Corporate Governance, Agency Problem and Incomplete Contracts

Launching an area for discussion without proper understanding of the vital issues involved is like embarking on a field without the suitable apparatus. The subject under consideration, corporate governance, should be studied with the following considerations at hand: The right understanding of the commonly shared connotation or definition of term/s being used;  The right view of how distinctive countries try to safeguard and protect shareholders and stakeholders from financial managers drawn from the countries’ varied laws, cultural and political environmental framework, the business forms and ownership of shares in each country, which can significantly alter the code of ethics. Furthermore, these differing codes can simultaneously affect the way each country transacts business in the management level to the advantage or disadvantage of both the shareholders and stakeholders.

Success in rightly understanding corporate governance in any given country is a reflection of one’s individual perception on the various regulations being instigated and revised in the micro and macro level to mirror out the nature of not only the rights of shareholders but an equitable treatment of all shareholders at large (big or small) measured by current profits in short term focus, and the treatment of stakeholders as well for the medium to long term focus, all these to promote an impartial control by all proponents by the degree and power they give to managers, thus, leading to a level of confidence that can spawn entrepreneurial investments in the local and global market. These regulations or codes are so-called disciplines or practices designed primarily as self-regulating or co-regulation that marks the true value or worth of a single or common investment except that the risk involved is placed at the disposal of shareholder’s agent who has its own distinctive values.

Therefore it gives rise to an issue on agency problems because of conflict of interest, and of what sort of contingencies should these relationship put in place so that the unanticipated cost ‘unspecified by the initial contract’ and surpluses would be equitably shared by all the parties that belong to the firm including its creditor. Before embarking on the issues that arise from agency problem, it is well to note that there are a mixture of agency relationships that may be present in any given economic and business life and its corresponding related problems that may arise due to such relationships. Added to that is the role of ownership structure of various corporations and how each are compensated, what is the structure of the board of directors, what are the duties and responsibilities of the executive and non-executive directors, manner and promptness in monitoring and takeover procedure.

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The Nature of Agency Problems

The rise of large scale business organizations after the industrial revolution whose ownership structure included stock holders, or people from different sectors of society that come up to provide necessary funds, gave way to an array of conflicting interests. In this kind of set-up, ownership risk-bearing and managers’ control are completely separate functions. Each function reflects the interest of the one performing it. Ownership must carry the brunt of vulnerability and managers must act entrepreneurially (Keasey and Wright 1993 as quoted by Bhuiyan & Biswas 2006) at the expense of their own livelihood or career. In the words of Prowse (1996) as quoted by Bhiuyan & Biswas (2006.

), “Creditors doing business with firms, want to be sure that they will be repaid, which often means firms taking on less risky projects…managers would rather maximize benefits to themselves by preferring policies that justify paying them a higher salary, or divert company resources for their personal benefit or simply refuse to give up their jobs in the face of poor profit performance. Large shareholders with a controlling interest in the firm would, if they could, increase their returns at the expense ofminority shareholders. ” This situation describes the most common principal-agent problem existing in most firms when managers take risks which do not quite reflect the interests of its shareholders. In other words, problems arise due to the fact that company directors/managers do not handle their own money but other peoples’. Their attitude will differ from shareholders in that they cannot be expected to have the same anxious watchfulness over what is not truly theirs and for which they do not suffer much personal loss.

This separation of owners and managers has given way to shareholders’ inability to perform any kind of control over those whom they have chosen to represent and protect their interests. These parties, however, are bound by contract. In these contracts, the principal (or owners) appoint/engage the agent to execute or perform services on their behalf. All decision-making is left in the hands of the managers, which affects both parties. The problem thus arises when the principal and the agent’s interests and views clash with each other. Brousseau and Glachant (2001) give examples of such conflicting relationships:

• The agent is generally assumed to a risk-averter and the principal to be a risk seeker or risk-averter;
• The agent might have a shorter duration with the organization than the principal;
• The agent’s earnings are fixed (in the absence of incentive payments) while the principal is the residual claimant;
• The principal does not directly take part in the management decision-making and control (i. e. ownership is separated from management);
• There is information asymmetry between the agent and the principal; in fact the principal is ignorant of many details of the agent’s activity.

