Corporate Governance & Social Responsibility
1. Introduction
Agency problems arise when an agent acts on behalf of a principal. Actions may not be in the best interest of the
principal. Different interests between principal and agent.
- Agent and principal both want to maximize their utilities
Moral Hazard: once a contract is signed, it may be in the interest of the agent to behave badly or less responsibly
Examples: insufficient effort, entrenchment (extravagant investment, like buying corporate jets), self-dealing, lack of
transparency, accounting manipulations
Complete contracts to mitigate the principal agent problem. Should specify what managers must do in each future
contingency of the world, and what the distribution of profits will be in each contingency.
According to Williamson (1984), complete contracts are not possible in practice, because it is impossible to predict all
future contingencies of the world. They would be too complex to write and difficult/ impossible to monitor and reinforce
by outsiders such as a court of law.
Don’t need a highly paid manager if complete contracts are possible.
Asymmetric information → moral hazard. A necessary condition for moral hazard to exist, and for complete contracts to
be an impossibility, is the existence of asymmetric information.
Principal cannot keep track of agent’s actions at all times due to costs. Usually, agent has more information.
Separation of Ownership and Control
Jensen & Meckling: Principal-Agent Problem
- Owner-manager: no conflict of interest arising from non-pecuniary benefits, maximum incentive to work harder,
additional revenue will always be accrued by her
- Then if the firm grows, and (1-α)% of the shares are sold, agent has only α% of the shares, conflict of interest
starts, less incentive to work harder, if agent works harder, the fruits go to the shareholders
The agent knows how to run the firm but lacks funds to finance its operations. The principal has the required funds but is
not qualified to run the firm.
What if the manager runs the company in her interests rather than the principal?
Agency costs: sum of these three components
- Monitoring: observing the agent and keeping a record of the agent’s behavior, and intervening to constraint the
agent’s behavior and to avoid unwanted actions
- Bonding cost: incurred by the agent to signal credibly to the principal that she will act in the interest of the
principal. E.g., buy shares of the firm
- Residual loss: incurred by the principal, agents may not make the decision that maximizes the value of the firm.
E.g., taking on negative NPV projects or not doing anything.
Two forms of agency problems:
- Perquisites: consumption by the management. (E.g., CEO Mansions, giving jobs to family members, corporate
jets, hiring staff that is not able, buying a stake in a soccer club)
o Benefit: accrue to the management
o Cost: borne by the shareholder. Stock price decreases (ST) and firm underperforms (LT).
- Empire building: FCF problem (FCF is bad) (e.g., buying other firms whose PVGO are negative). Management
pursues growth rather than shareholder maximization. Management should invest only in projects with NPV >0.
NPV < 0 destroys shareholder value.
, o Manager enjoys increasing the size of the firm due to power and social status, and managerial
compensation grows with company size (Goergen (2012)).
Company has limited investment opportunities, shareholders have access to wide range of investment opportunities.
,Classical agency problem versus expropriation of minority shareholders
Most stock exchange listed firms have large shareholders that have a substantial degree of control over firm's affairs.
Two different types of shareholders: controlling- and minority shareholders
Expropriation of minority shareholders by large shareholders can be in the form of tunneling, transfer pricing, nepotism,
and infighting.
Costs go to minority shareholders.
Nepotism:
- Appointing family members to the top management positions
- Suboptimal allocation of human capital
- Managerial entrenchment: protecting against hostile takeovers and internal disciplinary actions
Infighting:
- Fight among the large shareholders, often occurs with families
- Example: Puma versus Adidas. Both founded by brothers in 1924 together, split firm in 1948. Build two rivaling
world market leaders in sportswear. Family battle still on today.
, 2. Executive Compensation
Managerial incentives:
- Manager: human capital is tied to the firm, cannot diversify, earns a rent for her service
- Shareholder (risk bearer): hold residual claim to firm assets, right to sell her stake of the firm, can diversify
Solution: proper incentives
Which components of executive compensation does your firm use? Check the Annual Proxy Filing
Executive compensation:
- Total compensation: equity- non-equity pay
- Base salary, bonus, equity pay, other
Salary: determined through benchmarking, like industry and size
Bonus: performance measures and standards, pay for performance
Most firms use >1 performance measure:
- Financial performance (accounting-/ stock based): earnings, EBIT, sales share price
- Operational performance: customer satisfaction, product development
Problems:
- Accounting measures are backward looking and easy to manipulate
- Stock price: hard(er) to manipulate, forward looking. Does it reflect managerial effort (only)?
