Effective Mechanisms for Dealing with Agency Problems

Agency costs increasingly become a significant part in a business’s expenditure. For years, many scholars and practitioners have contributed their time, knowledge, experiences in researching, and published many papers about agency problems. They recommend and also prove these recommendations through empirical tests on how to mitigate the costs from agency problems and enhance the firm’s performance.

There are internal approaches (compensation structure, governance, capital structure) and external approaches (take-over market, government regulations) to deal with agency problems (Cheng & Indjejikian, 2009).

However, so far these mechanisms are addressed separately in dealing with certain agency problems. In this paper, I aim to synthesize the internal approaches that companies can choose by themselves.

This paper is compiled with the purpose of reviewing the contemporary literature (from 2005 to 2010) about agency problems and mechanisms for moderating the agency costs.

I will also give suggestions about factors that managers should consider when choosing mechanisms in dealing with agency costs in specific conditions including country of origin, size of the company, age of the company, and type of agency problems.

I also suggest ideas for further research. The remainder of this paper is organized as follows: part 2 is a literature review about agency problems and mechanisms to mitigate agency problems; part 3 is a list of recommendations for managers and suggestions for further research; part 4 is the conclusion.

Literature review

Originating with the seminal works of Jensen and Meckling in the 1970s, literature about agency problems has made tremendous steps. To make my research more convenient, I will review literature about agency problems, agency costs, agency types, and the necessity of defining a specific type of agency problem.

Agency problems are defined as problems happening due to conflicts of interests between a principal and an agent. An agent is hired by a principal and is supposed to perform on behalf of the principal with the aim of maximizing the principal’s benefits. However, the agent also has his own interests, and, during the time working for the principal, he may diverge from the ultimate purpose of working for the principal and may perform for his own benefit. In the financial field, there are two primary types of agency problems: between shareholders and managers, and between equityholders and debtholders (Brigham & Ehrhardt, 2003).

First, I address the agency problem between shareholders and managers. When a company is set up, the founder is the owner and manager. He will act on behalf of himself to create more wealth. If the owner sells a part of his ownership to outsiders, the owner-manager will not possess 100% of the company and a conflict of interests occurs. The insider manager/owner will not behave in a way that maximizes the company’s wealth and will have a tendency to take advantage, consuming for his personal desire at company’s expense. The less company stocks the managers own, the more likely conflicts of interests will occur (Brigham & Ehrhardt, 2003).

The solution to the shareholders-managers agency problem is aligning the interests of managers with those of the shareholders, forcing them to work in a way that maximizes shareholders’ wealth. The incentive compensation is used to encourage managers, for governance structure to monitor them, or for leverage to constrain them. To execute the solutions, costs occur, and they are called agency costs. There are three main types of agency costs: costs occurring due to applying methods to monitor managers’ actions such as fees for using independent auditors; costs arising due to setting up the company’s organization in order to limit the managers from diverging shareholders’ interests; and opportunity costs that happen when shareholders take time to get a consensus before letting managers take action (Brigham & Ehrhardt, 2003).

Next is the agency problem between equity holders and debt holders. The debtholders give loans to the firm and get returns from firm’s cash flow in the form of interest payments. The interest rate applied for each loan is calculated based on the existing risk level of the firm at the time the loan is issued. After receiving the loan, the stockholders take action through their management in the company and change the risk level, such as selling some assets and investing in risky projects. The debt value decreases because more debt risk is borne. In case the risky project is successful, debtholders will not receive more returns because their income is fixed. However, if that project fails, debtholders have to share the risks. In this case, the interests of the two parties are not aligned. In order to protect their benefits, the debt-holders will apply some mechanisms such as stricter covenants or rising interest rates. This causes the company difficulty in accessing the financial market and the debt costs increase. This creates agency costs (Brigham & Ehrhardt, 2003). To alleviate agency cost from debts, equityholders’ and debtholders’ benefits should be balanced; scholars suggest the use of incentive compensation and convertibles in a company’s leverage (Ortiz-Molina, 2007; Siddiqi, 2009).

