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What does agency problem mean?
Agency problems are behavior issues that arise out of the formal separation of management and ownership of a professionally managed company such that they form the key determinant of the capital structure and the distribution of policy decision. In this case, shareholders are twisted by the management who fill their pockets at the shareholders expense. Agency problems are present because of the separation that is created by directors and fiduciaries that make decisions based on their shares in a company rather than the rational interest of the actual shareholder. On the other hand, company management, in annual board meetings, interact with these directors and fiduciaries rather than the actual shareholders and are therefore not truly answerable to them. This provision, removes that guilt of greedy behaviors by management of public companies (Schroy, n.d.).
Clarke (2004) notes that corporate governance is a historical effort to resolve the following and related agency dilemmas through its principles and mechanisms. Firms cannot rest all decisions upon shareholder vote even though they are supposed to be under effective monitoring mechanisms. Secondly, shareholders with a large total share have to be restrained against using their powers to bully other shareholders in decision making. Thirdly, investors will prefer liquidity over the commitment put in place for monitoring and finally, investors performance measurements can be misleading and lead managers to focus on inappropriate objectives while on the other hand such information may weaken the firms competitive advantage. In a strong argument for the case of corporate governance, Hart (1995) indicates that agency problems are the reason why companies need to have a corporate governance mechanism. The author indicates that,
In the absence of agency problems, all individuals associated with an organization can be instructed to maximise profit or net market value or to minimise cost. Individuals will be prepared to carry out their instructions since they do not care per se about the outcome of the organizations activities. Effort and other types of costs can be reimbursed directly and so incentives are not required to motivate people. In addition, no governance structure is required to resolve disagreements since there are none (Hart, 1995 p.678).
What are the remedies for the agency problem?
There are several solutions to the agency problem and more than one solution may be incorporated in a new company structure. Company shareholders can elect a board of directors that is independent of the management thus serving as a mechanism against management insensitivity attributed to the agency problem (Clarke, 2004). Another way is to have executive stock options that align the interests of the owners with that of the managers. Having a small pool of shareholders is also another solution; therefore, shareholding of public companies should be concentrated. In some case, overseas listing of the company shares serves as a barrier against agency problems for companies located in countries having a weak investor protection policy. Compliance with the Sarbanes-Oxley Act is another way of reducing agency problems (Madura, 2008).
The Sarbanes-Oxley Act
The Sarbanes-Oxley Act was enacted in 2002 to enhance the standards for public boards and their management as well as their accounting firms so that major scandals witnessed in the same period concerning loss of asset value because of financial book manipulation. According to Clarke (2004), the disaster that befell corporate America in 2001/2002 involving a prolonged series of revelations of malfeasance relating to what previously were regarded as leading corporations, resulted in the dramatic intervention of the US Congress and the passing of the Sarbanes-Oxley Act (p.153).
The act ensures that there is a reliable financial reporting, which maintains investors confidence in the company as well as the integrity of the securities exchange. The act introduced a public company accounting board. The act stipulates that management have to have a sound internal control structure to ensure there is proper financial reporting and sound effective governance. In addition, auditors have a role to access and report the relevancy of managements assessment on the financial health of the company. The act strengthens the discipline and structure of organization and instills ethical values by emphasizing on the correct procedures that the whole organization has to follow. To ensure obedience to the act, it comes with severe penalties provisions (Wagner & Dittmar, 2006).
Solution to Parmalats case
The Parmalat case study concerns the giant food company, Parmalat, of Italy that became corporate insolvent because of fraudulent bonds. The collapse of the food giant unmasked the dirty deals that international banks were making using offshore centers that do not fail under the jurisdiction of their home regulatory authorities. Prior to the downfall of Parmalat, the company was rated as fourth in size among Europes food companies. According to Celani (2004), Parmalat controlled half of Europes milk (including milk products) market. The company claimed that it had a liquidity of 4 billion euros, which was later on found to be non-existent. In addition, 8 billion euros invested in the company could not be accounted for during the declaration of insolvency. The significance of the bankruptcy case of Parmalat comes out of the fact that it represents 1.5 per cent of the Italian gross national product, which is larger than the combined ratio of other notable collapses, the likes of Enron and WorldCom to their national GNP.
The company, with 34 thousand employees, practiced a speculative scheme of luring investors funds and spread it across 260 interconnected international offshore dicey units. Unfortunately, the greed of the company was too much and none of its speculative entities turned profitable. Most of the speculative entities involved significant investments in high-risk derivatives operations (International Commercial Crime Services, 2005).
Reports to the investigations of the collapse of the company indicate that it was a pawn of banks, which has invested and managed the dicey arrangement. By the act of pursuing global acquisitions back in 1997, Parmalat was able to join the international market with success. It succeeded in becoming the largest cookie maker in the United States just before 2001 when its subsidiaries started making losses. To cushion itself against these loses the company chose to enter the high-risk deliberative market, an action that proved catastrophic. Furthermore, the company ventured into speculative enterprises such as the Parmatour tourism agency that could not provide a return on the huge sums of money poured into them (Celani, 2004).
