The Agency Problem

Management-stockholder relations
So long as a company is closely held, the control group and the stockholders are identical and
seldom is there a conflict of interest between them. However, once a company goes public it
acquires a group of shareholders who depend on the management for the safety and profitability
of their investment. In short, an agency principal relation is established where the management is
the agent and the shareholder is the principal. This relation implies a commitment by
management that the outside shareholders will be treated fairly in such matters as cash payouts,
expansion policies, accounting probity, and the level of executive compensation, and that in
general the company affairs will be directed vigorously and conscientiously.
AREAS OF POTENTIAL CONFLICT
Although there is an identity of major interests between shareholders and management, it is
unrealistic not to recognize that these interests are likely to diverge at some important points.
Usually, the conflicts are only potential, and the corporate policy (especially if the firm has good
earnings) can easily accommodate the differing economic positions of the two groups.
1. Managerial and Board of Directors Compensation
A strongly entrenched management is able, within wide limits, to set its own compensation.
Obviously the higher the officer and executive salaries the smaller the earnings available for the
common shareholders. On the other hand, a level of managerial compensation that moves up
with improved company earnings provides incentives for top-notch performance. If a firm
wishes to attract exceptional administrative talent, it has to offer a competitive economic reward.
Nevertheless, at some point the boundary is crossed between sufficient and too much. The gist of
agency theory deals with the construction of a compensation or reward system so that the
interests of the agent (the management) largely coincide with those of the principal (the
shareholders). It is possible for inside owners and managers to enhance their personal enjoyment
and wealth at the expense of the outside shareholders. Beneath the froth and turmoil, the basic
question remains: how is corporate governance to be structured and how is management to be
paid so that its interests coincide with the long-run prosperity of the shareholders?
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2. Board of directors compensation

Shareholders should look at the directors cash pay and be wary when the cash compensation of
the directors seems too high, compared to other directors pay in the same industry. If the pay is to
high, the directors are unlikely to question or scrutinize any managerial report, since their job
would have become too precious to them.
Of course, the board should be rewarded. They have an important balancing function within the
governing framework of the corporation. However, their current annual cash pay and the
accompanying perks should be moderate. Their major compensation should be an award of
substantial amounts of common stock, restricted, not saleable for five years or after retirement
whichever comes later. Compensation in the form of restricted shares would focus the directors
on the interests of the long run stockholders. The board should be concerned about helping shape
policies for a viable firm which generates a satisfying return for its shareholders over time.
3. Stock options
The stock option entitles the holder to buy shares in the near future at a fixed price which is set
below the forecasted market. Presumably, the option ties the managers to the shareholders
interest of maximizing the value of the companys stock. However if the stock option is short
term, it fixes the managers attention on the short term horizon. Unfortunately, the most lucrative
way to cash in on an option is to manipulate the books, defer expenses and anticipate revenues,
so that the market is fooled and the price of the shares rises sharply just at the time the manager
prepares to sell his option
Moreover, the shareholders may fail to realize how much economic value they may be allowing
to the management in the form of stock options. Because no asset leaves the company nor is any
explicit liability created, the corporations accounts do not register the impact of the option. Yet
these options represent a potential dilution of the equity of the shareholders, and if the number of
shares under option is a large enough fraction of the total shares outstanding, exercising the
option could reduce the earnings per share. The existence of the options can act as a drag on the
potential appreciation of the common stock.
Worse yet is the case where large options and saleable shares are granted to a top manager just
before his retirement. The manager would be happy if financial activities could be manipulated
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so that the stock reached the high point at the time of his leaving and it wouldnt matter if this
price was not likely to be supported by the market over any length of time as the disaster would
come after the manager has gone!
4. Dividends and Retained Earnings
The theoretical value of a common stock is the discounted value of its future cash dividends and
net buybacks over purchase price plus a possible final sale or liquidation value. Since the present
value of a future dividend or buy back cannot equal that of the immediate payments, the current
level of buybacks and dividends is important in setting the intrinsic value of the stock
Stockholders are, therefore, extremely interested in the managements dividend or buy back
policies. Retained earnings have value to the stockholder only as they can be invested profitably
at a rate of return within the company that at a minimum equals the market equity discount rate
and thereby generates increased earnings and future dividends. Management may evaluate the
importance of dividends or buy backs versus retained earnings differently than the shareholders.
Usually management obtains more of its current income from salaries and bonuses than from the
cash throw off on the shares it may hold. Salaries are likely to continue as long as the firm is
operating. Retained earnings appear to be a source of capital carrying little obligation. Its use
increases the safety and survival chances of the firm. To a conservatively oriented management,
keeping the firm alive (and assuring continuing salaries) may appear more worthwhile than
keeping the return on the shareholders investment as high as possible.
A conflict between the stockholders and the company officers over the level of retained earnings
can also arise if the managements time preference for future income differs from that of the
shareholders. Or the management may be stingy with cash outflow because it overestimates the
relative profitability of investment in the company with the alternatives open to the shareholders
in other areas of the economy.
5. Excessively Conservative Financial Structure
An excessively conservative financial structure has a disproportionate amount of equity
financing and relatively little debt. Of course, the degree of conservatism, or risk, in the financial

structure must be judged in the light of risks the firm faces. An overly conservative asset
structure contains a high proportion of liquid, low-earning assets in relation to the needs of
the business. Quite possibly a company could have both an ultraconservative asset structure and
an excessively conservative financial structure. Both conditions are the results of a timorous or
greedy management.
An extremely conservative financial structure may develop if all financing is accomplished
through new common stock issues. An ultra-conservative financial structure results if internally
generated funds are used to finance the firm to the exclusion of other sources. A financial
structure containing a minimal debt component relieves the management of the fear of failure;
however, it raises the cost of capital to the firm. Stockholders are deprived of the extra profits
that would accrue through the use of judicious leverage.The firm should carry some debt as a
matter of principle, since it is a constant reminder to the management that there is a cost of
capital. The effort and planning required to service the debt should help to keep the managers
from becoming complacent.

