Agency theory: management versus stockholders
Agency theory deals with the conflict of interest between managers and shareholders. We may
think of managers as agents of the owners. Stockholders delegate decision-making authority to
managers on the condition that the agents will act in the stockholders’ best interest. However, it
18 INTRODUCTION
has often been argued that the objectives of managers may differ from those of the firm’s stockholders.
Because the stockholders of most MNCs today are well diversified, the control of these
companies is separated from ownership. This situation allows managers to act in their own best
interest rather than in the best interest of the stockholders. Thus, some managers may be concerned
with their own welfare, such as their own income, power, self-esteem, and prestige. The
welfare of managers, therefore, could be increased by management decisions that tend to lower
stockholder wealth.
To ensure that managers act in the best interest of the stockholders, the managers must be
monitored and rewarded with appropriate incentives. Incentives could include stock options,
bonuses, and perquisites. Monitoring can be carried out by reviewing management perquisites,
auditing financial statements, and limiting management decisions. Agency costs include incentives
and monitoring costs. It is reasonable to assume that managers will undertake actions that
are relatively consistent with stockholder wealth maximization. This is because over the long run,
their own goals, including survival, will largely depend on the value of the firm.
In this text, we explain the issues and concepts of international finance as though managers
act on behalf of the firm’s stockholders. Nevertheless, the size of some MNCs can make it difficult
to determine whether all managers make decisions on the basis of this single corporate objective
– stockholder wealth maximization on a global basis. For example, financial managers of
MNCs with many subsidiaries may be tempted to make decisions that would maximize the value
of their respective subsidiaries at the expense of their parent company. Consequently, the agency
costs of assuring that managers try to maximize stockholder wealth can be larger for MNCs than
for purely domestic companies.
Corporate governance
Few issues in the literature and in practice on corporate finance have received as much attention
in recent years as corporate governance. In the USA and in other countries, there is new interest
in how firms’ decision-making structures are organized, the priorities of these structures, and
the structures’ effect on shareholders. Corporate governance refers to the way in which
major stakeholders exert control over operations of a company. The rights of the company’s stakeholders
in corporate governance are determined by each nation’s laws, legal institutions and conventions,
and regulations. However, corporate governance is often narrowly defined as the
prudent exercise of ownership rights toward the goal of increased shareholder value (Gillan &
Starks 1998). In the USA, corporate governance has evolved from a system with a few yet influential
individual investors around the turn of the last century to the present environment in
which large institutional investors flex their shareholder muscle. Institutional investors include
pension funds, mutual funds, university and other nonprofit endowments, and insurance
companies.
Today, large institutional investors actively encourage effective corporate governance practices
to maximize their investment returns. Major corporate governance issues include board independence,
executive compensation, and anti-takeover devices. Unlike other stakeholders that have
dealings with the corporation – customers, suppliers, lenders, and labor – common shareholders
do not have contractual protection of their interests. Thus, shareholder activism is an important
part of corporate governance to ensure that managers take actions to mitigate agency
problems (conflicts) and thus increase shareholder value.
SHAREHOLDER ACTIVISM Any activity by an investor that tries to change the status quo
through voice, without the control of the company, is known as shareholder activism. The voice
reflected in the most common form of shareholder activism covers a broad spectrum of activities,
such as a shareholder proposal for proxy fight, direct negotiation with management, and
public targeting of a corporation.
Proxy represents the assignment of the voting right to management or a group of outsiders.
If earnings are poor and stockholders are dissatisfied, an outside group may solicit the proxies in
an effort to overthrow management and take control of the business. This is known as a proxy
fight. When performance analysis reveals problems with a company’s governance practices, shareholders
will directly negotiate with management for needed changes in the company’s practices
and policies. Public targeting is the use of media to send information to other investors about
the problems and needed changes at a company. The issues addressed by these voice activities
span a wide range of topics, but most often pertain to issues of social policy or corporate governance
reform.
CHANGES IN CORPORATE GOVERNANCE Since 1980, a number of changes have made US managers
more responsive to the interests of shareholders. These changes include a more active
takeover market, an increased usage of executive incentive plans that increase the link between
management performance and corporate performance, and more active institutional shareholders,
who have demonstrated a growing tendency to vote against management (Grinblatt &
Titman 1998). In addition, as one corporate scandal after another broke in 2002, President
George W. Bush signed into law the Sarbanes–Oxley Act on July 30, 2002, which would likely
reduce agency problems (Nofsinger & Kim 2003).
