Agency relationships underpin any governance situation, in which there is a separation of ownership and control of an organization. Agency involves two parties: the principal and the agent. In most situations, the agency is the director responsibility for the performance of the organization and this party reports to the principal in a fiduciary relationship. The principal is the shareholder in the case of a public company but this is less straightforward in public sector organizations, involving taxpayers and a hierarchy of public sector servants who intermediate on behalf of the state and the taxpayer.
Agency problem: The agents are granted both expressed and implied authority to deal with third parties on behalf of their principal, and they are held accountable under corporate governance for their actions and outcomes.
Should a situation arise where the interests of the principal and agents are not necessarily aligned, an agency problem arises.
Agency costs can include:
– The time and expense of reviewing published information, and then attending meetings to monitor and scrutinize the board’s performance;
– Paying for the services of independent experts and advisers;
– External auditor’s fees; and
– transaction costs associated with managing the shareholding
An agency cost is a cost incurred by the shareholder (the principal) in monitoring the activities of company agents (i.e., directors). Agency costs are normally considered as ‘over and above’ existing analysis costs (such as those involved in making an initial investment decision) and are the costs that arise because of compromised trust in agents (directors).
They can be classified under two headings; costs associated with monitoring the agent, and those termed residual loss.
Monitoring costs
This type of agency cost includes costs associated with attempts to control or monitor the organization. The most important of these will be the provision of information to shareholders, such as financial statements and annual reports detailing company operations.
Large organizations are required, usually as part of listing rules, to communicate effectively with major shareholders. Meetings attended by the key board members including the chief executive can be arranged and institutional shareholders invited, although these will take time and money both to organize and deliver.
The AGM is a regular meeting that can be utilized by shareholders to ask questions of the company.
Many companies utilize performance-related incentive schemes to encourage directors to make decisions that are in the best interest of the shareholders. The most effective of such schemes is that of offering directors share options, usually with a specified period of time (several years) in which the shares cannot be sold. This provides the incentive for their decision making to reflect the requirements of shareholders for long-term share price growth.
Residual loss
Residual loss costs are a part of agency costs. These are costs that attach to the employment of high caliber directors (generally outside of salary) and the trappings associated with the running of a successful company. The packages of the board members may include benefits in kind such as company cars, medical insurance and school fee payments and would be considered a residual loss to shareholders.
Reducing agency costs
These agency costs could be reduced when direct action is taken to resolve the alignment of interest problem, which would improve board accountability. The employment of sufficient independent non-executive directors to monitor and scrutinize the executive members of the board should have a positive influence on their behavior and inspire confidence from shareholders.