Nowadays, with the evolution of the business world, many new agency problems occur. Margaritis and Psillaki (2010) mention other types of agency problems such as conflicts of interests between shareholders who are executing company control and shareholders who are not, or minority shareholders. This happens when controlling shareholders who usually own a substantial portion of a firm’s ownership make decisions that are not beneficial for minority shareholders who do not have enough power to affect the decisions with voting rights. Overinvestment problems happen when there are surplus free cash flows and managers investing in projects that are not value-added without facing financial constraints (D’Mello & Miranda, 2010). Underinvestment problems arise when a company acquires too many debts, and the risk of default makes managers reluctant to invest and analyze thoroughly before deciding. Sometimes these managers ignore risky but high return projects and choose investments in safe projects without good returns (Margaritis & Psillaki, 2010). Cohen and Yagil (2006) mention another type of agency cost, which arises from using money to pay dividends and not investing in positive Net Present Value (NPV) projects.

In general, agency problems are related to the structure of ownership. The problems occur when the owners do not totally operate their businesses by themselves and when the owners acquire debts to finance the business. In other words, the benefit sharing among parties make people think and act more for themselves and lead to conflicts of interests. The shareholders and the managers, the majority shareholders and minority shareholders, the equityholders and the debtholders all invest in businesses, perhaps in different forms, and want their returns. However, with the participation of many parties, no one will be able to get all of the returns.

Each agency problem has its own core causes. Each mitigation mechanism also has its strengths and weaknesses. Thus, in order to deal effectively with a specific agency problem, we have to analyze the causes of the problem and choose the most suitable approaches to deal with it. In order words, we have to know what agency problems we are facing and why they occur. In the next section, I will review the mechanisms for dealing with agency problems.

Scholars and practitioners posit many approaches (internal and external) for curbing agency problems (Cheng & Indjejikian, 2009). I will concentrate on internal mechanisms that companies can choose actively by themselves. They are compensation structure, corporate governance, and capital structure. However, the different aspects in operating the economy in each country should be considered at first, because the agency theory was developed and mostly tested in full-market economies such as the U.S., Canada, or Europe. In other countries, if the economies are not operated in the same ways as the U.S., Canada, or Europe’s, the agency theory may not be totally supported (Barakat, 2008; Jo & Kim, 2008). In order words, the country of origin should be considered when deciding how to deal with agency problems.

Compensation structure

The conflicts of interest between managers and shareholders cause agency costs. Shareholders put money into a company, and they want their wealth maximized. Managers are hired to manage the company’s day-to-day activities. They invest their human capital in the company, and they want to maximize their investments as well. If the interests of the managers are attached to those of the shareholders’, this divergence is solved (Kanagaretnam, Lobo & Mohammad, 2009; Zhang, Bartol, Smith, Pfarrer & Khanin, 2008). Stemming from this approach, companies offer incentive compensation to executives as a way of encouraging them to act in value-added ways to shareholders. Thus, in the executives’ incomes, besides basic salaries and quarterly bonuses, there are some incentive payments tied to their company’s performance in order to encourage executives to pay more attention to long-term performances. There are two popular types of incentive compensation: stock ownership and stock-option grant.

When the managers join the company, they are given a certain amount of stocks with preferred pricing or other ways to connect their interests with their company’s interests. While stock ownership gives managers the feeling of keeping real wealth, the stock-option grant gives executives opportunities to purchase a certain amount of their company’s stock at a predetermined price for a specific range of time in the future. Managers will own the stocks if they execute their rights, or their options will expire. The logic of these incentives is that managers will try their best to increase the company’s stock price because they can get more returns. This behavior benefits shareholders as well.

When this mechanism is put into practice, its effect is inconsistent. Some studies argue that incentive compensation such as the stock-option grant help alleviate equity agency problems (Zhang, 2009; Zhang et al., 2008; Edmans, Gabaix & Landier, 2008). However, other studies provide adverse results (Harris, 2009; Kanagaretnam et al., 2009). The differences in results come from the differences in the samples taken and indicators used for testing. On average, the effects of compensation to alleviate agency problems are favorable. Although the empirical studies support incentive compensation, there also are some divergences. Some scholars prove that stock ownership works better in solving agency problems and also mention that out-of-the-money options do not reduce the agency problems, but stimulate them (Zhang et al., 2008).

It is easy to understand that even though managers’ benefits are tied to those of the company, if the current stock price is higher than their predetermined price, it is a more attractive situation for managers. However, in the case of out-of-the-money options, the current stock price is lower than the predetermined price. The reasoning for setting up the option price in this way is wise because it forces executives to do their best to push their company’s performance, increasing stock price so that they gain when they exercise their options. However, the way the option price is set up also has negative outcomes. In order to gain from their options, managers will do everything to enhance the stock price, including manipulating the performance data. This destroys the effect of the mechanism. Furthermore, the stock market responds negatively to such information about financial data restatement. This gives executives constraints, and these constraints are even stronger when they have stockownership (Zhang et al., 2008).

