Table of Content
1 Introducing the Research Paper
1.1 The P-A Theory
1.2 Figure: Managerial Utility and Perks
1.3 Moral Hazard and Adverse Selection
1.4 Incentive Schemes
1.5 Figure: Incentive and Risk Bearing
1.6 Figure: Optimal Risk Sharing Contract
2 Development of Executive Compensation
2.1 1960 – 1980 Growth versus Profit Development
2.1.1 1980 – 2000 Stock Option Boom
2.1.2 2000 – Now Is Excessive Risk Taking the Norm?
2.2 Corporate Governance
3 Case Study: Enron and its P-A Problem
3.1 The Role of Arthur Andersen – Cooking the Books
3.2 Lessons Learnt
4 P-A Theory in a Political Context
‘’What are the common wages of labour, depends everywhere upon the contract usually made between those two parties, whose interests are not the same. The workmen desire to get as much, the masters to give as little as possible.’’
Adam Smith, 1978, p. 66
It is claimed that lucrative executive compensation packages have led to irresponsible risk taking and a decline in shareholder value. This research paper is an economic approach to analyse the relationship between principals and agents, whereby the focus lies on executive remuneration incentives. The paper uses the example of Enron’s corporate failure to build a case for the principal-agent framework and analyses executive payment schemes. Aspects on the origins and possible solutions for the principal-agent relationship are looked into. The paper concludes that Enron’s compensation scheme has led to its failure.
1 Introducing the Research Topic
Shareholder wealth maximisation is an Anglo-American philosophical, managerial firm’s objective that is behind financial decision making based on the assumption that stock markets are efficient. In practice this is translated into maximising the value of a company’s shares for a given level of risk, but problems occur in aligning interests of shareholders (principal) and a company’s managers (agents). Our daily lives are shaped by principal-agent problems. The Principle-Agent relationship is a classic problem in economics and as I find a very interesting and relevant issue in corporate governance that has not been researched enough.
This research paper commences in section (I) by examining the principal-agent theory its origins, problems and possible solutions, whereby there is a strong focus on executive compensation. Section (II) analyses compensation development over the last 45 years, in particular stock options. The two first sections build the ground knowledge for section (III) where the principal-agent framework and compensation structures are analysed for Enron. The papers argument is that Enron’s compensation scheme has been responsible for its failure. Section (IV) consists of the paper’s conclusion and an attempt to look at the principal-agent problem in a political context. The paper is mostly based on economic theory and to some extent relies on human resource management. Additionally, this paper aims on answering the following questions: What is the Principal-Agent theory? How is compensation linked to a firm’s growth and value? Are executives receiving too high benefits? Is there an optimal compensation scheme? Why conflicts between shareholders and senior managers remain? And whether recent corporate scandals brought about changes to board rooms, accounting practices, laws and regulations?
The competitive nature of stock markets for shareholders’ funds can aid to ensure adherence to the maximising objective, but how can this be achieved? According to shareholders, managers should follow a simple rule when making investment decisions: to take on projects until the marginal rate of return equals the market-determined discount rate, as stated by Copeland and Weston (2003, p. 20). This means that shareholder wealth is the present value of cash flows discounted at the opportunity cost of capital. The term ‘profit’ in this paper refers to the rate of return in excess of the opportunity cost for funds used in projects of equal risk. Risk is a situation in which more than one outcome might occur and the probability of each possible outcome can be estimated.
1.1 The P-A Theory
“Principal-Agent theory [is] a branch of theory which examines the ways in which a principal may secure the behaviour he seeks from an agent […]”, so Davies and Lam (2001, p. 523). Between shareholders and managers of a company exists a vertical relationship, whereby the two parties differ in their abilities and interests due to a separation of ownership and control. Managers serve as an agent to act on behalf of the shareholders (the principal). Managers are not necessarily seeking maximum profit as shareholders are not well enough informed about their performance. Shareholders are private individuals with shareholdings and limited time to spend monitoring their performance.