First, the threat of a hostile takeover for inefficiently managed companies tends to encourage
managers to make decisions that enhance stockholder wealth. Other companies are more likely
to acquire undervalued companies at a low price and might layoff existing managers.
Second, these days many companies partially compensate their executives with stock options
that encourage managers to make decisions that maximize their company’s stock price. Stock
options and other types of incentive plans such as bonuses are designed to increase the link
between management performance and corporate performance.
Third, institutions have become more active as shareholders and have compelled managers to
act in the stockholders’ best interest. Increased shareholder activism by institutions has occurred
at the same time as the rapid increase in institutional investor holdings during the past two
decades. These holdings have grown from approximately one-quarter of US equity markets in
1980 to over one-half today. Two rule changes in the early 1990s by the US Security and
Exchange Commission have also sparked the active role of institutional investors. The first
change, which required complete disclosure of executive compensation packages, put managers
under greater pressure to perform up to their level of compensation. The second change made
it easier for shareholders to get information about other shareholders and reduced the cost of
staging a proxy fight.
Fourth, a series of recent accounting scandals at companies such as Enron and WorldCom
compelled the government to introduce a host of new laws and regulations so that managers may
not pursue their own private interests at the expense of shareholders. For example, the Public
Company Accounting Reform and Investor Protection Act of 2002, otherwise known as the
Sarbanes–Oxley Act, sets up a new overseeing body to regulate auditors, creates new laws to
increase corporate responsibility, and increases punishments for corporate white-collar criminals.
The Act establishes a nonprofit organization called the Public Company Accounting Oversight
20 INTRODUCTION
Board to oversee the audit of public companies and to protect the accuracy of audit reports.
These and other reforms introduced after recent corporate scandals are expected to strengthen
US corporate governance practices.
NATIONAL DIFFERENCES IN CORPORATE GOVERNANCE Although national legal systems in
industrialized countries share many common elements, laws for corporate governance have
notable differences. The UK and the USA are often viewed as prototypes of a market-oriented
financial system (the AS model), whereas Continental Europe (France and Germany) and Japan
are generally regarded as typical representatives of a bank- or relationship-based system (the CEJ
model).
In AS countries, institutional investors make up an important part of the financial system. In
CEJ countries, banks represent the most important part of the financial system. Equity finance
is important in AS countries, and institutional shareholders exert a great deal of corporate control.
The accepted objective of the AS model is to maximize shareholder value. In 1998, an international
advisory panel to the Organization for Economic Cooperation and Development (OECD)
endorsed shareholder value maximization as the primary goal of companies. On May 27, 1999,
the OECD officially adopted “OECD Principles of Corporate Governance” recommended by
its advisory panel. Consequently, corporate policies throughout the world are now undertaken
with more awareness about their impact on the stock price. Other countries have just begun to
adopt American-style corporate governance practices in an effort to force local companies to make
decisions that would satisfy their respective stockholders.
OECD Principles of Corporate Governance are intended to achieve two goals. The first goal
is to assist member and nonmember governments in their effort to improve the legal, institutional,
and regulatory framework for corporate governance in their countries. The second goal
is to provide guidance and suggestions for stock exchanges, investors, corporations, and other
parties that have a role in the process of developing good corporate governance. The document
for the OECD Principles of Corporate Governance covers five areas: (1) the rights of shareholders,
(2) the equitable treatment of shareholders, (3) the role of stakeholders, (4) disclosure
and transparency, and (5) the responsibilities of the board.
Although securities markets are more important in market-based systems, banks are prominent
in both systems. A crucial distinction concerns the roles that banks play. In AS countries,
banks are one of many sources of external finance for companies. They compete with bond and
commercial paper markets, along with markets for equity, to provide funds to companies. And
bank loans are typically provided through arm’s-length market transactions. In CEJ countries,
particularly in Japan, banks are the main source of funds for many companies and thus take an
active role in monitoring the decisions of the borrowing firm’s management. The influence
of Japanese banks is further enhanced by their stock ownership. In contrast with the USA,
Japanese banks can hold common stock up to 5 percent of a company’s shares. In addition, the
large cross-holdings of Japanese firms make corporate decision-making heavily influenced by close
personal relationships between top executives, who sit on each other’s boards of directors.
Individual shareholders have little voice and this results in relatively low return on capital.
