Company Law and Agency Theory: Directors' Fiduciary Duty and Agency Conflicts, Lecture notes of Management Accounting

Download Company Law and Agency Theory: Directors' Fiduciary Duty and Agency Conflicts and more Lecture notes Management Accounting in PDF only on Docsity! AGENCY THEORY The Law of Agency An agent is a person who acts on behalf of another person, the principal, in dealing with other people. For example, a selling agent acts on behalf of a principal, a manufacturer of goods, to sell goods on the manufacturer’s behalf. Similarly, a stock broker is an agent who acts on behalf of a client (the principal) to buy or sell shares on the client’s behalf. The agent acts on the name of the principal, and commits the principal to agreements and transactions. In company law, the directors act as agents of the company. The board of directors as a whole, and individual directors, have the authority to bind the company to contractual agreements with other parties. Since most of the powers to act on behalf of the company are given to the board of directors, the directors (and the management of a company) have extensive powers in deciding what the company should do, what its objectives should be, what its business strategies should be, how it should invest and what its targets for performance should be. The powerful position of the directors raises questions about the use of this power, especially where the owners of the company (its shareholders) and the directors are different individuals: - How can the owners of the company make sure that the directors are acting in the best interests of the shareholders? - If the directors act in ways that the shareholders do not agree with, what can the shareholders do to make the directors act differently? Fiduciary Duty of Directors As agents of the company, directors have a fiduciary duty to the company. A fiduciary duty is a duty of trust. A director must act on behalf of the company in total good faith, and must not put his personal interests before the interests of the company. If a director is in breach of this fiduciary duty he could be held liable in law, if the company were to take legal action against him. Legal action by a company against a director for breach of fiduciary duty would normally be taken by the rest of the board of directors or, possibly, a majority of the shareholders acting in the name of the company. Agency Law and Challenging the Actions of Directors In practice, it is very difficult for shareholders to use the law to challenge the decisions and actions of the company’s directors. If shareholders believe that the directors are not acting in the best interests of the company, their ability to do something about the problem is restricted. - The shareholders can vote to remove any director from office, but this requires a majority vote by the shareholders, which might be difficult to obtain. - In a court of law, shareholders would have to demonstrate that the directors were actually acting against the interests of the company, or against the clear interests of particular shareholders, in order to persuade the court to take legal measures against the directors. In summary, although there is a legal relationship between the board of directors and their company, the shareholders cannot easily use the law to control the decisions or actions that the directors take on behalf of the company. Concepts in Agency Theory: The Agency Relationship Whereas agency law deals with the legal relationship between a company and its directors, the theory of agency deals with the relationship between: i. a company’s owners; and ii. its managers (directors). Agency theory is based on the idea that when a company is first established, its owners are usually also its managers. As a company grows, the owners appoint managers to run the company. The owners expect the managers to run the company in the best interests of the owners; therefore a form of agency relationship exists between the owners and the managers. Many companies borrow, and a significant proportion of the long-term capital of a company might come from various sources of debt capital, such as bank loans, lease finance and bond issues (debentures, loan stock and so on). Major lenders also have an interest in how the company is managed, because they want to be sure that the company will be able to repay the debt with interest. The Agency Relationship Agency theory was developed by Jensen and Meckling (1976). They suggested a theory of how the governance of a company is based on the conflicts of interest between the company’s owners e. Time horizon: Shareholders are concerned about the long-term financial prospects of their company, because the value of their shares depends on expectations for the long- term future. In contrast, managers might only be interested in the short-term. This is partly because they might receive annual bonuses based on short-term performance, and partly because they might not expect to be with the company for more than a few years. Managers might therefore have an incentive to increase accounting return on capital employed (or return on investment), whereas shareholders have a greater interest in long- term value as measured by net present value. Agency costs Agency costs are the costs of having an agent to make decisions on behalf of a principal. Applying this to corporate governance, agency costs are the costs that the shareholders incur by having managers to run the company instead of running the company themselves. - Agency costs do not exist when the owners and the managers are exactly the same individuals. - Agency