1.2 Agency Problems and Control of Corporations

Corporate finance isn't just about money—it's about people too. In companies, shareholders own the business, but managers run it. This setup can lead to conflicts, as managers might not always act in shareholders' best interests.

To keep things in check, companies use various tools. These include boards of directors, compensation plans, and rules about transparency. The goal? Make sure everyone's working towards the same thing: a successful, profitable company.

Principal-Agent Relationship in Governance

Defining the Principal-Agent Dynamic

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• Principal-agent relationship occurs when one party (principal) delegates decision-making authority to another (agent) to act on their behalf
• In corporate governance, shareholders typically serve as principals, while managers act as agents running the company
• Information asymmetry exists between principals and agents (managers often possess more detailed information about company operations and performance)
• Separation of ownership and control in modern corporations creates potential conflicts of interest between shareholders and managers
• Agency theory examines how to structure relationships and incentives to align interests of principals and agents

Corporate Governance Mechanisms

• Corporate governance mechanisms address agency problems and ensure managers act in shareholders' best interests
• Board of directors provides oversight and makes key decisions on behalf of shareholders
• Independent directors offer objective oversight and reduce potential conflicts of interest
• Audit committees (composed of independent directors) oversee financial reporting and internal controls
• Shareholder voting rights allow for election of directors and approval of major corporate decisions

Agency Problems: Shareholders vs Managers

Managerial Misconduct

• Managerial empire-building occurs when managers pursue growth strategies increasing their power and prestige (acquisitions, expanding into new markets)
• Excessive risk-taking by managers jeopardizes long-term stability (aggressive investments, high-leverage strategies)
• Shirking or moral hazard arises when managers exert less effort due to lack of direct consequences (delegating critical tasks, avoiding difficult decisions)
• Perquisite consumption involves managers using company resources for personal benefits (luxury office furnishings, private jet usage)

Financial Manipulation and Entrenchment

• Earnings management and financial misreporting can occur to meet short-term performance targets (accelerating revenue recognition, delaying expense recognition)
• Managerial entrenchment happens when executives implement strategies making it difficult for shareholders to replace them (staggered board terms, poison pill provisions)
• Information asymmetry between managers and shareholders can be exploited for personal gain (insider trading, selective disclosure)
• Short-termism leads managers to prioritize quarterly earnings over long-term value creation (cutting R&D expenses, postponing necessary investments)

Mitigating Agency Problems

Compensation Structures

• Performance-based compensation packages aim to align managers' interests with shareholders (stock options, restricted stock units)
• Long-term incentive plans (LTIPs) encourage focus on sustainable, long-term value creation (multi-year performance targets, deferred bonuses)
• Clawback provisions allow companies to recoup compensation in cases of financial restatements or misconduct
• Balanced scorecards incorporate both financial and non-financial metrics in executive compensation (customer satisfaction, employee engagement)

Governance and Transparency Measures

• Mandatory disclosure requirements and regular financial reporting reduce information asymmetry (quarterly and annual reports, 8-K filings)
• Say-on-pay provisions allow shareholders to vote on executive compensation packages
• Whistleblower protection programs encourage reporting of unethical or illegal practices (anonymous reporting hotlines, anti-retaliation policies)
• External auditors verify financial statements and internal controls (annual audits, Sarbanes-Oxley compliance)

Corporate Governance: Aligning Interests

Structural Considerations

• Corporate governance encompasses systems, principles, and processes for company direction and control
• Separation of CEO and Chairman roles enhances board independence and improves management oversight
• Board diversity (gender, ethnicity, expertise) contributes to more comprehensive decision-making and oversight
• Board committees (audit, compensation, nominating) focus on specific governance areas

External Influences and Best Practices

• Institutional investors play active role in corporate governance (engaging with management, exercising voting rights)
• Proxy advisory firms provide recommendations on shareholder voting decisions (ISS, Glass Lewis)
• Corporate governance codes and best practices provide guidelines for companies (NYSE Listed Company Manual, UK Corporate Governance Code)
• Shareholder activism can drive changes in corporate strategy and governance practices (proxy contests, shareholder proposals)