The question of what types of agency problems that incentive compensation will mitigate arises. Edmans et al. (2008) prove that the compensation mechanism works effectively with large agency problems such as choosing strategy and investment projects. Small agency problems such as perquisite consumption will be solved more effectively with direct monitoring (Edmans et al. 2008). Furthermore, there is an interesting finding about compensation policy. If increasing incentive compensation is used to alleviate the agency problem of equity, decreasing the compensation is applied to mitigate the conflicts of interests between shareholders and bondholders (Ortiz-Molina, 2007). When the incentive compensation works well, managers will act according to shareholders’ benefits and choose investment policies that maximize shareholders’ wealth at debtholders’ expense. This hurts debtholders, and it makes the conflicts more severe. In this case, reducing the compensation for managers is a solution.

Corporate Governance

Corporate governance is also a mechanism used to deal with agency problems. Managers are hired to operate the company; in order to prevent them from deviation, one solution is to monitor them: look at their activities so that shareholders can stop any improper decisions before they become worse. Governance is mostly exercised by the board of directors who control executives based on the company’s rules and regulations. Usually board members are also firm executives. People debate that if executives can control themselves, then shareholders do not need to establish supervisory boards. Then outside directors, representatives of large shareholders, institutional shareholders, mutual funds, and even the state are nominated for boards of directors with the expectation of increasing supervisory effectiveness (Margaritis & Psillaki, 2010).

To enhance the monitor role of the board of directors and to separate the power of executives and board members, outside directors’ appointments become an inevitable trend. At first, outside directors execute their jobs to maintain their reputations in the field. Later on, to attract capable directors and to stimulate them, companies start offering stock-based incentive compensation. Linn and Park’s (2005) empirical study proves that the compensation plans for directors work well in mitigating agency problems.

However, there is also a question about whether these incentive compensations really encourage directors to work on behalf of shareholders’ interests or to protect their incomes rather than their reputations. There are reasons for this skepticism. Boumosleh (2009) states that agency problems appear in the same way as with executives’ compensation packages. To protect their benefits, directors tend to depend on managers and to compromise in making financial reports. However, Kumar and Sivaramakrishnan (2008) argue that boards that are less dependent on executives seem to perform worse than boards that are more dependent on company executives. Fernandes (2008) supports this result. The research infers that there may be agency costs arising from setting up a board of directors, but the benefits in reducing agency problems outweigh the costs.

The question arises of which agency problems will be solved effectively with the governance structure. Chi and Lee (2010) state that corporate governance is effective when agency risk is high; the company has surplus free cash flow. Edmans et al. (2008) prove that direct monitoring is effective for small agency issues such as perquisite consumption. It is inferred that the direct intervention of directors will effectively impede managers from using cash resources in unproductive ways such as investing in projects or activities that do not generate value for shareholders but bring benefits for themselves. If the boards work effectively, a generous donation, an unnecessary overseas meeting, or purchasing a private airplane cannot occur. Scholars also mention that more mature companies with few investment opportunities may have excessive free cash flows; these cash resources may trigger unproductive investment or perquisite consumption (Oswald & Young, 2008; Zhang, 2009; D’Mello & Miranda, 2010; Sedzro, 2010).

Capital Structure

The roots of agency problems are the imperfect alignment of the principals’ and agents’ interests. Managers do not only work for the company’s benefit but also for themselves. These personal benefits include consuming excessive perquisites such as luxurious vacations, overseas conferences, or investing in projects that are risky and do not enhance the value of the shareholders. Chi and Lee (2010), D’Mello and Miranda (2010), Masulis, Wang and Xie (2009) mention the existence of surplus cash flow is the condition that entitles managers to make unproductive investments. Thus, to impede the managers from acting in a way that is not value-added, surplus free cash flow should be reduced. Therefore, the question arises of how to lessen the amount of cash available within a company and simultaneously encourage managers to work more value-added. The answer is using leverage. In order words, the firm should change its capital structure and increase the debt/equity ratio.

