Business Finance Assignment 1

Describe the nature of the Agency Problem and the related corporate governance
issues. Explain some of the actions that shareholders can take in order to deal with the
problem with specific reference to the Companies Act. Describe the various ways in
which the shareholders’ interests have also been protected.

Introduction
This paper reviews and analyzes the agency problem as applicable to incorporated
companies. An attempt will be made to get an insight into the literature dealing with this
interesting subject. As aptly summed up by Jassim (1988), finance theory posits that the
goal of economic organizations is to maximize stockholders' wealth. Attainment of this
goal was not an issue when owners were also managers. However, in the present day,
corporate ownership has become increasingly diffused, with very few companies still
being owned by their managers. The separation of ownership and management raises the
issue of the relationships between owners and managers. In such a set up, directors and
managers have a leeway to substitute their own interests in place of those of shareholders.
This is possible because of information asymmetry between shareholders and managers;
which tend to give managers a leverage to act at cross-purposes with advancement of
shareholder needs. Such a phenomenon, commonly referred to as “agency problem” is
prevalent in modern day corporates. The writer will look at the corporate governance
implications of the agency problem as well as the statutory and non-statutory remedies
that the shareholders may resort to in order to minimise their vulnerability.

Definition of terms
Agency Problem
Jensen and Meckling (1976) define the agency relationship as a contract under which one
party (the principal) engages another party (the agent) to perform some service on their
behalf. As part of this, the principal will delegate some decision-making authority to the
agent. Applied to finance theory, the agency problem refers to the conflict of interest
arising between creditors, shareholders and management because of differing goals
(www.investopedia.com, 30/09/08). The agency problem emanates from the arrangement

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where the interests of the agent differ substantially from those of the principal because of
the impossibility of perfectly contracting for every possible action of an agent whose
decisions affect both his own welfare and the welfare of the principal (Brennan, 1994).
Emanating from this problem is how to induce the agent to act in the best interests of the
principal.

The agency problem arises due to the separation of ownership and control of business
firms. In theory the shareholders, being the owners of the firm, control its activities. In
practice, however, due to a diffuse and fragmented set of shareholders, the latter appoints
a board of directors to direct the affairs of the company. The board would similarly
delegate the duty of day to day running of the organisation to managers. In terms of this
arrangement therefore, managers are the agents of the board whereas board members are
also agents of the shareholders. As the discussion that follows will show, an agency
problem exists when shareholders, directors and managers have conflicting ideas on how
the company should be run.

Corporate Governance
Corporate governance can be defined as the system by which corporations are directed
and controlled in line with stakeholder expectations (King II Report, July 2001). Such
task is placed upon the shoulders of directors and senior management. Corporate
governance facilitates the attainment of common sense business objectives like effective
business and risk management, establishing and maintaining good relations with
shareowners, ensuring reasonable and sustainable returns, compliance with applicable
laws and regulations among others.

The Institute of Directors (IOD) in South Africa (2002) identifies seven (7) characteristics
of good corporate governance that must be exhibited by individuals who make decisions
on behalf of a company. These are discipline; transparency; independence; accountability;
responsibility; fairness and social responsibility. The various characteristics listed above
will be fully explored with reference to how they have been incorporated in the
Zimbabwe’s Companies Act. In light of the agency problem, corporate governance

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principles assist in lessening the worry among investors about the “professional manager”
who wields excessive power. From this understanding, it can be argued therefore, that
corporate governance practices basically sets parameters which attempts to regulate
instances giving rise to agency problems.

Nature of the Agency Problem and Corporate Governance Implications

Nature of the Agency Problem

Inherent in any principal-agent relationship is the understanding that the agent will act for
and on behalf of the principal. The agent assumes an obligation of loyalty to the principal
that he will follow the principal’s instructions and will neither intentionally nor
negligently act improperly in the performance of the act. An agent cannot take personal
advantage of the business opportunities the agency position uncovers. A principal, in turn,
reposes trust and confidence in the agent. These obligations bring forth a fiduciary
relationship of trust and confidence between principal and agent.

