Question (Agency Problem and Corporate Governance Solution)
The principal-agent problem (which exists between shareholders and managers) is one of the central problems in corporate governance. Explain this problem and critically discuss how corporate governance mechanisms can help to mitigate agency problems in publicly listed companies. So, the Agency Problem and Corporate Governance Solution is given below.
The topic is about Agency problem as well as principal-agent problem between shareholders and managers in an organization and the role of corporate governance mechanism to reduce this agency problem. The background of the study is that Agency problems between shareholders and managers is a matter of conflict of interest where each party have different motive or interest. Here, Shareholders prefer to increase wealth maximization and managers prefer to have high incentive for their effort in the organization. Meanwhile, the background of the study is also related to the role of corporate governance mechanism where corporate governance provide the solution to monitor managers and observe regular activities by the shareholders to handle their worse decision. Governance is exhibited by the board of directors who has the power to control managers’ activities as per the rules and regulations of the company (Biswas and Bhuiyan, 2008).Board of directors must be responsible for monitoring the activities of managers and separating power of executives. In that case, the appointment of outside director and additional board members is a good trend by offering them stock-based incentive compensation. Because this plan work well for directors in reducing agency problems. However, the fact is to identify about whether incentive compensations work well on behalf of interest of shareholder or work well for protecting income rather than reputation. Similarly, agency problems may also create due to compensation package or managers. So, it may not be unseen where director depends on manager to get their benefit also and they compromise to prepare the financial report. So, there is still some argument regarding this mechanism and therefore it needs to have detail expiation. So, the report will show how corporate governance mechanism helps in reducing agency costs or agency problem.
Discussion (Agency Problem and Corporate Governance Solution)
In general, agency problem can be mitigated by applying different corporate governance mechanisms internally and externally. Corporate governance mechanisms applied internally is focused on the primary interest in response to Board of Directors and the owner’s equity structure of company who are UK listed companies under UK Company Law where it is mechanized to design a two-tier board structures, and they are Board of Directors and Supervisory Board. These bodies will be playing the role internally to set governance mechanism. Corporate governance mechanisms applied externally is focused on mechanism of developing corporate control for market, adopting the functional activities external auditing, and providing the protection of investor legally.
The mechanisms of Debt Financing, managerial ownership, Ownership concentration, Board of Directors, Managerial compensation and growth opportunities will be explained as follows in the context of publicly listed companies in UK:
1. Debt Financing
Agency problem is related to the aspect of asymmetric information problem and free cash-flow. It is a popular mechanism by debt financing obligation work well for mitigating agency problem. For example, bank debt can reduce asymmetric information conflict between outside investor and manager. (Burton, Helliar and Power, 2004) argued that bank’s willingness in response to the renewal and renegotiate of loan implies a good relationship between creditor and borrower and it illustrates that the firm is financially qualified. So, it is argued that bank debt financing is like an advantage for publicly listed companies in UK for monitoring activities of the company and very handy for processing information. (Holland, 2008) argued that it is the beneficial for minimizing information cost for the lenders while it has the access of information to the form of publicly available. Therefore, it has the option of playing the screening role to evaluate the performance of the company who is actually the borrower and monitor the course of action of the borrower effectively.
So, agency problem between shareholder and managers could be mitigated with short-term debt as it may support to low information cost asymmetries for issuing short-term debt and it would be beneficial to low refinancing risk. So, short term debt financing is an important corporate governance mechanism that signifies lender’s ability to reduce agency problem.
2. Managerial Ownership
The reason behind the conflict of interest as well as agency problem or agency cost arise between shareholder and manager just because of the separation between ownerships and control. In that case, the mechanism of corporate governance play a significant role by finding a fruitful way to mitigate the conflicts of principal agent problem. It is true principal agent problem increase conflict and it has bad impact on firm valuation.
