Shareholder and Manager Agency Relationship - Case Study Example

Running header: Agency Problems Student’s name: Instructor’s name Subject code: Date of submission Executive summary This paper looks at the agency problem that arises between managers as the agents and the shareholders as the principal. In this regard, the paper argues that organizations should adopt bonus payment and equity based incentives in their attempt to solve risk aversion problems and horizon problem. The paper also discusses the role of non-salary component in resolving the agency problems. The paper also notes that though managers would prefer short term cash pay incentives, shareholders would prefer otherwise and hence a compromise has to be made. In conclusion, the paper argues that whatever compensation scheme is adopted, it should be in the best interests of all the parties concerned. Table of Contents Executive summary 2 Table of Contents 3 Introduction 4 Risk Aversion 4 The horizon problem 6 Non salary component of management compensation 7 Short-term cash over long-term equity bonuses 8 Why shareholders might choose to vote against reports with too high a proportion of pay as short term cash bonuses rather than long-term incentives 9 Conclusion 10 References: 11 Agency Problems Introduction An agency relationship occurs when a principal hires an agent to perform duties on his behalf. Out of this relationship, agency problems may arise as a result of conflict of interest between the principal’s needs and those of the agent. In business, there are mainly two agency relationships including that between managers and stakeholders and managers and creditors. In the case of managers and stakeholders, the manager may act on his best interest while disregarding the shareholders’ interests. In this regard, agency problems include risk aversion by the managers as well as horizon problems among others. In their bid to resolve the agency problems, managers are given incentives which may be short term or long term. This paper is an overview of the agency problems and the steps that organizations take in their bid to resolve this problem. Risk Aversion One of the problems in the shareholder/manager agency relationship that pay contracts are designed to overcome is the risk aversion problem. Simply put, the problem of risk aversion in this case refers to the tendency by the agents who when faced with two investments with similar or differing expected returns would prefer the one with lower risk. In this case, the agent/the manager would stay away from making high risk investments which the shareholders would prefer even with the knowledge of the fact that when the risk is high, the returns would also be high and this would be of greater benefits to the shareholders who are interested in high returns from their investments (Balsam, 2011). In other words, Shareholders generally accept that the higher the risk, the higher the potential return. However, managers differ from this view since they are willing to take less risk for the company as this is normally a key source of income for them. Should they continue to take less risky projects, this will lead to lower returns or profits which are not in the shareholders’ interests. The agents/managers being risk averse would be reluctant to accept investment proposals from the shareholders with uncertain payoffs as opposed to investing shareholders’ funds in investments that have higher levels of certainty though with probably lower expected payoffs. For instance, such managers would prefer investing shareholders’ funds in projects that have high returns in the short run whose returns are more certain to be realized as opposed to investing in projects that would have lower returns initially and which also have huge capital outlay but whose returns would be enjoyed for a longer time. For instance, given the opportunity to invest in government bonds or in oil prospecting, such managers would prefer to invest in government bonds rather than in oil prospecting. Investing in government bonds would be more certain and the risk is almost negligible since the government will certainly pay both the principle and the interest. However, investing in oil prospecting is highly risky given the huge capital outlay and the uncertainty of the findings, however, should the prospecting be successful, and the shareholders stand to gain a great deal (Amir and Senbet, 1985). For the risk averse manager, investing in government bonds is better as long as their incentives are assured. On the other hand, shareholders would prefer investing in the more risky project that assures them of greater returns in future. As such, the risk aversion problem arises from the fact that the manager/agent would like to undertake projects with less or no risks but obviously with lower returns as opposed to the shareholders/principal who would prefer that the agent/manager undertake projects with high risk but with high rate of return. As explained above, an agency problem between the shareholders/principal and the managers /agent exist where the manager is risk averse. As such, if the shareholders are to overcome these risk aversion problems and hence enjoy the benefits associated with taking risks, the contract between the two parties should be designs in such a way that it reduces risk aversion. In this regard, the pay contracts ought to be structured in a way that both the shareholders/principal and the manager/agent share in the risks as well as the benefits that would emanate from such risky investments (Fade, 2012). In this regard, it should be clear to the manager that he stands to lose nothing from undertaking the risky project as long as he/she acts in good faith. Such a pay contract should then be structured such that the agent/manager gains from the success of the contract through inclusion of a bonus portion in the pay contract. In this regard, the manager will act in good faith and implement such high risk projects in the hope that when the company’s earnings