Managers are hired to act on behalf of the shareholders of a firm. However, this is not always the case as both parties have different objectives. The difference in interests between shareholders and managers ‘derives from the separation of ownership and control in a corporation’ (Berk and DeMarzo, 2011: 921). Whereas shareholders are interested in maximising their own wealth, managers may have more personal interests which differ to that of the shareholders.
Downs and Monsen (no date, cited in Chin, Cooley and Monsen, 1968:435) suggest that managers self-interest lies in maximising their life-time income and that ‘such self-interest will be congruent with profit maximisation for the firm only in special cases’. This conflict between both the shareholders and the managers is termed the agency problem. Alongside the agency problem comes agency costs, which is the costs incurred to prevent the managers from prioritising their interests over the shareholders. It can be argued that the extent to which managers will have discretion to pursue actions that are not consistent with shareholder wealth maximization is severely limited. However, this is not always the case.
Managers may have discretion to pursue their objectives before those of the shareholders as there is information asymmetry between the two parties. Berk and DeMarzo (2011:533) state that the managers’ ‘information about the firm and its future cash flows is likely to be superior to that of outside investors’. This statement is reinforced by Aboody and Lev (2000:2749) who assert that ‘managers can continually observe changes in investment productivity’. This is a consequence of the responsibilities of manager being to run the business on a day-to-day basis, meaning they will have access to management and financial accounting data. As a result, managers will be in a position to make investment decisions that will maximise their wealth, without detection by the shareholders. On the other hand, shareholders ‘obtain only highly aggregated information on investment productivity at discrete points of time’ (Aboody and Lev, 2000:2749).
Their primary source of information about the performance of the company is from the annual reports, whose figures may be subject to manipulation. Healy and Palepu (2001:406) argue that, because of information asymmetry and agency conflicts between managers and outside investors, there has been a demand for such financial reports and disclosures. As suggested by Healy and Palepu (2001:408), a potential solution to the information asymmetry problem is ‘regulation that requires managers to fully disclose their private information’. This seems like a logical and simple solution, however, it will not be easy to carry out as there will be costs involved in the monitoring.
Although managers may be able to pursue their own objectives due to asymmetric information between them and the shareholders, this may be restricted by regulations such as the Sarbanes-Oxley Act of 2002. The act was passed following a number of high profile scandals, including the fall of Enron, with the overall intent of the legislation being to ‘improve the accuracy of information given to both boards and shareholders’ (Berk and DeMarzo, 2011:931). The act strengthened the criminal penalties for providing false information to shareholders and requires both the CFO and CEO to declare that the financial statements are accurate. With the act allowing penalties of fines up to $5 million and a maximum of twenty years imprisonment for providing misleading financial statements, managers will be more inclined to pursue actions consistent with maximisation of shareholder wealth, as they fear the risk of legal action being taken against them if they do not.
Corporate governance is, to a large extent, a set of mechanisms through which outside investors protect themselves against expropriation by the insiders’ (La Porta et al., 2000:4). One mechanism that is used to address the agency issue and ensure that managers are acting on behalf of shareholders is the close monitoring of managers’ actions. Although it may be a simple solution, there are costs involved. Berk and DeMarzo (2011:922) state that as no one shareholder has an incentive to bear these costs, as the benefits are then divided between all shareholders, they instead elect a board of directors to monitor the managers on their behalf. The directors’ duties include hiring the executive team, approving major investments and acquisitions, and dismissing executives if necessary (Berk and DeMarzo, 2011: 922).
The level of monitoring required differs across firms and is ‘based on the magnitude of the incentive gap between principal and agent’ (Beatty and Zajac, 1994, cited in Westphal and Zajac, 1994:125). However, the main factor affecting the level of monitoring provided is the cost, otherwise ‘all rational firms would monitor maximally, irrespective of the strength of incentive compensation contracts or other factors’ (Westphal and Zajac, 1994:125). Although the board of directors are hired to keep a close eye on top management, the agency problem may still exist. This will occur when the director’s duties in monitoring have been compromised as they have connections with management.