6. Expansion
In the shareholders view, expansion is worthwhile when it increases their reinvested returns.
The use of retained earnings to finance expansion is justified when the company can make the
going rate of return on equity on these funds. If the management, however, is not sufficiently
concerned about the stockholders, it may pursue expansion for the economic or the psychological
rewards that corporation officers receive simply from being associated with a larger firm. The
shareholders may well feel that the basic objective of the corporation is sacrificed if the
management follows a policy of dry or profitless expansion.
In many instances dry expansion is a further reflection of the failure of some corporation
administrations to recognize the implicit cost of retained earnings. The company may have a
consistently low dividend payout rate and fail to find profitable outlets for its funds. Yet the
management may be content because it feels that nothing need be paid on the surplus portion
of the equity. In other cases, the management may tend to overrate investment opportunities in its
own firm, or it may do its shareholders a disservice by acquiring subsidiaries at costs which their
earnings potential do not justify.
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The managements interests and the welfare of the shareholders are not equally served if the
company officers bring about profitless company growth purely in order to enhance management
prestige, to raise managerial perquisites, or to assuage their power drives.
7. Liquidating or Selling the Firm
The natural desire of the company officers to continue operations conflicts with the interests of
the shareholders if the foreseeable returns for the firm are not sufficient to cover the value of the
capital which can be withdrawn from the firm. The situation is, of course, similar if the company
or its assets can be sold as a unit for an amount exceeding the sum of the going market price of
its securities. Because a voluntary liquidation or sale eliminates executive incomes, it may well
meet with management resistance.
8.

Risky acquisitions

In contrast to a conservative management, a very speculative management may attempt to make

a quick fortune by making many rapid acquisitions, obtaining new properties with debt
financing, and mortgaging or leveraging the original company to the hilt. Such speculative
activities can bring great immediate gains for all, or it can result in the loss of the original equity
values in what might have been at the start a small but solid company. The shareholders cannot
legitimately complain if they knowingly accept these ventures. However, if the risk-taking
proclivities of the management are covered by deceptive practices, the shareholders may
have just reason to believe their interests had been breached.

DEALING WITH THE AGENCY PROBLEM

What can the stockholder do if his management seems incompetent or flouts his basic economic
interests? A number of alternatives have been suggested, although none of them appear to be
entirely successful.
1) managerial compensation:

Managers can be encouraged to act in stockholder's best interests through rewards which reward
them for good performance but punish them for poor performance. the compensation package
should be designed to meet two objectives:
1) to attract and retain capable managers, and
2) to align managers' actions with the interest of shareholders.
This can be achieved if compensation is linked to the managers' performance, eg
Annual bonus is based on firm's profitability.
Management receives a certain number of performance shares if the
company achieves predefined performance benchmarks.
Executive stock options may be granted based on the firm's market value of its
shares relative to other firms in the same industry.
direct intervention by shareholders: as the majority of stocks are often owned by
institutional investors such as insurance companies, pension funds, and mutual funds,
institutional investors can act as lobbyists for the body of shareholders and exercise
considerable influence over most of the firm's operations. Also any shareholders with
more than 1,000 shares can sponsor a proposal to be voted at annual shareholders'
meeting.
2) stockholder remedies
What can the stockholder do if his management seems incompetent or flouts his basic economic
interests? A number of alternatives have been suggested, although none of them appear to be
entirely efficacious.
Institute a Stockholder Suit A stockholder suit is valid only if the management has been guilty
of breaching its quasi-fiduciary position. The possibility of a suit serves only to remind the
management of the limitation of its powers.
Attend and Vote at Annual Stockholders Meetings The vast majority of shareholders do not
attend the annual meetings. But, contrary to common belief, it is possible (assuming a
responsive management) to have considerable influence at these meetings. Intelligent, incisive

questions force the management to consider their policies carefully. Independent stockholder
proposals can be submitted at the annual meetings.
Organize a Proxy Fight to Vote Out the Management (ie threat of firing) If the stockholders
are sufficiently outraged by the management, they may attempt to vote in a new board of
directors who will appoint a new management at the shareholders annual meeting. The
shareholders can succeed only if they can enlist a majority of the voting stock in his campaign.
Although the management's control over the voting mechanism is strong, they can still be
ousted directly or indirectly (such as a resignation).
the threat of takeovers: hostile takeovers are most likely to occur when a firm's stock is
undervalued relative to its potential because of poor management. The shareholders can simply
sell off their shares to a potential acquirer who can replace management with their own
management team.