Agency Problems and

Accountability of Corporate Managers

and Shareholders

Learning Obiectives:

be able to:
After studying this chapter, you should

1.. Recallthe agencY Problem'

specific issues'
2. Enumerate and explain the principal-agent

I 3.Enumerateandelaboratetheidentifiedagencyproblemsincorporate
governance.
I
the types of takeovers'
4. Ascertain the significant differences among

5.Showtheimportantrolestheexternalbodiesservetoimprovecorporate
governance.

AgencyProblemsandAccountobilityofCorporoteMonagersondShareholders|5-1

$
 8 Outrageous Executive Perks
by Kothy Kristof, Kiplinger.com, Apr. 5,20L7

It's annual-meeting seasorl which means shareholders are about to get their
once-a-year look at the pay and goodies given to corporate top dogs as disclosed in
company proxy statements.
The multimillion-dollar pay packages will make headlines but shareholders should
also mind the little things. While some perks are merely outrageous because they're given
to executives who earn vast fortunes, others have proved to be a sign of executive larceny
and lax oversight by a company's board of directors.
Here are eight of the most outrageous perks given to U.S. executives in history--
some long gone and some remaining.

52 Million Birthday Party

Comparry:Tyco lnternational (NYSE: TYC - News)

Perk recipient: Dennis Kozlowski
When Dennis Kozlowski's second wife hit the magic age of 40 in 2001-only a few
months after they wed--the former Tyco chief went all out. He threw a weeklong Roman-
themed party on the island of Sardinia-replete with scantily clad models, chariots and an
ice-sculpture vodka fountain made to look like Michelangelo's David. Tyco, now based in
Switzerland, paid half of the 52 million tab.
Tyco also paid for Kozlowski's dog-shaped umbrella stand (S15,000), a gold-plated
waste basket and artwork in his mansion--but apparently not with the company's
knowledge or consent. Four years later, Kozlowski was convicted of grand larceny for
misappropriating millions in shareholder assets for his own benefit.

Post-Mortem Non-Compete

Company:Shaw Group (NYSE: SHAW - News)

Perk recipient: James Bernhard
Companies are sometimes willing to pay executives vast sums for promises not
to compete or divulge company secrets when they change employers. But Baton Rouge-
based Shaw Group wants CEO James Bernhard to keep that promise a little longer than
normal--two years past death--and is willing to pay dearly for his silence in the grave.
According to the company's most recent proxy statement, Shaw will pay Bernhard
or his heirs--$tS million (plus interest) when he leaves for his promise not to compete--
even if he can't compete because he's dead.

5-2 | Good Governance and Sociol Responsibility

Housekeeping

Company:Tyson Foods (NYSE: TSN - News)

Perk recipient: Don Tyson
Don Tyson retired in 2001, but Tyson Foods was so grateful for his past leadership
that it financed vacations for Tyson and his close friends, paid their personal credit-card
bills and allowed him to charge unusual purchases--such as an 58,000 horse and a 520,000
oriental rug--to the company.
But perhaps the most objectionable perk was having Tyson company employees
clean Mr. Tyson's house and mow his lawn. According to a 2005 SEC settlement, Tyson
Foods spent $203,675 having employees clean five different homes owned by Don Tyson,
his family or friends. The company, headquartered in Springdale, Ark., also sprang for
584,000 in lawn-maintenance costs for the same five homes.

Flying School Bus

Company: Qwest Communication lnternational (NYSE: Q- News)

Perk recipient: Edward Mueller
Executives are often given the right to use the company jet for pleasure travel,
but their spouses, children and friends are usually only allowed to use the plane when
they're accompanying the employee. But Edward Mueller demanded an exception to that
rule when he became CEO of Denver-based Qwest in 2OO7 .
His employment agreement gave his wife and daughter the right to use the
company jet to commute to and from California, where his daughter was still in high
school. The phone company expensed 5281,,182 that year for Mueller family joy rides on
the jet and ended up buying his California home for a St.8 million premium to its resale
price, too.

Tax-Free California

Company: Occidental Petroleum (NYSE: OXY-News)

Perk recipient: Ray lrani
When Ray lrani moved to California to take Oxy's top job, he was apparently
horrified by the Golden State's high income tax rate. So in 1991, lrani struck an
employment deal that required Oxy to pay his state income tax bills.
Over the course of the next six years, the Los Angeles-based energy company
shelled out 55.8 million to pay taxes for lrani. But the problem with paying taxes for
someone is that even the tax payment is taxable. There's also tax on the tax on the tax,
making this one of the most egregious corporate perks in America. Occidental, long a
target of pay.critics, responded to shareholder objections by paying lrani a lump sum of
S95 million in \997 to buy out his contract and rescind the company tax subsidy.

Agency Problems ond Accountobility of Corporote Monagers ond Shoreholders | 5-3

Flying Cash Cow

Company:Apple Computer (Nasdaq: AAPL - News)

Perk recipient: Steve Jobs
ln 1999, Steve Jobs was "interim CEO" of Apple Computer, having returned in
L99V to the then-struggling company that had fired him a decade earlier. Directors were
so grateful for his leadership and his refusal to accept any cash pay--he still works for $1
annually--that they gave him a plane.
A $9O-million Gulfstream V is a pretty good perk. lt became even better in 2A02,
when the Cupertino, Cal., company started reimbursing Jobs whenever he used his plane
on company business. ln2OO2, Apple paid St.t million in flight-cost reimbursements for
his use for the past two years.

Super Security

Company: Oracle Corp. (Nasdaq: ORCL - News)

Perl< recipient: Larry Ellison
To say that Oracle's Larry Ellison is security-conscious is a bit of an
understatement. He installed at his expansive northern Catrifornia home
a security system
and Oracle, based in Redwood Shores, Cal., pays about S1.4 million annually to monitor
it. To put this in perspective, Qwest pays about 53,000 annually to protect Mueller.
Few details are available about Ellison's "residential security program" except
that it includes "security personnel."