Berger and Patti (2006) mention that greater financial leverage can help reduce the agency costs by impacting managers including threat of liquidation, and the pressure of making money to pay for debt interests and principals. Leverage also helps reduce the conflicts between shareholders and managers in many ways, including choosing projects to invest and payout policy. However, the relationship between leverage and agency cost is not exactly negative. When the firm uses too much debt, the increase in cost of financial distress means that bankruptcy will be bigger than the decrease in the cost from the shareholders-managers conflicts.

When the company uses debts, it has to pay for the interest and principal; the higher the debts, the greater the payment. To make more money to pay these debts puts stress on managers. If the company fails to make enough money to pay for its interest expenses and debt principal on the due dates, the company may come to default. If this happens, the managers will lose their jobs, their incomes, their perquisites, and their reputations. Thus, to protect their benefits, managers will act in a way that keeps the company alive, healthy, and prosperous. This is what the stockholders want.

One type of agency cost is the cost of overinvestment. D’Mello and Miranda (2010) state that in a firm that is not levered and has excessive cash flow after investing in positive NPV projects, the surplus cash is usually overinvested in cash or real assets rather than delivered to shareholders. Furthermore, it is possible for managers to put money in projects that are not thoroughly analyzed or even risky because there are excess liquid funds; managers do not have constraints about financial funds. These investments may not create value for shareholders. When leverage is applied, debts such as long-term loans are issued, and cash guaranteed for loan and interest payments consume significant parts of surplus cash, thereby reducing the free cash flow under the manager’s discretion. With the results from their empirical test, D’Mello and Miranda (2010) prove that debts play an important role in reducing the overinvestment problem.

Other ways to reduce the available cash and reduce opportunities for managers to waste the company’s resources is a payout policy-share repurchase and dividend payout. When the company has excessive cash, the possibility of using it in unproductive ways by controlling managers is high. In the above section, I mentioned using debt obligation to extract this cash. Cash extraction helps align interests between managers and shareholders, but payment is for creditors. There are other ways to make shareholders more pleased including paying money directly to them by applying a payout policy. This form of cash extraction is proven to alleviate agency problems, especially for companies that are mature, have massive surplus cash, and lack investment opportunities. Sedzro’s (2010) empirical study supports this option.

There is no obligation for managers to distribute the surplus cash to shareholders; therefore, the question arises of how to make them do this. Oswald and Young (2008) state that if the company has surplus cash and investment opportunities are not plentiful, “better managerial incentive alignment and closer monitoring by external shareholders are important factors stimulating such payout” (p. 796).

The use of leverage has two sides. It can reduce agency problems such as overinvestment due to surplus cash, but when too much debt is used the conflicts of interest between the equity holders and debt holders become serious and lead to the problem of underinvestment. Decreasing the incentive compensation will be the best choice to mitigate the conflicts of interests between shareholders and bondholders (Ortiz-Molina, 2007).

Mechanisms for dealing with agency problems are multifunctional. Each method mentioned above not only works effectively alone, but companies can substitute these mechanisms. Zhang (2009) posits that in order to alleviate the agency problems coming from surplus free cash flow, debt can be substituted for stock options. Debt and managerial equity ownership can also be used as alternative methods in controlling equity agency problems as seen in Barakat (2008). Within debt use, convertible bonds have different effects in comparison with straight debts (Ortiz-Molina, 2007; Siddiqi, 2009).

In dealing with agency problems between equityholders and debtholders, besides using the incentive compensation (Ortiz-Molina, 2007), convertible bonds are effective tools (Siddiqi, 2009). With the overuse of ordinary debts, the risk of default is high. Therefore, equityholders through managers will try to gain value at debtholders’ expenses. The introduction of convertible bonds into the existing structure of equity and straight debts gives the bondholders the right to convert debts into equity under some conditions. This conversion right reduces the conflict of interest between the two parties.

Recommendation to Managers

There are many approaches to mitigating the agency problems in which internal governance approaches such as compensation structure, direct monitoring, and capital structure can be applied by a company management decision. However, for external governance mechanisms such as government regulations or corporate take-over market mechanisms, the company cannot decide by itself (Cheng & Indjejikian, 2009). I will now provide recommendations about factors related to the approach choices the company can choose effective internal mechanisms on its own.