The Parmalat leadership was arrogant in their dealings, a good example of poor corporate governance. The banks that dealt with Parmalat directors in setting up offshore accounts are responsible for the agency problems that faced Parmalat. Parmalats case is an example of a companys failure at corporate governance. The company is an Italian food group that collapsed after its management failed to follow Italian corporate governance standards. These include having an independent director board and the correct composition of the internal control committee. The companys external auditor also failed to offer an early warning and a solution to fix the financial problems of the company.
A solution to the Parmalat case would be to employ the various remedies of agency management in the company as outlined above. The government should enact new regulations with clear provisions aimed at stopping fraud because fraud is the key influencer of bad governance. Ineffective accounting standards have to be corrected and strengthened so that the financial health performance of companies is readily reflected to shareholders. On the other hand, shareholders should ensure that the company management has multi-year focus for running the company as a way of preventing any future mistakes associated with stopgap measures to financial control out of the desperation to meet monthly and quarterly goals (Clarke, 2007).
The problem at Parmalat was attributed to the failure of the gatekeepers composed of the senior leadership and auditors, to act on the tale signs of impending collapse. This highlights the failure of a rule-based strategy at controlling company health status. Therefore, to remedy this problem, the correct solution has to be based on the creation of a culture of ethics. Management and stakeholders need to adopt mechanisms that promote the development of an ethical and responsible corporate culture. One way to do this is to have supervisory agencies that are powerful enough to enforce regulations of corporate governance (International Commercial Crime Services, 2005).
The Dominant Compensation Philosophy Nowadays
The dominant compensation philosophy nowadays is to have management form part of the company ownership so that it is concerned more with improving the shareholder intrinsic value rather than reducing it. Currently, most incentives are tied to the level of performance in absolute terms rather than the value creation of a consistent performance and sustainable profitable growth. According to Pettit & Ahmad (2000), the compensation outlook is short term, focusing on the year horizon and as a result, monthly and quarterly goals become exaggerated in their importance. This forces the management to employ perverse habits and accountancy. In most cases, the compensation strategy is a piecemeal attempt such that new plans are always added each successive year. The company ends up having more goals and measures than the total number of its employees.
Companies seek to have a competitive compensation for their management as a way to limit their retention risk. In this regard, organizations do not allow their total compensation to fall below the competitive rates. The same philosophy also prevents the total compensation from rising above the competitive rate and therefore cushions the shareholder from exorbitant costs to management. Allocation of company stock options, bonuses and other risk forms of compensations may not be a total solution in the provision of incentives against management retention risk. Furthermore, when directors receives large compensation payouts, the public complain and when managers leave for a competitor company, shareholders cannot say that they provided compensation lower than their competitors. It therefore appears that wealth compensation, for the sake of increasing shareholder value, has to include a substantial risk compensation to make the director a large shareholder (OBryne &Stewart, 1995).
What is the link between company size and executive pay?
Company size today determines the executive pay. However, the executive pay is offered in form of risk, as equity in the company. Big sized companies have the ability to offer greater compensation to their executives (Gomez-Mejia, 1997). These companies enjoy a larger market share and therefore their CEO has a daunting task of maintaining or increasing the already large market share hence their high compensation. Large companies have a larger dollar value median for CEO salaries than smaller companies. Moreover, as their size grows these companies increase the at-risk compensation of their executives at a much higher rate that for small companies. According to Hallock (2010), CEO pay tracks have tracked the market capitalization of their respective companies, historically increasing as the company grows. Executive pay trend has been captured by the Economist (2003), Bosses pay has moved inexorably upwards, especially in America. In 1980, the average pay for the CEOs of Americas biggest companies was about 40 times that of the average production worker. In 1990, it was about 85 times. Now this ratio is thought to be about 400 (p.13).
Limitations to Equity Incentives
Limitations to equity incentives include the volatility of the market, which is sometimes enigmatic and demotivating, and most employees are not poised to bear the compensation risk. Employees are bent on survival thus cannot make more aggressive bets when their shares are not performing well (Clarke, 2004). Another limitation is market mystery because many employees and their executives have limited financial expertise of the global capital markets and cannot comprehend valuation. Thus, they become prone to the sell-side analysis based on short-term measures and deferral of long-term initiatives in the company. Thirdly, non-operative nature of the equity incentives make them less of a motivation compared to cash incentives that allow linkage to be made on actions and their corresponding results. Lastly, equity incentives provide a poor line of sight of the relationship between the influence on employees and the traded security of the company. In some cases, stock options become end of year bonus and employees do not attribute the stock option to their performance thus defeating the logic of having equity incentives (Shijun, 2004).