Box Seats'Til Death

Company: General Electric (NYSE: GE - News)

Perk recipient: Jack Welch
Nobody knew what fabulous perks Jack Welch got from GE. The 2000 proxy
statement said he had only received 554,019 in giveaways. ln 2001, it was $17L,772,
mainly for financial counseling.
But, during a bitter divorce, Welch's ex-wife detailed a multimillion-dollar litany
of perks that GE provided, both before and after Welch retired. Among them: fresh
flowers and a wait-staff for his New York City apartment; floor-level seats for Knicks
games; a sky box ior Red Sox games and VIP seating at the French Open. Experts say the
resulting brouhaha is one of the reasons regulators revamped corporate-disclosure rules.
Welch subsequently gave up the bulk of his perks.

5-4 | Good Governance and Socisl Responsibility

 ThisChineseComputercEoWillRestoreYourFaithinHumanity
By Vincent Trivett, MinYanville
2012
finonce.yohoo.com/news, July 21,

States, and though

Bonuses make up a huge part of executive pay in the United
true there' The cEo of Lenovo
chinese incentive structures are different, the same is
a pretty darn nice way to
(LNGVY), a major chinese computer parts maker, has found
spend his.
yang yuanqing took in a $3 million bonus after the company reported a massive
year, ending Lenovo's best fiscal year
73% jump in profits in the first three months of the
extra s3 million' and he
to date. The company thanked Yang for his performance with an
offices, call centers' and
gave it all away to 10,000 lower-ranked employees in Lenovo's
Each worker received 2,000 RMB, or S3t4. This is about
the equivalent of a
factories.
month's salary for many Lenovo workers'
mind that the s3 million
Before you call Yang a selfless working-class hero, keep in
in various ways including salary'
is only part of the 514 million that he has been awarded
the employees of other
stock and other benefits for his work at the company. certainly,
tech companies are hoping that their CEOs follow suit'
has
According to a study by the Economic Policy lnstitute, cEo compensation
over the past few decades'
outpacecl the average worker's pay by astonishing margins
1"978 and 2011, far outpacing the
cEO compensation grew by a shocking 725%belween
growth of the stock market. The average worker's pay has only risen by
5J% in the same
period.
prodigious in the past few
Lenovo,s rise in the market for PCs has been quite
gap between itself and Hewlett-
years. lt blew past Dell (DEL[") and it's rapidly closing the
packard (HPa) in the global market for PCs running Microsoft (MSFT) Windows, according
(AAPL) doesn't make it into the
to this chart by lDC. ln the global computer market, Apple
top five, but it is third in US computer sales'

AgencyPrablemsandAccauntabitityofCorporoteMonagersondShareholders|5-5
 "The woy t calculate it, while I goined $lEg mittion (in options)
I created obout $gl bittion of wealth for shoreholders."
.- Dennis Kozlowski (rotionalizing his pay)

INTRODUCTION

The debate over corporate social responsibility is often vague or unrealistic or

both. The participants speak in terms of how corporations ought to be run without
specifying the legal changes that will produce these results. When social responsibility
advocates recommend legal fixes, they typically focus on their aspirations for how these
changes will function without fully analyzing how the proposals will actually operate in
the context of real world constraints on governing large firms.

The relevant legal issues for corporate social responsibility concern whether and
to what extent legal rules should mandate or restrict mechanisms of corporate
governance in order to ensure that corporate managers act in society's interests rather
than those solely of the shareholders. lt is helpful to begin the analysis by delineating
what the relevant questions do not concern.

First, although social responsibility is often referred to as a "corporate" concept,

it has no coherent meaning detached from the specific mechanisms by which
corporations are governed.

Second, the legal issue is not whether the corporation or any of the individuals
who manage it should care about society. There may be strong ethical or moral arguments
for socially-responsible governance. The question addressed here is whether the law
should mandate such governance, given lawmakers' inherent limitations, the potential
costs of legal rules, and disagreements about appropriate social objectives'

Third, there is no question whether the parties to the firm may contract to take
society's interests into account. The question is the extent to which the law should
mandate contracts intended to produce more socially-responsible governance or prohibit
contracts that constrain socially-responsible management.

Fourth, the specific question regarding corporate social responsibility is not

whether the managers should maximize profits, but rather in whose interests they should
manage. Managers can promote shareholders' interests without maximizing profits to the
extent the shareholders have some objective other than profit maximization'

The argument for laws intended to ensure more socially-responsible

management is that corporate managers who are forced to respond to shareholders'
interests may not maximize social welfare.

5-6 | Good Governance and Sociql Responsibility

\
Social responsibility theorists argue that markets alone cannot adequately
discipline corporate conduct, and that regulation of corporate conduct does not redress
all social harm because these harms are difficult to detect, regulation is difficult to design,
and sanctions may be ineffective. Shareholders care only about profits in the narrow
accounting sense rather than social welfare and take no moral responsibility for social
harm. Advocates of more socially-responsible governance accordingly argue for
empowering or compelling managers to run their companies with a view to society's
interests as well as those of shareholders. Directors are "mediating hierarchs" who do,
and should, respond to the interests of the various parties to the corporate contract,
including creditors, suppliers, and workers. One response to this argument is .,that
society's interests are not as inconsistent with those of shareholders as social
responsibility theorists assume. Markets can reflect political and socialtastes and socially-
relevant information. lt follows that managers who closely attend to shareholders'
interests have incentives to maximize social wealth.

Another response concerns the costs of legally compelling socially-responsible

governance-that is, of reducing managers' accountability to shareholders. Berle and
Means argued seventy years ago that the central problem with corporate governance is
that corporate managers are essentially free from effective shareholder discipline.

Enron and other notorious corporate scandals demonstrate that this agency cost
problem has not disappeared. Substantially restructuring corporate governance to reduce
managers' accountability to shareholders could exacerbate these problems. Adopting
recommendations by some commentators to make managers accountable to non-
shareholders could have similar consequences because empowering stakeholders leaves
managers effectively accountable to nobody.

lf corporate managers should not be made significantly less accountable to

shareholders, the remaining corporate social responsibility issue is whether firms ought
to be able to make them more accountable to shareholders. The initial question is
whether such a move is feasible. The governance of large corporations is based on the
general principle of "director primacy" which reposes basic management power in
corporate directors. The conventional mechanisms for controlling this power-
shareholder voting, fiduciary duties, and the market for corporate control-all have
significant gaps that inhere in the difficulty of controlling managers' discretion in publicly
held firn,s.

