Corporate Governance: Discussing The Principal-Agent Problem And Mechanisms To Mitigate It

Defining the principal-agent problem

The principal agent problem can be defined as the occurrence of an issue whereby an entity has been given the right to make certain decisions or take certain actions on behalf of the other entity.  The latter entity in the given case is the principal and the formal entity is the agent. However, the main problem arises, when there takes place a dilemma between the two parties when the agent looks out to act in their own interest but on the other hand, the entity seeks to act in the interest of the self in a situation whereby he is required to act in the interest of the principal (Bendickson et al. 2016). This is often taken to be a moral hazard. There are several examples of this kind of a conflict which takes place between the agent and the principal and some of these examples can be stated to be relating to the relationship of the management which acts as an agent and the shareholders who act as the principal. There are also several cases relating to the voters, politicians, markets, brokers and other mechanisms.

 According to Bebchuk, Cohen and Hirst (2017), the main problem in the given scenario arises when the different parties have conflicting interests and the information is asymmetric in nature which means that the information which is held by the management is more than that held by the shareholders, then the shareholders are in a doubt whether the decisions will be made in their favor or not. However, the particular situation cannot be taken to be impossible in nature and there exists various mechanisms which may be used to align the different interests of the agent with that of the principal. The main aim of the report is to highlight the agency problem between the management and the principle and understand it with the help of an example. In addition to this, the different mechanisms available to solve these problems shall also be discussed critically.

According to Bendickson et al. (2016), the Agency problem can be stated to be the conflict of interest which takes place between the managers and the shareholders which may stand in the way of achieving the goal of the maximization of the wealth of the different shareholders.  Tan and Tang (2016) ,states that the Shareholders can be stated to be the Principal in this case who are quite active in nature and the Management in any organization can be stated to be the passive agents. In any scenario, as agreed by Charitou, Louca and Tsalavoutas (2016), the shareholders are the complete owners of the business however, they do not have the capability to manage the different functioning’s of the organization on their own and may be forced to handover the management of the business to the different managers. Moreover, as they are quite large in number and spread in different locations as well, along with lagging the specific qualifications and hence, in this scenario, they have the power to elect the different members of the Board of Directors who will then be managing the firm and thereby delegating the authority.

Concerns for shareholders and management

According to Cumming, Johan and Schweizer (2017), these managers who are hired are required to act on behalf of the firm and protect the wealth invested in by the different shareholders, but very often this is not the case and the different managers generally start acting in their own interest as they are largely concerned with their personal wealth, job security, salary, fringe benefits and the prestige which comes with the job. Hence, this self-centered behavior on their side may lead to a loss of wealth for the different shareholders which then gives rise to a conflict.

Tan and Tang (2016) have argued that although various managers will try and compromise between their own needs and the needs of the shareholders but the agency problem arises because the shareholders would like them to act on their behalf. It has been stated in the concept of shareholder primacy that the business must act in the best interest of the shareholders and was quite prominently proven in Hutton v West Cork Railway Co Ltd (1883) 23 Ch D 654 at 673 per Bowen LJ. I .  De Massis et al. (2016),states that this agency problem is often fueled by the asymmetric information which is available to the managers and hence, the shareholders may be unable to understand the exact situation in hand. This asymmetric information tends to then disperse the power and provide the managers with additional power. Hence, situations like these often impact on the relationship between the shareholders and the company and can thereby lead to a loss to both the firm and the shareholders. In various cases, the shareholders may then hire a third party organization to solve the scenario and hence, the problem may be managed slowly (Nyoni 2015). The following section will discuss two of the problems in detail in order to understand the depth of it along with certain examples.

As discussed earlier, the main reason why the agency problem between the management and the shareholders tend to take place because there exists a conflict of interest between the two parties to the conflict. This means that when a company has shareholders, who have invented a certain sum of money towards the organization, then they expect to gain maximum gains out of the company`s profits in return of the money being invested by them and the risk associated with it. As they do not have the decision making power, they are often not aware about the different issues as well scenarios which takes place between the different parties at large. Hence, due to the money invested, they expect transparency from the firm and when in return they are not provided with this transparency they tend to lose control and end up getting into a conflict with the firm. According to Du Plessis, Hargovan and Harris (2018), things start going downhill when the management starts operating in their own interest. According to the 122(1)(g) of the Insolvency Act 1986 (Eprints.lanc.ac.uk 2018), the managers need to act in accord with the overall welfare of the firm. This means that, the different managers want to keep up with their own prestige and own benefits and for this reason, they may not make considerable use of the profits for shareholder benefits but rather than for their benefits at large. This is where the conflict of interest begins to take place when the shareholders are let into the belief that they are not being treated adequately and their returns are not being provided to them on time.  A similar problem took place with the case of Bernie Madoff whereby they created a slam business which costs their investors a huge sum of money.

