Most finance academics, as well as the governance guidelines of the TSX, assess the goal of the firm to be that of the creation or maximization of shareholder value. The problem is that nei- ther group actually runs a firm; that is what managers do.
In smaller firms, managers and owners are often the same people, which solves the prob- lem. Even some quite large Canadian companies have a controlling shareholder who ensures that managers act in the shareholders ’ best interests. However, for many companies the share- holders are widely dispersed, and the firm ’ s chief executive officer (CEO) is able to pack the BOD with cronies who will not challenge his or her authority. In other words, the firm has poor governance and few checks on management, and it may be run in management ’ s inter- est rather than in the interests of the shareholders. Further, the interests of managers and shareholders do not necessarily coincide.
As management theorist Gordon Donaldson has stated:
To say that management and shareholders have much in common is only to state the obvious. So do management and the labour force, consumers, or any other group having a vested interest in the corporate entity. But to extend this by saying that man- agement, in pursuing the corporate objectives as it sees them, necessarily serves the best interest of the stockholders, in either the short or long run, misstates the facts in certain important respects. It also leads to confusion in and misinterpretation of financial policy. 6
The Agency Relationship and Agency Costs
Managers are employees, and we now think of them as agents working on behalf of the share- holders—this is referred to as an agency relationship in exactly the same way that we referred to agency transactions in Chapter 1 in the context of hiring a broker to act for and advise us.
However, how hard managers work to serve the best interests of the shareholders depends on their personal interests and how they are compensated. This is one of the classic agency problems associated with the separation of ownership from management.
The costs associated with agency problems are referred to as agency costs . There are two major types of agency costs: (1) direct costs, which arise because suboptimal decisions are made by managers when they act in a manner that is not in the best interests of their compa- ny ’ s shareholders, and (2) indirect costs, which are incurred in an attempt to avoid direct agency costs. Indirect costs include those that arise from any restrictions placed on the actions of management, those associated with monitoring the actions of managers (which includes any compensation paid to the BOD), and those associated with management compensation schemes that will provide managers with incentives to act in the shareholders ’ best interests.
We elaborate on this last topic below.
Suppose you hire the daughter of a friend to clean up your yard. You could sit on the back porch and watch her to make sure she does a good job. However, this monitoring of her work is expensive for you; after all, you probably hired her because your time is valuable and you have other things to do. Monitoring her continuously defeats the purpose. Instead, you can compensate her to try to meet your objectives. Suppose you pay her $10 an hour and think the job will take four hours. What might happen when you come back after four hours? Unless she expects repeat business, which means her reputation is at stake, she ’ ll probably be only partly Learning Objective 2.3
Explain what agency costs are and how they affect the interests of management and shareholders.
agency relationship the relationship between the shareholders who own the company and the managers hired to work on their behalf
agency problems a problem that arises due to potential divergence of interests among managers, shareholders, and creditors
agency costs the costs associated with agency problems
6 Donaldson, Gordon, “Financial Goals: Management vs. Stockholders.” Harvard Business Review , May/June 1963.
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39 CHAPTER 2 2.3 The Role of Management and Agency Issues
done, because with a cost-plus contract, her incentive is to stretch out the job. Conversely, if you agree on a fixed fee, say $40, you ’ ll probably come back after four hours and discover that she left two hours earlier. Then you ’ ll have to check everything, because she ’ s probably taken short cuts. In this case, her personal incentive is to finish early. What you want to do is align her interests with yours so you don ’ t have to monitor and check her behaviour.
Like your interests and those of your friend ’ s daughter, the interests of managers and shareholders are usually fundamentally different. For example, shareholders tend to have a short-term interest in the firm and hold the shares and other securities of many entities in a large investment portfolio. If they see the managers acting contrary to what they would like, they are likely to sell their shares and go elsewhere rather than try to remove management through a costly proxy fight at the annual general meeting. It is simply too costly for most shareholders to fight to remove management in a large corporation; however, this is not to say it does not happen. For example, in 2012, U.S. hedge fund Pershing Square Capital Management waged an expensive, months-long war to successfully change the CEO of Canadian Pacific Railway. All too often, such proxy fights to change management fail because it is so expensive and time-consuming for one party to bear the costs.