However, the principal-agent relationship that subsists between the shareholder and the
directors on one hand and between the directors and managers on the other is fraught
with some problems. The agency problem is compounded by the conditions of
incomplete and asymmetric information as between the principal and the agent.
Shareholders (as principals), expect directors/board members (as agents), to make
decisions that will lead to the maximization of the value of their equity. In the same vein,
directors (as principals) expects management (as agents) to pursue strategies and
operations that contributes to the bottom-line and are in tune with the board’s
expectations. This scenario means that the shareholders who should stand to benefit from
the profitability of the company do not have direct control over what management (who
generate that profitability) does. This dilemma, which is a consequence of the separation
of ownership and control, raises worries that the management team may pursue
objectives attractive to them, but which are not necessarily beneficial to the shareholders.
The distance that is created between the shareholder and management team therefore

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breeds the problem of a serious lack of goal-congruence – where there is no alignment of
the actions of senior management with the interests of shareholders.

Corporate Governance Implications

Alleviation of discrepancies between shareholder and manager interests calls for strong
corporate governance measures if shareholders are to be protected from financial losses
resulting from corporate and market financial scandals.

Role of the Board

Corporate governance bestows a variety of duties on directors. Bonazzi L., Islam (2007)
defines the function of the board as a collective responsibility to determine the company’s
purpose and “ethics”; to decide the direction, i.e. the strategy; to plan; to monitor and
control managers and CEO; and to report and make recommendations to shareholders. To
ensure that directors diligently discharge these duties, personal liability attaches to
individual directors if the company can be shown to have been trading “wrongfully” or
illegally carrying out activities contrary to laws and regulations. This personal liability
will help lessen the agency problem caused by directors pursuing their own personal
interests.

Board Structures
One mechanism of corporate governance that may be used to ensure that checks and
balances are in place to minimise the agency problem would be to appoint independent
non-executive directors to the board of directors (Webb, 2006). Existence of independent
non-executive directors onto the board will ensure that management is monitored for
operational performance. For example, in terms of the RBZ Guidelines on Corporate
Governance (2004), all banking institutions’ boards should have a minimum of five (5)
directors, the majority of whom should be non-executive. Further, in terms of those RBZ
guidelines, the Chief Executive Officer (CEO) or the Managing Director (MD) of a bank
may not be a chairman of the board; a position which may only be filled by an
independent non-executive director. This position was also supported by Jensen (1993),
who suggests that ‘‘duality’’ reduces the monitoring power of the board of directors.

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Thus, a board more likely to protect shareholders from agency problems would be one
with separate individuals controlling the firm and the board (Bonazzi, 2007). Such a
board composition is important in ensuring that interests of minority shareholders are
protected and given due consideration in the decision-making process.

Related to this issue, firms whose CEOs are also part of the firm’s founding family tend
to have higher agency costs and monitoring needs than firms with unrelated CEOs. For
example, Morck et al. (2000) find that family management is inferior to professional
management. They show that these CEOs have less control over the agency problem than
CEOs who are not founders (or founder’s heirs) of the firm. Research has focused on the
theory that a strong board of directors is one that is able to effectively monitor
management and alleviate agency problems. Effective directors are typically those that
make the board more independent from the internal workings and individuals of the firm.

