Agency theory

Agency theory or agency relationship is the theory which looks at the relationship between the owners of the company in the form of shareholders (equity investors) and those have been given responsibility to take charge of the management of the company in the form of directors. Agency theory is one of the key concepts underlying the importance of corporate governance, which has taken prominent role in business activities in the last few decades. It has its roots in almost every aspect of business activities and plays a very significant role in decision-making by directors (both executive and non-executive directors). Research into ownership of shares in FTSE 100 companies (London stock exchange), indicated that less than five percent (5%) of all shares in FTSE 100 companies were held by management of such companies, and even in most cases management shareholdings came about as a result of share option in the form of bonuses. From the above discussion it means the general public (that is both major/ institutional investors and small shareholders) holds the majority of shares in listed companies rather than management. The concepts of agency theory has become a lot more important now than ever before, especially with the corporate collapses of major multinational companies such as Enron in 2001, WorldCom in 2001, Lehman brothers 2008, and the nationalisation of many financial institutions in recent months as a result of the global financial crisis. Lots of companies have been nationalised in recent times than ever before across all developed economies, such companies include Washington mutual, Bradford and Bingley, Northern rock etc.

To understand the concept of agency theory it is important to briefly discuss the characteristics of ordinary shareholders or equity investors of companies, some of such characteristics includes: Equity investors are deemed to be the owners of the company They have voting rights in general meetings In case of profit, they may receive dividend after tax In case of liquidation, they are the last in ranking to receive anything from their investment in shares The whole the share investment is not secured against any of the companys assets, and predominantly not redeemable. A shareholder therefore bears a significant risk on its investment in ordinary shares hence their interest needs to be protected from undue exploitation by management who have been given charge over the assets of the company to use it to achieve the objectives of the company especially the primary objective of maximisation of return to the shareholders.

The interest of shareholders may include: Increasing earning per share (EPS), and current share prices Increasing investor ratios such as dividend per share (DPS), dividend cover, dividend yield, price-earning (P/E) ratio Others may include the company improving its corporate and social responsibilities

Management are people who have been empowered to take charge / responsibility of the affairs of the organisation to achieve its objectives.

Some of their responsibilities include; setting of objectives, planning and control, decision-making, all with the aim of achieving the objectives of maximising the return to the shareholders and achieving the secondary objectives of the organisation as well. Management interest may include: Managing the firm to achieve its objectives Increasing the wealth and size of the company, by expanding the companys activities, the bigger the size of the company they manage the better they are perceived to be. Increasing their personal wealth by paying themselves high remunerations and other benefits Why conflict of interest between shareholders and management? To address the conflict of interest between shareholders and management, it is important to stress that even within the same class of shareholders, there may be conflicts, this conflict may relate to what proportion of the companys profit should be paid in the form of dividend and what proportion should be retained for future investments and for capital investment purposes. Other potential conflicts may involve companys ethical policies, its corporate and social responsibilities policies. The agency theory, considering the potential conflicts of interest between shareholders and management may arise as a result of several factors, some of such factors include: Reward to management Risk attitudes of management and shareholders Takeover decisions by management Time horizon of management Measures to reduce such conflicts of interest

Management rewards should be linked to their performance, such performance related pay should use several factors and variables rather than just the use of profits as the basis of giving bonuses, and it may be linked to share prices, successful capital investments Reward should be focused more on long-term instead of short-terms fixes and achievements Non-executives should be more proactive and responsive to changing business activities, and to hold management accountable, making sure that management are pursuing the objectives of the organisation and not their own objectives, there must be goal congruence in management activities. There should be close working relationship between management in the form of directors and all shareholder groups and not just directors seeking to meet the interest of only the major investors and taking the small shareholders view for granted. The company and all its major stakeholders, especially the regulators should make sure that management follow good corporate governance practises and become more corporate and socially responsible. Agency theory is equally important as corporate governance, since it forms the backbone of any successful corporate governance policies and regulations, (get the agency theory framework right and the corporate governance principles will more than likely be right) especially in the 21st century where there have been some of the major corporate collapses and lots of talk with regards to strengthening the corporate governance reporting by companies to make sure that it is effective and efficient in protecting the interest of shareholders and all other stakeholders.

Your comments, contributions, articles etc on the above article and any other accounting, business, finance and related issues is welcome. You can send us a mail on info@warmah.com Written by; William Armah Fellow; warmah.com