Mechanisms to mitigate the principal-agent problem

Stout and Blair (2017), believes that the second kind of problem which may take place is the Principal agent dilemma due to the asymmetric information divided between the management and the shareholders. When the shareholders feel that they are being cheated upon and that the actions of the firm are not inclined in line with the different objectives of the shareholders, they often assign and hire the third party investigators to check the case on their behalf. According to Miller (2005), this is where the dilemma comes into place whereby in majority of the cases the agent is inclined to act in the favor of themselves rather than in favor of shareholders. Moreover, the dilemma also takes place because of the distribution of asymmetric information between the different parties. The managers who are involved in the functioning of the firm may have access to additional information as they are aware of the intricate details of the firm but the other shareholders may not be aware of the specific information available and this is where they may be inclined to act in a moral hazard.

For instance, when the shareholders of an organization appoint certain managers to look after the operations of a firm and earn profits, the shareholders expect that they will be given a considerable share of the profit but the managers believe that they need to lookout for their own growth and profit which then results in a principal agent problem (Mazur and Wu 2016). This is the most common type of principle agent problem. One of the most famous case is the Enron problem whereby he directors ailed to carry out their roles and engaged in an illegal activity which then resulted in the conflict of interest between the shareholders and the directors.

The agency problem which exists between the shareholders and the management is stated to be quite unique in nature and may often result in the fallout and the termination of the different managers which can termed as very critical in nature. For this reason, various mechanisms are available which can be successfully employed by the different shareholders to keep a check on their performance of the different managers in the higher post. These methods have been elucidated in the following section.

Monitoring: Masulis and Reza (2014), states that the monitoring can be stated to be a considerably good way in which the management can keep a check on the different managers and their performance at large. In this mechanism the different shareholders can successfully employ a third party which will then keep a check on the performance of the management of the company where the shareholders have a stake in. However, there are chances that this issue may lead to another agency problem at large and may be only considered when the trust factor between the third party agent and the shareholder is quite high.

Monitoring as a mechanism for mitigation

Control over executive compensation: Another method which can be rightfully considered is to have a strict control over the compensation of the executive board (Martin and Peskowitz 2018). Very often the executive pay is decided by the Human resource department and the senior management themselves, without any involvement of the shareholders and this is the major loophole which is generally created by the executive board. Hence in order to ensure that they take a compensation which is genuine, the shareholders are required to ensure that they are successfully able to keep a check on the compensation having been made to the different board members.

Incentive compensation: In addition to this, in order to maintain ethicality, another solution is to provide an incentive as a compensation to the different board members which shall act as an instigation to perform considerably and maintain transparency into the different operations of the firm. According to Kostova, Nell and Hoenen (2016), the main logic behind the belief is that the different members of the organization often engage in these unethical activities because they are inclined by financial benefits, hence, in order to avoid this, it is crucial that, they are provided with certain financial benefits on top of their pay which will help in keeping the actions of these executive members in check.

Market for corporate control: The market for corporate control can be described as another mechanism which is very often also known as the external corporate control and comes into question when the internal governance of an organization fails (Rezaee, Wood and Gaillard 2017). In such a scenario, these firms are placed into the takeover markets whereby they are required to be taken over by acquirers. Hence, in such a scenario, a major share of the firm might be purchased by the acquirers and then they take control of the board which will ensure that the company share as well as the management stays in their hands. According to Ibrahim, Mathew and Archbold (2018), the acquirers believe that they will be able to manage the particular company well than the top management. Kostova Nell and Hoenen (2016), states that this move as adopted by the management of the firm often acts as a threat to the management of the firm, and they may fear losing out on their position and perform considerably well.

Harford, Wang and Zhang (2017), states that in order to avoid this scenario, the management may take in moves like poison pills or restructuring of assets to safeguard their own wealth as well as employment. The firm which acquires the particular organization, engages in the selection of some executives who may then be offered certain stocks and offers as incentives. Very often, this situation often results in a backslash for the firm whereby the takeover market may not be active and the takeover cannot be carried out in an effective manner.

Control over executive compensation

For instance, the Conrail rail corporation which was an underperformer, became the target for takeover by the CSX Transportation in the year 1997. The takeover company believed that the organization had not been performing well but lying in an attractive market. Hence, in lieu of the deal, the management undertook various poison pills, by giving the shareholders a discount on share purchase (Kostova, Nell and Hoenen 2016). Hence, this resulted in a sense of discouragement for other firms to takeover Conrail.

Conclusion

Therefore, from the given analysis, it can be stated that the agency problem between the agent and the principal is one of the most popular problems which takes place between the shareholders of the firm and the board of management. As the shareholders invest a considerable term of money into the business, they expect complete transparency and aim to ensure that they are given a large share of the profits. However, the managers on the other hand do not believe in the same philosophy and often tend to engage in the personal benefit programs and other initiatives which may not be necessarily beneficial in nature but instead result in a loss for the shareholders. The report highlighted the meaning of the agency problems and defined the meaning of it which was followed by a critical discussion of the agency problem between the shareholders and the managers. This was followed by the two basic types of problems and discussion of theory along with examples. The mechanisms which can be adopted by the shareholders to avoid these problems have been discussed at large which will then assist the different shareholders to look out for their share of money.

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