The Agency Problem And Control Of The Corporation

We've seen that the financial manager acts in the best interests of the stockholders by taking actions that increase the value of the stock. However, we've also seen that in large corporations ownership can be spread over a huge number of stockholders. This dispersion of ownership arguably means that management effectively controls the firm. In this case, will management necessarily act in the best interests of the stockholders? Put another way, might not management pursue its own goals at the stockholders'

Clifford W. Smith Jr. on Market Incentives for Ethical Behavior

Ethics is a topic that has been receiving increased interest in the business community. Much of this discussion has been led by philosophers and has focused on moral principles. Rather than review these issues, I want to discuss a complementary (but often ignored) set of issues from an economist's viewpoint. Markets impose potentially substantial costs on individuals and institutions that engage in unethical behavior. These market forces thus provide important incentives that foster ethical behavior in the business community.

At its core, economics is the study of making choices. I thus want to examine ethical behavior simply as one choice facing an individual. Economic analysis suggests that in considering an action, you identify its expected costs and benefits. If the estimated benefits exceed the estimated costs, you take the action; if not, you don't. To focus this discussion, let's consider the following specific choice: Suppose you have a contract to deliver a product of a specified quality. Would you cheat by reducing quality to lower costs in an attempt to increase profits? Economics implies that the higher the expected costs of cheating, the more likely ethical actions will be chosen. This simple principle has several implications.

First, the higher the probability of detection, the less likely an individual is to cheat. This implication helps us understand numerous institutional arrangements for monitoring in the marketplace. For example, a company agrees to have its financial statements audited by an external public accounting firm. This periodic professional monitoring increases the probability of detection, thereby reducing any incentive to misstate the firm's financial condition.

Second, the higher the sanctions imposed if cheating is detected, the less likely an individual is to cheat. Hence, a business transaction that is expected to be repeated between the same parties faces a lower probability of cheating because the lost profits from the forgone stream of future sales provide powerful incentives for contract compliance. However, if continued corporate existence is more uncertain, so are the expected costs of forgone future sales. Therefore firms in financial difficulty are more likely to cheat than financially healthy firms. Firms thus have incentives to adopt financial policies that help credibly bond against cheating. For example, if product quality is difficult to assess prior to purchase, customers doubt a firm's claims about product quality. Where quality is more uncertain, customers are only willing to pay lower prices. Such firms thus have particularly strong incentives to adopt financial policies that imply a lower probability of insolvency.

Third, the expected costs are higher if information about cheating is rapidly and widely distributed to potential future customers. Thus information services like Consumer Reports, which monitor and report on product quality, help deter cheating. By lowering the costs for potential customers to monitor quality, such services raise the expected costs of cheating.

Finally, the costs imposed on a firm that is caught cheating depend on the market's assessment of the ethical breach. Some actions viewed as clear transgressions by some might be viewed as justifiable behavior by others. Ethical standards also vary across markets. For example, a payment that if disclosed in the United States would be labeled a bribe might be viewed as a standard business practice in a third-world market. The costs imposed will be higher the greater the consensus that the behavior was unethical.

Establishing and maintaining a reputation for ethical behavior is a valuable corporate asset in the business community. This analysis suggests that a firm concerned about the ethical conduct of its employees should pay careful attention to potential conflicts among the firm's management, employees, customers, creditors, and shareholders. Consider Sears, the department store giant that was found to be charging customers for auto repairs of questionable necessity. In an effort to make the company more service oriented (in the way that competitors like Nordstrom are), Sears had initiated an across-the-board policy of commission sales. But what works in clothing and housewares does not always work the same way in the auto repair shop. A customer for a man's suit might know as much as the salesperson about the product. But many auto repair customers know little about the inner workings of their cars and thus are more likely to rely on employee recommendations in deciding on purchases. Sears's compensation policy resulted in recommendations of unnecessary repairs to customers. Sears would not have had to deal with its repair shop problems and the consequent erosion of its reputation had it anticipated that its commission sales policy would encourage auto shop employees to cheat its customers.

Clifford W. Smith Jr. is the Epstein Professor of Finance at the University of Rochester's Simon School of Business Administration. He is an advisory editor of the Journal of Financial Economics. His research focuses on corporate financial policy and the structure of financial institutions.

14 PART ONE Overview of Corporate Finance expense? In the following pages, we briefly consider some of the arguments relating to this question.

Agency Relationships

The relationship between stockholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his/her interests. For example, you might hire someone (an agent) to sell a car that you own while you are away at school. In all such relationships, there is a possibility of conflict of interest between the principal and the agent. Such a conflict is called an agency problem.

Suppose that you hire someone to sell your car and that you agree to pay that person a flat fee when he/she sells the car. The agent's incentive in this case is to make the sale, not necessarily to get you the best price. If you offer a commission of, say, 10 percent of the sales price instead of a flat fee, then this problem might not exist. This example illustrates that the way in which an agent is compensated is one factor that affects agency problems.

Management Goals

To see how management and stockholder interests might differ, imagine that the firm is considering a new investment. The new investment is expected to favorably impact the share value, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the stock value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost.

More generally, the term agency costs refers to the costs of the conflict of interest between stockholders and management. These costs can be indirect or direct. An indirect agency cost is a lost opportunity, such as the one we have just described.