rise, the manager will also benefit from earning a higher amount of bonus since bonus are generally pegged on the company’s earnings. In addition, such a pay contract should also ensure that the manager feels part of the company. This will ensure that he/she acts in good faith by ensuring implementation of projects that will give the biggest benefit to the company though the risk be high. In this regard, the shareholders can opt to give some shares to the manager since this will make the manager also want to improve his returns from the company in the long run. When he knows he can expect higher dividends in the long run, the manager will avoid being risk averse and act in a way that increases such returns. In essence, in a bid to deal effectively deal with the risk aversion problems, the pay contract should be structured such that it incorporates both bonus and equity components. Provision of bonus (Remuneration packages) that is linked to accounting earnings would be an incentive to managers taking higher risks in a bid to achieve higher bonuses. The horizon problem Horizon problem arises when the managers view the organization from a short term perspective as opposed to a long term perspective. In this regard, the managers would be interested in the success of the organization as long as they are managing it preferably in their interest to secure what they are earning from the company. This problem is thus magnified when managers have an expectation of staying with the company for a short period of time and are thus only concerned with the company’s performance as long as they are managing it. It means they do not have interest in its survival after they leave it and thus the decision they make currently may hurt the company’s survival after they leave it. Horizon problem is actually a bigger problem when decisions made by the manager affect the performance of the organization after they manager retires or leaves the organization. This is especially so if the manager is paid on the basis of current performance and as such he/she would have no incentive for caring about the firm’s performance after he/she has retired. This means that at the bare minimum, the manager has no incentive for investing in projects where the payback would begin after he retires or leaves the company. This is in line with Dechow and Sloan (1991) findings that an investment in research and development decreases when CEO’s near their retirement. As such, there is the need to structure managerial payment in such a way that it is based on stock performance after they retire. This would enable them adapt a long-term horizon of the company. According to Drever et al (2007), Horizon problem can be avoided by ensuring the manager has a longer-term view which could be induced by linking their bonuses to the share price or rewarding them in the form of shares. The equity pay option is deferred compensation since the manager will still earn dividends even after he/she leaves the organization. As such, he/she would have interest in continuing to earn good dividends even after he has left the organization and as such he will engage in activities that will ensure that this happens. As such, equity pay acts as an effective tool in reducing horizon problems. Accounting information plays a vital role in specifying the contractual terms of bonus plans designed to reduce the horizon problems. This is because the kind of activities that the organization involves itself in will greatly determine its future performance. As such, the managers with a long-term view of the organization will give financial reports that ensure the company’s long-term financial stability. On the other hand, financial information can also be used to depict a manager with a short term horizon of the organization based on the kind of financial information reported. Non salary component of management compensation As can be depicted from the case, the top 100 companies use range non salary components in their management compensation packages. These non-salary components in executive pay arrangement are vital to the shareholders and to the managers as they act to minimize the agency problems as discussed above. As such, there are many types of non-salary compensation components that are designed to motivate the managers to act in the best interests of the organization/ shareholders depending on the kind of agency problem they are supposed to tackle. These non-salary components include short term incentives such as bonuses and together with salaries they are known as total cash compensation (TCC). These short term incentives are formula driven and have a performance criteria attached to them which depends on the role that the executive plays within the organization. For instance, the sales director may have a short term performance incentive that is a bonus based on incremental revenue growth turnover. On the other hand, a CEO’s incentive may be based on the organization’s revenue growth as well as profitability. In this regard, the incentives are aimed at boosting the company’s performance in the short run by boosting sales and profitability (Hansmann and Kraakman, 2004). On the other hand, long term incentives such as equity options and long-term bonuses are aimed at motivating the management to have a long-term horizon of the company as discussed above. In other words, they are supposed to make the management feel part and parcel of the organization and hence act in its best interest by engaging in activities that enhance its long-term survival even after they have left the company. For instance, a manager who has been given stocks in the company will work hard to ensure that the company pays good dividends in the future since he/she will also benefit. In addition, he/she will also want the company to invest in high risk projects that ensures increased dividends in the future as opposed to short-lived current financial gains. This is in the best interest of the shareholders. In other words, the non-salary