costs start to arise as soon as some of the shareholders are not also directors of the company. - Agency costs are potentially very high in large companies, where there are many different shareholders and a large professional management. Agency costs can therefore be defined as the ‘value loss’ to shareholders that arises from the divergence of interests between the shareholders and the company’s management. There are three aspects to agency costs. They include: i. The costs of monitoring: The owners of a company can establish systems for monitoring the actions and performance of management, to try to ensure that management are acting in their best interests. An example of monitoring is the requirement for the directors to present an annual report and accounts to the shareholders, setting out the financial performance and financial position of the company. These accounts are audited, and the auditors present a report to the shareholders. Preparing accounts and having them audited has a cost. ii. Residual Loss: Agency costs also include the costs to the shareholder that arise when the managers take decisions that are not in the best interests of the shareholders (but are in the interests of the managers themselves). For example, agency costs arise when a company’s directors decide to acquire a new subsidiary, and pay more for the acquisition than it is worth. The managers would gain personally from the enhanced status of managing a larger group of companies. The cost to the shareholders comes from the fall in share price that would result from paying too much for the acquisition. iii. Bonding costs: The third aspect of agency costs is costs that might be incurred to provide incentives to managers to act in the best interests of the shareholders. These are sometimes called bonding costs. These costs are intended to reduce the size of the agency problem. Directors and other senior managers might be given incentives in the form of free shares in the company, or share options. In addition, directors and senior managers might be paid cash bonuses if the company achieves certain specified financial targets. The remuneration packages for directors and senior managers are therefore an important element of agency costs. Reducing the Agency Problem Jensen and Meckling argued that when they act in the interest of the shareholders, managers bear the entire cost of failing to pursue goals that are in their own best interests, but gain only a few of the benefits. Incentives should therefore be provided to management to increase their willingness to take ‘value-maximising decisions’ – in other words, to take decisions that benefit the shareholders by maximising the value of their shares. Several methods of reducing the agency problem have been suggested. These include: i. Devising remuneration packages for executive directors and senior managers that give them an incentive to act in the best interests of the shareholders. Remuneration packages may therefore provide rewards for achieving a mixture of both long-term and short-term financial targets and non-financial targets. ii. Having a large proportion of debt on the long-term capital structure of the company. Jensen and Meckling argued that the problems of the agency relationship are bigger in companies that are profitable but have low growth in profits. These companies generate a large amount of free cash flow. Free cash flow is cash that can be spent at the discretion of management, and does not have to be spent on essential items such a payment of debt interest, taxation and the replacement of ageing non-current assets. It is in the interest of shareholders that free cash flow should be either: a. Invested in projects that will earn a high return (a positive net present value), or b. Paid to the shareholders as dividends. The directors and other senior managers of a company might want to invest free cash flow in projects that will increase the size of the company. These could be projects that will earn a high return. In a low-growth company, however, it is likely that managers will want to invest in projects that increase the size of the company but are only marginally profitable and would have a negative net present value. One way of reducing this problem would be to have a high proportion of debt capital in the capital structure of the company. Interest must be paid on debt, and this reduces the free cash flow. Management must also ensure that new investments are sufficiently profitable so that the company can continue to pay the interest costs on its debt capital. iii. Having a board of directors that will monitor the decisions taken for the company by its executive management. A different method of reducing the agency problem is to make the board of directors more effective at monitoring the decisions of the executive management. a. A board will be ineffective at monitoring the decisions of management if it is dominated by the chief executive officer (CEO). This is because the CEO is the head of the executive management team. The board would be especially ineffective in a monitoring role if the CEO is also the chairman of the board. b. Fama and Jensen (1983) argued that an effective board must consist largely of independent non-executive directors. Independent nonexecutive directors have no executive role in the company and are not fulltime employees. They are able to act in the best interests of the shareholders. c. Independent non-executive directors should also take the decisions where there is (or could be) a conflict of interest between executive directors and the best interests of the company.