(Elloumi and Gueyié, 2001) suggested that the interest between shareholder and manager in response to managerial ownership alignment can reduce the agency problem or agency conflict within the firm. According to his suggestion, the relationship between agency conflict and managerial ownership is likely linear for the firm where it is given the chance of acquiring all of the shares of the company by the mangers. It has been analyzed that the alignment of managerial ownership and the interests of outside shareholders works well to mitigate the agency cost by applying the tools of reducing managerial incentives.
On the other hand, it is also analyzed that, managers focus on external activities and they intend to get private benefit and involve themselves to some extent of risky projects at the other investors expenses and this is called non-linear relationship between these two entities. So, it is revealed that the impact of managerial ownership in reducing agency problem or costs largely depends on trade off relationships where the effect of alignment of managerial ownership and entrenchment effect have the significance (Elloumi and Gueyié, 2001).
Therefore, it is recommended to go for non-linear relationship between managerial agency cost or agency problem and managerial ownership alignment by which managers will not get over benefits and shareholders have not high control over them. This is to be noted that, the managerial ownership will be at low levels of managerial ownership.
3. Ownership Concentration
There is another alternative for reducing agency problem by applying the mechanism of corporate governance and this is called the mechanism of concentrated ownership or ownership concentration. Theoretically, it is very common for the shareholders to play the role of monitoring the managerial activities of the company as well as control the management. However, this aspect of monitoring power and the monitoring benefits depend on the equity proportion of the shareholders. (Kumar and Zattoni, 2017) illustrated that, shareholder who are concentrated as small shareholder and average shareholder has no incentives or some cases have very little incentives for playing the role of monitoring behaviour. On the other hand, shareholders who have the proportion of substantial equity, they are applicable to get more incentives for playing the role of supervising the management and they are quite good to do it effectively. The fact is that the larger of portion of share or equity hold by the investors of shareholders, they have high incentives and they are stronger in response to monitoring the managerial activities and, they also provide effort effectively for protecting the investment they have in the company.
It is also argued that shareholders who have large portion of equity then it may help in mitigating agency problem with manager, even it is also argued that shareholders who have large portion of equity may create problems or do harmful conflicts between the shareholders who are proportionately minor and smaller. It may happen when the shareholders who have large portion of equity got the full control of the company by their equity rights and intend themselves in doing expropriation procedure in response to the expenses shareholder who are minor. A
So, (Pass, 2004) figured out that, the expropriation incentive is stronger when corporate governance insulate large shareholder from takeover threat or monitoring and the agency cost may also increase. (Vaida, 2011) suggested to apply the corporate governance mechanism in terms of ownership concentration where all level of shareholders and managers will be benefitted and there must have the aspect of accountability for all level of shareholders, especially for the larger portion of equity shareholders. They must have to be accountable for their course of actions, roles and responsibilities because there is no exception to limit their control and monitoring power over the small and minor shareholders as well as the managers also.
4. Board of Directors
Corporate governance mechanism plays the important role and it is mostly performed by the board of directors in response to the aspect of controlling the managerial activities and monitoring management (Ingley and Van der Walt, 2001). This is to be argued that the effectiveness corporate governance mechanism which is played by board of directors largely depend on their composition, formation or size. It is pointed out that, large boards have the maximum power in monitoring the managerial activities of management compare to small boards and, therefore, it is like to be defined as the organizational effectiveness by the monitoring power of large boards.
(Ingley and Van der Walt, 2001) figured out that Large boards with maximum power support in strengthening the connection between company and its other stakeholders regarding strategic option for the company that work well to create corporate identity. Large boards of corporate governance also helps in mitigating agency problem by the means of establish proper coordination among the stakeholders, developing effective communication system to minimize the conflict and setting standard for effective and efficient decision-making.
In corporate governance mechanism, the independence of a board characteristics is also work well for reducing the agency problem or principal agent problem. It is also pointed out that Boards with maximum shares proportion of non-executive director may limit the exercises of managerial discretions by exploiting monitoring ability and protecting reputation as effective and independent decision maker.