One type of accountability mechanism that might be considered is to weaken

managers' grip on the firm's cash through partnership-like devices that mandate
distributions and permit dissatisfied owners to cash out. These mechanisms have not
been used as tools of public corporation governance at least partly because the effects of
tax makes distributions to owners unattractive. Other factors also may play a role,
including large firms' need for financing flexibility in the light of changing business needs,
which in turn may require that managers decide distributions. ln other words, greater
managerial accountability to shareholders might be infeasible because it would increase

Agency Problems ond Accountability of Corporate Manogers and Shareholders | 5-7

 operating costs more than it would reduce agency costs. lf so, it is
unnecessary even to
reach the issue of whether these mechanisms are otherwise
socially desirable.

An agency problem occurs when the interests of stockiroiders,.the

board of
directors, and/or the management of the company are not perfectly
aligned or when
these entities conflict. ln publicly-held companies, there are a variety
of individuals with
an interest in the performance of the company. The managers
and executives who run
the company on a day-to-cJay basis, the shareholders who own stock,
and the board of
directors who oversee the company's business development all
may have different aims
or ideas of how the business can be run.

Executives of a corporation, for example, may be interested

in achieving good
long-term growth of the company. since their performance is
measured by how the
company do in both the short term and the long run, the decisions
they make are based
on the goals of generating profit both now and in the future.
This may mean they wish to
engage in capital expenditures now to secure a possible benefit
or gain in the future.

AGENCY PROBLEM IN CORPORATE GOVERNANCE

Agency theory suggests that the firm can be viewed as a loosely

defined contract
between resource providers and the resource controllers. lt is
a relationship that came
into being occasioned by the existence of one or more individuals
called principals,
employ one or more other individuals, called agents, to carry out
some service and then
entrust decision-maki.g rights to the agents. ln corporate context,
the key agency
relationships are those between stockholders and BODs, Executives,
and managers.
Recent laws in response to corporate financial accounting scandals
in the U.s. and olher
countries however redefined these relationships in a more specific
ways. There now exist
a cascading nature of principal agent relations. For instance, shareholders are
the
principalof the board of the directors, board nf directors
on the other hand are principal
of the executives, managers, and auditors.

PRIf\ICIPAL-A6ENT SPECIFIC ISSUES

Diversification vs. Dividends

use of free cash flows which are by description, resources of
the principal
generated after investment in all projects, managers prefer
this funds to be invested in
additional product diversification while shareholders prefer the
funds to be declared as
dividends so long as it is backerj by income. Control on how
the available funds will be
used or invested is another example of agency problem.

Managerial Opportunism

There are examples or instances wherein shareholders return will not be

maximized to the fullest because of unrelated diversification
and growth which leads to
increased compensation for managers nr:t to mention that
it reduces the employment

5-8 | Good Governance and Socia! Responsibility

risk of top managers, This explains why we see some subsidiary companies that are still
alive even when they are becoming more of a liability than an asset to the holding
company because some officers and managers want them to be there; "it is hard to let go.
of these management fees." Without the watchful eyes of the advisers we cannot expect
that all of these facets can be seen by the shareholders or even by the maiority
shareholder himself.

Power Supremacy vs. Technical Expertise

Some of the corporate investors, most especially institutional investors, are just
putting their money with expectation of dividend at a certain time. lt is not that these
shareholders doesn't know how to run their own corporations; it is just that they have
excess funds and they want to have productive placements of these furrds. The nature of
their intention made them rely only on expertise of the agents. \Jhat is left to the
shareholders is supreme power over the corporation which is rarely being talked about
and sometimes not an issue from the operating point of view. lt is a clear picture of agents
doing the real things and principals waiting for the ultimate result.

Trust
Another specific agency issue is trust. Shareholders have more trust than doubts
to the agents and they are entrusting everything as far as operation including the charting
of the corporation's future to its directors a nd officers. lt is the kind of c*mfort that agents
are taking pleasure from that would sometimes make them lose their balance. This failure
in balance is one of the essential component of managerial opportunism; the prevailing
agency problem.

IDENTIFIED AGENCY PROBLEMS

Adverse Selection
Another identified problem in principal-agent reiationship is the insufficiency of
information that is normally obtainable to the principal and to the agents; this is the core
concept of adverse selection. Agents (executives and managers to be in relation to the
board of directors) present their working paper. in 16sum6s; they discuss their
qualifications in interviews, principals screen the agents to be, rnost of the screening
process is acttlally anchored on the inforrnation provided by the agents. Based on suclr
information, the principals decide whether such agents are accepted or not for positions.
ln some cases, such r6sum6s are later found to contain inaccurate inforrnation, or
versions made in interviews are later documented as not the same as what is desired in
real performance.

lnsufficiency of information may also be done by the principals through

misrepresentation of information or provide incomplete or half-cooked information.
Principals in interviewing prospective accountants, for example, may afflrm that high
ethical standards are to be maintained in processing as well as in reporting financial
information to shareholders. Based on this representation, agents believe it as something

Agency Prablients antl Accauntabitity af Carporate Managers ctnd Sharehalders | 5-9

 some of them will find out
so cr:nsistent with their training and beliefs. Unfortunately,
Corporate agents in accepting
later that what has been said is not really happening.
just being informed that the
positions as accounting or finance managers are sometimes
company figures musl reflect a specified level of
profit at the end of the fiscal year'
The words of the principal during
regardless of what the actual accounting records reflect'
principal in this case is
the initial interview are not supported with actual events or the
figures.
becoming inconsistent by trying to influence the financial

Agency Costs
to
Resources to be sacrificed to keep an eye on things that are perceived or need
are significant costs in a
be closely controlled from the perception of the principal
power and responsibility'
pr.incipal-agent relationship. since the principal is delegating
activities to have reassurance
cautious principals will carry out some type of monitoring
principal. These activities
that decisions are most favorable from the point of view of the
party assurance like compliance
include repclrts, observation visits, supervision and third
activities are cost-
audit and external financial statement audit. None of the mentioned
free.

behavior are
When the above efforts of the shareholder to alter the managerial
wealth due to inappropriate
not present, there will normally be some loss of shareholder
be excessive if shareholders
managerial actlons. on the other hand, agency costs would
with shareholder
would attempt to ensure that every managerial action is in accordance
costs to be borne by
interests. Therefore, the most favorable amount of agency
costs should be increased as
shareholders is determined in a cost-benefit context; agency
peso increase in shareholder
long as each incremental peso spent results in at least a
wealth.