Agency theory deals with the conflict of interest between managers and shareholders. We may
think of managers as agents of the owners. Stockholders delegate decision-making authority to
managers on the condition that the agents will act in the stockholders’ best interest. However, it
18 INTRODUCTION
has often been argued that the objectives of managers may differ from those of the firm’s stockholders.
Because the stockholders of most MNCs today are well diversified, the control of these
companies is separated from ownership. This situation allows managers to act in their own best
interest rather than in the best interest of the stockholders. Thus, some managers may be concerned
with their own welfare, such as their own income, power, self-esteem, and prestige. The
welfare of managers, therefore, could be increased by management decisions that tend to lower
stockholder wealth.
To ensure that managers act in the best interest of the stockholders, the managers must be
monitored and rewarded with appropriate incentives. Incentives could include stock options,
bonuses, and perquisites. Monitoring can be carried out by reviewing management perquisites,
auditing financial statements, and limiting management decisions. Agency costs include incentives
and monitoring costs. It is reasonable to assume that managers will undertake actions that
are relatively consistent with stockholder wealth maximization. This is because over the long run,
their own goals, including survival, will largely depend on the value of the firm.
In this text, we explain the issues and concepts of international finance as though managers
act on behalf of the firm’s stockholders. Nevertheless, the size of some MNCs can make it difficult
to determine whether all managers make decisions on the basis of this single corporate objective
– stockholder wealth maximization on a global basis. For example, financial managers of
MNCs with many subsidiaries may be tempted to make decisions that would maximize the value
of their respective subsidiaries at the expense of their parent company. Consequently, the agency
costs of assuring that managers try to maximize stockholder wealth can be larger for MNCs than
for purely domestic companies.
Corporate governance
Few issues in the literature and in practice on corporate finance have received as much attention
in recent years as corporate governance. In the USA and in other countries, there is new interest
in how firms’ decision-making structures are organized, the priorities of these structures, and
the structures’ effect on shareholders. Corporate governance refers to the way in which
major stakeholders exert control over operations of a company. The rights of the company’s stakeholders
in corporate governance are determined by each nation’s laws, legal institutions and conventions,
and regulations. However, corporate governance is often narrowly defined as the
prudent exercise of ownership rights toward the goal of increased shareholder value (Gillan &
Starks 1998). In the USA, corporate governance has evolved from a system with a few yet influential
individual investors around the turn of the last century to the present environment in
which large institutional investors flex their shareholder muscle. Institutional investors include
pension funds, mutual funds, university and other nonprofit endowments, and insurance
companies.
Today, large institutional investors actively encourage effective corporate governance practices
to maximize their investment returns. Major corporate governance issues include board independence,
executive compensation, and anti-takeover devices. Unlike other stakeholders that have
dealings with the corporation – customers, suppliers, lenders, and labor – common shareholders
do not have contractual protection of their interests. Thus, shareholder activism is an important
part of corporate governance to ensure that managers take actions to mitigate agency
problems (conflicts) and thus increase shareholder value.
SHAREHOLDER ACTIVISM Any activity by an investor that tries to change the status quo
through voice, without the control of the company, is known as shareholder activism. The voice
reflected in the most common form of shareholder activism covers a broad spectrum of activities,
such as a shareholder proposal for proxy fight, direct negotiation with management, and
public targeting of a corporation.
Proxy represents the assignment of the voting right to management or a group of outsiders.
If earnings are poor and stockholders are dissatisfied, an outside group may solicit the proxies in
an effort to overthrow management and take control of the business. This is known as a proxy
fight. When performance analysis reveals problems with a company’s governance practices, shareholders
will directly negotiate with management for needed changes in the company’s practices
and policies. Public targeting is the use of media to send information to other investors about
the problems and needed changes at a company. The issues addressed by these voice activities
span a wide range of topics, but most often pertain to issues of social policy or corporate governance
reform.
CHANGES IN CORPORATE GOVERNANCE Since 1980, a number of changes have made US managers
more responsive to the interests of shareholders. These changes include a more active
takeover market, an increased usage of executive incentive plans that increase the link between
management performance and corporate performance, and more active institutional shareholders,
who have demonstrated a growing tendency to vote against management (Grinblatt &
Titman 1998). In addition, as one corporate scandal after another broke in 2002, President
George W. Bush signed into law the Sarbanes–Oxley Act on July 30, 2002, which would likely
reduce agency problems (Nofsinger & Kim 2003).
