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Navigating the Agency Problem

Businesses, especially those publicly listed, confront a challenge rooted in the distinction between management and ownership. While managers are responsible for the day-to-day operations, they are usually agents for the owners and don’t always have a stake in ownership themselves, which rests with the shareholders. Ideally, managers should automatically act in the shareholders’ best interests. However, in reality, ensuring that managers prioritise the company’s collective goals over their personal ambitions requires a structured system. To circumvent such predicaments, it becomes imperative to establish an appropriate framework conducive to long-term shareholder value creation. Commonly referred to as corporate governance, this framework defines how companies are managed and controlled, with the ultimate objective of optimising value for shareholders while upholding ethical principles and recognising the interests of all stakeholders. This nurtures trust, fostering responsible business conduct, and mitigates conflicts of interest. In this newsletter, we delve into the ‘agency problem’, the potential conflict that can develop between an owner and an agent, as it relates to both the management and the board.

At the top of that framework lies the board of directors, which is effectively the bridge between the owners of the company, the shareholders, and the people that run the company for them, the managers of the company. The board’s function is to set the company’s aim and objectives and to ensure they are achieved. Codes of corporate governance are there to provide the framework, which will assist boards to meet the expectations of those they serve but it is board leadership that generates the drive on which the growth and prosperity of individual companies depends. 

There are three important qualities that we believe boards ought to have. First, the board must have the relevant balance of experience to add value, which includes a balance between insiders (who know the business well) and outsiders (who can bring fresh perspectives). Second, they must have the time and space to perform their tasks to the best of their ability. And third, they must show commitment to their role and their responsibilities.

In this sense it is the role of the board to mitigate the predicaments which business managers are faced with in their day-to-day tasks such as information asymmetry, excessive risk taking, lack of motivation, short-term focus or self-interest, among other agency-related problems.

One of the most effective ways for the board to solve these problems is by designing and endorsing the right accountability and compensation structure. As I discussed extensively in one of my previous newsletters (Inspiring Leadership) boards need to design pay packages with incentives and contract structures tied to long-term fundamentals, value creation and with substantial risk of forfeiture. This discourages excess risk taking and prevents individualistic decision making. 

The Wells Fargo unauthorised accounts scandal serves as a cautionary tale about the limitations of corporate governance and the agency problem. In 2016, it was revealed that Wells Fargo employees had opened millions of unauthorised bank and credit card accounts in customers’ names without their knowledge or consent. This deceptive practice was driven by sales quotas and incentives that pressured employees to meet unrealistic targets.

This scandal underscores the potential pitfalls of tying compensation to performance metrics. While incentives can drive desired behaviours, they can also inadvertently encourage unethical conduct when employees feel the need to meet targets at all costs. In this case, the pressure to achieve sales goals led to fraudulent practices that harmed customers and tarnished the bank’s reputation.

The Wells Fargo case also highlights the importance of board oversight and the challenges of identifying unethical behaviour within large organisations. The scandal revealed a failure of internal controls and proper governance mechanisms, as the practices persisted for years without adequate detection. It raises questions about the effectiveness of the board in ensuring ethical conduct and risk management. 

This example demonstrates that while strategies like compensation structures and board oversight are important, they are not sufficient on their own.  Although managers may be more prone to be enticed by self-benefit, a board of directors, as a group of individuals, are in fact equally susceptible. Therefore other methods and policies are important to complement the right incentive structure in mitigating the agency problem.

The theory is that shareholders select their directors and authorise them to run the company on their behalf and then the board in turn sets the aims of the company and appoints managers to carry out those aims. In practice, however, the shareholders of most public companies have little say in the appointment of directors. The lack of a keen and consistent sense of accountability to the shareholders is a basic reason why many boards have failed to achieve the results that were expected of them. It is, in the first instance, the responsibility of their chairman to ensure that their board matches up to the legitimate expectations of their shareholders.  But at the end of the day, it is the responsibility of shareholders to make sure their companies are headed by effective boards and to hold them accountable for their performance. 

The corporate debate over the last few years has centred around shareholder activism. Shareholders have realised their neglect in monitoring their companies. This has resulted in successive waves of campaigns trying to erode boardroom entrenchment by convincing directors to respond to shareholders’ calls for accountability, transparency, and stewardship. Boards have just as much need as executives to have their performance assessed. No board can truly perform its functions of establishing a company’s strategic direction and monitoring management’s success in executing that strategy without a system for evaluating itself. 

