Agency Conflicts and Corporate Governance By Dr. Babandi Ibrahim Gumel

This article aims to discuss the presentation made on the topic during the LIGS University Webinar presentation to students. The webinar introduced and defined agency conflicts in an organization and further extended the lesson to understand corporate Governance and how corporate governance policies reduce or eliminate agency conflicts. With the example of the corporate Governance of Citigroup between 2007 -2012, the presentation facilitated learners understanding of how corporate governance policies can trigger an agency conflict and how it may be reduced or eliminated.

Learners will learn the impact of corporate Governance on corporate valuation and how a corporation graduates from no agency conflict status in multiple agency conflict situations. Notwithstanding the understanding of types of likely conflicts in an organization, the webinar exposed students to the different kinds of corporate governance policies and how they helped lower the cost incurred by corporations. The webinar will highlight the internal control provisions commonly used by the corporate organization to manage agency conflicts effectively. 

Example of Corporate Governance (Citigroup 2007-2012)

In 2007 – CEO Vikram Pandit had a wild ride regarding compensation, where he sold his hedge fund to Citi group and made a $167 million profit. In late 2007, Pandit was appointed CEO of Citi with cash pay of $1.2 million and over $19 million in stocks and options (Guerrera, 2012).  Due to the global economic crisis of 2008, Pandit offered and took $1 in salary in 2009 and 2010 (Guerrera, 2012). In 2011, as things improved, Pandit received a base salary of $1.75 million and retention bonuses of $23 million. In 2012, the board of Citi recommended a salary increase to $15 million to Pandit, plus a bonus plan recommending the top five executives could earn up to $18 million if the combined income of Citi exceeded $12 million (Guerrera, 2012). Angrily, the shareholders of Citi voted against the proposed compensation plans (Guerrera, 2012).  The shareholders' reaction was prompted due to the 2011 pretax income earned by Citi, which legitimized the proposed bonus even if Citi lost $7 million pretax income in 2012 (Guerrera, 2012). The Board members of Citi considered the shareholders' votes as non-binding and ignored the vote. Large Shareholders of Citi sued the board for breach of duty (Guerrera, 2012). This is one of the similar incidences happening around the globe and should be taken seriously when handling corporate governance policies (Guerrera, 2012). Listeners of the webinar were advised to keep this in mind while we rolled through the presentation.

Agency Conflicts

If a founder or owner of a business serves as the overall manager of an organization, it is unlikely for such an organization to have agency conflict. The owner will reap the benefits accruing to the organization and will take all the liabilities of the firm. When the owner started to employ people to work in the firm, the situation changed: because the owner would not share the full benefits and losses with the employees—making the firm vulnerable to conflicts. The conflict increases if the owner sells shares to an outsider or employs someone to manage the firm's affairs. The dispute arises between a firm's owners, employees, managers, and creditors.

Agency conflicts occur when owners authorize other people to manage firms on their behalf. The agency relationship comes into effect whenever a person (principal) hires another individual (called an agent) to act on his behalf and perform services with the delegated authority of making decisions (Brigham, E. F. & Ehrhardt, M. C., 2016). Agency conflicts result in increased costs, leading to a firm's value reduction. Three types of agency conflicts resulted in increased cost to an organization and ways to reduce or resolve them as follows: conflicts between stockholders and creditors, a conflict between inside owner/managers and outside owner, and conflict between managers and shareholders (Brigham, E. F. & Ehrhardt, M. C., 2016).

The behaviors of managers that will harm the intrinsic value of a firm

The behaviors of managers that will harm a firm's intrinsic value include spending less time and less effort on activities that will maximize the firm's value. Rather than use the firm's fund on the shareholders' actions, some managers' behavior is to use funds to satisfy their own needs, such as lavish offices and corporate jets, etc., called nonpecuniary benefits (Chandra, 2018).  Managers avoid value-adding but difficult decisions that may harm their friends.

Avoiding taking too much or enough risk by managers results in skipping the right project that will add value due to fear of being sacked or having a distorted image.  Firms with positive FCF can have managers that stockpile in the form of marketable securities instead of returning it to investors for possible investment in good opportunity growth firms (Emery, D. R., Finnerty, J. D., & Stowe, J. D., 2011). Managers tend to hold certain vital information needed by investors; if such a habit is established, investors are likely to discount the expected free cash flows at a higher cost of capital, resulting in the reduced intrinsic value of the firm.