Direct agency costs come in two forms. The first type is a corporate expenditure that benefits management but costs the stockholders. Perhaps the purchase of a luxurious and unneeded corporate jet would fall under this heading. The second type of direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess the accuracy of financial statement information could be one example.

It is sometimes argued that, left to themselves, managers would tend to maximize the amount of resources over which they have control or, more generally, corporate power or wealth. This goal could lead to an overemphasis on corporate size or growth. For example, cases in which management is accused of overpaying to buy up another company just to increase the size of the business or to demonstrate corporate power are not uncommon. Obviously, if overpayment does take place, such a purchase does not benefit the stockholders of the purchasing company.

Our discussion indicates that management may tend to overemphasize organizational survival to protect job security. Also, management may dislike outside interference, so independence and corporate self-sufficiency may be important goals.

Do Managers Act in the Stockholders' Interests?

Whether managers will, in fact, act in the best interests of stockholders depends on two factors. First, how closely are management goals aligned with stockholder agency problem

The possibility of conflict of interest between the stockholders and management of a firm.

goals? This question relates to the way managers are compensated. Second, can management be replaced if they do not pursue stockholder goals? This issue relates to control of the firm. As we will discuss, there are a number of reasons to think that, even in the largest firms, management has a significant incentive to act in the interests of stockholders.

Managerial Compensation Management will frequently have a significant economic incentive to increase share value for two reasons. First, managerial compensation, particularly at the top, is usually tied to financial performance in general and oftentimes to share value in particular. For example, managers are frequently given the option to buy stock at a bargain price. The more the stock is worth, the more valuable is this option. In fact, options are increasingly being used to motivate employees of all types, not just top management. For example, in 2001, Intel announced that it was issuing new stock options to 80,000 employees, thereby giving its workforce a significant stake in its stock price and better aligning employee and shareholder interests. Many other corporations, large and small, have adopted similar policies.

The second incentive managers have relates to job prospects. Better performers within the firm will tend to get promoted. More generally, those managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.

In fact, managers who are successful in pursuing stockholder goals can reap enormous rewards. For example, one of America's best-paid executives in 2001 was Sanford Weill of financial services giant Citigroup, who, according to Forbes magazine, made about $216 million. Weill's total compensation over the period 1996-2001 exceeded $750 million. Michael Eisner, head of Disney, earned a not-so-Mickey-Mouse $738 million for the same period. Information on executive compensation, along with a ton of other information, can be easily found on the Web for almost any public company. Our nearby Work the Web box shows you how to get started.

Control of the Firm Control of the firm ultimately rests with stockholders. They elect the board of directors, who, in turn, hire and fire management. The fact that stockholders control the corporation was made abundantly clear by Steven Jobs's experience at Apple, which we described to open the chapter. Even though he was a founder of the corporation and was largely responsible for its most successful products, there came a time when shareholders, through their elected directors, decided that Apple would be better off without him, so out he went.

An important mechanism by which unhappy stockholders can act to replace existing management is called a proxy fight. A proxy is the authority to vote someone else's stock. A proxy fight develops when a group solicits proxies in order to replace the existing board, and thereby replace existing management. For example, in 2001 forest products giant Weyerhaeuser Co. attempted to purchase rival Willamette Industries, but Willamette's management rejected Weyerhaeuser's overtures. In response, Weyerhaeuser launched a proxy battle, and, in a very close contest, succeeded in its attempt to place its nominees on the board.

Another way that management can be replaced is by takeover. Those firms that are poorly managed are more attractive as acquisitions than well-managed firms because a greater profit potential exists. Thus, avoiding a takeover by another firm gives management another incentive to act in the stockholders' interests.

Business ethics are considered at www.business-

ethics.com.

ethics.com.

PART ONE Overview of Corporate Finance

Work the Web

The Web is a great place to learn more about individual companies, and there are a slew of sites available to help you. Try pointing your web browser to finance.yahoo.com. Once you get there, you should see something like this on the page:

'YX&COlFINANCE M

Dow 10167.15 -132.23 (-1.28%)

Nasdaq 1960.70 -00.01 (-3.26%1

S&P300 118042 -18.36 M J3%1

10-YrBond 5272% -0.068

NYSE Volume 1,101,647,000

Nasdaq Volume 1449359D00

Get Quotes 11 Detailed "^symbol lookup

Get Quotes 11 Detailed "^symbol lookup

To look up a company, you must know its "ticker symbol" (or just ticker for short), which is a unique one-to-four-letter identifier. You can click on the "Symbol Lookup" link and type in the company's name to find the ticker. For example, we typed in "PZZA," which is the ticker for pizza-maker Papa John's. Here is a portion of what we got:

There's a lot of information here and a lot of links for you to explore, so have at it. By the end of the term, we hope it all makes sense to you!

Conclusion The available theory and evidence are consistent with the view that stockholders control the firm and that stockholder wealth maximization is the relevant goal of the corporation. Even so, there will undoubtedly be times when management goals are pursued at the expense of the stockholders, at least temporarily.

Stakeholders stakeholder

Someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm.

Our discussion thus far implies that management and stockholders are the only parties with an interest in the firm's decisions. This is an oversimplification, of course. Employees, customers, suppliers, and even the government all have a financial interest in the firm.

Taken together, these various groups are called stakeholders in the firm. In general, a stakeholder is someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm. Such groups will also attempt to exert control over the firm, perhaps to the detriment of the owners.

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  • Selina
    What is agency problem and control?
    8 years ago

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