After reviewing contemporary studies about remedies for agency problems, the process of choosing a workable mechanism to deal with these types of costs will be examined. Which ones will be chosen: compensation, governance, capital structure, or a mix? The answer is a mix because it is more feasible to use all available tools to solve the existing problems. Each mechanism has its own pros and cons, and in some cases, this tool can be a substitute or supplement for another. For instance, Zhang (2009) posits that in order to alleviate the agency problems coming from surplus free cash flow, debt can be substituted for stock options. In addition, debt and managerial equity ownership can be used as alternative methods in controlling equity agency problems (Barakat, 2008). Another option is issuing convertible bonds, which have different effects in comparison with straight debts (Ortiz-Molina, 2007; Siddiqi, 2009). However, mixing these mechanisms to produce a good mechanism should be thoroughly considered. In my opinion, when choosing the use of a remedy, managers should consider the current status of the company, including country of origin, size, age, capital structure, and type and level of existing agency problems.

The first factor is the country of origin. Developed economies fully operate under market mechanisms such as the U.S., Canada, and Europe; most economic theories are developed from these perspectives. Thus, businesses operating in emerging countries, especially in ones that do not fully operate under market mechanisms will have to analyze more conditions than businesses in the U.S., Canada, and Europe. In some other countries, due to their typical characteristics, agency theory is not totally supported (Barakat, 2008; Jo & Kim, 2008).

The second factor is the company’s size. If the firm is small or medium, the separation between ownership and management is smaller, so the agency problem is also smaller. In this case, a direct monitor mechanism is effective enough. When the company expands, the opportunity to waste resources becomes bigger. In addition to a direct monitor, the creditors’ monitor and incentive compensation will be applied to mitigate agency problems.

The third factor is the company’s age. If the firm is young and has many investment opportunities, chances for conflicts of interests are not serious. In this case, direct monitors and compensation structures are effective. If the firm is mature and lacks investment opportunities, surplus cash flow is available and chances for wasting resources are also available. Debt should be introduced together with two other mechanisms. In this case, the use of a mix between straight debts and convertible debts should be considered because they work more effectively according to empirical studies (Siddiqi, 2009).

The fourth factor is the ownership structure. When the company has total equity, agency problems from debts do not exist. Thus, agency problems from equity will be analyzed. If the company’s capital structure is a mix of equity and debts, both types of agency problems should be considered. With agency problems occurring between shareholders and managers, all three mechanisms including incentive compensation, governance, and capital structure can be used with cost and benefit considerations to employ the remedy. When dealing with agency problems from debts, incentive compensation and convertibles seem more effective.

The fifth factor is the type and level of agency conflicts: agency problems from equity or from debts, such as overinvestment or underinvestment, perquisite consumption, or surplus free cash flow. When we look for solutions to a problem, we first have to know what the problem is, then choose a remedy to cure it. It is possible that there are many problems occurring at the same time. From the economic view, the most serious, most value-destroyed problem should be cured first. However, the extreme point where agency cost is zero is not easy to reach, so the company usually looks for points where the benefit is bigger than the costs from agency problems.

These recommendations are drawn from the review of previous studies. However, these studies are not perfectly homogenous. The data sources are varied and the methodologies for analyzing these data are also different between the studies. Therefore, I think that it is helpful if there are studies about all agency problems and effective solutions for them in each industry such as banking and manufacturing, and in each region such as developed and emerging countries, because each industry has its own characteristics and so does each region. It is more useful if there are studies to put all agency problems and their solutions in a multi-dimensional matrix to provide companies with a reference to look for mechanisms to deal with their specific agency problems because among companies in each industry or in each region, there are differences in the types or levels of agency problems, and there are sets of mechanisms for these problems. For instance, a thirty-year-old chemical company in China is supposed to face problems of overinvestment and perquisite consumption; this company will use this reference with variables: manufacturing company, mature period, emerging country, overinvestment, perquisite consumption; and look for suggestions about effective mechanisms to deal with its own situation.

Conclusion

With the purpose of synthesizing the agency problems in businesses and internal solutions for these problems and recommending factors that affect the mechanism choices, I arranged my paper by starting with reviews of agency problems from equity and from debts. Then I reviewed three popular internal mechanisms for dealing with agency problems including compensation structure, governance structure, and capital structure. I concluded with recommendations for conditions to take into account when choosing a remedy such as country of origin, size, age, company’s capital structure, and type and level of existing agency problems.

With the increase of agency costs in companies’ expenditure, how to choose effective mechanisms to mitigate these costs becomes a significant decision. Therefore, studies about how to improve the quality of these decisions are necessary. I believe that this paper will give some useful references about what aspects matter when managers choose internal mechanisms for dealing with agency problems.