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Shareholders (Owners of a company) versus managers: the principal agent conflict

Updated on March 26, 2013
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Conflict of interests

Managers exercise the day-to-day control of running the business. Because shareholders own but do not have the time, expertise or inclination to manage the business themselves, they appoint managers as their agents. In other words, a principle-agent problem could very well arise when managers pursue objectives attractive to them. For Example:


  • Managers will tend to maximise their own benefits (such as bonus packages, working conditions, benefits, status), some of which may not obviously be in the interests of shareholders in that they have not earned them. In addition, managers may be unwilling to take risks that might jeopardise their positions or employment, whereas shareholders can spread their risk by investing in many different enterprises. This means that managers may turn down value-creating investment opportunities because of the perceived risks involved.
  • Another problem for shareholders is that, managers have detailed information about the organisation that is generally unavailable to shareholders. This is called Information asymmetry.
  • It is also highly likely that managers are intensely focused on the short-term whereas many investors buy shares as a long-term investment. This presents a problem if organisations seek short-term gain at the expense of a long-term value.

Self-seeking managers can behave in illegal ways. The most notorious example of this was the scandal perpetrated by Robert Maxwell (A British media proprietor and member of parliament), who raided his company's pension fund to fund an illegal share price support program. The government at that time took this as a signal that it must intervene to protect the general public. Subsequently, a series of committees of investigation were set up to establish better and more open corporate governance procedures, as embodied in the successive reports of corporate governance reforms in the UK (Cadbury report, Greenbury, Hampel, and Higgs committees).


Some Measures By Shareholders to Look after their Interests

Shareholders also need to protect themselves against management fraud and self-interest. They can monitor the actions of managers through internal and external auditing, and they can ask questions and vote at the annual general meetings. Such monitoring costs money and time. Shareholders sometimes create incentive schemes for managers to encourage the pursuit of shareholders' wealth maximisation.


Problems with incentive schemes (Performance-related pay)

The major problem of performance-related pay (or an incentives scheme) is that of finding an accurate measure of managerial performance. For example, managerial remuneration can be linked to performance indicators such as profits, earnings per share and return on capital employed. However, the accounting information on which these three accounting performance measures are based is open to manipulation by the same managers who stand to benefit from performance-related pay. Profit, earnings per share and return on capital employed may also not be good indicators of wealth creation, since they are not based on cash and they do not have a direct link to shareholder wealth maximisation.


Corporate Governance comes into play

Corporate governance means the system by which companies are managed and controlled. Its main focus is on the responsibilities and obligations placed on the executive directors and the non-executive directors, and on the relationships between the firm's owners, the board of directors and the top tier management. The interaction between these groups leads to the defining of the corporate objective, the placing of constraints on managerial behaviour and the setting of targets and incentive payments based on achievement.

The board of directors has the responsibility of overseeing the company, acting as a check on "managerialism" (another terminology to define management's interests which may conflict with shareholders), so that shareholders' best interests are appropriately prioritised. The board sets company-wide policy and strategic direction, leaving the executive directors to manage day-to-day activities. It also decides who will be an executive director (subject to shareholder vote) and sets their pay. In addition the board oversees the reporting of accounting results to shareholders. The board should also take a keen interest in the ethical behaviour of senior managers.

But Corporate Governance was nowhere to be found during the financial crisis. For more info watch this video: http://www.youtube.com/watch?v=3ktx_cmzflU


To Conclude, it can be said that, both these parties have their interests to focus on. But obviously in a corporate culture, a shareholders' position and value is much greater than that of a manager working as an agent for a company. But what do we say about recent financial and banking crisis? is it because some managers are acting in their self interest? or the blame should be placed on shareholders who may have neglected the needs of the managers? Or was it just greed by all the parties involved? This I leave it to you, dear reader, to decide.

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    • Waqas Ghori profile image
      Author

      Waqas Ghori 4 years ago from Newport

      Thanks SidKemp for your positive contribution and reading :), I agree with you that shortsightedness of shareholders is another problem, that's where greed comes into play. I would write something in detail about this issue in the near future.

    • SidKemp profile image

      Sid Kemp 4 years ago from Boca Raton, Florida (near Miami and Palm Beach)

      Thank you. This is a fine introduction to management-shareholder conflicts. Voted up and interesting. I hope you'll write about the other side of the problem - shortsighted shareholders focused on quarterly profits who do not allow excellent executive managers to create long-term success.