Finally, in terms of agency costs, there is a special cost that has become a veritable “hot potato”: moral hazard . Suppose that instead of hiring someone to clean up your yard, you accept your son ’ s offer to volunteer to do the job. In this case, your son might think that he can do a quick job, knowing that you will finish it off—his behaviour changes because he knows that you will bail him out. So although your son might do a great job in someone else ’ s yard, he does a poor job for you. If you think of your son as Lehman Brothers Holdings Inc. or Bear Stearns Companies, Inc., and the U.S. government as you, the parent, you can see how the concept of moral hazard became important in 2008.
In 1998, the U.S. government bailed out a hedge fund called Long-Term Capital Management (LTCM) because it was deemed to pose a systemic risk to the U.S. financial system—that is, it imposed an externality on others. This resulted in a common understanding that a financial institution could take risks because, in the event of failure, the U.S. government would bail out the institution. This is the moral hazard problem: knowing that the U.S. government had bailed out LTCM, the behaviour of other institutions changed. This problem is also why, on September 15, 2008, the U.S. government forced Lehman Brothers into bankruptcy, even though it was much larger than LTCM and its failure posed a much greater risk to the financial system. In retrospect, it is now acknowledged that forcing Lehman Brothers into bankruptcy was a huge mistake, since it triggered the credit crunch, financial market meltdown, and the worst recession since the Great Depression of the 1930s. The U.S. government ’ s bailout of its banks after the Lehman crisis illustrates that moral hazard is still with us and, if left unchecked, could distort markets.
Despite the moral hazard problem, the fact remains that institutions that are too big to fail cannot be allowed to fail. As a result, a new acronym has entered the financial lexicon: SIFI, a systemically important financial institution, which is just another way of saying a bank that is too important to be allowed to fail. Allowing a SIFI to fail, it is argued, would trigger a global financial meltdown similar to what happened in 2008–9. Assuming we cannot break up SIFIs, we have to regulate them more carefully. In 2011, the Basel Committee on Banking Supervision opted for this approach in its new regulations (Basel 3). 7 So far, about 30 large international financial institutions have been identified for this “extra careful” supervision and more exten- sive regulation, none of them in Canada. That may sound like a blow to Canada ’ s prestige, but it means that the Canadian banks have more leeway to grow. They just have to be careful not to grow so large they become a SIFI and attract too much attention!
moral hazard the fact that individuals ’ behaviours may change if they are not exposed to the full consequences of their actions
7 For details on Basel 3, see the Basel Committee on Banking Supervision website, www.bis.org/bcbs/basel3.htm.
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40 CHAPTER 2 Business (Corporate) Finance
Aligning Managers’ and Owners’ Interest
We have discussed a variety of agency problems that explain why managers don ’ t necessarily pursue the best interests of the shareholders—mainly because their investment in the corpo- ration goes much deeper than that of a typical shareholder. Donaldson argued that the main implication was that managers of regular corporations tend to be more conservative than would seem justified by the shareholder approach, since they don ’ t face the moral hazard problem of being too big to fail. Donaldson further analyzed four key areas and found that in each area, managers make different decisions than the ones shareholders would make. These are illustrated in Table 2-1 .
Learning Objective 2.4 Explain the importance of aligning the interests of management with the interests of shareholders in a corporation.
TABLE 2-1 Areas of Disagreement
Managers Shareholders
Performance appraisal Accounting ROI/cash Market prices
Investment analysis IRR of best division WACC external
Financing Retentions, debt, new equity Debt, retentions, new equity
Risk Preservation of firm Portfolio
For example, when being appraised, managers want to be judged relative to accounting numbers, such as profits and return on investment (ROI), because they can control these num- bers. In contrast, shareholders are interested in the stock market performance, because they want managers to create shareholder value. Similarly, in investment analysis (choosing pro- jects), managers want to choose the internal rate of return (IRR) of their best project, relative to other divisions of the firm or past performance, because, again, this is what they control. 8 In contrast, shareholders are interested in what they can do with the money, which can be meas- ured by comparing the return on a project with the firm ’ s weighted average cost of capital (WACC). If the firm can ’ t meet the shareholders ’ criterion, shareholders believe it should give the money to them so they can invest elsewhere. Obviously, managers don ’ t like this idea.
