imposes costs on the firm—and ultimately on the owners of the firm. There is also a possibility that managers who feel secure in their positions may not bother to expend their best efforts toward the business. This is referred to as shirking, and it too imposes a cost to the firm.

Finally, there is the possibility that managers will act in their own self-interest, rather than in the interest of the shareholders when those interests clash. For example, management may fight the acquisition of their firm by some other firm even if the acquisition would benefit shareholders.

Why? In most takeovers, the management personnel of the acquired firm generally lose their jobs. Envision that some company is making an offer to acquire the firm that you manage. Are you happy that the acquiring firm is offering the shareholders of your firm more for their stock than its current market value? If you are looking out for their best interests, you should be. Are you happy about the likely prospect of losing your job? Most likely not.

Many managers faced this dilemma in the merger mania of the 1980s. So what did they do? Among the many tactics,

■ Some fought acquisition of their firms—which they labeled hostile takeovers—by proposing changes in the corporate charter or even lobbying for changes in state laws to discourage takeovers.

■ Some adopted lucrative executive compensation packages—called golden parachutes—that were to go into effect if they lost their jobs.

Such defensiveness by corporate managers in the case of takeovers, whether it is warranted or not, emphasizes the potential for conflict between the interests of the owners and the interests of management.

Costs of the Agency Relationship

There are costs involved with any effort to minimize the potential for conflict between the principal’s interest and the agent’s interest. Such costs are called agency costs, and they are of three types: monitoring costs, bonding costs, and residual loss.

Monitoring costs are costs incurred by the principal to monitor or limit the actions of the agent. In a corporation, shareholders may require managers to periodically report on their activities via audited accounting statements, which are sent to shareholders. The accountants’ fees and the management time lost in preparing such statements are monitoring costs. Another example is the implicit cost incurred when shareholders limit the decision-making power of managers. By doing so, the owners may miss profitable investment opportunities; the foregone profit is a monitoring cost.

The board of directors of corporation has a fiduciary duty to shareholders; that is the legal responsibility to make decisions (or to see that decisions are made) that are in the best interests of shareholders. Part of that responsibility is to ensure that managerial decisions are also in the best interests of the shareholders. Therefore, at least part of the cost of having directors is a monitoring cost.

Bonding costs are incurred by agents to assure principals that they will act in the principal’s best interest. The name comes from the agent’s promise or bond to take certain actions. A manager may enter into a contract that requires him or her to stay on with the firm even though another company acquires it; an implicit cost is then incurred by the manager, who foregoes other employment opportunities.

Even when monitoring and bonding devices are used, there may be some divergence between the interests of principals and those of agents.

The resulting cost, called the residual loss, is the implicit cost that results because the principal’s and the agent’s interests cannot be perfectly aligned even when monitoring and bonding costs are incurred.

Motivating Managers: Executive Compensation One way to encourage management to act in shareholders’ best interests, and so minimize agency problems and costs, is through executive compensation —how top management is paid. There are several different ways to compensate executives, including:

Salary. The direct payment of cash of a fixed amount per period.

Bonus. A cash reward based on some performance measure, say earnings of a division or the company.

Stock appreciation right. A cash payment based on the amount by which the value of a specified number of shares has increased over a specified period of time (supposedly due to the efforts of management).

Performance shares. Shares of stock given the employees, in an amount based on some measure of operating performance, such as earnings per share.

Stock option. The right to buy a specified number of shares of stock in the company at a stated price—referred to as an exercise price at some time in the future. The exercise price may be above, at, or below the current market price of the stock.

Restricted stock grant. The grant of shares of stock to the employee at low or no cost, conditional on the shares not being sold for a specified time.

The salary portion of the compensation—the minimum cash payment an executive receives—must be enough to attract talented executives.

But a bonus should be based on some measure of performance that is in the best interests of shareholders—not just on the past year’s accounting earnings. For example, a bonus could be based on gains in market share. Recently, several companies have adopted programs that base compensation, at least in part, on value added by managers as measured by economic profits.

The basic idea behind stock options and restricted stock grants is to make managers owners, since the incentive to consume excessive perks and to shirk are reduced if managers are also owners. As owners, managers not only share the costs of perks and shirks, but they also benefit financially when their decisions maximize the wealth of owners. Hence, the key to motivation through stock is not really the value of the stock, but rather ownership of the stock. For this reason, stock appreciation rights and performance shares, which do not involve an investment on the part of recipients, are not effective motivators.

Stock options do work to motivate performance if they require owning the shares over a long time period; are exercisable at a price above the current market price of the shares, thus encouraging managers to get the share price up, and require managers to tie up their own wealth in the shares.

Currently, there is a great deal of concern in some corporations because executive compensation is not linked to performance. In recent years, many U.S. companies have downsized, restructured, and laid off many employees and allowed the wages of employees who survive the cuts to stagnate. At the same time, corporations have increased the pay of top executives through both salary and lucrative stock options. If these changes lead to better value for shareholders, shouldn’t the top executives be rewarded?

There are two issues here. First, such a situation results in anger and disenchantment among both surviving employees and former employees.