Conflict sf lnterest
and that is conflict of
Agency theory pulls an essential problem in organizations
personal objectives that compete
interest. A corporation's managers can or may have
Because the
with the owners' objective of maximization of shareholder wealth'
shareholders authorize executives and managers to manage
the firm's resources, a
potential conflict of interest exists between the two groups'

In the majority of large publicly-traded corporations,

agency conflicts are almost
generally own only a small
certainly considerable because the firm's managers
percentage of the common share. Therefore, shareholder wealth
maximization could be
For instance' managers
subordinated to an assortment of other managerial objectives'
may have a primary objective of maximizing the size of the
firm' ln creating a large' swiftly
for lower-
growing firm, executives increase their own status, create more opportunities
and enhance their job security
and middle-level managers, improve the status of salaries,
because an unfriendly iakeover is less likely. As a result,
current management may push
their individual
for diversification at the cost of the shareholders who can easily diversify

540 | Goad Gavernance snd Sociol Responsibility

portfolios simply by buying shares in other companies, agents in this case are creating
leverage out of shareholders' (principal's) resources.

Managers can be encouraged to take action in the in shareholders' best interests

through incentives, constraints, punishments and other control mechanisms. These
methods are effective only if shareholders can closely monitor all of the actions being
undertaken by the managers. However, if close monitoring is infeasible, this might lead
to a morol donger problem. lt is a problern where agents take unobserved actions against
the principals' interests because it is impracticable for shareholders (principals) to
monitor all managerial actions performed in the different levels in the organization. To
reduce the moral danger problem, shareholders (principals) must incur agency costs to
monitor agent's activity.

Legal Requirements vs. Opportunistic Behavior

The culture of opportunism as manifested by excessively paid executives and

managerscombined with the financial accounting scandals in US companies presented a
very strong reflection of the ineffectiveness of principal-agent relationships and the
massive deficiency of the current agency theoretical efforts and practices. As a
consequence of the surge of scandals in the decade prior to 2002, the U.S. Congress
enacted the Sarbanes-Oxley Act of 2002, which imposed new regulations on public
companies and their auditors. Such rules are understood to be effective in making sure
that executives do their obligations in doing things expected from them, protection of the
principal or the investing public is just one of them.

This law not only strengthens the protection of the investors (shareholders) but
also affects the hierarchy of principal-agent relationships: shareholders are principals of
public companies and their immediate agents are boards of directors. Boards of directors
are principals; their agents are the executives selected to carry out policies and the
independent auditors they engage to audit the financial statements of the company. The
principal-agent relationships continue to lower levels of organizations.

Self-l nterested Behavior

Agency theory suggests that, in imperfect labor and capital markets, executives
and managers will seek to make the most out of their own value at the expense of
corporate shareholders. Agents have the capability to operate in their own self-interest
rather than in the best interests ofthe firm because executives and managers know better
than shareholders whether they are capable of meeting the shareholders' objectives or
not. Another issue which tempts self-interested behavior is the absence of clear and
compelling evidences that it is the agents that is at fault or responsible and consequently
to be blamed or be crowned on the final outcomes of the organization positive or
negative. This reality can lead to maverick behaviors of some BOD or executives which if
not checked by the principals, may spin out of control and the next thing the shareholder
may know is that the agents got more than the shareholders rightfully deserved.

Agency Problems ond Accauntobility of Corporate Monagers and Shareholders | 5-71,

 proof of
self-interested executive and managerial behavior includes the
consumption of some corporate resources in the form of stratospheric privileges,
unrelated diversification. Apparent effort of trying to avoid optimal risk positions,
whereby risk-reluctant managers bypass profitable opportunities in which the firm's
shareholders would wish they invest in; BODs and executives sometimes prefer to be
secrrred in a status quo instead

This can lead to a conclusion by outside investors that the firm will make decisions
contrary to their best interests. For that reason, investors will be unwilling to pay the real
rnarket price of the firrn's securities; instead, investors will only pay the firm securities at
a discount.

Remedies Within Shareholders

Proxy Voting

Under the law, a shareholder has no right to cast votes by proxy in shareholders'
meetings without special authority given by the supposed voting shareholder. The
solution is by proxy voting which refers to an exercise of voting in behalf of shareholders
through the use of a special authority given by the shareholder/principal. ln this process,
the one who would cast votes would either by another shareholder or a fund manager.
For practical reasons, proxy voting is norrrally used in corporations by voting
shareholders, for it permits shareholders who have confidence in the judgment of
another shareholder or investment and fund managers to vote for them. lt also provides
the required quorum of votes to undertake important corporate undertakings.

ln corporate settings, proxy voting's use is normally limited to voting at the annual
meeting for directors, for the sanctioning of acts of the directors, for the increase or
decrease of capital, and for other crucial amendments in the policies of the organization'
These proposed amendments ancJ changes are summarized in the memorandum circular
sent to shareholders before the annual shareholders' meeting. Stock-transfer book will
be closed at a certain number of days before the annual shareholders' meeting to give
time for the corporate secretary to prepare a list of stockholders and the number of
strares held by each shareholcler. Then, voting will be based on shareholdings of each
shareholder shown in the stock book. Shareholders with proxy arrangernents are listed
and all proxies are then checked against this list.

. ln proxy voting system, in the absence of the principalfrom the annual meeting
of a business corporation, the proxy, being given the authority, has the right to vote in all
instances, but the proxy is not having the right to debate or otherwise participate in the
proceedings since this is outside of the authority given to him. The right to argue and
participate in the proceedings is reserved only if you are a voting shareholder of the
corporation.

5-12 | Good Gsvernance and Saciol Responsibility

Benefits of Proxy Voting

The following are the areas where proxy system accrues benefit to the
principal/shareholder more especially if the proxy is a fund manager:

o Routine Decisions
lnvestment and fund managers serving as proxies will generally vote for
uncontested director or trustee nominees, other minor things like changes in
company name and other procedural matters related to annual meetings. These
are example of things that are not practically sensible for all the stockholders to
be present and vote on the above concern.

o Governance
Proxies especially fund manager will generally vote for charter and
amendments of by-laws, on rnatters related to compliance with applicable laws
and regulations affecting the organization.

o lssues on Anti-takeover
Proxies and fund managers normally will vote for proposals that
necessitate shareholders' confirmation of anti-takeover measures and proxy
system provides a swift and effective way of piling up these poison pills.
Considering that proxy's right is specific, once poison pills are there, it can never
be redeemed by the company through the use of proxy unless another separate
authority to do so is given by the principal. Proxies in this situation will be serving
working horses on anti-takeover concerns.

