Ethics and Conflicts of Interest

March 22, 2017
CONFLICT BETWEEN MANAGERS AND SHAREHOLDERS

Shareholders expect companies to hire managers who competent, willing and courageous enough to take the necessary legal and ethical actions that will maximize intrinsic stock prices.

This requires technically competence managers that can put the necessary effort into identifying and implementing the actions that add value. However, because managers are humans, agency conflicts can arise where the manager executes actions that fulfill self-interests and ensures job stability and personal reward over the prosperity of the corporation.

This means managers are less likely to report poor performance, bad quality and their own incompetence, eliminate their own job to reduce overhead, lower their salary to reduce budgets, etc.

Companies must take measures to align manager goals with those of the stockholders. Otherwise, the business cannot maximize corporate value.

There are six indicators that identify ways in which a manager’s behavior might be detrimental to a company’s intrinsic value.

1. Managers might not exhort the time, knowledge and effort required to maximize firm value. Rather than focusing on corporate tasks, they might spend too much time on other external activities. They may favor putting their time into serving on the boards of other companies, giving speeches and media interviews, and writing books (furthering their own prominence), or on nonproductive activities, such as golf, entertaining and travel (living the good life).
2. Managers might use corporate resources on activities that benefit themselves rather than shareholders. They might use company money on such perquisites as lavish offices, memberships at country clubs, museum-quality art for corporate apartments, large personal staffs, and corporate jets. Because these perks are not actually cash payments to the managers, they are called nonpecuniary benefits.
3. Managers might avoid making difficult but value-enhancing decisions that harm friends in the company. For example, a manager might not close a plant or terminate a project if the manager has personal relationships with those who are adversely affected by such decisions, even if termination is the economically sound action.
4. Managers might take on too much risk or they might not take on enough risk. For example, a company might have the opportunity to undertake a risky project with a positive NPV. If the project turns out badly, then the manager’s reputation will be harmed and the manager might even be fired. Thus, a manager might choose to avoid risky projects even if they are desirable from a shareholder’s point of view. On the other hand, a manager might take on projects with too much risk. Consider a project that is not living up to expectations. A manager might be tempted to invest even more money in the project rather than admit that the project is a failure. Or a manager might be willing to take on a second project with a negative NPV if it has even a slight chance of a very positive outcome, because hitting a home run with this second project might cover up the first project’s poor performance. In other words, the manager might throw good money after bad.
5. If a company is generating positive free cash flow, a manager might stockpile it in the form of marketable securities instead of returning FCF to investors. This potentially harms investors because it prevents them from allocating these funds to other companies with good growth opportunities. Even worse, positive FCF often tempts a manager into paying too much for the acquisition of another company. In fact, most mergers and acquisitions end up as break-even deals, at best, for the acquiring company because the premiums paid for the targets are often very large. Why would a manager be reluctant to return cash to investors? First, extra cash on hand reduces the company’s risk, which appeals to many managers. Second, a large distribution of cash to investors is an admission that the company doesn’t have enough good investment opportunities. Slow growth is normal for a maturing company, but this isn’t very exciting for a manager to admit. Third, there is a lot of glamour associated with making a large acquisition, and this can provide a large boost to a manager’s ego. Fourth, compensation usually is higher for executives at larger companies; cash distributions to investors make a company smaller, not larger.
6. Managers might not release all the information that investors desire. Sometimes, they might withhold information to prevent competitors from gaining an advantage. Other times, they might try to avoid releasing bad news. For example, they might massage the data or manage the earnings so that the news doesn’t look so bad. If investors are unsure about the quality of information managers provide, they tend to discount the company’s expected free cash flows at a higher cost of capital, which reduces the company’s intrinsic value. If senior managers believe there is little chance they will be removed, we say that they are entrenched. Such a company faces a high risk of being poorly run, because entrenched managers are able to act in their own interests rather than in the interests of shareholders. The accounting frauds perpetrated by Enron, WorldCom, and others that were uncovered in 2002 raised stock prices in the short run, but only because investors were misled about the companies’ financial positions. Then, for example, when Enron finally revealed the correct financial information, the stocks tanked. Investors who bought shares based on the fraudulent financial statements lost tens of billions of dollars. Releasing false financial statements is illegal. Aggressive earnings management and the use of misleading accounting tricks to pump up reported earnings is unethical, and executives can go to jail because of their deceptions. When analysts speak of taking actions to maximize stock prices, they mean making operational or financial changes designed to maximize intrinsic stock value, not fooling investors with false or misleading financial reports.

By putting the right people in management and aligning management goals to corporate goals, it will minimize or eliminate conflicts of competing objectives. Ethics must be part of the culture, annual objectives and performance reviews. For it to be effective, there must be rewards and consequences to instill ethical behavior.