Second, the downsizing, restructuring, and lay-offs may not result in immediate (or even, eventual) increased profitability. Consider AT&T in 1995: In a year in which the company restructured, barely made a profit, eliminated 40,000 jobs, and its stock had lackluster returns, the chief executive officer (CEO) received salary and bonuses of $5.2 million and options valued at $11 million. If the restructuring pays off in the long-run, the CEO’s pay may be justified, but meanwhile, there may be some unhappy AT&T shareholders: The average annual return on AT&T stock over the period 1996–2001 was –23.19%.6

Another problem is that compensation packages for top management are designed by the board of directors, which often includes top management. Moreover, reports disclosing these compensation packages to shareholders (the proxy statements) are often confusing. Both problems can be avoided by adequate and understandable disclosure of executive compensation to shareholders, and with compensation packagesdetermined by board members who are not executives of the firm.

Owners have one more tool with which to motivate management— the threat of firing. As long as owners can fire managers, managers will be encouraged to act in the owners’ interest. However, if the owners are divided or apathetic—as they often are in large corporations—or if they fail to monitor management’s performance and the reaction of directors to that performance, the threat may not be credible. The removal of a few poor managers can, however, make this threat palpable.

Shareholder Wealth Maximization and Accounting “Irregularities”

Recently, there have been a number of scandals and allegations regardingthe financial information that is being reported to shareholders and the market. Financial results reported in the income statements and balance sheets of some companies indicated much better performance than the true performance or much better financial condition than actual.

Examples include Xerox, which was forced to restate earnings for several years because it had inflated pre-tax profits by $1.4 billion, Enron, which is accused of inflating earnings and hiding substantial debt, and Worldcom, which failed to properly account for $3.8 billion of expenses. Along with these financial reporting issues, the independence of the auditors and the role of financial analysts have been brought to the forefront.

It is unclear at this time the extent to which these scandals and problems were the result of simply bad decisions or due to corruption.

The eagerness of managers to present favorable results to shareholders and the market appears to be a factor in several instances. And personal enrichment at the expense of shareholders seems to explain some cases.

Whatever the motivation, chief executive officers (CEOs), chief financial officers (CFOs), and board members are being held directly accountable for financial disclosures. For example, in 2002, the Securities and Exchange Commission ordered sworn statements attesting to the accuracy of financial statements. The first deadline for such statements resulted in several companies restating financial results.

The accounting scandals are creating an awareness of the importance of corporate governance, the importance of the independence of the public accounting auditing function, the role of financial analysts, and the responsibilities of CEOs and CFOs.

Shareholder Wealth Maximization and Social Responsibility When financial managers assess a potential investment in a new product, they examine the risks and the potential benefits and costs. If the risk-adjusted benefits do not outweigh the costs, they will not invest.

Similarly, managers assess current investments for the same purpose; if benefits do not continue to outweigh costs, they will not continue to invest in the product but will shift their investment elsewhere. This is consistent with the goal of shareholder wealth maximization and with the allocative efficiency of the market economy.

Discontinuing investment in an unprofitable business may mean closing down plants, laying off workers, and, perhaps destroying an entire town that depends on the business for income. So decisions to invest or disinvest may affect great numbers of people.

All but the smallest business firms are linked in some way to groups of persons who are dependent to a degree on the business. These groups may include suppliers, customers, the community itself, and nearby businesses, as well as employees and shareholders. The various groups of persons that depend on a firm are referred to as its stakeholders; they all have some stake in the outcome of the firm. For example, if the Boeing Company lays off workers or increases production, the effects are felt by Seattle and the surrounding communities.

Can a firm maximize the wealth of shareholders and stakeholders at the same time? Probably. If a firm invests in the production of goods and services that meet the demand of consumers in such a way that benefits exceed costs, the firm will be allocating the resources of the community efficiently, employing assets in their most productive use. If later the firm must disinvest—perhaps close a plant—it has a responsibility to assist employees and other stakeholders who are affected. Failure to do so could tarnish its reputation, erode its ability to attract new stakeholder groups to new investments, and ultimately act to the detriment of shareholders.

The effects of a firm’s actions on others are referred to as externalities.

Pollution is an externality that keeps increasing in importance.

Suppose the manufacture of a product creates air pollution. If the polluting firm acts to reduce this pollution, it incurs a cost that either increases the price of its product or decreases profit and the market value of its stock. If competitors do not likewise incur costs to reduce their pollution, the firm is at a disadvantage and may be driven out of business through competitive pressure.

The firm may try to use its efforts at pollution control to enhance its reputation in the hope that this will lead to a sales increase large enough to make up for the cost of reducing pollution. This is called a market solution: The market places a value on the pollution control and rewards the firm (or an industry) for it. If society really believes that pollution is bad and that pollution control is good, the interests of owners and society can be aligned.

It is more likely, however, that pollution control costs will be viewed as reducing owners’ wealth. Then firms must be forced to reduce pollution through laws or government regulations. But such laws and regulations also come with a cost—the cost of enforcement. Again, if the benefits of mandatory pollution control outweigh the cost of government action, society is better off. In such a case, if the government requires all firms to reduce pollution, then pollution control costs simply become one of the conditions under which owner wealth-maximizing decisions are to be made.