Proxy system is not without negative implications. Froxy voting is said to lack
deliberative features due to the limited authority and instructions given by their
principal/shareholder. Thus, proxies cannot modify their decision on the deliberation
process; a process where strength and weaknesses of the arguments as well as counter
arguments are theoretical ly tested"

Derivative Suit
A derivative suit is a lawsuit filed by a shareholder on behalf of the corporation
against a third party. More often, the third party referred to here is an insider of the
corporation, directors and other senior officers of the company. A shareholder derivative
suit has this unique feature in the sense that under the corporation law, the management
which is composed of directors, officers and other senior managers are mandated to be
partly responsible in bringing and defending the corporation against the suit. ln the case
of derivative suit, it is the stockholder who will initiate the suit in cases where
management has failed to do so.

Agency Problems ond Accountabitity of Corporote Manogers and Shareholders | 5-73

Specific Feature

While, under the Corporation Code of the Philippines shareholders are the
owners of a corporation but for practical reasons, they are not empowered to manage
the day-to-day operations and other routinary concerns of the corporation. lnstead,
shareholders appoint directors, and the directors in turn appoint executives and high
ranking managers. Derivative suit allows a shareholder to bring an action in the name of
the corporation against the parties that may cause or is allegedly causing harm to the
corporation. When the directors, officers, managers, or employees of the corporation are
not keen on filing an action, a shareholder may first petition them to do so. lf such petition
is unsuccessful, the shareholder may do it himself to bring an action on behalf of the
corporation. Any reward monetary or otherwise of a successful action will be awarded to
the corporation and not to the individual shareholders that initiated such action.

Process

ln initiating this action, a shareholder must satisfy various requisites to prove that
he has a strong and valid status before being permitted to proceed with the action. The
shareholder may be required to meet some qualifications. One of these qualifications
might be the minimum value of his holdings in the corporation and the minimum duration
of his being a shareholder. ln addition, the shareholder who is about to initiate the action
may be required to post a bond or other fees to compensate whenever his action is
u nsuccessfu l.

Takeover
Corporate takeover is the "general term referring to transfer of control of a firm
from one group of shareholders to another group of shareholders. Change in the
controlling interest of a corporation, either through a friendly acquisition or an unfriendly,
hostile, bid. A hostile takeover (with the aim of replacing current existing management)
is usually attempted through a public tender offer."

Types of Takeover

o Friendly Takeover
. Before a bidder ccmpany makes an offer for another company, it usually
inform first the board of directors of the company to be taken over. When the
board thinks that accepting the offer serves the shareholders interest better, it
then recommends the said offer be accepted by the shareholders.

ln closely-held or privately-held companies, since the shareholders and

the board of directors is usually the same people or closely connected with one
another, private takeovers are normally friendly. lf the shareholders are in
agreement to sell the company, then the board is usually of the same mind or
sufficiently under the commands of the equity shareholders to cooperate with
the acquiring company.

5-14 | Good Governonce ond Sociql Responsibility

 o Hostile Takeover
A hostile takeover permits the "acquirer to be" company to bypass the
target company's management if it is uncooperative and unwilling to agree to a
merger or takeover. A takeover is regarded as "hostile,' if the target company,s
board cast-offs the offer but the "acquirer to be" is persistent to pursue it. lt can
also be considered hostile if an offer was made without informing the target
company's board ahead of time.

A hostile takeover can be done in several ways, the following are some of
these

1'. By making a tender offerwhereby the acquiring company makes a public

offer
the price of which is way higher than the current market price making it hard
for the existing shareholders to resist.
2. By engaging into a proxy fight whereby the acquiring company persuades
enough shareholders, usually a simple majority is sufficient, to replace the
management with a new one. This new management will be installed
purposively to approve the takeove r.
3. Another isby quietly purchasing enough stock in the open morket, known as
a "creeping." The purpose of this is to gather enough holdings that can
somehow influence the decisions within the corporation. A 20% shareholding
is already significant enough for one voice to be heard and influence
management

There are risks involved in hostile takeovers considering that in this type
of takeover, the acquirer to be or the bidder knows only what is publicly available,
and what is publicly available may not be all true or given that it is all true, are all
things ought to be made public are really reported? one of the dangers of a
hostile takeover is that, if there such a as "poison pill,, in a takeover issues, there
can also be "landmines" being planted by the old management before they go
and have the burden of clearing it be left to the new management. This is one of
the reasons why banks and other financiers are less-willing to back hostile bids
because of the level of risk involved.

o Reverse Takeover
Reverse takeover (RTo) is a type of merger used by private companies to
become publicly-traded without passing through an initial public offering (tpo).
At first, the private company buys large portion of publicly-traded company,s
share enough to control the publicly-traded company. The private company's
shareholder then uses their shares in the private company to exchange for shares
in the public company. At this point, shares floating will now be the private
company's shaie and the private company has effectively becorne a publicly-
traded one. This takeover is also known as a "reverse merger', or ',reverse lpo."

Agency Problems ond Accountobitity of Corporate Monogers ond shareholders

| 5-!S
 With "reverse Inerger" or "reverse IPO", the private company has saved
itself from paying expensive fees related to an initial public offering. RTO however
is not all good side considering that the company does not acquire any additional
funds through the merger transaction, the company should have enough funding
for the company to complete the transaction on its own.

o Tender Offers
Atender offer is a corporate finance term which means a type of takeover
proposal that is public and open invitation, usually coursed through media by a
prospective acquirer to all stockholders of a publicly-traded corporation
("acquired to be") which is the target corporation. The tender offer typically
involves approaching a current shareholder and making an offer for all or part,
normally majority, of the held shares. Shareholders of the target corporation will
be given offer to tender their stocks for sale at a specified price during a specified
time. ln this type of takeover proposal, the bidder/acquirer communicates
directly to the stockholders of the target company and the directors of the target
company may not necessarily endorse the proposal.