Managers and shareholders also differ in their approach to risk and financing. Donaldson argued that shareholders take a portfolio approach because they hold many securities. This allows them to diversify risk and have the firm be more aggressive, whereas managers see their careers totally tied up with the firm and act conservatively. This approach is carried over to financing, where managers follow a “pecking order”: they want to retain earnings first, rather than pay them out in dividends; then use bank debt; and finally issue new equity only as a last resort. In contrast, shareholders want the firm to use debt, which makes the firm riskier at first;
then use only shareholders ’ money by retaining earnings; and lastly issue new equity.
There is no question that Donaldson correctly identified the key differences in the goals of managers and shareholders. But this situation is like hiring your friend ’ s daughter to work in your yard: it is a question of providing the correct incentive to get managers to do what you want. At the time Donaldson was writing, most managers were compensated through salaries and bonuses, which has changed as BODs have become more aware of the need to make managers act like shareholders.
Table 2-2 lists the 10 highest-paid executives in Canada in 2014, with a breakdown of their compensation. The major components of income are base salary, annual bonus, all other compensation, share-based awards, option-based awards, and pension value. Notice that, in all cases, straight salary compensation is relatively low compared with the total package—
most of which comes in the form of annual bonuses, pension contributions, and share com- pensation, which comes in two forms: grants of restricted stock awarded under incentive plans, and stock options. With stock options, if the company ’ s stock price goes above a certain level, the executive gets the right to buy the stock at a fixed lower price.
8 We will discuss ROI, IRR, and WACC in later chapters.
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41 CHAPTER 2 2.3 The Role of Management and Agency Issues
TABLE 2-2 Canadian Executive Compensation, 2014 Executive
Organization
Name Base Salary Bonus
All Other Compensation
Share-Based Awards
Option-Based Awards
Pension Value
Total Reported Compensation
John Chen BlackBerry Ltd. $341,452 $684,054 $0 $88,689,513 $0 $0 $89,715,019
Donald J.
Walker
Magna International Inc.
$358,924 $11,634,643 $193,267 $7,757,165 $3,473,275 $0 $23,417,274 Gerald W.
Schwartz
Onex Corp. $1,435,694 $19,700,252 $0 $0 $0 $0 $21,135,946
Hunter Harrison
Canadian Pacific Railway Ltd.
$2,421,592 $7,289,700 $582,344 $3,662,444 $3,661,937 $14,152 $17,632,169 Mark
Thierer
Catamaran Corp. $1,325,256 $2,125,932 $41,966 $10,943,301 $1,894,012 $0 $16,330,467 Donald
Guloien
Manulife Financial Corp.
$1,438,720 $3,329,088 $101,890 $5,274,666 $3,516,444 $823,400 $14,484,208 John
Thornton
Barrick Gold Corp. $2,760,950 $10,491,610 $180,618 $0 $0 $828,285 $14,261,463
Paul Wright Eldorado Gold Corp. $1,514,000 $3,974,250 $0 $2,744,125 $2,744,125 $2,812,202 $13,788,702 Bradley
Shaw
Shaw
Communications Inc.
$2,500,000 $6,957,500 $435,675 $0 $0 $3,450,930 $13,344,105
Steven Williams
Suncor Energy Inc. $1,361,731 $2,055,000 $155,945 $4,955,500 $3,894,000 -$37,500 $12,384,676 Source: Data retrieved from “Executive Compensation,” The Globe and Mail Report on Business, June 6, 2015, B8. ©The Globe and Mail, Inc. All rights reserved. Reprinted by permission.
The idea behind share incentive plans is to have the interests of CEOs and senior managers coincide with those of shareholders. Often, shares are granted when the company reaches certain objectives, such as revenue targets or investment returns. In such cases, the manager has an incentive to get the share price up as high as possible. In the same way, if executives are given the right to buy shares at a price of $50 when they are selling for $40, then they have an incentive to get the share price over $50 to trigger the option. If the share price never reaches
$50, the options are worthless. Both types of share programs have the basic objective of align- ing the interests of shareholders and managers, and traditionally have been used to trump the comments made by management theorists like Gordon Donaldson.