1. Introduction
Agency problems arise when an agent acts on behalf of a principal. Actions may not be in the best interest of the
principal. Different interests between principal and agent.
- Agent and principal both want to maximize their utilities
Moral Hazard: once a contract is signed, it may be in the interest of the agent to behave badly or less responsibly
Examples: insufficient effort, entrenchment (extravagant investment, like buying corporate jets), self-dealing, lack of
transparency, accounting manipulations
Complete contracts to mitigate the principal agent problem. Should specify what managers must do in each future
contingency of the world, and what the distribution of profits will be in each contingency.
According to Williamson (1984), complete contracts are not possible in practice, because it is impossible to predict all
future contingencies of the world. They would be too complex to write and difficult/ impossible to monitor and reinforce
by outsiders such as a court of law.
Don’t need a highly paid manager if complete contracts are possible.
Asymmetric information → moral hazard. A necessary condition for moral hazard to exist, and for complete contracts to
be an impossibility, is the existence of asymmetric information.
Principal cannot keep track of agent’s actions at all times due to costs. Usually, agent has more information.
Separation of Ownership and Control
Jensen & Meckling: Principal-Agent Problem
- Owner-manager: no conflict of interest arising from non-pecuniary benefits, maximum incentive to work harder,
additional revenue will always be accrued by her
- Then if the firm grows, and (1-α)% of the shares are sold, agent has only α% of the shares, conflict of interest
starts, less incentive to work harder, if agent works harder, the fruits go to the shareholders
The agent knows how to run the firm but lacks funds to finance its operations. The principal has the required funds but is
not qualified to run the firm.
What if the manager runs the company in her interests rather than the principal?
Agency costs: sum of these three components
- Monitoring: observing the agent and keeping a record of the agent’s behavior, and intervening to constraint the
agent’s behavior and to avoid unwanted actions
- Bonding cost: incurred by the agent to signal credibly to the principal that she will act in the interest of the
principal. E.g., buy shares of the firm
- Residual loss: incurred by the principal, agents may not make the decision that maximizes the value of the firm.
E.g., taking on negative NPV projects or not doing anything.
Two forms of agency problems:
- Perquisites: consumption by the management. (E.g., CEO Mansions, giving jobs to family members, corporate
jets, hiring staff that is not able, buying a stake in a soccer club)
o Benefit: accrue to the management
o Cost: borne by the shareholder. Stock price decreases (ST) and firm underperforms (LT).
- Empire building: FCF problem (FCF is bad) (e.g., buying other firms whose PVGO are negative). Management
pursues growth rather than shareholder maximization. Management should invest only in projects with NPV >0.
NPV < 0 destroys shareholder value.
, o Manager enjoys increasing the size of the firm due to power and social status, and managerial
compensation grows with company size (Goergen (2012)).
Company has limited investment opportunities, shareholders have access to wide range of investment opportunities.
,Classical agency problem versus expropriation of minority shareholders
Most stock exchange listed firms have large shareholders that have a substantial degree of control over firm's affairs.
Two different types of shareholders: controlling- and minority shareholders
Expropriation of minority shareholders by large shareholders can be in the form of tunneling, transfer pricing, nepotism,
and infighting.
Costs go to minority shareholders.
Nepotism:
- Appointing family members to the top management positions
- Suboptimal allocation of human capital
- Managerial entrenchment: protecting against hostile takeovers and internal disciplinary actions
Infighting:
- Fight among the large shareholders, often occurs with families
- Example: Puma versus Adidas. Both founded by brothers in 1924 together, split firm in 1948. Build two rivaling
world market leaders in sportswear. Family battle still on today.
, 2. Executive Compensation
Managerial incentives:
- Manager: human capital is tied to the firm, cannot diversify, earns a rent for her service
- Shareholder (risk bearer): hold residual claim to firm assets, right to sell her stake of the firm, can diversify
Solution: proper incentives
Which components of executive compensation does your firm use? Check the Annual Proxy Filing
Executive compensation:
- Total compensation: equity- non-equity pay
- Base salary, bonus, equity pay, other
Salary: determined through benchmarking, like industry and size
Bonus: performance measures and standards, pay for performance
Most firms use >1 performance measure:
- Financial performance (accounting-/ stock based): earnings, EBIT, sales share price
- Operational performance: customer satisfaction, product development
Problems:
- Accounting measures are backward looking and easy to manipulate
- Stock price: hard(er) to manipulate, forward looking. Does it reflect managerial effort (only)?