Why cash incentives be a solution for the pay-performance problem
Cash incentives could be the solution to pay-performance problems; however, without addressing the underlying problems of poor performance, a focus on compensation, as a motivating factor will not succeed. Cash incentives usually come after the performance of the company has already been measured and therefore does not serve as a success in modifying the behavior necessary for good governance. In this regard, cash incentives must not be implemented alone and have to be incorporated together with equity. In addition, the equity grant has to be a fixed share grant rather than a fixed value grant so that it augments the sensitivity of pay to performance. To solve the pay-performance problems, the company should have a linkage of its yearly and long-term plans with the ratio of bonus used in its grant multiplier. Finally, cash incentives have to be in tandem with the value generated in the company rather than the returns of the company. The latter links to the shareholder interest and influences an increase in share sensitivity (Ittner, Lambert, & Larcker, 2003). Cash incentives peg on the actual performance of the firm rather than the growth in the firms book value. According to Charan (2003), Net income is an accounting figment of sortsan estimate at bestand one that often sheds little light on where the money is actually being made; cash, on the other hand, is real (p.181). In reference to Sun & Cahan (2009), change in CEO cash compensation exhibits a strong positive relation with both changes in return on equity and stock returns (p.195).
Big Bath
Big bath is an accounting term that refers to the practice of taking a large proportion charge out of an asset during a single year so that subsequent years show a minimal reduction in net income. The term is associated with the desire to minimize additional expenses in the following year by lumping up the projected expenses in the current years financial books. In the big bath, a company reduces significantly the value of its assets so that a marginal improvement in the later years is reflected as a net income on the same asset when they are sold (Shijun, 2004).
Big baths are often termed as restructuring charges that the company has to take. In calculating the big bath, a company does not rely on the current financial year earnings, instead it uses cumulative earnings of the company. The big bath is taken on the accounting earnings rather than economic earnings thus making a company appear profitable. For example, a company making account earnings of ten dollars for every share consecutively in the past five years decides to take a big bath of seventy five dollars in the sixth year. Although the company will make an accounting loss in the sixth year, the loss does not affect the perception that the company was profitable in the previous five years (Monks & Minow, 2004).
How to Create an Owner-Employee Contract to Share Value Creation
Owner-employee contract to share value creation is an alternative approach to remedy the persistent confines of the dominant total compensation strategy. It is possible to have an owner-employee contract however; the contract has to be reached through a combination of features. These features include a better and single measure, by measuring the economic value added will simultaneously include profits,capital and costs of capital, which converts the present value into a flow measure. Thus, Employee Value Assessment (EVA) measurement directs resources efficiently to the maximization of shareholder value (Sun & Cahan, 2009).
Secondly, goal setting has to be value-based; this are established using the fair market value and establish the correct performance standard. Thirdly, there should be a multi-year accountability and this is achieved by having annual payments as a function of annual performance but in relation to the cumulative performance of the multiple years. This kind of contract stretches the management horizon. The owner-employee contract has to have an equity-like payoff where an unlimited downside or upside guards against short term behaviors that are damaging to the company. It also serves as a continuous motivation linked to the company performance that does not periodically turn off like other motivation initiatives that are switched off in exceptional years (Pettit & Ahmad, 2000).
References
Celani, C. (2004). The story behind Parmalats bankruptcy. Web.
Charan, R. (2003). Ten questions every board member should ask. Fortune, 148(10), 181-186.
Clarke, T. (2004). Corporate Governance. An International Review, 12(2), 153-161.
Clarke, T. (2007). International Corporate Governance. New York, NY: Routledge.
Economist. (2003). Wheres the stick. Economist, 369(8345), 13.
Gomez-Mejia, L. R. (1997). Managerial control, performance and executive compesation. Academy of Management Journal, 30(1), 51-70.
Hallock, K. F. (2010). A look at CEO pay. Web.
Hart, O. (1995). Corporate governance: some theory and implications. The Economic Journal, 105, 678-689.
International Commercial Crime Services. (2005). Parmalat scandal examined at CCS lecture series. Web.
Ittner, C. D., Lambert, R. A., & Larcker, D. F. (2003). The structure and performance consequenses of equity grants to employees of new economy firms. Journal of Accounting and Economics, 34, 89-127.
Madura, J. (2008). International Financial Management (9th ed.). Mason, OH: Thompson South-Western.
Monks, R. A. & Minow, N. (2004). Corporate governance. West Sussex: John Wiley & Sons Ltd
OBryne, S. O., & Stewart, S. (1995). Journal of Applied Corporate Finance, 8(2), 77-86.
Pettit, J., & Ahmad, A. (2000). Compesation strategy for the new economy age. New York, NY: Stern Stewart & Co Research.
Schroy, J. O. (n.d.). The agency problem and business ethics. 2011. Web.
Shijun, C. (2004). R&D Expenditures and CEO Compensation. The Accounting Preview, 79(2), 305-328.
Sun, J., & Cahan, S. (2009). The effect of compesation commitee quality on the association between CEO compensation and accounting performance. Corporage Governance, 17(2), 193-207.
Wagner, S., & Dittmar, L. (2006). The unexpected benefits of Sarbanes-Oxley. Web.
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