Tender offers are efforts to secure outstanding shares of stock of a given

company through means other than purchasing the traded shares in the open
market. lntentionally to make the tender offer attractive, the purchase price is
set above current market value. To persuade the shareholders of the target
company to sell their holdings, the acquirer will offer price usually includes a
premium on top of the current market price of the target company's shares. For
example, if a target company's shares are trading at P20.00 per share, an acquirer
might offer P24.00 per share to shareholders with the clause that at least majority
of the shareholders agree.

The employ of a tender offer is a familiar approach when an individual or

entity is kicking off a takeover bid. Takeover bids may be conducted for a variety
of reasons; one of which is there may be an interest in acquiring a profitable
company and embed it into a conglomerate as one of the overall corporate
growth strategy. A takeover bid may also be a tactic to gain control of the assets
of the company with motive towards methodically dismantling the operation and
selling off the various assets individually for profit.

Finoncing o Takeover

Financing a takeover is an act of funding for the purpose of obtaining control over
a corporation through the purchase of stock or any other means; the process of providing
capital for someone to establish control of another corporation.

o Debt Financing
ln principle, a company acquiring another pays a specific amount of
money for the merger transaction to complete. This money can be raised in

5-1.6 | Good Governance ond Sociol Responsibility

 several ways. While the acquiring company has enough money to finance the
transaction, some acquiring company chooses not to bleed out its cold cash for
this. Usually, to finance the takeover, it will borrow from a bank or raise the funds
needed through issuance of bonds. This acquisition which is financed by debt is
known as leveraged buyouts and the debt will usually be booked in the balance
sheet of the acquired company. The acquired company then has to pay back the
debt. This technique is often used by private equity companies to iessen the
impact of cash flows at the same time. Debt financing could reach as high as 80%
of the purchase price leaving only 20% to be raised internally by the acquiring
company.

o Partial or Fuli Equity Conversion

This is done by giving the shareholders of the target company offers that
include a debt instrument in partial or in full payment of shares. This arrangement
is attractive compared to a spot cash transaction from the taxation point of view
considering that spot cash deals, being treated as disposal are open and exposed
to taxation (capital gains tax which is 6%). This tax exposure is partly sheltered if
transactions will be in the form conversion from equity to debt making the once
shareholders a debt investor of the corporation"

o Share Swap/All Share Deal

ln a takeover, sometimes the transaction can entirely be financed by a
share swap or all share deal. There will be no money involved; instead the bidder
company issues its own new shares to the shareholders of the "acquired to be"
company. ln this case, the acquiring company will end up as the majority
shareholder and have the control over the company's crucial issues. The
shareholders of the company being acquired, being the minority, may still have
significant influence over the merged entities. lnfluence may include
management rights in the merged companies, board and executive seats, and
personnel contribution.

EXTERNAL FORCES AFFECTING GOVERNANCE

COMPETITORS

Competitors refer to corporations and other business entities, private or public,

offering the same product or services that the company is offering. This affects
governance considering that, to the eyes of the investors, the best run business are the
most attractive for investment. Competition makes the corporation on guard on what to
do for itself to gain competitive advantage over its competitor and at the same time, scout
for things that would make your competitor at a disadvantage.

AEency Problems and Accountability of Corporote A/lanqgers snd Sharehctlders | 5-17

FINANCIERS

Financier is a term given to a person or entity who manages routinely huge

amount of money. This person or entity usually involved in the activity of lending money,
project financing, large-scale investment or large-scale management of money. Financlers
affects company's governance in the sense that being the fund provider, financiers wants
their investment secured. They only invest in companies with a good track record and
reputation to protect and this may mean that the company will be around for a longer
period of time.

REGULATORY AGENCIES

Regulatory agency, in general, refers to a public authority or government agency

responsible for exercising autonomous authority over some area of corporate activity in
a regulatory or supervisory capacity. An independent regulatory agency is a regulatory
agency that is independent from other branches or arms of the government. Regulatory
agencies deal in the area of administrative law regulations; that is enforcing rules and
regulations and imposing supervision or oversight for the benefit of the public at large.

Regulatory agencies are more often than not a part of the executive branch of
the government or have statutory authority to perform its functions with oversight from
the legislative branch such as Congress. Their actions are generally open to legal review.
Regulatory authorities are commonly set up to enforce standards and safety, to oversee
use of public goods and to regulate commerce.

WATCHDOGS

Watchdog refers to independent organizations trying to police a particular

industry or corporate conduct to make certain that the activities of these companies are
accordance with the acceptable standards and existing laws.

PREDATOR COMPANIES

Predator companies refer to corporations that are always on the watch and
waiting for a chance to take-over a certain company, be it via friendly or hostile takeover.

INFORMATION ENHANCERS, PROVIDERS AND GATEKEEPERS

"Properly understood, Enron is a demonstration of gatekeeper failure, and the

question it most sharply poses is how this failure should be rectified."
John C. Coffee
"Understanding Enron: lt's about Gatekeepers, Stupid"

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 "The failure of this network of gatekeepers was a recurring theme in the business
scandals. ln too many instances, the gotekeepers in pursuit of their own financial self-
interest compromised the values and standards of their professions.... ln the recent round
of corporate scandals, the first tier-the managers-failed, and then the gatekeepers failed
as well."
AAA&S, Report of the American
Academy's Corporate Responsibil ity Steeri ng Comm ittee

Gatekeepers refer to independent third party persons or entity whose

cooperation is important because they have the capability to at least deter, if not prevent
misconducts of corporations. Examples of gatekeepers are accountants, lawyers, bankers,
analysts, rating agencies and examiners. The aforementioned entities and people are
considered gatekeepers to financial markets by providing information on investment and
business concern to investors and fund providers. ln the past decade, independent
accountants have been accused not only of being aware of accounting irregularities but
even of aiding and indirectly supporting the violators.

Arguably the most notorious corporate scandal in modern times "The Enron
Scandal" is one good example of the gatekeepers' failure. The firm, Arthur Andersen, is
even suspected of putting more emphasis on hauling its more profitable professional
engagement with the company than on confirming that the company's financial records
and reporting Were in order. Gatekeepers' role is very important especially during this
time wherein number of investors in financial market have increased. Some of these
investors are not technically well-versed in financial things exposing them to real risk.
Mitigating this risk means that they will be dependent on information provided by
financial gatekeepers.