However, there are some boards which do not conform to codes of corporate governance
like the Cadbury (1992) Report, hence are susceptible to manipulation by management to
the detriment of the shareholders. Core et al. (1999) examine a wide range of board
characteristics and find that firms with weaker governance structures have more agency
problems, and that these firms tend to perform worse than strongly governed firms.
Specifically, they find an inverse relationship between board strength and a number of
board characteristics. Among these are the proportion of inside directors, board size, gray
directors (those directors who are not employees of the firm but receive payment from the
firm for services other than directorial duties), and when the CEO is also the board chair.
Shivdasani and Yermack (1999) find that gray directors have a conflict of interest and can
enhance management entrenchment by their presence on the board. All these
characteristics do not auger well with tenets of good corporate governance as they reduce
independence and therefore lead to poorer monitoring by the boards. A board which is
dominated by directors who are also members of the executive employees of the
company are not independent. Such a set up would mean that managers and board
members may pursue goals which do not necessarily lead to the maximization of the
value of the share holder's equity. As Webb (2006) observes, such a board would

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encourage “entrenchment” and “managerialism”. By entrenchment, management would
be protecting themselves through reducing the monitoring power of the board.

Where executive directors seek to entrench their positions in this manner, the board
would have diverted from performing its “stewardship” role which advances shareholder
interests. Since the board may not be fully independent from management and there is a
large gap between the management and the board, the managers and the board may be
tempted to have goals that compete with shareholder wealth maximization. Simon
Herbert (quoted in Baysinger and Hoskisson, 1990) proclaimed that managers might be
“satisfiers” rather than “maximisers”, i.e. they tend to act in a risk-averse manner and
seek an acceptable level of growth because they are more concerned with perpetuating
their own existence than with maximising the value of the firm to its shareholders.

The following are some of the specific conflict areas which are exacerbated by poor
corporate governance practices, namely:

Earnings retention conflicts

Managers may increase retained earnings in order to finance some projects which would
not necessarily enhance shareholder wealth. Such grandiose managerial investment
policies (Easterbrook, 1984), may not produce results that are clearly apparent to the
shareholders as it may be to management. The resultant growth grants to management a
larger power base, job security, greater prestige/status, and an ability to dominate the
board and award themselves higher levels of remuneration, (Jensen, 1986). On the other
hand, shareholders would prefer higher levels of cash distributions, especially where the
company has few internal positive Net Present Value (NPV) investment opportunities,
hence producing a clash of interests between principal and agent.

Time Horizon Agency Conflicts

McColgan (1991) observes that conflicts of interest may also arise between shareholders
and managers with respect to the timing of cash flows. Shareholders will be concerned
with all future cash flows of the company into the indefinite future. However,

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management may only be concerned with company cash flows for their term of
employment, leading to a bias in favour of short term high accounting returns projects at
the expense of long-term positive NPV projects. For example, research and development
(R&D) expenditures would tend to decline as top executives approach retirement
(Dechow and Sloan, 1991). This is because R&D expenditures reduce executive
compensation in the short-term, yet the retiring executives won’t be around to reap the
benefits of such investments. Healy (1985) also posits that time horizon agency conflict
may also lead to management using subjective accounting practices to manipulate
earnings prior to leaving their office in an attempt to maximise performance-based
bonuses.

To mitigate against negative consequences of the agency problem outlined above, various
statutory and non-statutory mechanisms may be employed as analysed below.

Statutory Protection available to Shareholders: The Companies Act [Chapter 24:03]

Legislation in the form of the Companies Act (hereafter to be referred to as “the Act”) has
been promulgated to afford shareholders some protection in the face of challenges caused
by the agency problem. Such protection is critical given the vast powers that directors
have. As noted by Volpe (1979) (citing Tett and Chadwick: Zimbabwe Company Law),
directors may act individually or corporately as a board, or in committees or by
appointing one or more managing directors or managers responsible to them. As a board,
the directors may concern themselves with anything between the extremes of day to day
management and overall policy and responsibilities.

Qualifications and Appointment of Directors

Section 173 of the Act proscribes who may become a director. For example, a person
with any legal disability, an unrehabilitated insolvent and a person convicted of certain
classes of economic crimes are not eligible for appointment as director. The objective for
placing such restrictions as noted by Christie (1998) is to keep directorship and
management of the company under responsible hands. This screening process will give

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solace to the shareholder who would know that his investments are under the stewardship
of directors who can be trusted.

