Agency Theoy

Agency Theory

The main problem in the case is that the CEO, Mr. Rodriguez, did not uphold his duty of care to the shareholders. Agency theory holds that the management of a company is an agent of the shareholders and should undertake actions that support the improvement of shareholder wealth at the firm. There are several points where this did not take place. The company's strategy of being a low-cost provider may have worked initially but it eventually became apparent that the company was suffering a decline in sales. The response of Mr. Rodriguez was to leave the strategy unchanged. Worse, he undertook significant misconduct and failed to safeguard the interests of the shareholders by giving luxurious bonuses to the staff and using company funds to finance his high-flying lifestyle. His action to call for an increase in the revenues from the accounting department was illegal, and directly misleading, and absolutely against the best interests of the shareholders.

The Board of Directors is responsible for oversight of the officers of the company. At best, they were negligent in this duty, which again is a breach of the agency agreement. The BOD needed to be aware of the slumping sales, be aware of Mr. Rodriguez's illegal and unethical actions and needed to take action. Even with the lousy strategy, the role of the BOD is to ensure that the firm has competent management, and should have either worked with the CEO to create better strategy or taken steps to replace the CEO. In each of these cases, the agency agreement between the shareholders and the Board, and the shareholders and the CEO, was subject to breach, with the result being that the shareholders would eventually find their wealth eliminated.

2. The situation needed to be prevented at the level of the Board. It is the role of the Board to ensure that the company is being run well. Thus, the Board needs to be aware of what the company is doing, how it is competing and how it is spending the money. There clearly was no real interest on the part of the Board to address this situation. The Board relied on financial reports provided by the officers, and the auditor. It took at least five years for the Board to hire a new auditor and by then it was too late to safeguard the shareholders' wealth. The Board should have been able to determine the CEO's failings much earlier and taken steps to deal with the problem many years previous.

There are other issues here as well. Regulators are supposed to be willing to act in situations where illegal activities are taking place, as this securities fraud clearly was illegal. The regulators seemed unaware that the officers and the auditors were entirely fictionalizing the company's results.

There is also a role that the shareholders play as well. The shareholders were more than happy to blindly accept what the CEO was telling them. They hire the Board in order to provide oversight, and it does not appear that the shareholders did anything to examine the way that the Board was conducting its business. The shareholders should have rotated some of the Board members, and made sure that the Board members were external. The shareholders are also responsible for hiring Board members that have some financial experience and can conduct their own independent audits of the financial figures that the CEO is presenting. There was no evidence of any shareholder activism, and they did nothing to protect their own interests.

3. The shareholders did not do the right thing initially in protecting their investment. While the shareholders typically rely on the Board to act as their agents, it does not appear that the shareholders subjected the Board to much scrutiny. Instead, the shareholders did not rotate the Board, and the Board that they did hire was clearly not very good at doing its job. With no oversight and no rotation of Board members, the shareholders were clearly unwilling to do the right thing. They were happy to get more dividends despite the flagging sales, something that would have been uncovered by independent observers.

Only at the end of the scenario did the shareholders do the right thing, when they launched their lawsuit against the CEO and the company for their losses. They were subject to considerable breach of the agency agreement, and this directly led to their investments being lost. However, buying stock is very much a situation of caveat emptor. The shareholders will be subordinated to creditors for their share of the company assets. Thus, the shareholders at this point, even if they win the suit, are likely to see pennies on the dollar for their investments, if anything at all.