In the present era of Corporate Modernization, unlike the traditional activities, it is not the owners which runs the company, infact they hire competent management to work on their behalf. Moreover, every owner(shareholder) consider that the managers so appointed to work on their behalf will act in the best interest of their owners and will assure shareholder’s wealth maximization. Infact, in present complex corporate era, the performance of the company depends upon, how competent the management is adapting the dynamic business environment and related circumstances. Thus, the ability to properly adapt and implement the changes in the business environment signifies the quality of management of the company. Hence, whether the managers are able to increase shareholder wealth, will depend upon their ability to adopt the interaction of two major sets of factors i.e external factors and internal factors. Since external factors like consumer preference, price movements, government policy and cyclical market forces are beyond the control of the company, it leaves the managers and their ability to encapsulate and develop prudent planning strategies that fit the business to the environment, that ensures that their decisions proposes shareholder’s wealth maximization and the entity survive and prosper in the near future.
However, since the shareholders are largely dispersed, it is most possible that the decision of the managers in relation to corporate activities will more likely in their own interest and helps in increasing the wealth of the managers rather than the shareholders. Thus, the aim of the company, which we earlier discussed should be shareholder wealth maximization is often not compatible with the interests of the managers, as over working in the organization and leading it onto the path of profits, they prefer to maximize their own wealth even at the expense of the shareholders. This discrepancy of interests of two parties leads to agency conflicts, among which the conflict of interest between following parties is discussed:
- Managers and Shareholders
- Managers and Creditors
1. Conflicts of interest between managers and shareholders
In the present corporate era, most conflicts arise in public limited companies and the most severe conflict of interests arise between the shareholders and the managers of the company. Even though the shareholders have a significant position in the operations of the company where they have a Right to Participate in Annual General Meetings, they are still faced with situation of conflict of interests with their managers. Shareholders of the company have the right to appoint and dismiss the managers, appointing audit committee, nominating committee and even have the right to sell their own shares so as to bring the company at lines of being taken over, but still, the conflicts of interests arise between the managers and shareholders because of the following reasons:
- Since managers always prefer their own job security and high compensation levels, they may avoid to escape the take over attempt, even if the takeover would have been in the interests of the shareholders.
- Managers always prefer investments with low risk, as investing in such projects decrease the danger of financial distress and hence, managers are able to avoid losses on their own capital and portfolios. However, high risk investment always comes with high profits and cash flows which are in the interests of shareholders.
- Managers always prefer short term investment products while shareholders prefer long term investments which increase their return more than short term investment.
- Managers tend to avoid the problems resulting from reduction in employment levels, which increase with the changes in the control of the company(Jerzemowska,2006)
In conclusion, the conflict of interests between the managers and the shareholders because the managers are more interested in increasing their own compensation and in order to do so, they increase the size of the company as their remuneration and managerial levels are positively correlated with size of the company. Such decisions are implemented by managers even if they are not in the interests of the shareholders. Such activities cause conflicts as managers, tend to value the expansion of the company while the shareholders are more oriented towards decisions that maximize the value of their shares.
2. Conflicts between creditors and mangers (shareholders)
Another source of agency problem is the conflict between the creditors of the company and the managers(shareholders). The shareholders are the common individuals or the institutions who owns the shares of the company while the creditors are the bondholers in the company. Conflict between these two parties is the second most important conflict of interests that exist in the company and is related to conflict of decision between the shareholders and the debtholders of the company in relation to financing of projects. Since, creditors of the company are most interested in the cash flows and the capital structure, any act of increasing debt financing will cause a serious concern to the creditors of the company because as the debt increases, free cash flow available to the company reduces and so does there concern relating to financial risk of the company. On the other hand, if bankruptcy costs are kept at low level, increase in debt financing increases the market value of the company and so does the wealth of the shareholders. Another reason of conflict between the managers(shareholders) and creditors is related to dividend payment and share re-purchases. Since such actions reduce the market value of the bonds of the company but increase the value of the company’s shares, creditors are most likely to end up in conflict with the managers. Creditors always prefer that the firm which has financial strength should use them in according to preference to them for the repayment of debt. Thus, creditors always thrive to force the managers to reduce their financial risk and bankruptcy threat by repayment of their debts and not by working in the interests of the shareholders.
