Principles of Agents

Any Introductory Business course will teach you that shareholders are the owners of the firm. The shareholders elect the Board of Directors to oversee the firm on their behalf. The Directors appoint the company President and the other members of the executive team who are responsible for the day-to-day operations. The Directors and executive team are the agents of the principal owners of the company.

Economists have long studied a situation known as the Principal-Agent problem. This inefficiency occurs when the objectives of the principals, the shareholders, differs from the agents, the executives. Finance theory suggests that individual investors want to maximize returns and minimize risk. This implies using the equi-marginal principle to strike a balance between the two.

The Board and executive may have an objective of maximizing their own income or their own power. Agents typically share in profits by way of bonuses, but not in losses. A company that has negative net income does not require the company president to pay back salary or previous bonuses, nor do they encumber future bonuses. This is just one example of how the Principal-Agent problem can manifest itself.

Evidence of the Principal-Agent problem appeared in several places this week. The first, as related in a Reuters article, involves the investment bank Goldman Sachs (GS). There is currently a proposal to split the role of Board Chairman and the role of CEO between two people.  The idea is that the Chairman oversees the activity of the CEO which is a management position. This may prevent the risk taking activity that lead to the banking collapse of 2007-2008. The company, however, has put forward a legal challenge to prevent a vote on the motion. Essentially, the company is using shareholders’ money to the detriment of shareholders.

JP Morgan Chase (JPM) is also fighting a legal battle in an attempt to prevent shareholders from voting on a motion to break up the company. See the American Banker article for the details. The rationale is similar to the Goldman Sachs situation.  JP Morgan has four distinct businesses, some of which are vastly riskier than others. This not only puts the whole company at risk, but affects the optimal pricing of the firm. In the finance world, they refer to the plan to break up the company as “unlocking value”. Again, the company is using shareholders’ money to their detriment.

Perhaps the most troubling revelation this week was something that was not reported. Apple (AAPL) has $136 billion in cash and marketable securities on its balance sheet that it refuses to return to shareholders. (Source: SEC filing) Apple is currently showing Owners’ Equity of $127 billion which means the entire book value of the company, plus some, is being held in cash. The problem with this is that cash earns less than 2% on average. For example, if that money were returned to shareholders they could purchase shares of Altria Group (MO), that currently pays dividends of 5.3%. Returning half of the $127 billion would double Apple’s return on equity without hampering their ability to operate.

Goldman Sachs, JP Morgan and Apple are just three examples of the Principal Agent problem that caught our attention this week. There will be more next week and the week after that. We can’t help but wonder if the Principal-Agent problem would exist if agents had principles.