Further, the Act requires directors (the agents) to be appointed by shareholders (the
principals). Section 174 of the Act gives members/shareholders an opportunity to
consider merits of each director individually. In terms thereof, no appointment of two (2)
or more directors may be made by the same resolution at a general meeting. Thus, the
qualifications required of directors as well as the appointment procedure to be followed
ensure that incidents of adverse selection and moral hazard are minimised.

Removal of Directors by Shareholders

To ensure that some checks and balances exist, the Act has a procedure for the removal of
directors by shareholders. In terms of section 175 of the Act (read with section 135),
shareholders can utilize their power from the democratic process of voting by which
means they can elect or dismiss directors. When appropriately used, the power to remove
directors from office would effectively afford shareholders protection against errant
directors who tend to pursue practices that work at cross-purposes with interests of
shareholders.

Fiduciary Duties of Directors: No Conflict of Interest

As noted by Christie (1998), the relationship between the director and the company is a
unique one. A director stands in a fiduciary relationship to the company. As such, a
director is statutorily bound by the Act to discharge his duties and exercise his powers for
the benefit of the company, not his own. This should be reflected in two major ways;
firstly, that directors should act with skill and care and secondly, that they should act in
good faith. Thus, to protect the interests of shareholders of the company, a director is
required to exhibit that degree of skill which can reasonably be expected of a person of
his knowledge and experience and avoid any conflict of interests. Table “A” Articles as
read with section 186 of the Act therefore places a special procedure to be followed
where directors are required to declare any possible conflicts of interests that may
compromise their objectivity when discharging company business. Such a procedure

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helps preclude incidents of abuse by directors and managers who stand to benefit from
inside information they may have gained by virtue of their positions in the company.

Convening of Members’ Meetings

In terms of section 124 of the Act, every public listed company is obliged to convene a
statutory meeting where directors should present a statutory report. Further, every
company (both private and public) should convene an annual general meeting (section
125), where specific business to do with the affairs of the company is discharged.
Additionally, members have the power to call for or requisition an extra-ordinary general
meeting. These various meetings are significant in advancing corporate governance and
reducing the agency conflict as they assist in bridging the information asymmetry
existing between shareholders and managers. How this is achieved is discussed below:

Annual Reports and other Disclosures

Section 146 requires management to lay the company’s accounts (i.e. the balance sheet
and the profit and loss account signed by two directors) at an annual general meeting of
members. An external auditor’s report should also be annexed to such accounts. Further,
and in terms of section 147 of the Act, there should be attached to these accounts a
directors’ report outlining the state of the company’s affairs.

Significant issues of corporate governance arise here. Effective corporate governance by

company boards requires both good information and the will to act on negative
information. The requirement to distribute the company’s accounts and other reports to
members forms the hallmark of transparency and accountability by the agents to their
principals. As pointed out earlier in this paper, such disclosures are critical for the
advancement of corporate governance and for ensuring that information asymmetry is
reduced as between agent and principal. Further, it is agreed that the publicity which
comes with such disclosures places management under compulsion to take shareholder-
value maximising decisions as managerial labor markets tend to discipline poorly
performing managers (Kaplan and Reishus, 1990).

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Thus, the platform afforded by statutory and other meetings and the reports that are
presented at those meetings gives shareholders an opportunity to assess not only “what” a
company reports but also “why” particular actions were taken.

Personal Liability of Officers and Auditors

Managers and company auditors may not afford to conduct the affairs of the company
recklessly as doing so would result in personal liability attaching to their actions (see
section 190 of the Act). Further, in terms of section 189, directors are encouraged to have
regard to the interests of the company’s members, principally to do with profit
maximization. However, the weakness of this provision is that it is merely directory and
not peremptory/compulsory.

Limits on Power of Directors

As a way of averting corporate scandals where directors would end up prejudicing the
shareholders, section 183 (1) (b) of the Act prohibits directors from disposing of the
undertaking of the company or of the whole part of such company’s assets without the
approval of the company in a general meeting. This limits the powers of directors to
unilaterally do as they wish with the company’s assets, hence preventing the possibility of
ripping-off shareholders. This way, shareholders are protected from overzealous directors
and management.

