5.3.2.1 Market for Corporate Control Theory
The potency of agency theory relies on the aptitude that agents are self-interested. Critics (e.g.
Marris 1964) contend competitive capital market forces reduce the potential for such behaviour to prevail such that aberrance from the profit maximisation goal of the firm leads to decline in share prices. The decline in share prices exposes the firm to take-over threats,
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which effectively monitor managerial behaviour through the mechanism of the market for corporate control (Manne 1965). The mechanism of the market for corporate control compels that where incumbent managers act in a manner that leads to adverse firm performance, the share price will fall to a level that induces need for new management to revive the firm‟s value. Like most markets, the effectiveness of the theorem depends on the efficiency of the market for corporate control as well as the cost of takeover being higher than the gains of replacing management (Davis and Stout 1992). Given that the market for corporate control prevails in enforcing managerial efficiency to reduce agency problems, the need for accounting disclosures as a curb on agency costs is critiqued.
Jensen and Meckling (1976) challenged the market for corporate control concept as an alternative to provision of information, as the idea perceives the firm as a distinct object with a boundary between itself and its environment. Rather, they viewed the firm as a medium where various market players with divergent objectives attain an equilibrium position through contractual obligations. Therefore, the firm‟s behaviour is synonymous to the market‟s behaviour and such similarity is attained through the contractual relationships between managers, shareholders, and other stakeholders. Hence, agency theorists extend the realm of their hypothesis to suggest that like manager, all other stakeholders in the firm serve their own interests which are the very premise for their involvement in a contractual relationship with the firm (Davis and Stout 1992). Therefore, participants in the market for corporate control do not operate in mechanisms that subvert agency problems in the firm.
As another criticism for the market for corporate control, Williamson (1963) are of the view that transactions of capital are “too costly” as an enforcer of the profit maximising behaviour. That is, waiting for share price declines to assess whether managers are acting in the interests of shareholders is a dearer price to pay compared to monitoring through disclosures. Further, Singh (1971) and Deakin and Singh (2008) presented evidence that the market for corporate control is at least partially ineffective and may be justified if it operates in parity with other market settings.
Deakin and Singh (2008) ascertains that the three fundamental theories that explain the relevance of information to investors rather than acclaiming that the market for corporate control theorem disregards the relevance of disclosures. The theories identified include agency, information
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asymmetry and incomplete contracting which all support the argument that managers pursue their own interests. Even when investors try to reduce management discretion through corporate governance mechanism, the mechanisms involve costs of agency nature. For example, aligning investors‟ needs with managerial interests through pay incentives presents a cost of agency despite the likelihood that the action may reduce management‟s tendency to marginalise investors‟ value creation.
Lastly, Scherer (1980) reviewed literature on market for corporate control as a monitoring device for management self-interest behaviour. The conclusion suggested that the assumption of take-overs as a viable deterrent to management‟s tendency of pursuing their interests is rarely defensible.
Reflecting the arguments for and against the market for corporate control, based on the objectives of this study, the essence for complementing and supplementing may on one side reflect the discussion by Jensen and Meckling (1976). Though management and shareholders have conflicting interests, the contractual arrangement between the two parties compels management in order to provide complementary and supplementary narratives in an attempt to reduce information asymmetry to attract capital from investors. However, the cohorts of the market for corporate control may argue that the reason for management‟s provision of complementary and supplementary narratives is a self-interest realisation that if investors are not adequately informed, they may reduce their interest in the firm. The resultant fall in share prices may lead to take-over bids and a change in management (Manne 1965). Therefore, the current management prevents the change in management that may arise from take-over bids by ensuring that investors are provided with useful disclosures, such as complementary and supplementary narratives.
5.3.2.2 Market for Managerial Talent
Another line of literature (e.g. Alchian 1968; Alchian and Demsetz 1972; Fama 1980) disagrees with the provision of disclosures as a solution to agency costs and proposes that market for managerial talent mechanisms are sufficient to control managerial behaviour.
Fama (1980, p. 289) explicitly stated that:
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“…the firm is disciplined by competition from other firms, which forces the evolution of devices for effectively monitoring the performance of the entire team and of its individual members. In addition, individual participants in the firm, and in particular its managers, face both the discipline and opportunities provided by the markets for their services, both within and outside the firm.”
However, Fama (1980) subjected the effectiveness of this theory on the ex-post reward of managers for their performance, that is, compensation for their behaviour. For example, management is conceptualised to act in the interest of the shareholders if there are share option plans that compel management as shareholders to align their interests with interests of other shareholders. Empirical evidence that concurs that the market for managerial talent is associated with agency costs shows positive market returns with introduction of (1) long-term managerial plans (e.g. Brickley et al. 1985); (2) short-term executive plans (e.g. Tehranian and Waegelein 1985) and (3) the golden parachute agreements (e.g. Lambert and Larker 1985).