Parties are assumed to desire to maximize their own interests subject to constraints imposed by the structure, hence problems arises with agency relationships. Bromwich gives an example of this, when management maximizes their own interest by “accumulating not only pecuniary benefits and shirking but also a wide variety of non-pecuniary benefits, such as luxurious offices, unnecessary “high tech” equipment and foreign trips. ” Problems can be categorized into those arising between shareholders and top management, between controlling and minority shareholders and between shareholders and creditors. From where do these conflicts arise? They usually crop up when there is irregularity or lop-sidedness in information, difference in attitudes toward risk and differences in decision-making rights. Shareholder-management problem. This is said to arise from difference in sensitivity to what is termed as “firm-specific” risk. This refers to how a decision maker “ranks alternative choices differing in their riskiness.

” (Heinrich, 2002) This ranking usually depends on the decision maker’s preferences but will also depend on how the decision maker’s payoff varies with the riskiness of the chosen alternative. Controlling and minority shareholders. When the controlling majority exercises liberty in diverting portions of the firm’s resources for their own benefit without or perhaps at the expense of the non-controlling or minority shareholders, then conflicts may arise. These benefits to the majority shareholders may take the form of transferring profits to other firms in which the “controlling shareholders has a large cash flow stake or of asset sales at bargain prices to firms owner by the controlling shareholders.

” These minority stockholders suffer because these diversion decisions reduce the cash flow, thus minimizing the firm’s value to them. Creditors and shareholders. The role of creditors in the firm is mostly based on contract and thus they have no participation whatsoever in the firm’s internal activities. Once the firm has acquired debt, the tendency is to prefer to undertake more risky investment projects. This gives discomfort to the creditor because although they have no internal involvement in the firm, yet should anything happen to the debt service or if the company gets bankrupt, they naturally will share in the losses. Incomplete contracts

To better understand the concept of incomplete contracts, it is essential to start to understand the concept of contracts. Economists define a contract to be an “agreement under which two parties make reciprocal or mutual commitments in terms of their behavior – a bilateral or two-sided coordination arrangement. ” (Brousseau & Glachant 2001). In this definition we note that contracts serve to regulate coordination at a bilateral level and to allow us to examine key issues such as: the nature of difficulties associated with economic coordination, provisions for coordination, conceptualization of rules and decision-making structures that frame agents’ behavior.

It also helps us to understand changes in the structures that frame economic activity. Thus, a study of contracts in simple terms allows us to analyze coordination mechanisms within an economic framework and within a given time since contracts do expire. Brousseau and Glachant (2001) noted that three main theoretical frameworks arise from the concept of contracts, namely, “incentive theory”, “incomplete-contract theory”, and “transaction-cost theory. ” “Incentive theory” emerges from a situation where an under-informed party (principal) comes up with an incentive scheme to persuade the agent, or informed party, to disclose information or behave in line with the interests of the principal.

The incentive system consists of compensation being restricted to the behavior of the agent. “Transaction-cost” theory, on the other hand, assumes that the principal and the agent have limited abilities to operate in a sphere in which they are unaware or ignorant of the problems that may arise, thus disenabling them to come up with complete contracts. It “simultaneously deals with the efficiency of adjustments ex post and constraints on the performance of contracts. ” (Brousseau & Glachant 2001) This theory insists on protecting parties from the possibility for opportunistic deeds on behalf of the other and provides motivation to commit to the contract. It also insists on private resolution mechanisms, i. e.

, the contracting parties must agree in advance on courses of action for settling differences/disagreements). The incomplete-contract theory, the most recent of the three, examines the effect of the institutional framework on contract design although its foundations are derived from the study of the effect of property-right allocations on the distribution of the residual surplus between principal and the agent, and on both incentives to invest. Imagine a situation where an investor intends to invest his money on the stock market by means of an agent. He either opts to give an incentive to the agent at the end of a specific time (incentive theory).

