Agency Issues Relating to Multinational Companies

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Table of Contents

Introduction
Agency conflicts
Challenges of a running an MNC
Conclusion
Reference list

Introduction

As per the agency theory, conflicts arise where the principal, or owner of the business, appoints another party, known as the agent, to act on their behalf. For most companies, two types of conflicts come about: conflicts between shareholders and debt holders, and conflicts between shareholders and managers. In multinational companies (MNC), conflicts are much higher given the size and complexity of the MNC (Jensen & Merkling 1976, 360). For a typical MNC, the top management has to further delegate authority and control to foreign subsidiary managers which may create conflict between the top management of the parent company and foreign subsidiary managers, who act as their agents.

Agency conflicts

Agency conflict arises due to differing interests and the asymmetry of information between the principal and the agent. Shareholders and debt providers have different interests as to the use of funds provided. Shareholders may require managers to invest in high risk activities that promise high returns so as to achieve maximum returns on their investments. From the debt provider’s point of view, such activities increase the risk of default. In the event of success, shareholders will reap the most returns while debt providers only receive the fixed interests; hence there is no incentive for them to agree on risky projects. In the event of failure, both the shareholders and the creditors share the losses (Foss and Foss 2005, 543).

The agency problem is a feature of most modern organizations which separate ownership from control. The shareholders of are the owners of the company, while the management serve as their agents, and are in charge of operational decisions (O’Donnell 2000, 538).

The primary task of the management is to maximizing the shareholders’ value, through increasing profits, although this is not usually the case due to differing goals. There exists information asymmetry between the principal and the agent since the agent is in a better position to gauge their capabilities in comparison with owner expectations, and because the managers have more access to information due to the daily involvement in the business of the owner (Birkinshaw & Hood 1998, 785).

The agency problem that exists in multinational corporations can be defined by the agency relationship between the headquarters’ top management and subsidiary managers. Subsidiaries of the parent company do not always follow the interests of the headquarters, and often pursue their own goals. Therefore, the headquarters and the subsidiaries may have different interests which may cause the MNC to fail in achieving its objectives (Nohria & Ghoshal 1994, 491)

While the headquarters of the MNC defines the organizational structure and sets the objectives of each division, each subsidiary maintains its own decision making autonomy (Matsusaka 2001, 427). Divisions have their delegated control and authority over their operations while the headquarters retains the power to overrule some decisions made by the divisions. Divisions may try to follow in the interests of the headquarters because of resource dependency. According to the resource dependency theory, subsidiaries will let the parent company to exercise power over them in order to get favorable resources in terms of budget and resource allocations.

Subsidiaries with relatively strong bargaining power are able to be more flexible in their operations, and are therefore more able to pursue their own interests rather than those of the parent company. The level of bargaining power is dependent on the influence that such divisions have in the allocation of limited resources, or their level of contribution towards the MNC’s revenues (Osborne & Rubinstein 1990, 37). Divisions with strong bargaining power will thus have more control over their decisions, rather than following strategies meant to please the headquarters.

Agency conflicts affecting multinational corporations are therefore a result of the resource dependency theory. Divisions that are deemed as important for their contribution to the parent company’s success, and the continuity of the organization as a whole, have more autonomy and further agency conflicts within the organization (Rugman & Verbeke 2001, 239).

Divisions with stronger bargaining power are able to limit attempts by headquarters to control their resources, but such divisions are still not independent legal entities, and thus still have to follow the strategic directives provided by the headquarters. Divisions may selectively provide information to the headquarters in order to improve their position in the allocation of resources, implying that reports will be biased to reflect good performance only.

Agency costs can be described as the expenses brought about by agency conflicts. Due to the separation of ownership and control, and the delegation of control to agents, owners of a company have less monitoring abilities. Monitoring costs are expenses incurred by the owners of a corporation to measure the performance of the management. Such costs could include audit expenses, whereby shareholders expect to get reports from both internal and external auditors. These costs are significantly higher in multinational corporations due to their complex structure (Cantwell and Janne 1999, 124).

