Agency theory is an idea in the business world that views a company as a set of loosely held contracts among the different players within that company.
The parties central to agency theory are principals, those that supply the capital, and agents, those who manage the day-to-day affairs of the firm. These relationships are not necessarily harmonious.
Shareholders essentially forego control and entrust management to act in their best interests. As a means of mitigating conflicts of interest and preventing management from making decisions that benefit themselves, a system of checks and balances is necessary. This system is known as corporate governance.
Corporate governance is the set of processes, customs, policies and laws by which companies are directed, controlled and regulated. It involves the relationship between the management, board of directors, shareholders and employees, and if well-defined, other stakeholders such as creditors, suppliers and customers. It is typically defined by the corporate charter, bylaws, policies and by law.
The relevance and importance of corporate governance has significantly increased in the last two decades due to high-profile scandals involving abuse of corporate power, fraudulent financials and in some cases criminal activity.
As a result, several countries either enacted guidelines or passed legislation intended to avoid reoccurrences and greatly improve investor protection. Most notable are the Cadbury Code in the United Kingdom, which followed the collapse of reportedly financially sound Asil Nadir’s Polly Peck consortium, and Sarbanes-Oxley in the United States, a direct result of the infamous bankruptcy of Enron.
Enron, which once had a stock price of US$90 a share in 2000, was trading at less than a $1 in 2001. Enron had nontransparent financials that did not fairly reflect its operations and finances with shareholders and analysts. In summary, its accounting practices incorrectly accelerated income even if such income was uncertain, inflated asset values and moved liabilities off the books.
The extremely well compensated executive management of Enron were directly responsible for the fraudulent accounting practices and their auditor, Arthur Andersen, was subsequently accused of reckless standards in their audits due to conflicts of interest over significant consulting fees. After years of phenomenal growth, the company announced a restatement to its financials of a reduction of earnings of $613 million, for a three-year period, and an increase in liabilities by $628 million due to accounting violations, which was the beginning of the end for Enron.
The gist of the improvements in corporate governance involved more accountability from the board of directors and executive management. For instance, Sarbanes-Oxley mandates that senior executives take individual responsibility for the accuracy and completeness of corporate financial reports, that the principal officers certify and approve the integrity of the company financials.
Further measures established independent oversight of public accounting firms providing auditing services, restricting auditing firms from providing non-audit services for the same clients, enhanced
financial disclosure that includes off-balance sheet transactions, and criminal penalties associated with white collar crimes and conspiracies. Despite these progressive efforts earlier in the decade, the global financial crisis was not avoided later in the decade.
While corporate governance, rule of law and regulatory oversight are the essential mechanisms for investor interests and protection, the honesty and integrity of the board and management are first and foremost.
Anthony Galliano is chief executive of Cambodian Investment Management.