Agency Challenges of Corporate Governance
Describe the system of legal responsibilities among shareholders, the board of directors, and top managers in large, public U.S. corporations. Then explain how, in practice, agency problems arise that may lead to manager behavior inconsistent with their fiduciary duties to shareholders. Finally, note how the government and firms are trying to manage the agency issues in corporations today.
-Explained the legal responsibilities of shareholders, the board of directors, and top managers in large, public U.S. corporations
-Explained agency problems of manager actions inconsistent with fiduciary duties
-Explained government and corporate actions to overcome agency problems
Write your analysis in a 2-page Word document formatted in APA style.
***Please provide an Introduction and Conclusion paragraph***CITE any sources you use by using the APA guidelines. ***Start each sentence with a TOPIC sentence***CITE ALL references used in the paper**Please provide reasoning & examples, PLEASE MAKE SURE EACH PAGE IS A FULL PAGE, Thanks!
We begin by looking at corporate governance—the way in which top managers are managed for the good of shareholders. In many firms this is not an issue. Managers and owners are the same in many small and medium-sized firms. But as firm size increases, separation between the shareholders who legally own the firm and the managers who make the day-to-day decisions also increases. Making sure that the managers’ actions reflect the best interest of the shareholders is the subject of cooperate governance.
This leads to a discussion of the nature of agency and the problems that arise in firm governance. We will also look at the role of the board of directors and some of the reasons that the board is often not able to oversee managers effectively for the shareholders. And we will look at the growth of institutional investors and the ways in which these large shareholding institutions are changing the power in the corporate governance relationships of large firms. Finally, we will contrast some aspects of corporate governance in the U.S. with those in Germany and look at how the role of equity capitalism in Germany is changing that economy.
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Agency Issues in Corporate Governance
In a business that is organized as a corporation, the managers are the agents of the shareholders. They have a fiduciary duty to act in the shareholders’ best interest when making business decisions. This is true even if a decision is not in the best personal interest of the manager. Where shareholders can oversee managerial action and respond to poor decision-making, the manager has a strong incentive (retaining the job) for acting in the shareholders’ best interest. However, where managers can act opportunistically, there is said to be an agency problem. Agency problems are considered to be quite common in most large firms.
Examples of agency problems include actions by management to increase their compensation excessively, make acquisitions that increase the size of the firm without increasing the performance of the stock, and award itself perks that are not necessary for the effective functioning of the business, such as private jets, hunting lodges, luxury boxes at sport stadiums, and lavish receptions for friends and colleagues. Of course, all of these things could be justified if they were part of the activities that enhanced the firm’s performance. But in spite of managerial statements that they do just that, often they produce limited benefits to the firm that are far below the costs incurred—costs that are paid by the shareholders.
One way that the agency problem has been addressed in recent years is through the use of stock options. Stock options seek to place the manager in the shoes of the shareholder so that they have a common interest in increasing the long-term value of the stock. Options can be exercised in the future at a price set in the current time. Should the stock price rise before the exercise date, the managers could acquire the stock on that future date at a significant discount. Thus, by effectively making a large percentage of the managers’ compensation dependent on stock performance, stock options give managers an incentive to make decisions that would increase the value of the stock in the long term.
Recent scandals involving the re-setting of option prices and the re-setting of option granting dates suggest that this is, in fact, something that managers pay attention to. Unfortunately, the scandals also suggest that managers sometimes use their power to try to circumvent this disciplinary tool. Thus, a tool designed to limit agency abuses actually has become the subject of agency abuses.
Role of the Board of Directors
The shareholders actually have a second set of agents in the corporation—the board of directors. The board is elected by the shareholders to be their representatives and to oversee the major strategic decisions of the top management team. The board, however, is often strongly under the influence of the very party it is supposed to monitor—the top managers.
Top managers can control a board through the nomination of insiders to board membership. These are most often members of the management team who end up effectively overseeing themselves. Outside directors who are supposed to be more objective are often selected for participation on the board because of their close association with the top management team of the firm. These are related outsiders, and once again their willingness to hold management to tough standards or to ask difficult question about managers’ strategic decisions is suspect in many cases. Only independent outsiders are likely to be able to exercise oversight without conflicts of interest.
Looking at all this, one may wonder why the stockholders allow their agents to be so co-opted by top management. The answer is that the shareholders in many cases have little power to determine who is nominated to sit on the board. Candidates officially come from a nominating committee set up by the board. As expected, someone friendly to the current board, and hence to current management, is often the sole nominee. Because in most cases shareholders are only offered one formal candidate in an election, it is very difficult for someone other than the nominee of the top management team to join the board. One exception to this is proxy battles. One way in which proxy battles can be effectively mounted is through the action of institutional investors. We look at them next.
