RACY CASES -36 Principal-Agent conundrum


 

A V Vedpuriswar and V Pattabhi Ram

Chatshow was handling one of the final sessions on corporate finance. He was explaining to the class the principal-agent tiff. While textbooks talked about the principal agent relationship in their opening chapter, the mercurial professor had intentionally held it back till the end because he ardently believed that all introductions should come at the end!  His take was simple: only after the students had appreciated the gravity of finance would they be able to appreciate what finance deals with.  Some original thinking indeed!

Walking up and down the aisle, (the class called it Chatshow’s catwalk!), Chatshow said, “Agents, often pursue goals which are different from those of the principal. So, agents have to be enticed to act in the best interests of the principal.”  Boka jumped the gun and asked, “Sir, any examples?” Chatshow turned silent and looked at the class – an indication that they must respond to Boka’s query.

Flowers’ hand went up immediately. “The share holder of a bank is a principal; the managers are the agents.  The goal of the bank’s shareholder (principal) is to maximize the bank’s profit. But the bank’s profit depends on the actions of its managers (agents) who have their own goals. A manager may take a customer to dinner on the pre­tense that he is building a relationship with him, when in fact he might simply be having a ball”.  A backbencher whispered, “Hey anyone here whose dad is a banker?”

Even as giggles broke out, Goggles chipped in, “In relation to the teller, the manager acts as the principal.  He would like the customer to have a minimum queuing time whereas the teller (agent) might like to spend more time with the customer to have his problems resolved”.  Flowers’ felt that these weren’t the savviest of examples.  Nevertheless the discussion had gathered momentum.

Chatshow stepped in: “The principal-agent conundrum lies at the heart of corporate governance. The interests of the shareholders and managers do not converge.” Boka who had done some work on corporate governance for his summers said, “The agency problem is complex. Just giving orders and attempting to make employees obey them won’t do. In many cases, it is not possible for the shareholders to monitor the managers or even for the managers to monitor the employees”. Flowers, who fought for grades with Boka, nodded.  And then added, “To achieve their goal, the firm’s owners (principals) must induce the managers (agents) to work in the company’s interests. And in turn the man­agers (principals) must induce the other employees (agents) to work efficiently”.  Well said; but how was it to be done.

Chatshow offered some perspective. “Each principal attempts to get things done by creating incentives that induce each agent to work in the interests of the principal. Behavioral scientists call this goal congruence. The goals of different stakeholders like employees, managers and owners must be aligned”. He then asked, “Folks, how do you think this can be done?”

The class had read about CEOs drawing fancy salaries.  And of how the previous batch had drawn an average salary of one million INR. They understood the language of money.    Goggles, whose dad was a hotshot CEO, said, “We can issue stock options. By giving employees a stake in the business, it is possible to imbibe in them a feeling of ownership.  This would lead to better performance on the job, leading to higher profits and hopefully greater market capitalization.”

The girl in the middle row (she always sat there and was so dubbed GITMR) pointed out, “We should look at incentive based pay for everybody. For exam­ple, managers can share in a firm’s profits for meet­ing profit targets, and employees may be given bonuses for meet­ing production or sales targets. This will motivate them to maximize output and sales.”   The baby-faced topper Debbie interjected: “Another option is for principals to appoint a group to monitor the actions of agents more closely. For example, shareholders, despite being owners, do not have the time or the competence to monitor the functioning of the company. They therefore appoint the board of directors to act as trustees and impose checks and balances on the managers.”  Chatshow was impressed at the simple solution.

It was at this point that Boka brought in a dissenting view.  “But will these measures really solve the problem?” he asked.  “Managers may manipulate profits. They may window dress the financial statements. They may not invest sufficiently in long gestation projects, which will deliver profits only in the long run. They may drive the plant too hard to maximize production without investing in maintenance” he offered by way of elaboration. GITMR saw the point and said, “With profits going up, their incentives will go up. The stock price may move up temporarily, as the markets will not be privy to the private information managers have about the exact state of affairs in the company. This will enable managers to encash their stock options. But in the long run, the shareholders of the company will be put to disadvantage.” Flowers remembered what he had heard from his seniors.  That the B-School’s placement officers when given the option of placing one graduate at Rs 9 lakhs per annum and two at Rs 5 lakhs each had plumbed for the latter because their incentive pay was based, among other things, on how many students were placed!

Neta who aspired to be a politician, pointed out: “Both in India and abroad the agency problem looks intractable. See what has happened at Hewlett Packard (HP). HP’s CEO, Carly Fiorina, merged HP with Compaq to create an empire that would rival IBM in size. She forgot the cultural differences between the two companies. She greatly exaggerated the synergies. And while trying to achieve them, she questioned many of the core values of HP, thus rubbing several employees on the wrong side. Many good employees left HP. Consequently, the merger bombed.”  Debbie who had read that piece added, “Recently, Fiorina was sacked by the board for failing to reward shareholders. But going by press reports it would seem that the lady has lost little. She was given an attractive severance package of about $21 million and is now in contention for the post of World Bank president!”

The gong went.  And Chatshow was happy at not just igniting a discussion but in once again realizing that his wards had their finger on global events.

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About Pattabhi Ram

A chartered accountant by profession, a writer by passion and a teacher by accidental choice.
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