The influence and determination of institutional investors, particularly large asset managers, in supporting shareholder proposals is growing and helping to improve board accountability and oversight. According to a report by Ernst & Young, 74 per cent of institutional investors said they had increased engagement with companies on governance issues. Proxy access—which allows shareholders to nominate their own candidates for board positions in a company’s proxy statement, is also growing. A report by The Conference Board found that over 70 per cent of S&P 500 companies had adopted some form of proxy access, up from 48 per cent in 2015. In addition, proxy advisory firms like ISS and Glass Lewis are playing a significant role in influencing and improving shareholder votes on issues related to executive compensation, transparency, board composition and accountability as well as other governance matters. 

At Seilern, our policy is to vote on all resolutions at each of our investee companies’ Annual and Extraordinary General Meetings, including shareholder resolutions and corporate actions. We do this because it is our duty and fiduciary obligation to exercise the rights that we have as shareholders in the best interests of our clients. We take the opportunity to vote seriously as it allows us to encourage boards and management teams to consider and address areas where we have concerns, along with areas that we want to support. We have internal voting principles as well as access to proxy voting research, to assist us with the assessment of resolutions and contentious issues. Although we are cognisant of proxy advisers’ voting recommendations, we do not delegate or outsource our stewardship activities when deciding how to vote on our clients’ shares.

For example, for the 2021 Annual General Meeting of Assa Abloy, we voted against the re-election of all board members. The company takes a bundled approach for the voting of directors which is not good practice as it does not give shareholders the chance to vote against individual directors. We chose to vote against the re-appointment of all directors as we considered it a weakness in the corporate governance practices of the company. Notably, we considered the number of truly independent directors to be too low, and the composition of the Audit and Remuneration Committee to be insufficiently independent. 

Assa Abloy is a business where a large amount of control is exercised by two organisations which are linked (Investment AB Latour and Melker Schorling AB). Due to Assa Abloy’s dual voting share structure, these two organisations control 40.3 per cent of the vote with 12.6 per cent of the share capital. While we have a large degree of trust in the competence of these two organisations, which have been responsible for successfully growing the company to its current state, we believe the appropriate checks and balances provided by independent directors could be improved. Notably, the Audit Committee and the Remuneration Committee could have increased independent representation. We engaged with the company to explain our concerns ahead of the AGM and voted against the re-election of the board members.

While shareholder activism has the potential to hold boards and managers accountable, it’s not always a panacea. Some critics suggest that activist shareholders might prioritise their own short-term financial gains over the company’s overall health and long-term success. Additionally, excessive shareholder activism could lead to a fragmented decision-making process, making it harder for a company to execute a cohesive long-term strategy. And, while strengthening board oversight is crucial, sceptics argue that an overly intrusive board might hinder managerial autonomy and efficiency. A board that constantly second-guesses management decisions could slow down the decision-making process and stifle innovation. It’s essential to strike a balance between vigilant oversight and allowing management the necessary flexibility to respond to dynamic market conditions.

It is, however, clear that aligning personal interests with the greater good is an unequivocal necessity. Corporate managers and directors shoulder the pivotal duty of guiding their companies toward enduring prosperity. In this journey, they must navigate the intricate currents of the agency problem with the compass of integrity. But it is with shareholders where the ultimate responsibility lies. Their role transcends that of mere investors, extending to vigilant guardians of sustained value creation. 

F. León,

31 August 2023

Any forecasts, opinions, goals, strategies, outlooks and or estimates and expectations or other non-historical commentary contained herein or expressed in this document are based on current forecasts, opinions and or estimates and expectations only, and are considered “forward looking statements”. Forward-looking statements are subject to risks and uncertainties that may cause actual future results to be different from expectations.  Nothing in this newsletter is a recommendation for a particular stock.  The views, forecasts, opinions and or estimates and expectations expressed in this document are a reflection of Seilern Investment Management Ltd’s best judgment as of the date of this communication’s publication, and are subject to change. No responsibility or liability shall be accepted for amending, correcting, or updating any information or forecasts, opinions and or estimates and expectations contained herein.

Please be aware that past performance should not be seen as an indication of future performance. Any financial instrument included in this website could be considered high risk and investors may not get back all of their original investment. The value of any investments and or financial instruments included in this website and the income derived from them may fluctuate and you may not receive back the amount originally invested. In addition stock market fluctuations and currency movements may also affect the value of investments.

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