Question

2. Agency conflicts between managers and shareholders

Remember, an agency relationship can degenerate into an agency conflict when an agent acts in a manner that is not in the best interest of his or her principal. In large corporations, these conflicts most frequently involve the enrichment of the firm’s executives or managers (in the form of money and perquisites or power and prestige) at the expense of the company’s shareholders. This usurping and reallocation of shareholder wealth is most likely to occur when shareholders do not have sufficient information about the decisions and actions being made by the firm’s management.

Consider the following scenario and determine whether an agency conflict exists:

Daniel owns Daniel’s Tantalizing Tees, a T-shirt shop in a small college town in Kansas. With a staff of three part-time employees, Daniel operates the business in accordance with his personal goals, dreams, and capabilities.

Does Daniel have an agency conflict to deal with?

No; as both the owner and operator of Daniel’s Tantalizing Tees, Daniel has not created the necessary agency relationship through which an agency conflict can exist.

Yes; as both the owner and operator of Daniel’s Tantalizing Tees, Daniel has created the necessary agency relationship through which an agency conflict can exist.

No; by having part-time, as opposed to full-time, employees, Daniel is prevented from experiencing an agency conflict.

Yes; there is always an inherent conflict of interest between owners and operators (managers).

Consider the following scenario and determine whether an agency conflict exists:

Five years ago, Li created a plant-care business that grew, stocked, and maintained fresh plants in office buildings throughout Denver. Over time, The Green Zone Inc. (TGZ) has grown from a proprietorship into a corporation, now reaching far beyond Denver. To finance and support this growth, TGZ issued shares that were sold to TGZ employees, Li’s family members, and selected outsiders. Li is TGZ’s chairman of the board of directors and CEO, but he is no longer the largest shareholder.

At the latest annual meeting, two mutually exclusive proposals were placed on the ballot for discussion and vote. The first was put forth by Li and TGZ’s management team, and the second was proposed by a small group of other shareholders. Both groups are adamantly opposed to the other group’s proposal, even though both proposals would likely have the same effect on TGZ’s value and riskiness.

Does an agency conflict exist between TGZ’s management and the small group of opposing shareholders?

Yes; an agency relationship exists, and an agency relationship always gives rise to agency conflicts, regardless of the actual behavior of the participants.

No; Li was the original owner of TGZ, so he would always be sensitive to the concerns of the firm’s current owners (shareholders) and would not engage in an agency conflict.

Yes; any conflict or disagreement between the firm’s managers and its shareholders constitutes an agency conflict.

No; although an agency relationship exists between TGZ’s management—including Li as TGZ’s chairman and CEO and the firm’s shareholders—there is no agency conflict, because no expropriation or wasting of the shareholders’ wealth has occurred.

For the past 40 years, companies have attempted to attract, retain, and encourage managers by developing attractive compensation packages. These compensation packages have also been intended to reduce potential agency conflicts between these managers and the firm’s shareholders.

In the best interest of shareholders, compensation packages should be structured in a way such that managers have an incentive to maximize the   value of the company’s common stock price.

Edinburgh Industrial’s stockholders are mostly individual investors, and there is relatively little institutional ownership. If several pension and mutual funds were to take large positions in Edinburgh Industrial’s stock, direct shareholder intervention would be   likely to motivate the firm’s management.

Echo Farm Supply’s stock price is currently trading at $20 per share. The consensus among market analysts is that the stock should trade for $27.5 per share, given the amount, timing, and riskiness of the company’s dividends. Is Echo Farm Supply more or less likely to receive a hostile takeover bid?

More likely

Less likely

Answer 1

Scenario 1- Daniel T-shirts. The scenario states that Daniel operates the shop as per his personal goals and capabilities. An agency relationship will exist when he does not intend the best for his employees and is just concerned about his personal goals. In this case, though there are no shareholders he is accountable for conducting business in a fair and ethical manner. He should ensure that his employees are treated in a fair manner. The second option which states that an agency relationship may exist and this may create an agency conflict is appropriate.

Scenario 2- An agency relationship exists between TGZ management including Li and the shareholders. Though this may not necessarily lead to an agency conflict as long as Li and the management acts in the best interests of shareholders. An agency conflict would arise only when the management takes actions which are not in the best interests of shareholders. So the fourth option which indicates that although a relationship exists but there is no conflict is the appropriate option.

Scenario 3 - Undervalued shares are more prone to hostile takeovers. The public owns a majority of such shares and when offered a better price, they are ready to give up the shares. This makes a takeover easier. Thus a hostile takeover bid is more likely.