It ’ s doubtful that share compensation schemes have successfully met their objectives, however. The stock market peaked in October 2000, and prices subsequently dropped almost 50 percent by the spring of 2002. Technology shares dropped even more: some investors pur- chased Nortel at $122 and saw it go bankrupt in the 2000s. Many may have purchased Research In Motion (RIM), now BlackBerry, shares and watched an eerily similar performance. 9 It would be nice to think that the senior management groups at Nortel, RIM, and other tech companies suffered those losses along with their shareholders. However, what happened was that the option grants and share incentive schemes were retooled to continue to provide incentives to management. So if the stock fell 50 percent and made existing options worthless, new ones were granted to continue to provide incentives for managers; the argument was that otherwise management would leave and go elsewhere.
9 BlackBerry, formerly RIM, shares dropped from over $130 to under $7. James Balsillie and Mike Lazaridis, co-CEOs, both took in over $5 million in 2011 and were tied for 51 st place on the Canadian executive compensation scale just as successive new RIM products bombed and the company ’ s shares swooned. To their credit, Balsillie and Lazaridis moved aside to let new management take over.
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42 CHAPTER 2 Business (Corporate) Finance
Was such compensation necessary to keep these managers? Who would want to hire away the manager of a company whose stock price had fallen 50 percent? But then, the com- pensation committees of the BODs granting these options and share grants were not always completely independent of the CEO who received them. 10 The important point is that the interests of managers and shareholders are not aligned if, on the downside, managers do not suffer along with the shareholders. This is the issue discussed in Finance in the News 2-1 , which describes shareholders voting against Barrick Gold Corp. ’ s pay practices in 2015—
practices they viewed as excessive given Barrick ’ s poor stock performance. In fact, managers have an incentive to use short-sighted measures to pump up the share price so they can exer- cise their options or share grants. For the managers, this is a “heads they win, tails they don ’ t lose” strategy.
Chastened Chairman John Thornton Agrees to “Refine”
Barrick Compensation
BARRICK GOLD CORP. CHAIRMAN John Thornton vowed to change how he is compensated after shareholders voted against the company ’ s pay practices.
The Tuesday vote is a blow to the world ’ s biggest gold producer, which had already revamped its executive compensation plan in the wake of Mr. Thornton ’ s controversial signing bonus two years ago.
“We have heard you loud and clear,” Mr. Thornton said at Barrick ’ s annual meeting of shareholders. “We will go back and refine our system, particularly as it relates to me.”
Mr. Thornton said preliminary results showed that 75 per cent of the votes cast were against Barrick ’ s compensation practices, marking the second time in three years that investors have rejected its pay plans.
Canadian pension funds and others had criticized Mr. Thornton ’ s 36- per-cent pay hike for 2014 as unwarranted in a year when Barrick under- performed. Shareholders also said they would withhold support for the directors involved with setting the pay or the entire board.
The so-called “say on pay” motion is non-binding. It is unclear how direc- tors will tweak the current pay practices. The company scores executives on a set of goals, such as balance sheet strength. But Mr. Thornton ’ s compensation
is more subjective and determined by the compensation committee—a point that one proxy adviser likened to a “black box.”
Other companies are in the spotlight over pay practices. Last week, Canadian Imperial Bank of Commerce shareholders rejected its remuneration plans after the bank awarded two retired executives a total of $25-million.
Of the $12.9-million (U.S.) in compensation that Mr. Thornton received for last year, $7-million was used to buy Barrick stock. Mr. Thornton said he now holds 1.4-million shares in Barrick. He has repeatedly stressed the importance of executives owning a stake in the company.
“I am aligned with you. I am one of you. I am you,” he told shareholders.
Mr. Thornton, a former Goldman Sachs executive, has replaced most of the executives since succeeding Barrick founder Peter Munk as chairman one year ago.
Source: Excerpted from Younglai, Rachelle. “Chastened Chairman John Thornton Agrees to ‘Refine’ Barrick Compensation.” The Globe and Mail , April 28, 2015. Available at www.
theglobeandmail.com. © The Globe and Mail Inc. All rights reserved. Reprinted by permission.