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Agency Costs
Jensen and Meckling define the agency relationship as a contract under which one party (the principal) engages another party (the agent) to perform some service on their behalf. As part of this, the principal will delegate some decision-making authority to the agent.These agency problems arise because of the impossibility of perfectly contracting for every possible action of an agent whose decisions affect both his own welfare and the welfare of the principal.
Managers bear the entire cost of failing to pursue their own goals, but capture
only a fraction of the benefits.
Agency costs are can be seen as the value loss to shareholders, arising from divergences of interests between shareholders and corporate managers. Jensen and Meckling defined agency costs as the sum of
- monitoring costs,
- bonding costs, and
- residual loss.
Monitoring costs are expenditures paid by the principal to measure, observe and control an agent’s behaviour.They may include the cost of audits, writing executive compensation contracts and ultimately the cost of firing managers. Initially these costs are paid by the principal, but Fama and Jensen argue that they will ultimately be borne by an agent as their compensation will be adjusted to cover these costs.
Bonding costs
Given that agents ultimately bear monitoring costs, they are likely to set up structures that
will see them act in shareholder’s best interests, or compensate them accordingly if they
don’t. The cost of establishing and adhering to these systems are known as bonding costs.
They may include the cost of additional information disclosures to shareholders, but management will obviously have the benefit of preparing these themselves.
Residual loss
Despite monitoring and bonding, the interest of managers and shareholders are still unlikely to be fully aligned. Therefore, there are still agency losses arising from conflicts of interest. These are known as residual loss.They arise because the cost of fully enforcing principal-agent contracts would far outweigh the benefits derived from doing so.
Combined Code
Last blog we've discussed on the surface of Sarbanes Oxley, this time, lets look into what Combined Code brings towards Corporate Governance:-
1) Does the Code support better board performance over time?
Agree, the proposition that the Code supports better board performance over time. However, investors can only assess boards by measuring theperformance of the company in delivering growth in earnings and dividends and a satisfactory return on capital employed. This needs to be done over at least a complete business cycle if it is to be meaningful. Shareholders have found the introduction of board evaluations to be helpful, particularly when a board has
chosen to set out its conclusions in some detail.
2) Is the “comply or explain” approach working effectively?
“Comply or explain” normally works well. However, there can be a presumption by companies that investors should accept an “explanation” and investors are known to be reluctant to accept any explanation when there is a breach of a key principle of their guidelines. The pressure points are often around remuneration and director independence and in these instances boards need to consider how best to deal with the legitimate concerns of shareholders. There is little doubt that among smaller companies these issues are more difficult to deal with due to limited resources at
company and investor level. Companies have increased significantly the amount of engagement with shareholders on directors’ remuneration. For AIC (Association of Investment Companies),
it does not believe that the comply or explain approach is working effectively. However, this is not the fault of the Combined Code itself. ( in exam, based on scenario given either effective or not)
3) Do disclosures on the Combined Code in annual reports provide useful information to shareholders at proportionate cost to companies?
The disclosures are helpful and in most cases essential if shareholders are to be fully informed as to how the directors have carried out their responsibilities. However, the combination of growing corporate governance disclosures and the new accounting requirements means that annual reports are becoming so long that shareholders canstruggle to identify the important elements.
(See BPP manual approaches to corporate governance on the discussion of benefits of combined code and drawback in the form of voluntary code)
Aguilera, R.V. (2005). ‘Corporate Governance and Director Accountability: an Institutional Comparative Perspective’, British Journal of Management, Vol. 16: S39-S53.
Corporate Social Responsibility (CSR)
-Concerned with the ways in which an organisation exceeds the minimum obligation to stakeholders specified through regulation and corporate governance.
Organisation responsibilities.
Our discussion is theoretically based on the Corporate Social Responsibility (CSR) pyramid of Carroll (1991).
Economic - economic responsibilities of a business organisation management are to be produce goods and services of value to society so that the firm may repay its creditors and sharesholders.(must do).It is important to maintain a strong competitive position.Legal - legal responsibilities are defined by the government laws that management is expected to obey.(have to do).It is important to comply with various federal, state, and local regulations and also It is important to provide goods and services that at least meet minimal legal requirements.
Ethical - ethical responsibilities of an organisation management are to follow the generally held beliefs in a society(should do). It is important to perform in a manner consistent with expectations of societal mores and ethical norms.It is important that good corporate
citizenship be defined as doing what is expected morally or ethically.Ethical responsibilities in
this sense are often ill-defined or continually under public debate as to their legitimacy,
and thus are frequently difficult for business to deal with.
Philanthropic - philanthropic responsibilities are the purely voluntary obligation a corporation assumes. i.e provide day care centers, donation.It is important that managers and employees participate in voluntary and charitable activities within their local communities.It is important to assist voluntarily those projects that enhance a community’s "quality of life."
The distinguishing feature between philanthropy and ethical responsibilities is that the
former are not expected in an ethical or moral sense. Communities desire firms to
contribute their money, facilities, and employee time to humanitarian programs or
purposes, but they do not regard the firms as unethical if they do not provide the desired
level. Therefore, philanthropy is more discretionary or voluntary on the part of
businesses even though there is always the societal expectation that businesses
provide it.
Finally, business is expected to be a good corporate citizen*. This is captured in the philanthropic responsibility, wherein business is expected to contribute financial and human
resources to the community and to improve the quality of life.
*Corporate citizenship - business strategy that shapes the values based on the company mission and choices made each day by its executives, managers and employees as they engage with society. 3 core principles define the essence of corporate citizenship & company should apply them in a manner appropriate to its distinct needs :- minimising harm, maximising benefit and being accountable and responsive to stakeholders. (Boston Center for corporate Citizenship)
Examples of CSR : Merck donates medicine to prevent river blindness, Body Shop states no animal testing and donates money for people without homes.
Steps to ensure successful of CSR:
1) To comply codes or principles created by
- Government or multilateral agency such as the UN Global Compact Principles.
- External groups - .i.e CERES Principles
- Own company corporate business principles
3)Social auditing - Hiring independent auditors to assess the impacts of a corporation on society which focuses on corporate performance, environmental performance, social performance.
4) Creating Higher/Senior executives for role of a Chief Ethical Officer.
5) Embedded such CSR in Mission statement.
Reference: Carroll, The pyramid of corporate social responsibility: towards the moral management of organizational stakeholders Business Horizons, July-August, p39.
R. W. Ackerman and R.A. Bauer, Corporate Social Responsiveness (Publishing Co, 1976).
