Controlling Conflicts Between Stakeholders
As we discussed in the an earlier section, the various stakeholder groups can and will fight. These conflicts play a critical role in the financial landscape.
Controlling the Shareholder-manager conflicts has received much attention. There are many ways this conflict can be lessened, but before this can be done it is worth examining what shapes the conflicts may take.
Shareholders and management can disagree over many things:
Managers may wish to hold more cash, they may wish to lower the firm's risk and subsequently increase job security, they may not want to work hard, they may want to pay employees more than they deserve, they may want other perks such as a fancy office or a jet plane. These are but a few of the nearly infinite number of things that managers and shareholders can disagree over.
Since well before the time of Adam Smith, these "agency costs" have been well documented and studied. The arise due to the fact that managers are people and will act in what they believe to be their own best interests. (See Theories of Human Behavior). The fact that managers and shareholders have differing incentives is well established. Thus to lower agency costs these incentives must somehow aligned.
One way to align incentives is to constantly watch over managers and if the effort is not what shareholders expect, to remove managers. This can be classified as the managerial labor market which can act as a constraint on management forcing them to act in shareholders' best interests. However, this constant shareholder monitoring is expensive and only partially successful (often the managers have better information and are more knowledgeable).
The Board of Directors (BOD) is the group that is designated to look out for shareholders' interests and monitor management. The Board is elected by shareholders with the fiduciary obligation to look out for the best interests of shareholders. For many reasons, this is only partially successful. (for example management is generally also on the BOD).
It is often easier to align incentives with a compensation contract that makes the manager better off if the shareholders are "happy" than to constantly monitor management. This can be done indirectly with giving raises to managers who make shareholders "happy", or by giving bonuses if certain measures (usually accounting-based) are met. However these methods do have problems--for example any accounting based measure leads to short term thinking and may be counterproductive since managers often influence and control accounting practices.
Using market-based compensation is often a more efficient method. This can be done either through stock options, Stock Appreciation Rights (SARs), pay based on MVA, or pure stock ownership. Over the past 15-20 years there has been an explosion in the use of executive stock options. These options (long-term calls) rely on the high leverage aspects of options to align managerial interests with Stockholder interests. Although the use of stock options has come under some attacks by those who feel they have led to too high a level of pay, it is widely acknowledged that managers are more focused on stock returns than in past decades.
Controlling Bondholder-Shareholder problems
Bondholders and Shareholders can also have disagreements. These disagreements can be over many things. For example, Myers (1977) (and others) suggested that firms with much debt would be more likely to pass up positive growth opportunities since the benefits might accrue to bondholders and not shareholders.
The firm's bondholders and stock holders can likewise disagree about the amount of risk the firm has. For example, if we view the equity of a levered firm as equivalent to a call option we can easily see how shareholders have an incentive to increase the riskiness of the firm. (That is the payoff to shareholders is unbounded so there is some positive probability of a large payoff, whereas debt holders' payoff is limited.) To prevent this type of opportunistic behavior, bondholders would
- Not lend money to the firm
- Presume that shareholders will increase the riskiness of the firm and thus bondholders would charge a higher interest rate as a means of "price-protecting" themselves.
- Require a "neutral third party" to help monitor firm.
- Write restrictive contracts that limit what shareholders can do with the money.
- Rely on shareholder reputation to limit their opportunistic behavior (that is the shareholders will likely need more money in the future and if they take advantage of shareholders now, they will not be able to borrow money in the future).
- Agree to lend money but only if they could convert the debt into equity (convertible debt) or if the firm's shareholders agree to buy back the debt if something "bad" happens (puttable debt).
In reality, all of these are used to varying degrees at different times.
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