AGENCY THEORY NOTES

Agency refers to the relationship which submits between two parties, one
party called the principal engages another one called agent and gives
agent authority and mandate to act on the principal’s benefit. The
actions of agent are binding on the principal. In finance, stockholders
are owners of the firm and are therefore the principal. However, they
are not involved on the management of running of the firm for a number
of reasons.

1. They may not have the necessary skills and expenditure of managing
   the firm.
2. They may not have them to run the firm.
3. They may be geographically dispersed to manage the firm.
4. They may be too many to manage a single firm.

Therefore enjoy management directors who ask on their behalf the
directors are the Agents. They are given capital authority and other
resources for use or that they can generate profits on behalf of
principle stakeholders. The concept of entrusting resources with
individuals where they are expected to give an account of how the
resources are used is called stewardship. The directors/top management
are required to combine the where they have utilized he resources
entrusted. Usually a conflict of interest arises when the agents pursue
their own interest at the expense of the stockholders.

1.2 Types of Agency relationships

1. Shareholders versus Management
2. Shareholders versus Long-term Creditors
3. Shareholders versus Auditors
4. Shareholders versus Government
5. Shareholders versus Branches

1.2.1 Shareholders versus Management
The management of a firm take some actions which are inconsistent with
the goal of shareholders of wealth maximization and this will cause a
conflict of interest.

The various causes of this conflict include the following:

• Incentive Problem
  Top managers have a fixed salary and may not have the
  incentive/motivation to work harder in order to maximize the
  shareholders wealth. This is because, irrespective of the benefit
  they make, their records is fixed they will therefore maximize on
  leisure’s and work less. This will be against the interest of the
  shareholders hence the conflict.
• Consumption of perks/perquisites
  Perquisites refer to the high salaries and generous fringe benefits
  which directors’ award themselves. This will take the form of
  directors’ remuneration, expensive cars, expensive holidays,
  expensive assistance, post office etc. all these will constitute an
  expense to the company and will therefore reduce the amount of
  dividend paid to ordinary shareholders and who are the true owners
  of the company. Therefore, the consumption of perks by directors is
  against the interest of shareholders as it reduces their wealth.
• Differences in Risk Profile
  Shareholders prefer high risk; high return projects since they have
  diversified investments that is, if one firm
  or project one collapses it will have an insignificant effect on their overall wealth. Managers on the other hand, will prefer low return investment since they have a personal fear of losing their jobs in case of a given project/company collapsing. This is because managers do not have multiple jobs and can therefore not be diversified. This forces them to strive for returns for shareholders and not necessarily the maximum. This difference is risk profile is therefore a source of conflict.
• Difference in Investment/Evaluation Horizon
  Managers prefer to undertake profit which are profitable in the
  short-term so that they can take credit when they are still in the
  company shareholders. On the other hand, prefer long-term investment
  which is consistent with the going concern concept of the firm. A
  conflict will therefore occur since directors will undertake short
  term investment against shareholders’ desire for long term
  investment projects.
• Management Buyout
  The management may attempt to acquire the business of the principal
  (shareholders). They would do this by forming nominees companies who
  buy the shares of the company at the stock exchange. Once they get a
  majority shareholding. This is equivalent of staging a coup and
  taking over the business of the shareholders. This causes conflict
  between agency and principal.

Solutions to the preceding type of agency problem

• Compensation plans
• Board of Directors
• Takeovers
• Specialist Monitoring
• Auditors

1.2.2 Shareholders versus Long-term Creditors
The shareholders who are the owners of the firm have the responsibility
to raise capital for the business. Where they are unable to rise, they
go to long-term creditors. These creditors will extend loans to the firm
with hopes that, they will get interest of the principal amount. In such
a situation a debt holder becomes the principal while shareholder the
agent. The interest charged will depend on the riskiness of the
borrower, the existing capital structure, asset backing as well as the
expected capital structure and the future asset structure of the firm.
Debenture traders may require security for their loan either having a
specific charge or a general charge on all the assets of the business.
Shareholders may prejudice the position of creditors hence conflict of
interest in the following ways.

1. Disposal of assets used as collateral for the debt
   In this case, the bond holder (creditor) is exposed to more risk
   because he/she may not receive the loan given in case of liquidation
   of the firm.
2. Assets/investment situation
   In this case, the shareholder and the bondholder will agree on a
   specific low risk project. However, this project may be substituted
   for a high risk project whose flows have a high standard deviation.
   This exposes the bond holders because should the project collapse
   they may not recover all the amounts lend.
3. Payment of high dividends
   Dividends may be paid from the current net profit and the existing
   retained earnings. Retained earnings are an internal source of
   finance. The payment of high dividends will lead to a low level of
   capital investment and this will reduce the market value of the
   shares and the bond. Also the firm may borrow debt to finance the
   payment of the bonds, from which no returns are expected this will
   also reduce the value of the firms and the bond.
4. Borrowing more debt capital
   A firm may borrow more debt using the same assets as collateral for
   the new debts. The value of the old debt will therefore be reduced
   if the new debt takes priority on the collateral incase of the firm
   is liquidate. This exposes the first bond holders/lenders to more risk.
5. Under investment
   This is where the firm fails to undertake a particular project or
   fails to invest money or capital in the entire project if there is
   an expectation that, most of the returns from the project will
   benefit the bond holders. This will lead to the reduction in the
   value of the firm and subsequently in the value of the bond.