To make the responsibility legal for those who are in-charge with governance as
well as to third parties (gatekeepers) and the same protect the investing public, the U.S.
Government enacted the Sarbanes-Oxley Act. Ln all practical terms, this law was actually
the by-product of series of large corporate scandals; Enron and WorldCom are just two of
them. This act regulated with muscular intent the auditing and accounting industry in two
ways. One, it requires a certification from the cEO that the financial statement provided
by the company is reliable. This way the company's management cannot funnel down all
the blame to the auditors and other gatekeepers for undetected fraud and other
irregularities. This law also increases penalties for corporate fraud and irregularities. lt
also outlines the cascading responsibilities from the Board to other officers and eventually
to gatekeepers.

ln the current Philippine setup, it is a requirement that company's financial

statements which are filed with the Bureau of lnternal Revenue (BtR) and the Securities
and Exchange Commission (SEC) be accompanied with a Statement of Management
Responsibility (stvlR). ln this statement, the management acknowledges all the
responsibilities contain in the financial statement including its compliance with the
applicable laws and reporting standards.

Agency Problems ond Accountability of Corporate Manogers and Shoreholders | 5-1"9

INVESTMENT BANKERS

An investment banker is an individual or entity which acts as an agent for

corporation issuing securities. Some also maintain a brokerage or a dealership operation
and offer advisory services to its clients on investment concerns. These entities also have
a large role in assisting interested parties on mergers and acquisitions as well as in debt
restructuring. lnvestment banker is different from the traditional banks in that the iatter
does not accept deposit and provide loans to individuals or corporations.

Role of lnvestment Banker

ln time when corporation issues and sells new securities to increase funds, the
offering is called a primory rssue. The agent responsible for finding buyers for these
securities for sale is called the investment banker. lnvestment banker buys primary issue
from corporations and arranges immediate disposal of these securities to the investors in
public' Generally, investment banking finms perform three functions: investigation,
analysis and research (origination), underwriting (public cash offerings) and distribution.
Most of the time, a single investor banker does all the above functions; however, some
investment bankers are dedicated in certain functional areas only.

. Origination (lnvestigation, Analysis and Research)

Origination covers the secondary operations of discovery, investigation,
and negotiation. Discovery is the finding of a potential issue of securities;
investigation is the testing and analyzing of the investment credit of the potential
security issuer including the inherent reliability of the issue; negotiation is the
determination of the amount, the price, and the terms of the proposed issue.
lnvestigation typically involves an analysis of the financial history of the
corporation by accountants and other finance people, investigation of legal
factors, ocular survey of its physical property by engineers and other technical
professionals, and a thorough review of company's operation. lnvestigations and
analyses are conducted to determine whether a proposed issue has satisfactory
grounds to be offered to the public. ln a nutshell, the prirnary function of
investment banking is the cautious study of the soundness ancl reliability of the
corporation with the view of bringing its securities to the investment market.

o Underwriting (public Cash Offerings)

Underwriting is an arrangement with an investment banker whereby the
investment banker agrees to buys the entire issue at a set price. lt also refers to
the guarantee by the investment banker that the issuer company will receive a
certain minirnum amount of cash for their new issued securities for sale. The
investment banker buys a new security issue, pays the issuing company, and look
for buyers of these securities from the public at large, The upderwriter's
compensation is the difference between the price at which the securities sold to
the public and the price paid by the investment banker when it first bought the
securities from the issuer company. Underwriting can be completed in two ways,

5-20 | Good Governonce ond Social Responsibility

 first by ne.gotioted underwriting which is the agreed and arranged negotiation
between the issuing company and the investment banker. Second is competitive
bidding a setup in which the issuing company awards the offering to the
investment banker that bids the highest price.

ln case where large and risky securities issue is involved, investment

bankers pull together to form a syndicate. A syndicate is a temporary union of
investment bankers brought together for the purpose of selling new securities.
Originating house is term given to one investment banker who is chosen to
manage and handle the syndicate. There are two types of underwriting
syndicates, dividedandundivided.lnadividedsyndicate,eachmembergrouphas
legal responsibility of selling a portion of offerings allocated to them. However, in
undivided syndicate, each member group is legally responsible for unsold
securities up to the amount of its percentage of participation regardless of the
number of securities that group has sold.

r Distribution
Marketing the security issue is another role of an investment banker.
Here, the investment banker acts as a professional firm to distribute securities
efficiently for the corporation. The advantage this setup could bring to the issuing
company is it saves resources of the issuer considering maintaining a division
relating marketing and selling of securities is expensive. As investment banker, it
is expected that the firm has already established marketing and sales network to
distribute securities. And for a reputable investment banker with history of
selecting good companies and pricing securities, builds a broad client base over
time which further adds to the efficiency that securities can be sold.

lnvestment banker offers security to both the corporation issuing

securities and the investors buying securities, For corporations, the investment
banker offers an exact price guaranty on a certain date for securities to offer. The
issuing corporation runs no risk and should not have any, reservations r:f the
market and need not spend on resources with which it is not technically prepared
with. To the investor, the responsible investment banker offers protection against
dangerous securities. Making a solid and sound rssues of securities is the
investment banker's business, it is here where its reputation is being harnessed,
therefore it can be expected that the firm will take care of it at any cost.

STOCK EXCHANGES

Stock exchange refers to an entity which offers trading services and facilities for
stock brokers and traders, to buy and sell shares of stock and other securities. Stock
exchanges also offer services for the issue and redemption of securities as well as other
financial instruments including other arrangements such as the payment of income and
dividends.

Agency Problems and Accountobility of Corporote Managers and Shareholders | 5-2L

 The securities traded on a stock exchange include: shares issued by companies,
derivatives, pooled investment products and bonds. For an entity to trade a security on a
certain stock exchange, this entity must be listed in that particular stock exchange first.
Typically, there is a central location at least for recordkeeping and control, but trading in
this modern time is becoming less and less connected to such a place physically, modern
markets and businesses are now infrastructured with high technology; electronic
networks to be specific, which gives them advantages in terms of pace and efficiency.

