AGENCY PROBLEM AND CONTROL OF THE CORPORATION
American Merchant Corporation (AMC) is an American drug wholesale company formed in 2008 to provide over-the-counter (OTC) health care products and home health care supplies and equipment to a wide variety of health care providers located throughout the United States. The company is listed in the capital market with a total market capitalization of $2 billion. The stock price per share is $25.
The goal of AMC is to maximize the current value per share of the existing stock for the shareholders. Good financial decisions, all things being equal, increase the value of the stock of AMC, and bad decisions decrease the value of the stock. Good decisions are made to ensure that there is regular and adequate supply of cash flow, safety of shareholders’ capital, adequate rate of return on shareholders’ investments, and sound capital structure for the firm.
Because of the separation of management and ownership in corporations, the shareholders of AMC elect board of directors to ensure that management of the company carry out their duties in the best interest of shareholders to maximize the value of the firm. However, the separation of ownership and management creates agency problems and conflict of interest between management and shareholders.
Conflict of interest occurs because managers may want to maximize their own interests at the expense of shareholders. In 2018, management of AMC reported misleading financial statement through accounting manipulations to artificially increase profits and their bonuses. The Securities Exchange Commission (SEC) fined the company $2 million for reporting false financial information. The managers also took some actions that would increase their job security by merging and acquiring unprofitable businesses. The objectives of the mergers and acquisitions, they claimed, were to increase the size of the corporation, ensure operational efficiency, diversify risks, and increase profitability.
Management of AMC often makes decisions that are meant to increase their power, status, and salaries at the expense of shareholders. For instance, just last year the management purchased an expensive corporate jet and increased their executive compensation by 80% while the stock price of the company continues to decline from $32 to $25 in the capital market. There is an obvious abuse and misuse of corporate assets. This year being an election year the management is contributing corporate dollars to their favorite charities and political parties for glory and favors.
The board of directors is aligned with management and do not fully act in the interest of the shareholders. The chairman of the board of directors is the CEO of the company and has great control and influence over the board members. The issue of agency problems is not only common in AMC but in all corporations and poses a threat to the capital market and investor confidence. Corporate governance studies have, therefore, received global attention to ensure management accountability and to reduce or eliminate the principal-agent problem.
Please answer the following concept questions:
- Who are the owners of corporations? (choose one: shareholders, CEO, board of directors, management, or federal government).
- Does the goal of maximizing the value of corporations differ for financial management in a foreign country? Why or why not?
- Explain agency theory and describe three agency problems in AMC.
- Do you think agency problems are likely to be more or less severe in partnerships and sole proprietorships than in corporations? Why or why not?
- The current stock price of AMC is $25 per share. Another company wants to buy AMC and will pay $35 per share to acquire all the outstanding stock. AMC management immediately begins to fight off this hostile bid. Is management acting in the best interest of shareholders? Why or why not?
- Identify four corporate governance mechanisms that can be used to reduce the agency problems in corporations.