The key assumption here is that it is impossible to contract future actions when no third party can “verify”, ex post, the actual cost of some of the variables vital to the dealing between the agents. Here it is also assumed that the authority that oversees the implementation of the contract is also incapable of observing relevant variables, thus these cannot be included in the contract. And this makes for the incompleteness of the contract. In incomplete contracts it is assumed that all parties are given all information observable during each period of the trade. Uncertainty arises in these contracts because each party is unaware, cannot anticipate what the other party will do with respect to those variables which were not included in the original contract.

This is properly executed by contracting parties over two periods. In the first period the agents recognize non-verifiable variables or investments. The second period is committed to trade dealings where price and quantity are the only verifiable variables. The problem that might arise here is that it is only verifiable variables that are contractible and only on the second period of the trade can these variables be given values. The level of investment realized by the parties in the first period depends upon this contracted level of trade. After the first period, the ex ante level of trade is no longer optimal. Thus, it would then be optimal to renegotiate the amount of the trade, ex post.

Zingales (1997) notes that in considering incomplete contracts “it is necessary to allocate the right to make ex post decisions in unspecified contingencies. ” He observes that this residual right is both “meaningful and valuable. ” This is due to the fact that it gives an option to make decisions ex post. And this discretion can be used strategically in bargaining over the surplus. He further notes that only in the world of incomplete contracts can we discuss corporate governance as different from contractual governance. In an incomplete contracts world, corporate governance can be defined as the set of conditions that shape the ex-post bargaining over the quasi-rents generated by a firm.

A governance system has efficiency effects both ex-ante, through its impact on the incentives to make relationship-specific investments, and ex post, by altering the conditions under which bargaining takes place. A governance system also affects the level and the distribution of risk. The incomplete contracts approach has made the study of corporate governance understandable and meaningful with respect to allocation of ownership to the providers of capital who are dispersed, the stucture of capital and the importance of internal organization. Non-statutory Protection for Shareholders To shield themselves from the agency problems, shareholders can avail of other measures to address the issues at hand.

The appointment of non-executive directors (those who are not members of the management team) to counter the negative effects of a board dominated by the management team are considered by shareholders. This is effective in that non-executive directors would be more sympathetic to the goals of maximizing the wealth of shareholders and they would less favor decisions that are in conflict with these. Another measure that they can possibly take is the assigning of managerial and director incentives. It is generally agreed that the structure of executive compensation contracts can have a large influence on aligning the interests of shareholders and management. (McColgan 2001) Jensen and Meckling (1976) argue that the higher levels of incentives are proportionate to higher company performance.

Thus, effective compensation contracts should provide management with sufficient incentive to make value maximizing decisions at the lowest possible cost to shareholders. These incentives come in the form of basic salary, performance bonuses, performance-based share option schemes and long term incentive plans. Thirdly, the threat of firing. In most corporate governance literature, it has been noted by McColgan (2001) that one of the most consistent results is that directors are most likely to lose their jobs if they are poor performers. Thus, in order to keep their jobs, managers are forced to take shareholders maximizing actions and in that process protect the interests of the shareholders, thus addressing the given problem.

A company also may welcome large or institutional investors to overcome agency problems. They may have more skill, more time and a greater financial incentive to overcome this problem and closely monitor management. Also, large shareholders may be able to elect themselves into company boards and thus increase their ability to monitor management. Disciplinary takeovers. In the event of breakdown of internal control systems, takeovers are more likely to occur especially when there are large levels of free cash flows. (Jensen, 1986). This takeover takes place when the shares of the company are undervalued relative to their potential due to poor management.

This drastic move, however, may encourage management, for fear of losing their jobs, to resort to investing free cash flows in more efficient investment projects. Failed takeover attempts lead firms to sell off under-performing assets in order to increase focus on key profitable investments. Thus, we can perhaps conclude that take-over bids may be initiated not only for efficiency gains but also as a way of disciplining poorly performing management. Comparison between US, UK and Australian approaches compared to German, French and Japanese approaches. In the US, UK and Australia (let us designate this as group A) corporations are characterized by the separation of share ownership and managerial control of the corporation itself.