Other / Non-statutory protection available to Shareholders

Apart from the statutory provisions discussed above, other measures are also available to
be taken by shareholders to shield themselves from the agency problems. These will now
be considered below:

Appointing Non-Executive Directors

As stressed above, one of the reasons for the existence of the agency conflict is the
appointment of board members who are also members of the management team
(executive board members). The various reasons why this is so has also been discussed
above. To counter the negative effects of a board dominated by the management team,

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shareholders may consider shifting the board composition in favour of non-executive
directors. A non-executive board member would not normally sympathize with decisions
that are in conflict with the goal of maximising the wealth of shareholders. Fama and
Jensen (1983) argued that effective boards dominated by non-executive directors are
better able to separate the problems of decision management and decision control.
Outside directors are able to separate these functions and exercise decision control, since
reputation concerns, and perhaps any equity stakes they might have, provides them with
sufficient incentive to do so.

Managerial and Director Incentives

It is generally agreed that the structure of executive compensation contracts can have a
large influence in aligning the interest of shareholders and management (McColgan,
2001). Compensation contracts, and their revision, represent a financial incentive for
management to increase company value. It is argued that higher levels of such incentives
should be proportionate to higher company performance (Jensen and Meckling 1976).
Effective compensation contracts should therefore provide management with sufficient
incentive to make value maximising decisions at the lowest possible cost to shareholders.
The main forms of managerial and director compensation are basic salary, accounting-
based performance bonuses, performance-based share option schemes and long-term
incentive plans. The effectiveness of such incentives largely depends on the strategy
adopted. For example, companies with long-term investment opportunities should be
expected to employ compensation plans with contingencies which cause executives to
forfeit the compensation if they leave the company. Accounting-based bonus schemes
and performance-based share option schemes as modes of incentives will now be dealt
with below:

Accounting Based Bonus Schemes

Basing bonuses upon accounting measures of performance provides an improved
mechanism for aligning managers’ interests with those of the company’s shareholders
(McColgan 2001). However, Healy (1985) argue that paying executives on the basis of
accounting variables provides an incentive for management to directly manipulate the

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accounting system, and favour projects with short-term accounting returns at the expense
of long-term positive NPV investment. Bonuses related to company sales may further
encourage earnings retention and firm size growth, which doesn’t always equate with
payment of dividends hence shareholder wealth growth. Another weakness is that
accounting bonuses may also lead to a focus on the determining variables of these
compensation plans, perhaps leading managers to neglect other non-financial aspects of
performance like occupational health and safety; social investment; environmental
impact; and development and skilling of staff.

Performance Shares
The use of share options in executive compensation plans is generally seen as the one of
the most effective means of tying the interests of managers and shareholders. Under this
scheme, shares are offered to managers as a reward for performance which enhances
shareholder wealth. Such options give management the right to buy company stock at a
fixed price at given times in the future. As ownership of the company by inside managers
increases, so too does their incentive to invest in positive NPV projects and reduce
private perquisite consumption. The higher the value of the firm, the higher the value of
the options and the profit managers can make upon exercising them. Agrawal and
Mandelker (1987) report that stock options encourage management to make investment
and financing decisions which increase the variance of the firm’s assets. Additionally,
Denis et al. (1997) find that executive ownership is associated with greater corporate
focus, indicating that the severity of the managerial risk-aversion problem may be
reduced through higher equity stakes.

Closely linked to performance shares is the economic value added [EVA] mechanism
which can be used to tie managerial compensation to shareholder wealth maximization.
EVA is the performance measure most directly linked to the creation of shareholder
wealth over time. A positive EVA indicates that management is creating wealth for the
shareholders. It denotes an estimate of true "economic" profit, or the amount by which
earnings exceed the required minimum rate of return that shareholders and lenders could
get by investing in other securities of comparable risk.