Institutional Investors (1 of 2)
Institutional investors have fundamentally changed the relationships of shareholders, top managers, and the board of directors in many firms. They own a large number of shares and can vote in large blocks for or against board-of-director candidates based on how well they reflect shareholder interests. They can work together in proxy fights to nominate and support the election of candidates that are alternatives to those of the established management team. As a result, managers are becoming increasingly responsive to institutional investors.
Institutional investors include insurance firms like Prudential, large mutual fund families like Fidelity, and pension fund managers, among others. These firms are the actual owners of the stock. Investors, in turn, own a share of the mutual funds that own the company’s shares. Through this system, a very large number of people who have interests in the stock of publicly traded firms actually are only indirect owners. The institutions to which they give their investment money are the actual owners of the shares and as a result they have much more concentrated power.
And these institutions own a lot of shares. Many large institutions, with many funds under their management, own literally billions of dollars in equity in some firms. Companies such as General Electric or Microsoft find that most of their shares are owned by institutions. Some of these institutions, like Fidelity and the California Public Employees’ Retirement System (CalPERS), can have significant impacts on firms when they coordinate their actions. Many firms, including well-known ones like Disney and AT&T, have been the target of coordinated institutional investor action due to their poor performance.
Institutional Investors (2 of 2)
Institutional investors have the ability to exercise power in ways the individual shareholder never could. However, there are some limits to their ability to shape managerial action. First, these funds own the stock of a very large number of companies in their portfolios, but their ability to closely monitor and act on poor performance is limited to only a few firms at a time. They are more likely to focus on poor and very poor performance. Thus, firms can avoid the scrutiny of institutions by sustaining mediocre performance, even if higher performance is possible with improved management.
Second, it is very difficult for institutions to exercise their biggest threat—to sell the stock of a firm. Clearly, the selling of the large shareholdings of several major institutions would cause a panic on Wall Street and lead to the removal of management. But this would occur after only a small percentage of the institutional holdings are sold. The larger percentage still held by the institution would fall in value while still being owned, thereby destroying a lot of value for the institutional investors. The firms and the investors are, effectively, mutual hostages to each other.
Foreign Corporate Governance (1 of 2)
The issues of corporate governance that are encountered in the United States are similar to those encountered in most other developed, English-speaking, capitalist economies. However, once you leave the Anglo-American world, the nature of capitalism changes. In Germany, for example, the majority of the capital for all but a relatively few large firms comes from bank loans. Even for firms with large stock holdings, the role of the banks in influencing managers and voting the shares is substantial.
A German firm has two levels of management. On one level is the management board made up of the firm’s management team. On a higher level is the firm’s supervisory board, which oversees the management board, which is often chaired by the firm’s lead bank’s representative. Further, the supervisory board is made up in large part of representatives of labor. Although the supervisory board has the same oversight responsibilities as the board of directors in a U.S. firm, shareholders, obviously, have a much lower profile in this system.
Bank-based capitalism is often called relationship capitalism. In this system banks often extend credit and forgive debt payment tardiness in order to maintain the viability of the firm. Bankers often consider the long-term impact of sustaining a firm through tough times as a critical part of maintaining the economic life of the community. There is, not surprisingly, strong disagreement as to whether this is a better governance system.
Foreign Corporate Governance (2 of 2)
Clearly, in the German system, the discipline of the markets that shareholders depend on in the Anglo-American system is missing. This has led many analysts to conclude that the undisciplined allocation of capital in the German system is a key factor in both the country’s poor performance in the banking industry and the slowing growth of the overall economy over the last decade. Many Germans, however, would argue that this is a small price to pay for stable, if unexciting, economic performance in their communities.
In the last decade the role of capitalism in Germany has begun to change. Without a deep stock market, it is hard to raise the equity capital that is sufficient for large German firms to compete on the global stage. To access those capital markets, firms have to register in London or New York and comply with the host country’s security and disclosure laws. This has significantly changed the posture of German management in these firms as shareholders in those Anglo-American equity markets demand the same level of efficient and effective management that is expected of other firms traded on the New York or London exchanges.
Further, new global banking regulations, known as Basal 2, are pressuring German banks to apply more rigorous lending standards to their customers. The result of these trends has been stress in the German economy and for German citizens, as well as pressure firm managers to improve performance.
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