Solutions of the above type of agency problems
The Bond holders can take the following actions to protect themselves
against the actions of the shareholders:-

• Improve restrictive debt grants
  This involves including strict terms and conditions in the loan
  agreement or bond covenant. These restrictions may include; No
  disposal of assets without permission of lenders; No payment of
  dividends from retained earnings; No borrowing of additional debts
  until the current debt capital is fully repaid or serviced. The bond
  holders may recommend the type of project to be undertaken in
  relation to the risk level of the project. Maintenance of a given
  liquidity level by the borrower as indicated by the current ratio.
  Restriction on merges and acquisitions especially where any merger
  or acquisition will change the future cash flow pattern of the borrower
• Sinking fund provisions
  Some amounts of profits to be transferred annually into a fund for
  the purpose of the loan repayment.
• Callability provision
  This is where the debt lender is given a lee way to demand early
  payment of the debt by the borrower. If the borrower fails to pay
  interest charges on the due date, the lender might demand the
  repayment of the due loan before the end/lapse of the repayment
  period in which case the debt is said to have been “called”.
• Convertibility
  This will enable the lender to convert the bond into ordinary shares
  so that the bond holder becomes a shareholder
  This is particularly so if the borrower
  is unable to pay on the debt and is facing liquidation.
• Refuse to Lend
  The bond holders may refuse to provide capital to the borrower who
  has been involved in the misuse of debt capital in the past. Such a
  borrower will not be in a position to undertake viable project due
  to lack of investment capital. Alternatively, the lender can charge
  higher rates as deterrent mechanism.
• Representation
  The bond holder nay demand to have a representative in the board of
  directors of the borrowing company where the representative will
  oversee proper utilization of the debt capital
• Transfer of Assets
  On provision of debt capital, the lender may demand that, the assets
  used as collateral will be transferred to the firm (legal Ownership)
  passes to the lender and upon repayment of the loan, the asset is
  transferred back to the borrower.

1.2.3 Shareholders versus Auditors
Shareholders appoint auditors to satisfy the financial statement and to
establish whether they show a true and fair view of the state of as at a
particular date. Auditors are supposed to monitor the performance of
management on behalf of the shareholders. Since auditors act on behalf
of shareholders; they become agents, while the shareholders become the
principal.

AGENCY THEORY

Auditors may prejudice the interest of shareholders, thus causing agency
problems in the following ways:

• Colluding with the management in the performance of their duties
  whereby their independence is compromised.
• Demanding very high audit fees although there is insignificant audit
  work due to the strong accounts in existence.
• Issuing unqualified reports
  which might be misleading of which may make the public to lose upon
  relying on them.
• Failure to apply professional cadre and due to diligence in the
  performance of the audit work

Solutions to the preceding agency problem

• Firing
• Auditors may be removed from office by shareholders at the Annual
  General Meeting (AGM).
• Legal Action
• Shareholders can institute legal proceedings against the auditors
  who issue misleading reports, hence leading to investment losses.
• Disciplinary Action by the Profession governing Accounting Practice
• The profession governing Accounting practice in the country in
  question e.g. IGPAK in Kenya can also intervene on behalf of the
  shareholders. Such may be through suspension of the auditors,
  withdrawal of the practicing certificate, fines and penalties etc.

1.2.4 Shareholders versus Government
Shareholders and by extension the company operate in the environment
using license granted by the government. The government will expect the
company to operate the business in a manner which is beneficial to the
entire economy and society. The government is the principal and the
company is the agent. The company also carries on business on behalf of
the government because the conclusive investment environment for the
company and benefits from the company inform of taxes. The company and
its shareholders may take some actions that may prejudice the
interest/position of the government as the principal.

These actions include the following:

• Tax Evasion, this involves failure to give the accurate picture of
  the earning of the firm to minimize the tax liability.
• Involvement in illegal business in the firm e.g. drug trafficking,
  smuggling e.t.c.
• Lukewarm reception to social responsibility calls by the government.
• Lack of adequate interest in the safety of employees and the
  products and services of the company including lack of environment
  awareness concerns by the firms.
• Avoiding certain types and areas of investment as encouraged by the
  government through incentives so that investment can be done in such
  areas.

Solutions to the preceding agency problem
The government can take the following actions to protect itself and its
interest.

• Incurring monitoring costs
  For example the government will incur costs associated with
  statutory audits, investigation of company’s under company’s Act,
  back duty in the investigation cost to recover tax evaded in the
  past and VAT refund audits.
• Opening investment incentives
  To encourage investments in given areas and locations, the
  government offers incentives in form of capital allowance laid down
  in the second schedule of Cap 470.
• Legislations
  The government has provided a legal framework to govern the
  operations of the company and provide protection to certain people
  in the society e.g. regulations associated to disclosure of
  information, minimum wages and salaries, environmental protection
  e.t.c., guidelines on minimum disclosure in financial statements

1.2.5 Head Office versus Branch
Multi-national companies have diverse operations set up in different
geographical locations. The head office will Act as the Principal and
the subsidiary will act as the Agent. The subsidiary will pursue their
own goals, hence creating an agency relationship.
These conflicts can be resolved in the following ways:-

• Frequent transfer of managers
• Adopting a global strategic planning to ensure better communication
  of its vision.
• Having a voluntary code of Ethical practices to guide the brand
  management.
• An elaborate performance reporting system providing a two way
  feedback mechanism.
• Performance contracts for managers with commensurate compensation
  package for the same.