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Dec
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Written by:
admin
12/1/2007
 Directors of organisations are given the mandate to manage funds on behalf of shareholders for the achievement of the organisational purpose. In doing so directors are delegated (Jensen and Meckling, 1976) to manage the conflicting interests of several stakeholders.
Directors are compensated for their role. Such compensations, though, may not be necessarily aligned with organisation’s success, thus preventing the best choice of strategy for the purpose and increasing rather than diminishing the role of self-interests. DefinitionDirectors of organisations are given the mandate to manage funds on behalf of shareholders for the achievement of the organisational purpose. In doing so directors are delegated (Jensen and Meckling, 1976) to manage the conflicting interests of several stakeholders, as graphically shown here:
Directors are compensated for their role. Such compensations, though, may not be necessarily aligned with organisation’s success, thus preventing the best choice of strategy for the purpose and increasing rather than diminishing the role of self-interests.
Agency TheoryIt has to be noted that “owners” do not own the company in the strict sense, but its shares, as pointed out by Kay (1997). It nicely separates them from the company itself, in accordance with Agency Theory.
This situation gives them the right to ask directors to act in their behalf while making them accountable, as recognised by the same report extract.
The relationship is regulated by a contract (the Corporate Governance).
The annual reports are the main vehicles for communication between directors and shareholders and regulated to contain a minimum set of information.
Not a perfect schemeDespite efforts and publications such as the Combined Code of Governance (1999) issued in UK or the KonTraG in Germany, hazards keep occurring.
Extraordinary accounting scandals, such as Enron and WorldCom, have heavily damaged the trust relationship between investors and directors.
The functioning of the financial markets depends largely, if not primarily, on trust between sellers and vendors. All Stock Exchanges have high interests in transparency of accounts and trust for their validity.
Even traditionally forgiving exchanges such as the Tokyo Stock Exchange is toughening regulations and actions: for the first time since 1980 in just eight months the Exchange has delisted 3 companies for falsifying their accounts, thus sending a signal to directors and investors about a climate change (Morse, 2005). A significant change for a culture of traditional collusion among market players.
The 2003 release of the mentioned Code on Corporate Governance establishes performance indicators to formally evaluate each director’s contribution and commitment to the role, with the power to seek resignation of non-performing directors. It includes non-financial criteria such as: - risk management
- strategy formulation
- knowledge and competences
- internal and external communication guidelines
- joint board effectiveness
It also establishes clear objectives, roles, competences and influence for non-executive directors, who are supposed to challenge and probe assumptions as well as contributing to the strategy.
However, I believe these guidelines and controls can only work if enabled by a general cultural improvement and behavioural attitudes which do not tolerate hazards of this kind. Unfortunately ever increasing competition and change do not favour honest behaviours, especially when fighting for survival.
Main reasons of concern are:
- Remuneration <-> Performance link is weak at best. When is stronger, though, it may even be counterproductive, by favouring extreme behaviours (such as utilitarianism, account manipulation, distraction from operational aspects ).
- The annual report, which is a key source for directors’ performance measurement, is controlled by the directors themselves, although they have been recently required to swear about their correctness (Sarbanes-Oxley Act, 2002).
- Directors have inside information which shareholders lack, probably the single most importance source of problems. Insider dealers, for instance, would operate to the detriment of small investors.
- Auditors and rating agencies, even in the most optimistic scenario of independency, interact with the target company and get influenced (biased) by its management.
Rating agencies, in particular, influence the market while basing their assessment partially and unavoidably on information communicated to them.
Impact on the Efficient Market HypothesisThe issue of information (its accuracy, but also cost and speed of its dissemination) is central to EMH. In its strongest form all public and non public information is automatically and immediately reflected in the share price. Unfortunately this is at least hard to demonstrate; in practice, such imperfections can be and are exploited by insider dealers, even when they are banned from trading in particular periods of the year.
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