Shareholders, who in principle cannot participate in the day-to-day management of a company, are forced to enter into a relationship with managers who act as their agents in the management of the company. This relationship operates under the assumption that managers will act in the best interests of the shareholder (Shapiro, 1999). However, managers will likely, and naturally, act in self interest and the needs of the shareholders may not be in the forefront of their motivation. This raises the issue of the agency problem; the conflict between a company’s management and the shareholders when managers act to maximize their own wealth instead of acting to maximize the shareholders wealth. In theory, the agency problem is dealt through the use incentives to managers such as performance based compensation, the threat of disciplinary action and the threat of takeovers. Some of these measures are effective in controlling the actions of the managers on behalf of the shareholders. However, others such as disciplinary measures do not work effectively and have been known to fail (Shapiro, 1999).
Why disciplinary actions fail
One of the principal reasons why shareholders fail in the use of disciplinary measures to control the management of a company is because of the appointment procedures. Different companies have different modes of appointment of directors to the company’s board, but most of them are based on the shareholding capacity of shareholders. This means that institutional shareholders who most of the time have high shareholding in companies usually have a more vocal say on the appointment of directors. Directors appointed as such may have the interest of the appointing authority before the interests of the other shareholders and as such, any threat of being fired at an annual general meeting is reduced and does not have an impact on the decisions that they make as managers of the company (Pendergast, 1999).
The process of hiring directors is also another reason why disciplinary actions fail. At an annual general meeting, directors are proposed and hired by the shareholders. However, since such meetings occur only periodically and require a long process for their convention, the board of directors sometimes makes appointments to management without seeking approval of the shareholders, on the principle that those directors making the appointment are working on behalf of the shareholder. Such appointments lead to managers who work at the behest of the board of directors which appointed them rather than on the best interests of the shareholders.
For disciplinary actions to be effective, an overhaul of the whole management is always required. This is practically difficult to implement since it would require an agreement from all shareholders. Such an agreement may not be forthcoming and shareholders may be unable to make a unanimous decision. The result is that disciplinary measure will fail due to disagreements between shareholders. Finding appropriate replacement to a management removed in such a manner will be difficult due to the reputation that such a company will have developed, with potential managers being wary of being subjected to such dismissal at a future date (Ross, Westerfield & Jaffe, 2005).
Effective methods of dealing with the agency problem
Managerial compensation is the best way to deal with the agency problem. Management of the company is remunerated based on the performance of the company, especially the performance of the share price. This leads to the maximization of the shareholders wealth as managers will work towards increasing their income through improving the performance of the company (Bebchuk & Fried, 2004).
Another effective method of control of management by shareholders is through the threat of takeovers. Shareholders will be willing to sell their stake in a poorly performing company, and this is usually not in the best interests to the management who view such a move as a threat to their jobs since such moves usually result in the overhaul of management (Eisenhardt, 1989). The managers of the company will therefore cat to improve the performance of the company to discourage takeover threats and thus secure their jobs. These two methods should be preferred by shareholders over disciplinary actions because their effectiveness.
References
Bebchuk, L. & Fried, J. 2004. Pay Without Performance. Boston, MA: Harvard University Press.
Eisenhardt, K. 1989. "Agency theory: An assessment and review". Academy of Management Review 14 (1): 57–74.
Pendergast, C. 1999. "The Provision of Incentives in Firms". Journal of Economic Literature 37: 7–63.
Ross, S. A., Westerfield, R. W. & Jaffe, J. 2005. Corporate Finance. New York, NY: McGraw-Hill
Shapiro, A. 1999. Modern Corporate Finance. Englewood Cliffs, NJ: Prentice Hall.