Dobbs (2001, p. 267) shows that ownership is divorced from control, as ownership in practice is hold by a group of shareholders who for the most part do not play an active part in the day-to-day operation of the firm. A principal-agent problem exists within any firm. It emerges with the division of labour and exchange and arises when the principal wants to delegate a task to the agent. As stated by Laffont and Mortimort (2002, p. 28) delegation can be motivated either by the possibility of benefiting from some increasing returns associated with the division of tasks or lack of time as well as lack of ability. Managers can redirect a firm’s resources towards their own ends. Its activities are a collection of contracts between principals and agents, so Heffernan (1996, p. 21). In a Principal-Agent relationship one person usually knows more than the other, so that the principal is at the agent’s mercy. This is referred to as asymmetric information which can take the form of either ‘hidden information’ or ‘hidden action’ and lead to adverse selection or moral hazard respectively, see section 1.3 (Davies and Lam, 2001, p. 36).
Game theoretic ideas seek through the whole of agency theory. Due to the separation of ownership and control conflicts of interests arise, the so-called principal agent problem. Principal’s objective of wealth maximisation versus the agent’s personal objectives. Usually the latter is concerned with their pay, perks and job security. Unlike shareholders who can diversify their portfolio and thus spread their risk, the agent is exposed to employment risks should the firm fail. As already described by Berle and Means (1932) poor managerial performance is reflected in lower share prices and this way a company might be taken over and its management replaced (Douma and Schreuder, 2002, p. 110). Contracts can specify the exact relationship between an agent and principal. As mentioned by Lipczynski and Wilson (2001, pp. 288) this can take various forms (i.e. forcing contract) to reflect the minutiae of different risks in the market and market power of firms involved.
Williamson’s managerial utility maximising model (1963) introduces the concept of ‘expense preference’ whereby managers derive utility from three major types of expenses (Davies and Lam, 2001, pp. 20). These are (i) the amount managers can spend on staff (S), (ii) perks in addition to managers’ salaries (M) and (iii) discretionary profits (D). The basic form of Williamson’s model [U=f(S,M,D)] shows that managerial utility (U) depends on the levels of S, M and D available to the managers. Figure 1.2 reflects Williamson’s view that perks (horizontal axis) enhance managerial utility (vertical axis). As the volume of perks rises, the manager is happier and gets positive utility. But the marginal utility is declining up to the point where at point P1 marginal utility is zero. The volume of perks is now so high that the manager fears shareholders examination.
Alchian and Demsetz (1972) argued that there is a fundamental problem in the ‘team’ nature of production where it is difficult for a whole team to figure out whether an individual is shirking at the cost of the whole team (Davies and Lam, 2001, p. 32). This explains the existence of hierarchies in organisations. At each level in the hierarchy, managers face a principal-agent control problem due to asymmetric and imperfect information. Asymmetric information result in not maximising a firm’s profit, so Laffont and Martimort (2002, p. 46). Reward structures shall align agents and principals interests. On the assumption that the agent is a self-interested utility maximiser, Dobbs (2000, p. 266) states that under a flat rate pay the agent will be encouraged to shirk or free-ride.
Figure 1.2 Managerial utility and perks
illustration not visible in this excerpt
Source: Heather, 2002, p. 192
Lumby and Jones (2003, pp. 15) bring up the argument that managers are becoming shareholder wealth ‘satisficers’ rather than maximisers in the short-run, where managers are just doing enough to keep shareholders reasonably happy. So how can the principal ensure that the agent puts all its effort into achieving the principal’s goal? The answer is shareholder wealth maximisation. There are two main tools, which can be applied to align both parties’ interests: monitoring and motivating. Firstly, shareholders can develop a monitoring device. Some of the shareholders may know the senior managers of the firm they held shares off and are thus, able to monitor directly the managers’ actions. This however, is not possible in the case where the company is too big or/and where the shareowners are too widespread. In general this point is reached as soon as a private company commences listing their shares at the stock market. Therefore, one might argue that the principal-agent problem only exists for large companies in developed countries. In addition, monitoring can be undertaken through external auditors, board of directors and bonding. The latter means that the manager takes the initiative to bind himself and to be monitored, so Douma and Schreuder (2002, p. 119). Moreover, Copeland and Weston (2003, p. 20) argue that if managers would receive all their remuneration in forms of shares then monitoring costs would be zero. But due to nonpecuniary benefits such as larger office space and expensive lunches this type of scheme seems impossible, so the two authors.