Question

since the board of directors is made up of human beings with selfish tendencies, formation of board of directors irrespective of its configuration, cannot eliminate the agency conflict." fully evaluate this assertion. 3 pages double line spacing.

Answer 1

1. Lehman Brothers is often cited as an example of corporate governance failure largely due to poor oversight by the board Richard Fuld, former CEO of Lehman Brothers during its bankruptcy in 2008, still does not agree with this general evaluation. Seven years later in 2015, he gave a speech at a conference in New York.

2. Fuld spoke about Lehman’s risk management, as quoted in The Wall Street Journal: “Regardless of what you heard about Lehman’s risk management, we had 27,000 risk managers because they all had a piece of the firm

3. he problem, however, remains that Lehman’s employees owned a very small portion of the company stock, which did not solve its agency problem.

4. Lehman Brothers had a high-leverage, high-risk-taking business strategy supported by limited equity or instance, it took its leverage ratio up to 30 times its equity

5. It also had a culture of aggressive growth strategy, which focused on risky and complex financial products such as subprime, derivatives and commercial real estate markets, and failed to carry out deleveraging strategy in 2007 when the commercial real estate market slowed down

6. Why did Lehman’s board of directors not effectively oversee Lehman and leave it bankrupt? Their responsibilities are the oversight of and advisory to the company. After Lehman Brothers collapsed, many obervers have pointed out that it should not have taken excessive debts, diversified product portfolio and the board of directors should have monitored its strategy and risk management more carefully.

7. All of the root causes of Lehman’s failures can be traced back to the dysfunction of the board of directors and the agency problem.

8. What is the agency problem of the board of directors?

The agency problem arises in a situation where an agent (i.e. a director of a company) does not act in the best interests of a principal (i.e. a shareholder). When a principal chooses to act through others and its interest depends on others, it is subject to an agency problem. “The problem lies in motivating the agent to act in the principal’s interest rather than simply in the agent’s own interest.

9. he main problem is the asymmetrical information between a principal and an agent. An agent is hired in the first place largely because an agent can carry out the tasks a principal may not be able to perform due to lack of time commitment, skillsets or specific knowledge to run the business. After the agent starts working for the principal, he will likely have a greater level of information for the company, because he is the one who actually performs specific tasks on a regular basis.

10. The principal, on the other hand, can easily be left in the dark because she is not sure the performance that the agent carries out is exactly what is promised in their contractual relationship.

11. Lehman Brothers’ employees’ having a very small piece of the company ownership does not guarantee that they will act in the best interest of Lehman and effectively manage its risks. If Lehman were incorporated as a partnership firm such as general partnership or limited partnership where general partners put their own capital on the firm and personally assume personally unlimited liability, those partners would object to such a high risk. In other words, Lehman’s taking excessive risks was a classic example of the agency problem because employees and executives acted in their own best interest, which was performance-based compensation. To avoid this problem, the board of directors is formed. However, do directors effectively function as a safeguard for the interests of shareholders?

12. The board itself often creates the agency problem. A large public company such as Lehman has so many shareholders, and the composition of the shareholders constantly changes even by minute on the stock market. It is almost impossible for shareholders to directly run the company. Thus, shareholders hire third parties, directors, to minimize such agency problem between shareholders and employees including executives. Directors’ roles are to monitor and incentivize management on behalf of shareholders, their principal, including oversight of the company’s external audit (the audit committee), setting of the compensation scheme for executives (the compensation committee), evaluation of the company’s governance structure and processes (the governance committee), nomination of new directors (the nominating committee) or making decisions on the distribution of dividends

13. Directors own interests are more closely aligned with executives than with shareholders because executives protect their jobs. Once hired, a director maintains a closer relationship with executives, who he is supposed to monitor, than with shareholders, who elect him. It is probably because 1) the board of directors meet executives in person on a regular basis, thus developing interpersonal relationships with executives while indirectly communicating with shareholders through the company’s employees, executives or indirect communication channels such as investment relations (IR) information and 2) the job security of directors in fact lies in the hands of executives. CEOs often use their own contacts or executive search firms that the company has been using to hire directors and the nominating committee comprising of directors themselves control the hiring and firing process of directors

14. Thus, the job security of directors is actually determined by executives and directors (agents), not shareholders (principals). The agency problem is subject to arising if directors and executives continue to have authority over controlling directors.