A way of overcoming this problem is to hire directors who are independent to the company, as they are deemed to be better monitors of managerial effort. As Mehran (1995:166) states, outside directors are ‘more independent of top management and thus better represent the interests of shareholders than do inside directors’. Research has also proved this, showing that firms with boards made up of outside directors make less value-destroying acquisitions and are more likely to act in the interest of shareholders (Byrd and Hickman, 1992, cited in Berk and DeMarzo, 2011:922).
Monitoring may be an effective measure for ensuring managers’ act in the shareholders’ interests, however, Jensen and Meckling (1976, cited in Westphal and Zajac, 1994:125) ‘stress the primacy of incentive contracting as a first best solution to the agency problem’. Berk and DeMarzo (2011:921) state that the significance of the conflict of interest is dependent upon how closely aligned the managers and shareholders’ interests are, which therefore suggests that aligning their interests will mitigate the conflict. Attempts can be made to align these interests by providing incentives for acting in the right and punishment for acting in the wrong. These incentives need to be designed wisely to ensure that they achieve their intended goal and may differ for different managers in different companies.
Mehran (1995:165) suggests that ‘tying managers’ compensation to firm performance motivates them to make more value-maximising decisions’. An example of this would be to include stock options to executives. This would give managers an incentive to increase the stock price, as managerial wealth is now tied to the wealth of shareholders. Using these incentives works in mitigating the agency problem as it effectively gives manager’s ownership in the firm. In the case of Enron, ‘management was heavily compensated using stock options’ (Healy and Palepu, 2003:13). However, these were only based on short-term accounting performance. As a result, Hall and Knox (2002, cited in Healey and Palepu, 2003:14), through looking at Enron alongside other firms, raise the possibility that ‘stock compensation programs as currently designed can motivate managers to make decisions that pump up short-term stock performance, but fail to create medium- or long-term value’.
Westphal and Zajac (1994:123) propose that using compensation to align manager and shareholder interests is ‘potentially a double-edged sword’ as, although it may motivate managers’ to work in the shareholders’ interest, ‘linking a manager’s compensation too closely to firm wealth might lead to risk-avoiding behaviour’ on the manager’s part. This seems logical, as by giving managers ownership in the firm, their risk exposure increases. This is because they are now exposed to the firm’s risk, since a firm might not perform well for reasons unrelated to the managers’ performance.
Aboody, D. and Lev, B., (2000) ‘Information Asymmetry, R&D, and Insider Gains’, The Journal of Finance, 55 (6), pp. 2747-2766.
Berk, J. and DeMarzo, P., (2011) ‘Corporate Governance’, In Battista, D. (ed.) Corporate Finance, Harrlow: Pearson, pp. 927-931.
Chin, J.S., Cooley, D.E. and Monsen, J., (1968) ‘The Effect of Separation of Ownership and Control on the Performance of the Large Firm’, The Quarterly Journal of Economics, 82 (3), pp. 435-451.
Healy, P.M. and Palepu, K.G., (2001) ‘Information Asymmetry, Corporate Disclosure, and the Capital Markets: A Review of the Empirical Disclosure Literature’, Journal of Accounting and Economics, 31, pp. 405-440.
Healy, P.M. and Palepu, K.G., (2003) ‘The Fall of Enron’, Journal of Economic Perspectives, 17 (2), pp. 3-26.
La Porta, R. et al., (2000) ‘Investor Protection and Corporate Governance’, Journal of Financial Economics, 58, pp. 3-27.
Mehran, H., (1995) ‘Executive Compensation Structure, Ownership and Firm Performance’, Journal of Financial Econometrics, 38 (2), pp. 163-184.
Westphal, D. and Zajac, E.J., (1994) ‘The Costs and Benefits of Managerial Incentives and Monitoring in Large U.S. Corporations: When Is more Not Better?’, Strategic Management Journal, 15, pp. 121-142.