The Agency Problem of Corporate Governance

The prime aimMake you acquainted to the contractual approach to agency problems

Two approaches to the agency problem:

• The contractual approach or the “law and economics” perspective on financial contracting

• Protection of outside investors is based on legal rules and regulations made by the government

The contractual view of firms

A firm or an organization is regarded as a nexus of contracts.

It is a legal fiction that enters into bilateral contracts

between itself and its suppliers, workers, investors, managers and customers.

Imperfect contracts cause agency costs

Difficult to set up contracts that determine exactly how resources owned by a contractor shall be controlled.

Power: Control over valuable resources over and above that

determined through explicit contracts in a competitive market

Power or residual control rights (rights to make decisions in circumstances not fully foreseen by the contract) should be allocated to the owners (shareholder).

Notions of “cash-flow”

• Sales revenue after payment of operating expenses plus any allowance for depreciation. Essentially, the amount of money available for investments and dividends

• The “free cash-flow” is cash flow plus after-tax interest expenses less investments. Essentially, cash flow in excess of what can be profitably invested in the firm

Agency problems and costs according to pre- and post contractual opportunism

• Moral hazard: Opportunism arising when actions required or desired under the contract is not observable

• Adverse selection: Opportunism arising when one party has private information about something that affects the other’s net benefit from the contract and when only those whose private information implies that the contract will be disadvantageous for the other party agree to a contract.

Contractual approach to moral hazard:

• Relies on the idea that there are incentive efficient contracts.

• Does not take into account crucial institutional factors

(norms that ban bribes and corruption).

• Empirical studies from 1985 document a positive relationship between pay and performance

• Empirical study from 1990 show that executive pay rises and falls by about $3 per every $1000 change in the wealth of shareholders

Adverse selection: financial markets

Signalling models of share markets: • Assuming asymmetric information in the relations between

financiers and managers.

• The relatively uninformed parties have incentives to draw inferences from the choices made by the better informed parties

• When the informed parties recognize that their actions are interpreted as signals, they may attempt to manipulate the signals to convey a favourable message.

Illustrative example

Decisions about the financial structure of the firms• Managers in firms with higher earnings adopt higher debt

levels.

• The market values high earnings but cannot observe them directly, but the managers can

• A higher debt level signals better returns to the market, which responds by assigning a higher value to the firm.

• This increase in value compensates managers for the

increased risk of bankruptcy that comes with increased debt

Evidence of agency costs (studies of financial markets and markets for corporate control)

• Announcements of certain actions lead to fall in the stock price, which is evidence of agency costs (signal: free cash not returned to owners)

• Announcements of takeovers: 1) Bidder return on acquisitions is often negative, 2) Premium of equity trade

• Bidding managements overpay for acquisitions

• Hostile takeovers were only a small fraction of all takeovers in the 80s in the US.