Thus, a possible conflict of interests arises between the creditors and the managers as creditors always desirable that the company should involve into business strategies that will increase the chances of getting their investment paid back.(Boundless.com)
b)Unlike Traditional Organizations, businesses are now run by managers who are appointed by the owners of the company. Thus, the introduction of Modern Corporation has marked a new era of managing the business houses but at the same time have also brought a problem called ‘’Agency Problem’’.Agency problem arises when managers of the company who are obligated to work in the interests of the shareholders and undertake projects and corporate decisions that increase shareholder wealth, ultimately take decisions that may not be in the best interest of the shareholders but in that of manager’s interests. Thus, as the theory of agency and firm asserts that as the managers pursue strategies to magnify their own gains than that of shareholders, immediate mechanics should be applied in order to align and safeguard shareholder’s interests and also to ensure executives well being.
Thus, in order to solve the agency problem in Majujaya Technology Berhad, Employee Stock Option Plan can be uses to align the interest of both the groups of the company. The usefulness of ESOS Scheme is well documented in the academic literature where academic research conducted on ESOS by Agrawal and Knoeber(1996), Core and Guay(2001) and many other has concluded that ESOS can effectively align the interests of executives and shareholders.
Employee Stock Option Scheme, also known as ESO in Malaysia, is a stock option granted to the specified employees of the company where they are given an option, not the obligation, to to purchase the shares of the company at a specified price which is lower than the prevailing market price. (Investopedia)This stock selling option is different from general stock trading process as the stocks are not sold to the employees through exchanges and also without any put or call option embedded with purchase. Furthermore, even the employees who are given this option have to wait for a specified period of time to exercise this option.(Vermeychuck, 2008)
The main objective of ESOS is to align the interest between the managers and shareholders of the company because since the value of ESOS is directly related to the prevailing market price of the company’s stock, managers if given an option of ESOS will take projects only with positive Net Present Values that will not only increases manager’s share in the company but will also increase the wealth of the shareholders. Also, since managers always thrive to earn maximum compensation, providing compensation in the form of shares to the managers will control their excessive consumption and also the time-horizon of investments, which influence price of shares.(Fried, 2003) Moreover, as the equity participation of managers is increased, they are more likely to become more prudent and will avoid to undertake risky projects as this may now threaten even their own interests.
Although, the use of ESOS to avoid agency problems is gaining popularity but the appropriate use of ESOS is still questioned. In a study conducted by Berle and Means(1932) and Jensen and Meckling(1976), Malaysian companies face two types of agency problems i.e Type 1 and Type 2. Type 1 agency problem is related to owner-manager conflict where the academicians through their research confirmed that Type 1 problem can be eliminated through ESOS. However, for Type 2 problem, when large shareholders and managers use their controlling position in the firm to gain benefits at the expense of interest of non-controlling shareholders, is doubted to be solved through ESOS. Thus, with most of the Malaysian Corporates facing type 2 problems, the question related to overall effectiveness of ESOS scheme still remains unanswered.(Ghazali, 2008)
References:
Magdalena Jerzemowska (2006) The Main Agency Problems and Their Consequences, Malaysia: N/A.
ZAHIRUDDIN BIN GHAZALI (2008) THE USE OF ESOS AS INTEREST ALIGNMENT MECHANISM IN MALAYSIA: A MISMATCHED OF A PROBLEM AND SOLUTIONS , Malaysia: UNIVERSITI SAINS MALAYSIA .
J. Gregory Vermeychuk (2008) THE USE OF ESOS AS INTEREST ALIGNMENT MECHANISM IN MALAYSIA: A MISMATCHED OF A PROBLEM AND SOLUTIONS , New Jersey: Montgomery Investment Technology, Inc
Jesse Edgerton∗ (2011) Agency Problems in Public Firms: Evidence from Corporate Jets in Leveraged Buyouts, Washington D.C: Federal Reserve Board.
Lucian Arye Bebchuk and Jesse M. Fried (2003) EXECUTIVE COMPENSATION AS AN AGENCY PROBLEM , Cambridge: Harvard.
Investopedia () Employee Stock Option - ESO, Available at:http://www.investopedia.com/terms/e/eso.asp (Accessed: 12th February, 2014).
Investopedia () Introduction - The Agency Problem, Available at:http://www.investopedia.com/walkthrough/corporate-finance/1/agency-problem.aspx(Accessed: 12th February, 2014).
Boundless.com () Shareholders Conflicts with Bondholders, Available at:https://www.boundless.com/finance/introduction-to-the-field-and-goals-of-financial-management/agency-and-conflicts-of-interest/shareholders-conflicts-with-bondholders/(Accessed: 12th February, 2014).
O'Connor (2011) 'Cost of Capital', in CFA Institute (ed.) Corporate Finance. Boston: Custom, pp. 46-54.
O'Connor (2011) 'Capital Structure', in CFA Institute (ed.) Corporate Finance. Boston: Custom, pp. 72-78.