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Critique of the Performance Share scheme
On the flip-side, share option schemes may fail to provide the necessary incentive due to
the existence of other factors beyond the control of the managers that may affect the price
of the share. Examples are macro-economic factors like interest rates, inflation,
uncompetitiveness of the economy etc, which lead to a dip in share value. Further,
evidence on the benefits of managerial share ownership tends to generally be mixed.
While the theoretical arguments for increased incentives are unquestionable, empirical
evidence suggests that insider ownership may also come at the cost of entrenchment.
Many factors can influence the relationship between insider ownership and corporate
value, and as observed by McColgan (2001), recent evidence tends to suggest that
causality may even operate in the opposite direction.

Threat of firing
According to McColgan (2001), one of the most consistent empirical results in the
corporate governance literature is that directors are more likely to lose their jobs if they
are poor performers. Poorest performing management would lose their jobs at the
instance of directors, moreso should such poor performance be for prolonged periods. In
light of this, managers may be forced to take shareholder maximising actions simply in
order to keep their jobs and in the process protecting the interests of shareholders hence
reducing goal non-congruence between shareholders and management.

Block holder or Institutional Investors

The existence of large block investor(s) in a company may overcome the problem
normally encountered by small, atomistic shareholders who may not have the time, skill,
or the interest to monitor managerial activities. Institutional shareholders are better able
to overcome this challenge, as they may have more skill, more time, and a greater
financial incentive to overcome this free-rider problem and closely monitor management.
Additionally, large shareholders may be able to elect themselves onto company boards,
increasing their ability to monitor management. Denis and Sarin (1997) contend that the
purchase of large share stakes by outside investors represents a control threat to company

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management and can provide pressure for internal governance systems to operate more
efficiently. Blockholder pressure may also deter management from non-value adding
diversification strategies. Since such investors already hold diversified portfolios, further
risk-reductions aren’t of interest to them.

Further, institutional shareholders like pension funds, mutual funds, and insurance
companies can afford to exert direct intervention. The managers of these institutions
usually have the power and take an active interest in the management of the companies in
which they hold shares. They can lobby for the interests of all shareholders and suggest
ways in which the business may be run. Such direct intervention by shareholder
representatives will influence management into shareholder value maximization.

Disciplinary Take-overs
Disciplinary takeovers will occur in response to breakdowns of internal control systems
in companies with large levels of free cash flows [Jensen (1986)]. A hostile takeover is
likely to happen when the shares of the company are undervalued relative to their
potential due to poor management. Where managers fear that they may lose their jobs
following takeovers, they may react by investing these free cash flows in more efficient
investment projects. Safieddine and Titman (1999) find that targets of failed takeover
attempts significantly increase their leverage in the period immediately following the
failed bid. These firms then tend to sell off under-performing company assets in order to
increase focus on key profitable investments, perhaps reversing previously unprofitable
diversification policies. Thus, take-over bids may be initiated not only for efficiency
gains but also as a way of disciplining poorly performing management.

Critique of the Disciplinary Take-overs

The threat of takeover alone would not be enough to ensure complete coherence between
managerial actions and shareholder wealth. This can be attributed largely to the costs of
organising takeovers, in particular the high bid premiums (Jensen and Ruback, 1983).
However, management may actively seek to reduce the probability of takeover since it

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may result in loss of personal wealth and reputation. One way of achieving that would be
to improve profitability of the firm, which in turn would be beneficial to shareholders.

Conclusion
As has been shown above, agency problems are real in the business realm. The scope of
each type of agency conflict will differ from one firm to another, as will the effectiveness
of governance mechanisms in reducing them. However, hope is not lost for the
shareholder as various mechanisms may be employed, both statutory and non-statutory to
minimise the damage to shareholder wealth caused by agency problems. Each type of
governance and other mechanisms discussed in this paper can be important in reducing
the agency costs of the separation of ownership and control, and afford protection to the
shareholder.

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