First, the threat of a hostile takeover for inefficiently managed companies tends to encourage
managers to make decisions that enhance stockholder wealth. Other companies are more likely
to acquire undervalued companies at a low price and might layoff existing managers.
Second, these days many companies partially compensate their executives with stock options
that encourage managers to make decisions that maximize their company’s stock price. Stock
options and other types of incentive plans such as bonuses are designed to increase the link
between management performance and corporate performance.
Third, institutions have become more active as shareholders and have compelled managers to
act in the stockholders’ best interest. Increased shareholder activism by institutions has occurred
at the same time as the rapid increase in institutional investor holdings during the past two
decades. These holdings have grown from approximately one-quarter of US equity markets in
1980 to over one-half today. Two rule changes in the early 1990s by the US Security and
Exchange Commission have also sparked the active role of institutional investors. The first
change, which required complete disclosure of executive compensation packages, put managers
under greater pressure to perform up to their level of compensation. The second change made
it easier for shareholders to get information about other shareholders and reduced the cost of
staging a proxy fight.
Fourth, a series of recent accounting scandals at companies such as Enron and WorldCom
compelled the government to introduce a host of new laws and regulations so that managers may
not pursue their own private interests at the expense of shareholders. For example, the Public
Company Accounting Reform and Investor Protection Act of 2002, otherwise known as the
Sarbanes–Oxley Act, sets up a new overseeing body to regulate auditors, creates new laws to
increase corporate responsibility, and increases punishments for corporate white-collar criminals.
The Act establishes a nonprofit organization called the Public Company Accounting Oversight
20 INTRODUCTION
Board to oversee the audit of public companies and to protect the accuracy of audit reports.
These and other reforms introduced after recent corporate scandals are expected to strengthen
US corporate governance practices.
NATIONAL DIFFERENCES IN CORPORATE GOVERNANCE Although national legal systems in
industrialized countries share many common elements, laws for corporate governance have
notable differences. The UK and the USA are often viewed as prototypes of a market-oriented
financial system (the AS model), whereas Continental Europe (France and Germany) and Japan
are generally regarded as typical representatives of a bank- or relationship-based system (the CEJ
model).
In AS countries, institutional investors make up an important part of the financial system. In
CEJ countries, banks represent the most important part of the financial system. Equity finance
is important in AS countries, and institutional shareholders exert a great deal of corporate control.
The accepted objective of the AS model is to maximize shareholder value. In 1998, an international
advisory panel to the Organization for Economic Cooperation and Development (OECD)
endorsed shareholder value maximization as the primary goal of companies. On May 27, 1999,
the OECD officially adopted “OECD Principles of Corporate Governance” recommended by
its advisory panel. Consequently, corporate policies throughout the world are now undertaken
with more awareness about their impact on the stock price. Other countries have just begun to
adopt American-style corporate governance practices in an effort to force local companies to make
decisions that would satisfy their respective stockholders.
OECD Principles of Corporate Governance are intended to achieve two goals. The first goal
is to assist member and nonmember governments in their effort to improve the legal, institutional,
and regulatory framework for corporate governance in their countries. The second goal
is to provide guidance and suggestions for stock exchanges, investors, corporations, and other
parties that have a role in the process of developing good corporate governance. The document
for the OECD Principles of Corporate Governance covers five areas: (1) the rights of shareholders,
(2) the equitable treatment of shareholders, (3) the role of stakeholders, (4) disclosure
and transparency, and (5) the responsibilities of the board.
Although securities markets are more important in market-based systems, banks are prominent
in both systems. A crucial distinction concerns the roles that banks play. In AS countries,
banks are one of many sources of external finance for companies. They compete with bond and
commercial paper markets, along with markets for equity, to provide funds to companies. And
bank loans are typically provided through arm’s-length market transactions. In CEJ countries,
particularly in Japan, banks are the main source of funds for many companies and thus take an
active role in monitoring the decisions of the borrowing firm’s management. The influence
of Japanese banks is further enhanced by their stock ownership. In contrast with the USA,
Japanese banks can hold common stock up to 5 percent of a company’s shares. In addition, the
large cross-holdings of Japanese firms make corporate decision-making heavily influenced by close
personal relationships between top executives, who sit on each other’s boards of directors.
Individual shareholders have little voice and this results in relatively low return on capital.
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