Stocks, bonds and other securities that are initially offered to investors are by
definition done in the primary market and subsequent trading of this is done in the
secondary market. A stock exchange is considered as one of the most vital component of
a stock market. Supply and demand in stock markets is driven by a variety of factors
which, as in all free markets, influences the price of stocks. lt is not necessary that
issuances of stock and its subsequent issuances should be via stock exchange as parties
can agree to have this so called off-exchange trading; the sale, exchange, and other stock
related transaction that is not being done in local stock exchange.

Role of Stock Exchanges

3,. Raise Capital

The stock exchange offers companies with the facility to raise capital for
expansion and other corporate developmental projects by selling shares to the
investing public.

2. Mobilize Savings
lnvesting in stock exchange means pulling out money from deposits and
have it as part of circulation. This mobilized money adds more spin or causes
multiplier-effect to the economy by promoting business activities which benefit
several sectors such as trading, manufacturing, agriculture and services. The
bottom line of all of this money invested in stock market is economic growth and
improved productivity levels of firms.

3. Facilitates Growth
Some corporation sees acquisitions as a break to increase product lines,
augment distribution channels, protect itself against market unpredictability,
increase its market share, or acquire other business it believed an accessorythat
is necessary to achieve all of the above. The simplest way for the company to step
on a takeover bid for merger or acquisition is through the stock market which is
common way for a company to grow by acquisition or fusion.

4. Distributes Profit
Profit is being shared both by ordinary corporate investors who are
willing to wait until declaration of dividend takes place, and to those speculative
investors who are practically in the real trade of playing with the price. They are
the investors who actually in "haul and dump" business, they buy shares at a
certain price and sell these shares when prices increase.

5-22 | Good Governonce ond Sociol Responsibility

5. lmproves Corporate Governance
It is expected that companies that are listed are following a stricter
standards and reportorial requirements set by the stock exchanges and the
government considering the wide and varied scope of owners, and more
importantly, since it involves public interest. ln general, companies listed tend to
improve on their management standards and efficiencies for them to please
these shareholders who have different levels of demands and who are constantly
conscious on the return of their investments. Contrast that with private
companies (shares of which are not traded publicly) which are often owned by
the incorporators themselves and/or their families and are made as a training
ground for the younger generations who will soon become heirs. Sometimes
these companies are closed and owned by a few investors only thus giving
outsiders no chance of becoming a part-owner.

There are documented cases of failure of corporate governance in some

companies listed in the stock exchanges around the world during the last decade.
They are as follows: Enron Corporation in 2001 (US, Global), WorldCom in 2OO2
(US), American lnternational Group (AlG) in 2008 (US, Global), Lehman Brothers
in 2008 (US, Global), General Motors in 2009 (US, Global) and Satyam Computer
Services in 2009 (lndia). These companies were involved in the most widely
publicized corporate scandals, manipulations and tricks perpetrated by listed
companies.

These considerable loss of balance in corporate governance by some

public companies draws the conclusion that being publicly listed is no assurance
of a "watertight", fully ideal corporate conduct in all circumstances. Nevertheless,
it is still a widely accepted idea that stock exchange is really a "nest of better
managed companies."

Another facet that supports the contention that stock exchange can, in
one way or another, improve corporate governance is when a company is known
for its poor ethical and managerial track records, and is not an advocate of good
corporate governance, investors will definitely avoid the company's share. This
will make the shares unmarketable or unattractive, this will cause a sustained
decline of share price which may cause it to floor. ln stock exchanges, the worse
penalty for underperformance is the decline in price and it will be slapped on the
shareholders without due notice. The rescirt available to the stockholder in this
case would be dismissal of incompetent management teams. When this happen
at least a strong message is sent to the new set of management; one, be
concerned about matters involving governance and two, deliver the deliverables.

Agency Problems qnd Accountobility of Corporote Mqnqgers ond Shareholders | 5-23

 6. Creates Opportunities for Small lnvestors
ln contrast to other business endeavors that require large capitalizations,
investing in shares is open to both large and small investors. There is a minimum
amount for someone to trade in the local stock exchange depending on your
broker. Once the investor has an account, then he can easily buy the shares he
can afford. Also, depending on the type of account established, the investor will
be provided various trading features, researches, account support and other
value-added services. ln this context, stock exchange offers the chance for small
investors to own shares of the same companies being invested in by the large
investors.

7. Facilitates Raising Capital for the Government

Stock exchange is also serving as one of the government's avenue to raise
funds through issuances of bonds and other papers the latter guarantees. Funds
raised from these issuances will then be used by the government to finance the
operation of different departments of the government all the way down to the
bureaus, agencies and LGUs. Debt instruments carry interests. Remember that
government only has two main sources of funds: through taxation and from
borrowings.

8. lndicator of Economy
Stock exchange is the residence of the advance thinkers of the economy
and business. Prices of securities here could rise and fall depending on dictate of
the market which traders are on a full-time job of reading it in advance to their
advantage. ln general, except when there is manipulation, increase of securities
prices or prices that remain stable is a good indication that the economy in
general is stable and growing. On the other hand, the stock exchange is the only
facility that can provide information on a daily basis or even on real-time basis
about the general behavior of the stock market.

The ugly head of economic downturn can be spotted right away in the
behavior of the market, this can be gleaned from the hard figures in the stock
exchange. When there is an impending economic recession, depression, or
financial crisis, people don't need to read anything anymore, stock market figures
provide more than enough indications. The stock market behaves ahead of reality
so there is use for technical analysis. For the serious players, like the
businessmen, economists and stock traders, they see these tendencies or
behaviors by analyzing the details derived from the stock exchange data.

5-24 | Good Governance ond Social Responsibility

 Financial Press

Financial press refers to newspapers, magazines, TV channels, broadcast

programs and other media specializing in financial news and updates. prominent
examples include Bloomberg TV and The Financial Times in the US, The Asset in Asia;
Iocally, there is Business Mirror and Business World in print, Business Nightly over
ABS-
CBN ANC and other program devoted to covering the goings on in the business
sector on
a daily basis' The financial press is important to the overall business sector more
specifically on the financial sector as some companies often publish information on
these
media' This published information in turn will become the basis for some of their
investment decisions. The financial press provides an avenue where the information
sources and the information seekers meet.

i
I'

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| 5-25