The agency problem refers to the potential of conflict between the needs of the shareholders and those of managers.
By Daniel Ngwira
In small entities like sole traders, the agency problem is nearly zero because the business is managed by the owners.
In large entities, however, it is not possible for shareholders to run their business.
To begin with, a company may have several shareholders running into thousands. It would not be practical for all of them to run the entity. In that instance, shareholders appoint managers to run the company for them. Yet when that happens, shareholders will be exposing themselves to the risk that managers will act in their selfish interests as opposed to the interests of shareholders.
Professor of Commercial Law at the London School of Economics and Political Science Paul L Davies Cassel, in an Organisation for Economic Co-operation and Development (OECD) paper titled Company Law Reform in OECD Countries: A Comparative Outlook of Current Trends presented in Stockholm, Sweden, in December 2000, stated that: “One could say that the principal/agent problems between the managers and the shareholders as a class are most effectively met by shifting decision-making out of the hands of the agent (the managers) and into the hands of the principal (the shareholders).
“However, although this would solve these principal/agent problems at a stroke, the costs of such a strategy in a large company are normally far too high for the shareholders to bear. This strategy would deprive the shareholders of all the benefits to be gained from allocating decision-making to a small number of expert and committed managers. If in large companies centralised management is a sine qua non for effective conduct of the company’s business, this first class of principal/agent problem cannot be so easily eliminated. For this reason, all company laws are very cautious about allocating decision-making to the shareholders’ meeting on a mandatory basis.”
Thus a company needs an effective board because ultimately the board drives the success of an organisation. Without an effective board, a company risks failure. In the banking sector we have witnessed the failure of banks which were being run by professionals skilled in diverse areas; seasoned bankers, chartered accountants and lawyers.
One of the reasons for this failure has been that the boards have not been effective. The shareholders appointed the board members not to harness their skills but to serve their selfish interests of manipulating depositors’ funds.
Some of these boards rarely met in crisis thus further compounding the problem.
In history, we also notice the epitome of an ineffective board in the form of Enron. The board of Enron was misled on high risk accounting practices and poor financial reporting by the executives who included the former chief executive Jeffrey Skilling and the former chief financial officer Andrew Fastow. Billions of dollars in debt and failed projects were hidden causing the collapse of the entity. Added to that, the auditors, Anderson, covered up issues instead of exposing them to the shareholders.
To further reduce the risk at board level there is need to separate responsibilities at the head of the company. In essence this discourages the appointment of executive chairpersons. A model board should have a chief executive officer and a non-executive chairman of the board of directors.
In some countries like the United States, an executive chairman is quite a common phenomenon. Other safeguards should be put in place to ensure that there is no or limited abuse of power. In Zimbabwe, Patterson Timba could epitomise the executive chairmanship as he was in that role at Afre. Modern governance systems frown at such a role for lack of division of responsibilities between the day-to-day running of the business and the board.
To further reduce concentration of decision-making power in an individual or small group of people, the board is expected to have a healthy balance between non-executive and executive directors. A non-executive director (NED) is a member of the board of directors of a company who is not involved in the day-to-day running of the company. This is as opposed to an executive director, who is a member of the board who forms part of the executive management team.
Such a member of the board earns a salary for their services to the company whereas a NED earns a sitting allowance otherwise known as board fees. The trend is to have more NEDs than executives, with the inclusion of independent non-executive directors (INED) in order to strengthen board oversight. The business world has witnessed unscrupulous shareholders appointing NEDs and INEDs for cosmetic compliance without the intention of substance. This has been done through the “appointment” of shadow directors.
Shadow directors are likely to be common in cases where the sector in which an entity operates demands a lot regarding restricting owner involvement or management. This is common in locally-owned banks which went under in Zimbabwe. In those cases, shareholders who were non executives or who did not sit on the board were even more prominent than the executives. By and large, a shadow director is not recognised as a director at company law. This director issues instructions which the directors and executives act upon for fear of removal or restriction of benefits or with the expectation of maintaining their positions or a raise.
Such directors also have a tendency of entering into related party transactions or demanding loans from the entities without following due process. The burden of defence in these cases will be left with the CE. When things go wrong the shadow director has a tendency of abdicating responsibility arguing that they were not even part of management or the board, which on paper will be true.
Organisations with shadow directors rarely appoint executives and directors on the basis of competence. Appointments are usually on the basis of political correctness or so-called “strategic relationships”. The term “strategic” was often used in the failed Interfin Bank, to mean strategic to the interests of the individual decision-makers not the body corporate.
Directors are elected to the board by the shareholders or members of an entity. They should stay clear of any conflict of interest, and as such, can obstruct judgment and therefore result in sub-optimal decision making which would result in the non-maximisation of shareholders’ wealth. Directors run an entity on behalf of the shareholders.
They, therefore, are expected to make decisions and judgements to advance the interests of those they represent. In that regard, they must think, question and express themselves freely. Directors must go beyond correcting spelling mistakes and full stops in board packs and focus on the substance of the role. For that to happen, one must be experienced.
A balanced board should have directors with the skill set required by the company. Certain board committees require that board members have certain expertise, for instance the audit committee would need to have at least one board member with financial/accounting experience or recent such experience for that committee to be effective.
