Agency costs can be reduced by monitoring a manager’s efforts and actions and by intervening when the manager veers off course.
Monitoring can prevent the more obvious agency costs, such as blatant perks. It can confirm that the manager is putting in sufficient time on the job. But monitoring requires time and money. Some monitoring is almost always worthwhile, but a limit is soon reached at which an extra dollar spent on monitoring would not return an extra dollar of value from reduced agency costs. Like all investments, monitoring encounters diminishing returns.
Some agency costs can’t be prevented even with the most thorough monitoring. Suppose a shareholder undertakes to monitor capital investment decisions. How could he or she ever know for sure whether a capital budget approved by top management includes (1) all the positive-NPV opportunities open to the firm and (2) no projects with negative NPVs due to empire-building or entrenching investments? The managers know more about the firm’s prospects than outsiders ever can. If the shareholder could identify all projects and their NPVs, then the managers would hardly be needed!
Who actually does the monitoring?
1. Boards of Directors
In large, public companies, the task of monitoring is delegated to the board of directors, who are elected by shareholders to represent their interests. Boards of directors are sometimes portrayed as passive stooges who always champion the incumbent management. But response to past corporate scandals has tipped the balance toward greater independence. For example, the Sarbanes-Oxley Act (or SOX) requires that public corporations place more independent directors on the board—that is, more directors who are not managers or are not affiliated with management. In large companies, 85% of all directors are now independent.7
When managers are not up to the job, boards frequently step in. In recent years, the CEOs of Ford, CSX, AIG, and Wells Fargo have all been replaced. Boards outside the United States, which traditionally have been more management friendly, have also become more willing to replace underperforming managers. The list of recent departures includes the heads of Cathay Pacific, LafargeHolcim, Toshiba, Marks and Spencer, and Handelsbanken.
Of course, delegation of monitoring to the board brings its own agency problems. For example, many board members may be long-standing friends of the CEO and may be indebted to the CEO for help or advice. Understandably, they may be reluctant to fire the CEO or enquire too deeply into his or her conduct. Fortunately, the company’s directors are not the only people who scrutinize management’s actions. Several other groups serve to keep a wary eye on management.
2. Auditors
The board is required to hire independent accountants to audit the firm’s financial statements. If the audit uncovers no problems, the auditors issue an opinion that the financial statements fairly represent the company’s financial condition and are consistent with generally accepted accounting principles (GAAP).
If problems are found, the auditors will negotiate changes in assumptions or procedures. Managers almost always agree because if acceptable changes are not made, the auditors will issue a qualified opinion, which is bad news for the company and its shareholders. A qualified opinion suggests that managers are covering something up and undermines investors’ confidence.
A qualified audit opinion may be bad news, but when investors learn of accounting irregularities that have escaped detection, there can be hell to pay. In September 2014, the British supermarket giant Tesco announced that it had discovered material accounting irregularities and had overstated its first half profits by about $420 million. As the scandal unfolded, Tesco’s share price fell by some 30%, wiping $8 billion off the market value of the company.
3. Lenders
Lenders also monitor. When a company takes out a large bank loan, the bank tracks the company’s assets, earnings, and cash flow. By monitoring to protect its loan, the bank generally protects shareholders’ interests also.[1]
4. Shareholders
Shareholders also keep an eagle eye on the company’s management and board of directors. If they think that a corporation is not pursuing shareholder value with sufficient energy and determination, they can try to force change—for example, by nominating candidates to the board of directors.
There is a breed of activist investors who specialize in finding such underperforming companies and trying to convince them to restructure. These include Carl Icahn (Icahn Enterprises), Paul Singer (Elliott Management), Daniel Loeb (Third Point), and Nelson Peltz (Trian Partners). Peltz’s fund bought a large stake in DuPont and was able to force DuPont to cut back its operations and research and development (R&D) and to shed 10% of its worldwide workforce. It agreed to merge with Dow Chemical and to split the merged firm into three new, more focused companies. Other recent targets for activist investors include Navistar, Procter & Gamble, and the food giants Mondelez International and Nestle. A company’s shareholders appear to welcome the arrival of an activist investor for the announcement of the acquisition of a 5% holding by an activist prompts a 7 to 8% abnormal return on the stock.[2]
Smaller shareholders can’t play the activist investors’ game, but they can take the “Wall Street Walk” by selling out and moving on to other investments. The Wall Street Walk can send a powerful message. If enough shareholders bail out, the stock price tumbles. This damages top management’s reputation and compensation. A large part of top managers’ paychecks comes from stock grants and stock options, which pay off if the stock price rises but are worthless if the price falls below a stated threshold. Thus, a falling stock price has a direct impact on managers’ personal wealth. A rising stock price is good for managers as well as stockholders.
5. Takeovers
A company’s management is regularly monitored by other management teams. If the latter believe that the assets are not being used efficiently, then they can try to take over the business and boot out the existing management. We will have more to say in Chapters 31 and 32 about the role of takeovers and the market for corporate control.
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