Please prepare 5 PPT Slides on Gentile, Agency Theory and Corporate Governance. Please find attached DOC for reference. Prepare PPT from this ReadingsPPTURGENT.pdf

UVA-OB-1133 Giving Voice to Values

Rev. Sept. 16, 2016

This field-based case was prepared by Mary Gentile, Professor of Practice; and Daniel G. Arce, Ph.D., Department of Economics, School of Economic, Political and Policy Sciences, The University of Texas at Dallas. Names and other situational details have been disguised. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright © 2010 by Mary Gentile. All rights reserved. To order free copies, send an e-mail to [email protected] No part of this publication may be altered without permission.

Agency Theory and Corporate Governance1

Background: Moral Hazard and the Agency Problem

Beginning with Berle and Means (1932, The Modern Corporation and Private Property, Harcourt, Brace & World) it has been argued that a decentralized system of shareholders cannot properly constrain corporate managers to act in the shareholders’ interests. Instead, managers act in their own self-interest (they are opportunistic). This has led to an entire literature on incentives that align managerial behavior with the interests of shareholders. It is also the theory underlying the use of such incentives in corporate America.

More generally, the incongruence between shareholders and management is an example of what is known as a principal-agent problem. In such a situation there is a separation of ownership and control. This often results in a conflict of interest between the principal (owner) and the agent (who directly controls the activity). For example, upper management may be more interested in perquisites than ensuring that profit-maximizing activities are taken to their logical end. To rectify this, principals can create a contract that induces the agent to take costly actions that are in the interest of the principal, without monitoring. That is, incentive contracts are used to overcome a phenomenon known as moral hazard (hidden action). Conversely, if monitoring is not too costly the principal can substitute some monitoring activities (e.g., audits, analysts, and rating agencies) for financial incentives.

Moral Hazard Examples in Principal-Agent Relationships

Principal Agent Effort

Stockholders Management Profit maximization

Managers Workers Work effort

Stockholders CPAs Audit effort

Insurance Company Policy Holder Care to avoid loss.

Client Lawyer Settlements

Landowner Sharecropper Cultivation Efforts

The idea underlying an incentive contract is that the higher a fixed wage (salary) is, the less incentive there is for management to undertake activities that are in the interest of the firm but contrary to management’s well- being. Hidden action implies an information asymmetry between absentee shareholders and management that

1 This material is part of the Giving Voice to Values (GVV) curriculum. The Yale School of Management was the founding partner, along with the

Aspen Institute, which also served as the incubator for GVV. From 2009 to 2015, GVV was hosted and supported by Babson College.

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opportunistic executives can take advantage of. To overcome moral hazard the principal can commit to a certain payment contingent upon observing a desired outcome, but she cannot directly observe the actions taken by agent. An example is a contract with a lower fixed component (salary) and a higher variable component that is an imperfect measure of the agent’s long-term actions (e.g., stock options). Bonus payments contingent upon some observed outcome (e.g., earnings) can also be used to align shorter-term incentives. From this perspective, the firm can be viewed as a nexus of contracts that reflect the (moral) hazards that each participant faces.

In this way, the principle-agent model is viewed as the “official story” in that it is the dominant paradigm

of the theory of corporate governance that is taught within MBA programs. 2 Further, the operationalization of

agency theory is regarded by the popular press as the intellectual foundation for the shareholder value movement in Corporate America, resulting in a tripling of CEO compensation from 1980-1994, and a further doubling by 2001 (primarily through stock options).

Agency and Corporate Governance

Daniel is one of a group of founding scientists of a biotechnology firm that has recently gone public with a successful IPO. After the IPO he is now the Director of Product Development, but also finds himself in the unfamiliar territory of the compensation committee of the firm. A new board member on the compensation committee has raised the issue of instituting an incentive component of pay for management that is tied explicitly with the firm’s market performance. Her argument is that such a package will allow the firm to remain competitive in the market for managerial talent in the biotechnology industry. This argument is made in the context of the various rationales for incentive pay outlined above. Daniel is less sanguine, noting that the firm has successfully made it this far without such a program. Further, he feels that as the firm deals with products that are related to public health/safety, this responsibility should remain management’s first priority. In addition, he feels that the firm’s success has been due to research that is motivated by resolving health issues, rather than being motivated by products that provide the highest profit margin. Daniel feels that the human benefits of his firm’s activities should be the primary motivator, and that profits will follow. He is therefore against the notion that executive behavior must somehow be incentivized to create a culture of shareholder maximization. Daniel is in favor of retaining a culture that emphasizes the firm’s historical competitive

advantage  which is developing innovative products that serve the public trust  rather than acting so as to maximize one’s incentive package. Daniel believes in a pro-management perspective rather than a stylized approach that overemphasizes the potential for opportunism.

Discussion Questions

 What’s at stake for the key parties, including those with whom Daniel disagrees?

 What are the main arguments Daniel is trying to counter? That is, what are the reasons and rationalizations you need to address?

 What levers/arguments can Daniel use to influence those with whom he disagrees?

 What is Daniel’s most powerful and persuasive response to the reasons and rationalizations he needs to address?

2 The term “official story” originates from, Bebchuck, L and J. Fried (2004). Pay without Performance, Cambridge, MA: Harvard University Press.

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