Cassel avers that: “The most obvious way to make the board accountable to the shareholders as a class is to make it easy for the shareholders to remove directors of whom they disapprove. Thus, removal rights for shareholders, exercisable by ordinary majority, which can be exercised at any time and for any reason to remove all or any of the directors, would appear to be a powerful tool to make the board accountable. At least, this should be so where the removal rights are coupled with easily exercisable powers for shareholders to convene meetings to consider the removal of directors and where there is a good disclosure regime in place so that the shareholders can accurately evaluate the board’s performance.”
Thus removal of board members is another way of managing risk of failure for the company.
The Association of Corporate Treasurers states that a fiduciary responsibility is “a legal duty to act solely in another party’s interests” and that a fiduciary is “a person who occupies a position of trust in relation to someone else and is required to act for the latter’s benefit within the scope of that relationship”. Directors have a fiduciary duty to their principals. This is more emphasised when they are directors of a bank in which case they have a fiduciary duty to depositors as well. A director who has neglected this duty in the past cannot be trusted to carry this duty going forward. Company law embodies a framework to punish such directors.
Directors are an important body in that they are responsible for setting corporate policy, risk appetite and tolerance as well as putting in place systems and control. These functions determine whether the company will enhance or weaken shareholder value. The ultimate managers of the company are the directors. This is recognised through law and practice. The type of directors a shareholder appoints to the board determines the success or failure of that organisation.
Good corporate governance requires that the procedure of appointing directors should be as transparent and as rigorous as possible. Directors can be appointed at incorporation. In some jurisdictions directors so appointed are deemed to have retired at the first annual general meeting. Subsequent appointment of directors is done by members of the company through an ordinary resolution at an annual general meeting of the company or by other directors between the general meetings of the company.
On what basis are people usually appointed to the board? For one to be appointed as a company director there are usually no special qualifications other than that one must not have been disqualified as a director, they must not have previous convictions or in some jurisdictions one must not be above 70 years of age otherwise they need to be approved by 75% of the shareholders present at the meeting.
Large organisations tend to appoint people on the basis of qualifications and what they would have achieved in their lives. This reduces the risk of failure of the board and therefore the company.
On the other hand, government-run companies are known to appoint directors on the basis of political affiliation and sympathy. This has, to a great extent, affected the performance of parastatals and government owned companies. Appointments on such basis are unlikely to maximise shareholder value.
In such associations as the Zimbabwe Music Rights Association, appointment to the board is easy to achieve when one is a popular musician or popular among them even when they do not have the qualifications.
Given the sensitivity of the banking sector, central banks are particular about one’s qualifications and experience and cleanliness of records; a director has to go through a fit and proper test. The reason is that banks are very sensitive institutions. This does not mean that central banks are objective all the time.
There have been cases where central banks, like auditors, have been embroiled in corruption and other embarrassing behaviour. The appointment of crooks on a bank board or people who are viewed as such could affect its ability to attract deposits and thus result in failure.
In the worst case scenario, the entire banking sector may be affected by such appointment as depositors may lose confidence. This explains why in the past the Reserve Bank of Zimbabwe (RBZ) used to suspend directors and senior managers for five or so years where they presided over failed institutions. The idea behind the suspension is to de-contaminate the person and the financial sector to instil confidence into the system by which banks are governed.
In this regard, perception is more often than not reality. If one is seen to have caused the collapse of a bank, any bank that employs or appoints them to the board may inadvertently import reputation risk.
For us to learn that perception is reality, we have to look at the Zimbabwe Allied Banking Group (ZABG), an apparently noble venture at the time, in the face of massive bank failures towards mid-2000. ZABG was established by the RBZ following the demise of three banks, including one of the former success stories of indigenous banks, Trust Bank.
Despite appointing distinguished personnel to its board, ZABG failed to fly as it was always marred by litigation.
Investors and depositors perceived ZABG as a stolen asset and thus were not willing to do business with it. This is besides the fact that the restructuring of the deposits had been done by compulsion of a controversial law which appeared to have been hurried.
Yet it can be argued that a shareholder who is willing to appoint a person who presided over a failed bank can benefit from such an appointment in the hope that such a person may have learnt how to avoid or manage failure.
Indeed, there are cases where such people may have been overshadowed by shadow directors who may have been issuing instructions from the terraces. This is difficult to prove in the absence of any documented instruction; it is unlikely a shadow director would issue written instructions though. Besides, a question arises as to why such officials would not have resigned after noticing that they were being pressured to carry out unlawful or unethical instructions.
In conclusion, the character of a company’s board sets the tone for the organisation. If a shareholder appoints cronies, they are likely to get underperformance financially but they are likely to have their political interests well protected. Yet business and politics are two different things; a shareholder can appoint someone they do not relate well with politically or socially, but on the basis of performance. In appointing a board, the shareholder needs to consider the sensitivity of their industry and the impact of an appointment on various stakeholders. Appointing someone facing litigation is a sure case, for instance, that the company would be in the news for the wrong reasons.
In the modern business world where risk management is taking centre-stage, the first way of managing risk is to appoint the right board or an effective board; a combination of skill, clean records, positive perception by other stakeholders and education. The board members must have time for the particular company to which they have been appointed to. They should not sit on too many boards.
Ngwira is a chartered accountant, former bank treasurer and former university lecturer. He holds finance and business qualifications. — email@example.com/ cell: +267 73 113 161.