(Ingley and Van der Walt, 2001) proposed to develop a positive relationship between non-executive director and corporate performances where it will be preferred to have less confrontational role for non-executive director as they cannot do worst thing.
5. Managerial Compensation
There is another mechanism of corporate governance to reduce the agency problem between shareholder and manager and it the mechanism of managerial compensation in terms of compensation package provided to the management.
(Mallin, 2008) argued that that there is the contract of legal and valid compensation package for the managers that is approved by the company board of directors to motivate manager. The motivation largely depends on the financial reward or financial compensation packages by increasing remuneration or providing promotion for the course of action and performance evaluation. All these things are related to the wealth maximization of the shareholders because this is the ultimate goal of the company for which they pay all those managers for those who are responsible to provide best effort for the company success. It is also analyzed that when managerial compensation is increased, then it works well to reduce agency problem as because the managers are satisfied with the payment system and they also get motivation to provide best effort for achieving company success of wealth maximization.
So, the relationship between the level of pay and performance is very important to minimize the agency problem, and side by side it is also important to keep motivating the managers for the effort as they always thrive to get the recognition for the work performed. Therefore, the corporate governance mechanisms of Managerial compensation, has positive impact on to minimize agency conflicts between shareholders and managers.
6. Growth Opportunities
The effectiveness of corporate governance mechanism may vary with growth opportunities because when it is seen that agency problems is correspondent to the greater information asymmetry or underinvestment, then the mechanism of corporate governance work well to reduce the problem effectively in high-growth firms (Mallin, 2008).
(Mallin, 2008) argued that agency problems is correspondent to the conflict of interest over free cash flow usage, then mechanism of corporate governance work well to reduce the problem effectively in low-growth firms.
So, the mechanisms of Debt Financing signifies lender’s ability to reduce agency problem, managerial ownership limits the large shareholders control over the managers, Ownership concentration ensures the accountability for all level of shareholders, Board of Directors have the equity right to control and motor whole activities of managers to avoid the worst things, Managerial compensation ensures the satisfaction level of managers to work effectively for the firm’s success and growth opportunities helps to avoid the agency problem for large and small cash flow firms (Biswas and Bhuiyan, 2008).
References (Agency Problem and Corporate Governance Solution)
Biswas, P. and Bhuiyan, M., 2008. Agency Problem and the Role of Corporate Governance Revisited. SSRN Electronic Journal, 4(2), pp.65-68.
Burton, B., Helliar, C. and Power, D., 2004. The Role of Corporate Governance in the IPO Process: a note. Corporate Governance, 12(3), pp.353-360.
Elloumi, F. and Gueyié, J., 2001. CEO compensation, IOS and the role of corporate governance. Corporate Governance: The international journal of business in society, 1(2), pp.23-33.
Holland, J., 2008. The corporate governance role of financial institutions in their investee companies. Corporate Governance, 6(3), pp.204-205.
Ingley, C. and Van der Walt, N., 2001. The Strategic Board: the changing role of directors in developing and maintaining corporate capability. Corporate Governance, 9(3), pp.174-185.
Kumar, P. and Zattoni, A., 2017. Agency Conflicts and Corporate Governance. Corporate Governance: An International Review, 25(4), pp.220-221.
Mallin, C., 2008. Institutional shareholders: their role in the shaping of corporate governance. International Journal of Corporate Governance, 1(1), p.97.
Pass, C., 2004. Corporate governance and the role of non‐executive directors in large UK companies: an empirical study. Corporate Governance: The international journal of business in society, 4(2), pp.52-63.
Vaida, I., 2011. The Problem of Agency and the Problem of Accountability in Kant’s Moral Philosophy. European Journal of Philosophy, 22(1), pp.110-137.
Van den Berghe, L. and Levrau, A., 2002. The Role of the Venture Capitalist as Monitor of the Company: a corporate governance perspective. Corporate Governance, 10(3), pp.124-135.
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