In other words, managers who are usually non-owners and directors have a control over the company’s assets, and they are solely involved in the formulation of strategies and tactics in order to earn money for the company. On the other hand, there are the shareholders, who invest vast amounts of money (risk capital) which are used to finance purchases of company assets and make possible other activities of the corporation including raising money from creditors and other fixed claimants. This shareholder culture is unique to these countries. (Macey 2008) However, in countries like France, Germany and Japan (designate group B) the biggest companies are controlled by “powerful families, other corporations through complex corporate cross-holdings of shares, large banks, and, occasionally, by governments themselves. ” (Macey 2008).

The problem in this case is that shareholders are usually at the mercy of these powerful interests and shareholder interests are often relegated to the background and are mere afterthoughts of the managers of these companies. In the corporate governance model, group A countries have shareholders as the center of the corporation. It is a common practice that the corporation is governed for the benefit of the shareholders, subject to legal and contractual responsibilities of the company to third parties. In contrast to this, group B countries are said to be owned not primarily by the shareholders but by all stakeholder, meaning, including workers, customers, suppliers, etc. In these countries, thus, managers believe that their primary concern is to provide job security for workers instead of providing for shareholders interests as in the case of group A countries.

Another difference of approaches is that where shareholder wealth maximization is the ultimate governance promise to group A countries, it is not true to other countries in the world. In group B countries, it is not the promise of shareholder wealth that governs the corporation. Instead, the fundamental corporate governance premise is “that the corporation is a creation of the state, whose goals are to serve myriad and often conflicting societal interests. ” (Macey 2008) He also notes that these group B countries are not free to “commit themselves contractually to maximize profits for investors. ”But when this happens, investments or contracts may have been pressured by international competitiveness or market pressures. In group B countries, job security becomes a main corporate objective.

In the example of Canon Company, despite many ups and downs in profitability, it has never laid off any employees in its entire history. (Garcia et. al. 2008). In Germany, employees are very influential stakeholders and their welfare is top in terms of management concerns. They have small percentages of the firm’s total stock and the manager’s compensation is not so much focused on current profitability. (Garcia et. al. 2008) In the overall analysis, several elements determine a country’s corporate governance structure. In their discussion Garcia et al (2008) notes that in configuring their corporate governance schemes all can be summed up in two competing models: the shareholder-centered or outsider view vs. the stakeholder-centered or insider approach.

References

1. Bhuiyan, HU and Biswas, PK 2006, ‘Agency Problem and the Role of Corporate Governance, The Bangladesh Accountant, vol. 52, no. 25, pp. 109-117,
2. Brousseau, E and Glachant JM 2001, ‘Contract Economics and the Renewal of Economics, in The Economics of Contracts: Theories and Applications, Cambridge University Press, London
3. Garcia, R, Arino, MA, Rodriguez, MA and Ayuso, S. 2008, ‘Shareholder vs. Stakeholder: Two Approaches to Corporate Governance’, Business Ethics, A European Review, vol. 17, no, 3.
4. Heinrich, PR 2002, ‘Complementarities in Corporate Governance’, Springer, Berlin. Jensen, MC 1986, ‘Agency Costs of Free Cash Flow, Corporate Finance Takeovers,’ American Economic Review, vol. 76, no. 2, pp. 323-329.
5. Jensen, MC and Meckling 1976, ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, Journal of Financial Economics, vol. 3, no. 4, pp. 305-360.
6. Keasy, K, Thompson, S and Wright, M, eds. 2005, ‘Corporate Governance, Accountability, Enterprise and International Comparisons,’ John Wiley & Sons, England. Macey, JR 2008, ‘Corporate Governance: Promises Kept, Promises Broken, Princeton University Press.
7. Prowse, S 1996, ‘Corporate governance in international perspective: legal and regulatory influences on financial system development, The Economic Journal, Federal Reserve Bank of Dallas, 3rd quarter.
8. Zingales, L 1997, ‘Corporate Governance’, NEBR Working Paper 6309, National Bureau of Economic Research, Cambridge, MA.

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