components of management compensation packages are aimed at aligning management’s actions to the corporate vision hence overcoming the various agency problems including risk aversion and horizon problems among others. In the long run, this translate to better performance and hence profitability which is in line with the best interests of both the agents and the principals. Short-term cash over long-term equity bonuses As stated above, organizations may either use short term or long-term incentives or a combination of both in motivating the management to act in the best interest of owners. However, while the owners may prefer the executive to be compensated using long-term incentives, managers prefer short term cash over long-term equity bonuses. The reason behind this is that they are more certain of the company’s performance and hence of their incentives when they are in the helm as opposed to when they leave the company. As the saying goes, a bird in hand is worth nine in the bush. Short term cash incentives are more certain to come since they are paid in the current period and they motivate the managers to work very hard in a bid to earn them. On the other hand, the long-term equity bonuses are not certain to come. For instance they are more subject to effects of environmental changes such as economic crisis that affects the company’s performance. When such a scenario happens, the company will almost certainly not pay dividends in future. Similarly, if a subsequent manager defrauds the company and it leads to its liquidation, the manager will lose the above benefits (Huang, 2008). This would not be the case if the manager had already benefited from the short term incentives. With short term incentives, the manager would be completely detached from the company once he leaves or retires. On the other hand, any inappropriate act by the manager affecting the company’s future performance would still come to haunt the manager long after he/she leaves the company in the case of long-term equity bonuses. However, this does not align with shareholders’ interests. To the shareholders, the managers should be given long-term incentives which will make them feel part and parcel of the company thus making them work in the company y’s best interests in the long run. To the shareholders, the short cash pay incentives would only make the manager have a short term view of the company. This would make him/her detached to the company’s future performance and hence with no incentive to make him care about the company’s future after he/she leaves the company. Why shareholders might choose to vote against reports with too high a proportion of pay as short term cash bonuses rather than long-term incentives Shareholders of Australian entities have the ability to vote to show either their support or dissatisfaction with company’s remuneration reports. While this is non-binding on the board, they are obliged to take note of shareholders views. Shareholders might choose to vote against reports with too high a proportion of pay as short-term bonuses as opposed to long-term incentives. This might result from a number of reasons. First, the shareholders might view this as embezzlement of funds. To them, these funds should have been used in paying better dividends or in making investments that will lead to better dividends in future. In addition, shareholders prefer that managers be compensated through schemes that will make them feel part and parcel of the company through such long-term incentives such as equity bonus options (Josephine, 2008). To them, this would motivate the managers to work harder in a bid to ensure the company becomes more profitable which would assure both the managers and managers of better dividends. As stated above, long-term incentives would also make the managers have a long-term view of the company and hence be considered of the company’s survival even after they retire. This way, they would be motivated to invest in projects that assure the company of long-term growth and hence better returns in the long run. The shareholders would not realize this was the company to mainly use short-term incentive for their management and hence the reason they would vote against such schemes. Conclusion As discussed above, an agency problem emanates from the relationship between the manager as the agent and the shareholders as the principal. Such agency problems include risk aversion, horizon problem among other agency problems. This necessitates organizations to undertake various management compensation packages aimed at motivating the managers to act in the best interest of the shareholders. Such compensation packages may include salaries and non-salary packages. In addition, they may be short term or long term. While the managers may prefer short-term cash pays, shareholders may prefer that they be given long-term incentives. However, a compromise has to be given between these types of packages. However, as discussed above, whatever kind of compensation package that a company adopts should ensure the management acts not only in their best interests but also in the shareholders’ best interest. References: Balsam, S2011, Introduction to executive compensation, London, Rutledge. Huang, S2008, Executive compensation and Horizon incentives, Journal of Accounting and economics, vol. 16, pp. 55-95. Drever, H, Hall, N, Elizabeth, T2011, Introduction to corporate finance, London, Rutledge. Dechow, P&, Sloan, M1991, Accounting and corporate governance, Contemporary Accounting Research, Vol.13, no. 1, pp.19-25. Josephine, N2008, Fundamentals of corporate finance, New York, Taylor & Francis. Hansmann, H&, Kraakman, R2004, Agency problems and legal strategies, Oxford, Oxford University Press. Amir, B&, Senbet, W1985, Agency problems and financial contracting, Sydney, Prentice Hall. Fade, A2012, Corporate governance: Agency problem and regulation in Nigeria Banking industry: A case study of Oceanic bank Plc. and Union bank Plc., LAP LAMBERT Academic Publishing. Read More