Challenges of a running an MNC

Several financial statements may be enough for a small business, but MNCs with subsidiaries in various countries face bigger challenges. Different countries may use different sets of accounting standards, making the comparability of financial statements difficult. Subsidiaries will have to follow the financial statement reporting requirements of the host country for tax purposes, so the shareholders of the company have to incur costs of converting the financial statements of the various subsidies in order to allow for comparability of performance. Other methods of measuring performance of the management could be through capital markets. Capital markets measures performance of firms through share price evaluation, as indicated by share price movements.

Financial institutions, especially banks, face more stringent requirements by local governments and capital market authorities (Lamont 1997, 109). Banks are more sensitive to economic changes; hence they should be monitored on a periodic basis, thereby increasing monitoring costs. Due to the interdependence of banks and other financial institutions, the failure of one institution may have a knock on effect on the other financial institutions, as witnessed in the recent 2007-2009 global recession. As a result, banks are subjected to more scrutiny and stress tests which call for more monitoring (Baker, Gibbons & Murphy 2002, 66).

Banks have to be monitored not only by their performance, but also in terms of their financial soundness. While shareholders of a typical company are usually more concerned with the profitability of their companies, owners of financial institutions also have to monitor the solvency risks brought about by the high use of leverage. Governments around the world are leading the way in introducing rigorous policies that reduce the probability of bank failure so it’s also within reason for headquarters to ensure that the company remains financially healthy.

Owners of a company may choose to incur bonging costs when relating with management in order to restrict undesired behaviors from management. Bonding costs relate to transaction meant to try and converge the interests of the shareholders and those of the management. Agency conflicts between management and shareholders arise due to differing interests; hence the principal may initiate policies that will make the agent more responsible in their actions and act like principals (Cantwell & Mudambi 2005, 1128; Cantwell & Janne 1999, 144).

Agents may be allocated shares of the company which may give them a sense of ownership, thereby implementing business strategies that will benefit the owners (Birkinshaw, Hood & Jonsson 1998, 241). Residual loss is the reduction in welfare experienced by principals as they try to mitigate the negative effects of the agency relationship, for example providing managers with stock options causes to a loss in welfare and control for the principal. Agency costs are the sum of monitoring, bonding and residual loss.

The moral hazard problem exists between the parent company and its subsidiaries. Once given relative control over its operations, the company’s divisions may engage in operations that serve their own interests, which may jeopardize the objectives, and resources, of the parent company. The moral hazard problem grows as an organization increases in size.

As the enterprise grows, the top management of the company has to delegate some of its power to the subsidiaries so that they can be more adaptive and efficient in dealing with their immediate environments (Forsgren, Holm & Johansen 1995, 485). For multinational corporations, the headquarters has to delegate the decision making process to the foreign divisions. This means that the risk of moral hazard is greater in MNCs than in smaller corporations that may only have a few divisions under their control.

Moral hazard is brought about by information asymmetry (Bjorkman, Barner-Rasmussen & Li 2004, 422). The agents are usually more aware of their intentions than the principal in the agency relationship, and may therefore use the principal’s resources to achieve their own interests at the expense of the principal. The moral hazard problem is usually reduced through monitoring, whereby the principal follows up on the agents activities, in the process creating and increasing monitoring costs for the parent company.

Monitoring in this case is used to make sure that the activities of the agent are aligned with the objectives of the principal. In multinational corporations, differences in culture, nationality of foreign managers and regulations in the various host countries help increase the moral hazard problems of the MNC (Frost 2001, 117). MNCs have large and complicated structures which create challenges when monitoring the foreign divisions. MNCs will therefore have to incur higher monitoring costs than smaller companies since they ace larger and more complicated agency conflicts. Increase in the size of the MNC calls for greater internal auditing and control systems because of the increased delegation of power (Williamson 1996, 54).

The need for more efficient monitoring and internal control systems also increases with greater decentralization of the organization. The greater the decentralization in a company, the more complex the organizational structure, which has a tendency of slowing down communication. It takes longer for a message or a strategy to be communicated down from the headquarters of the parent company to the foreign divisional managers. Decentralization is necessary in MNCs in order to make subsidiaries more adaptive and efficient in foreign environments (Mintzberg 1979, 98).

MNCs face various challenges, starting from differences in cultural backgrounds of foreign managers, differences in first languages to differences in regulations implemented in host countries (Kuemmerle 1999, 15). Cultural differences vary more in the case of a multinational corporation than in smaller enterprises since an MNC’s divisions are location in various parts of the world, while divisions of smaller companies may only be located across the home country. This implies that foreign divisions should be allowed to implement their own unique organizational cultures due to the differences in cultural backgrounds. The organizational structure of a foreign subsidiary may therefore vary significantly from that of the parent company.