The provision of complementary and supplementary, if explained under the market for corporate control, would arguably be a means through which management communicate their performance to investors to protect their positions or remuneration. However, for the same reason, management may decide not to provide disclosures, such as complementary and supplementary narratives. Nagar (1999) modelled the relationship between disclosures by management and share pricing within the market for managerial talent. In the model, management is privy to the firm‟s performance and has discretion to disclose. If management discloses, it is uncertain about the investor reaction, which may either be a positive or negative assessment of the management.
The uncertainty on the part of management arises from unawareness about the investors‟
considerations in information assessment, thereby affecting the management‟s decision to disclose. If management decides not to disclose, the nondisclosure may be interpreted by investors a result of either untalented management or talented management that is afraid of uncertainty arising from disclosure. In either case, nondisclosure aggravates information asymmetry and may lead to managerial welfare losses and adverse valuation of the firm (Nagar 1999). On the other hand, effective information dissemination of investor expectations to management, through corporate governance and reward mechanisms, enhances management‟s
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provision of quality disclosure. The disclosures then reduce information asymmetry and in turn, guide investment decision-making (Nagar 1999).
5.3.2.3 Theoretical Legal Literature Critique of Agency Costs
Metzger et al (1986) criticise the role of disclosures based on agency with reference to early foundations of the agency theory in legal literature. Agency was originally a legal concept explaining the contractual relationship between the agent and principal. The legal contract imposed duties of loyalty on the agent. Clark (1985) argued that such an arrangement places a fiduciary duty of loyalty on the part of agent to the principal thereby preventing any sort of abuse of the managerial discretion.
Duska (1992) seemed to agree that the initial premise of the agency concept was loyalty by the agent suggesting that the introduction of the theory to management of the firm was the recognition that loyalty was the basis of any arrangement between owners and stewards.
However, the economic theory that humans are egoistic and will act with rationality to maximally benefit themselves debased any argument that retained loyalty as the reason for agency relationship. The self-interest economic theory was long established by Smith‟s (1776) classical work where he argued that humans are selfish and will not always look out for the interest of others although they are instances in which they compromise their interests to the benefit of others.
The loyalty legal literature concept of agency by Metzger et al (1986) arising from legal literature implies that the premise on which investors and management enter into a relationship is fidelity. Therefore, agency in this context arguably is not the underlying reason for the self-interest pursuit. One can therefore argue that the rationale for providing complementary and supplementary narratives portrays that both management and investors are aware of their agency fiduciary obligations and disclosures serve this awareness by reducing information asymmetry. However, as discussed by Smith (1776) that people pursue their own interests, the existence of the agency relationship between investors and management may have two implications about the motive of complementary and supplementary narratives.
Either, management may act in line with the guidelines by ASB (2005; 2006) and provide
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information that eliminates information asymmetry and useful for investment decision-making or management may pursue its own interests by providing disclosures that increase asymmetry and mislead investors.
5.3.2.4 Utility Maximisation Critique of Agency Costs
Under utility maximisation, agency would arise where agents tend to maximise their financial benefits from the principal. Critiques of the utility maximisation assumption of the agency theory contain that utility is hardly measurable and it is difficult to prove whether people maximise utility. Simon (1959) argue that most empirical work intended to measure utility are exploratory experiments that assume that participants intend to maximise utility. Davidson and Suppes (1957) further contend that in the experiments that are virtually “unreal”
circumstances participants merely tend to act in line with what the theory requires, that is, act as if they maximise utility. Therefore, assuming the results as functional in the real world may be erroneous. Further, May (1954) argues that minor adjustment in the assumptions may lead to a significant change in the outcome. Simon (1959) attributed large shift in outcome arising from the slight alteration of the utility maximisation conditions to the fact that the real world is very complex so that postulation of all choices under utility maximisation is a fallacy.
A simulation of this complexity and dilemma with regard to disclosures may be reflected in management rhetorical choices to report the opportunities arising from a calamity. For example, declaration of a war amongst countries presents a possibility of misplacing of people and increased hygiene and health risks. The situation incorporates utility maximisation opportunities in terms future turnover for pharmaceutical, temporary shelter and power generating companies. However, disclosing the situation as an opportunity may have a dual impact. On one end, it is a utility maximisation opportunity that may be viewed by shareholders as having a positive impact on share returns. Alternatively, investors who are socially conscious may view the company as being socially irresponsible by considering the situation as an opportunity, thereby withdrawing their stake in the firm. Chua (1986) argues that the different roles that accounting disclosures serve leads to augmenting the mainstream utility maximisation concept underlying agency theory with critical and interpretative
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viewpoints of the information. ASB (2005; 2006) advised that the paramount importance of information in the operating and financial review, that is, complementary and supplementary narratives, is to serve information needs of investors. In fulfilling this role, other users‟ needs such as those for creditors, employees, creditors and society ought to be considered as they affect the value of the firm, thereby influencing investors‟ decisions. This postulate seems to consider that agency between investors and managers alone may not explain the relevance of complementary and supplementary narratives, however, recognising the needs of other stakeholders as well as other needs of investors may explain the relevance or usefulness of the