Corporate Governance

Agency conflicts can decrease firms' value of stock owned by outside shareholders. Corporate Governance can reduce or eliminate such conflicts, thereby mitigating the loss in stock value.  Corporate Governance is defined as "the set of laws, rules, and procedures that influence a company's operations and the decisions its managers make" (Brigham & Ehrhardt, 2014, p. 528).

The corporate governance provisions are either carrots or sticks. The stick is the threat of removal because of a hostile takeover or because of the board of directors' decision.  The Carrot - if the managers of a firm are maximizing the value of the stock, they need not worry about being removed. Managers are offered incentives when they maximize the intrinsic value of the shares, which are part of the carrots approach (Fabozzi, F. J., & Markowitz, H. M., 2011). Thus, managers are compensated as most firms link performance to compensation. Some of the corporate governance provisions are for a firm's internal control. The internal control provisions are divided into five: board's monitoring and discipline, bylaws provisions that affect the likely hostile takeovers of the firm, compensation plans, accounting control systems, and capital structure choices (Chandra, 2018).

Monitoring and Discipline by the Board of Directors

Shareholders being the corporate owners of an organization, elect the members of the board who act as agents on their behalf. In the US, Nigeria, and other countries, their duty includes monitoring senior managers where they discipline them if they do not act on behalf of the shareholders through removal or reduction of compensations (Brigham, E. F. & Ehrhardt, M. C., 2016).  In Europe, an employee representative is included on the board. While in Asia, banks have representation on the board (Chandra, 2018). Areas needing monitoring and discipline include: The board of directors has a nominating committee, and the only candidate nominated by the committee is on the ballot.

In most cases, the CEO is also the board chairman and influences the nominating committee. In most cases, the management controls 51% of the shares, enabling them to control the voting process. Also, most of the board members are insiders (people with managerial responsibilities). The system that mitigated this problem of insiders' control is the requirement of NASDAQ and NYSE in the US that require a majority of board members to be outside the firm. Studies suggested that corporate Governance improves if: the CEO is not the chairman of the board, the majority of board members are business experts from outside, membership of the board is not too large, and compensation of board members is appropriately (not too high, not all cash, with exposure to equity risk through options or stock) (Brigham, E. F. & Ehrhardt, M. C., 2016).

Charter Provisions and Bylaws that Affect the Likelihood of Hostile Takeovers

Targeted repurchases can be banned through a shareholder-friendly charter, also known as greenmail (Brigham, E. F. & Ehrhardt, M. C., 2016). The charter does not contain a shareholder rights provision otherwise called poison fill. The provision of a poison fill will prevent taking over the company, which will help entrench management. The restricted voting rights in the provisions also embed the management of a firm. In a situation where managers cannot increase the free cash flows of a firm, another company can acquire the firm, change the management, and turn the company around with increased free cash flows.

Environmental factors outside a firm's control

The laws in the legal system, including environmental regulations and laws. Rules and laws of agencies such as the SEC are often treated with hefty fines in non-compliance. Other external factors include competition with other firms, block ownership patterns, and the issue of media and that of litigations (Brigham, E. F. & Ehrhardt, M. C., 2016).

Capital Structure and Internal Control Systems

The firm's capital structure can affect the managerial behavior of a firm. As the level of debt increases, the threat of bankruptcy opens and affects organizational behavior (Brigham, E. F. & Ehrhardt, M. C., 2016). High debt may lead to managers avoiding risky top projects that will increase the firm's value; thereby, underinvesting problems reduce the firm's value. Firms decide on an optimal capital structure to avoid the likely incidence of bankruptcy in an organization.

Conclusion

The webinar discussed topics that relate to agency conflicts and corporate Governance, including agency Conflicts and conflicts between stockholders and creditors, the conflict between Inside owners/managers and outside owners, and conflict between managers and shareholders. Other issues discussed in the webinar include the behaviors of managers that will harm the intrinsic value, corporate Governance, and the internal control provisions for corporate Governance. Learners were able to understand the implication of agency conflicts and how the right corporate governance policies helped reduce or eliminate them.

References

Brigham, E. F. & Ehrhardt, M. C. (2016). Corporate finance: A focused approach. Cengage Learning.

Chandra, P. (2018). Financial management: theory and practice. Mc Graw Hill India.

Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2011). Corporate financial management: Bridging the gap between theory and practice. Wohl Publishing.

Fabozzi, F. J., & Markowitz, H. M. (2011). The theory and practice of investment management. John Wiley & Sons, Inc