Differences in languages spoken in foreign divisions slow down communication efforts, and may also increase communication costs if the company employs translators to facilitate the communication process. Different regulatory frameworks in foreign countries will impact financial reporting standards, whereby foreign subsidiaries will be required to maintain their books of accounting in a specified set of accounting standards (March & Simon 1958, 36). The management of foreign divisions may therefore expect their performance to be measured on the basis of their foreign subsidiary reports, and may thus implement strategies that will reflect favorable performance levels. Because of the varying accounting standards, disagreements may arise as to what constitutes good performance.

Foreign subsidiaries’ financial statements have to be converted into the parent company’s financial reporting systems to allow for comparability and analysis (Buckley & Casson 1976, 17). Managers of foreign subsidies may focus efforts to boost performance, but the levels of performance may not match headquarters’ expectations because some of the elements that contribute to profitability may not be recognized in the parent company’s financial statements. Foreign subsidiaries may also not engage in activities that will be translated as profitable only from the parent company’s point of view. The differences in interests, or agency conflicts, could therefore be influenced in regulatory environments brought about by increased size MNCs, and subsequent delegation of control.

Delegation of control may also increase the number of reporting levels in an organization, which tends to create a multilayered hierarchical structure (Pearce 1999, 166). A multilayered structure leads to loss of control from the principal’s point of view because communication is largely affected and moral hazard problems persist. For multinational companies, communication is further negatively affected due to international manipulation as a result of different languages, cultures to political interferences (Ghoshal & Bartell 1991, 611). Government intervention and influence may deepen agency conflicts especially where foreign managers are aligned with political forces in the host country.

Since information asymmetry exists between the parent company and its subsidiaries, it becomes more difficult for the headquarters to monitor government and political interference with foreign operations. Decentralization and delegation may also lead to distortion of information especially through summarization and misinterpretation of information, thereby compromising the effectiveness of communication.

The added layers of reporting levels that arise due to the size and complexity of the MNC make the decision making process slower, given that such communication has to pass through each chain of command because of bureaucracy. This may add on to the opportunity costs that would have been avoided by the MNC if it allowed its subsidiaries to react fast and gain competitive advantage in their respective markets (Bartlett & Ghoshal 1989, 41).

Conclusion

In conclusion, the major sources of agency conflicts are moral hazard and adverse selection. Adverse selection problem arises where the agent has information that would be costly or even impossible for the principal to obtain, making it difficult for the headquarters to monitor the activities of its subsidiaries. As the MNC grows, profitability levels tend to grow only marginally as divisions of the company becomes increasingly risk averse. As subsidiaries compete for resources from the parent company, managers become increasingly risk averse as they try to protect their positions and bargaining power. As such, foreign managers will tend to uptake investment strategies that have worked for them in the past, ignoring riskier projects that could have offered better returns.

Some of the techniques that the parent company could use to monitor the performance and activities of the subsidiaries include the use of contracts, the board of directors and the use of capital markets. Agents may be required to sign contracts that will set performance targets for subsidiaries, which could help in setting the desired behavior. Outcome based performance contracts such as compensation contracts, rewards and commissions will motivate foreign managers to perform in order to secure their personal interests.

The board of directors of the MNC is responsible for setting the overall strategy for the whole organization, and uses its position in the company to impose their will on top management. Bonding mechanisms are usually incentives created for agents to perform in accordance with the principal’s interests, and include compensation packages like profit related bonuses, and promotions or other forms of recognition that may boost the reputation of the mangers, increasing their chances to better incomes in the future.

Despite measures taken by the headquarters to reduce agency conflicts, agency costs will always be high due to the difficulty in monitoring foreign managers. The agency conflict becomes more complex in large companies since shareholders delegate power and control to the board of directors, who in turn delegate power to the chief executive officers. In MNCs, the CEOs of the parent company are forced to delegate power to foreign managers. The principal, or owners of the company, seek to maximize the cost of the firm at minimal costs while agents seek to maximize their own benefits at minimal effort.

Reference list

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