The Principal-Agent and Moral Hazard Problem Zach Bishop Brian Lee Jonathan Mascolo Nicole Lee David Van Buren Hoa Pham

Moral Hazard in Equity Contracts The Principal-Agent Problem

Equity contracts: claims to a share in the profits and assets of a business. example: common stock A particular type of moral hazard that results from equity contracts is the principal-agent problem.

Principals: all the stockholders Principals: all the stockholders. They own the majority of a firm’s equity Agents: the managers that only own a small percentage of the firm. The moral hazard occurs when agents don’t try to maximize profits because they only receive a fraction of what the principals receive for the profits.

The Ice Cream Example Your friend Steve wants to open an ice cream store. It costs $10,000 but he only has $1000. He asks you to invest the other $9,000. This entitles you to 90% ownership of the ice cream store.

This means that if Steve works hard running the store and makes a $50,000 profit, he makes 10% of that which is $5,000. You make 90% of $50,000 which is $45,000. Steve could work less hard and spend the profit on other things because he isn’t being compensated enough. This is losing you money.

The moral hazard from principal-agent could be even worse because there is a chance that Steve pockets all the profits as cash and tells you that there were no profits this year. A more complicated real life example would be Steve buying other firms that increase his power but do not increase profits at all. The main problem is that the principals do not know completely what the agents are doing.

The Enron Scandal and Moral Hazard Enron, the 7th largest U.S. Company in 2001, filed for bankruptcy in December 2001. Company charged with securities fraud (fraudulent manipulation of publicly reported financial results, lying to the SEC) Enron investors and workers left with worthless stocks. Largest U.S. buyer/seller of natural gas and electricity. Enron heavily involved in energy brokering, electronic energy trading, global commodity and options trading, etc.

Enron’s Schemes 1993-2001: Enron senior management used complex and murky accounting schemes reduce Enron’s tax payments inflate Enron’s income and profits inflate Enron’s stock price and credit rating hide losses in off-balance sheet subsidiaries engineer off-balance sheet schemes to funnel money to themselves, friends, and family misrepresent Enron’s financial condition in public reports

Remedies to the Situation Reform of Generally Accepted Accounting Practices (GAAP) Prior to 2002. Separation of Auditor and Company. Reform of company regulation. Management liable for company reports. Sarbanes-Oxley Act (SOX) of 2002 U.S. legislative response to reform accounting procedures. Rules and regulations concerning auditing.

Ways to help solve the principal-agent problem There are four ways to help resolve Principal-Agent Problem: Production of Information: Monitoring Government Regulation Financial Intermediation Debt Contracts

Monitoring Monitoring Conflict with monitoring Is a way for the firms to reduce the principal-agent problem. Expensive Time consuming

Government Regulation Government sets up Laws. Standard accounting principles Criminal penalties Stiff laws on hiding and stealing profits Problems with Regulation The main purpose of government regulation.

Financial Intermediation Venture Capital Firm: pools the resources of their partners and use the funds to help entrepreneurs start a new businesses. Helps eliminate the free-rider problem.

Debt Contracts A debt contract helps regulate mangers Verify the firm’s profits A debt contract is a contractual agreement by the borrow to pay the lender fix dollar amount.

Financial Structure These four tools help shape the financial structure in the United States. They help share information to the public They regulate firms from trying to hide profits They reduce managers from only benefiting themselves Helps to keep the firms and the public on equal grounds

Moral Hazard the risk that one party to a transaction will engage in behavior that is undesirable from the other party’s point of view.

How Moral Hazard Influences Financial Structure in Debt Markets Debt Contracts are still subject to moral hazard even with the advantages Borrowers have an incentive to take on investment projects that are riskier than lenders would like.

Moral Hazard Risks It’s a very risky investment but if Steve is successful then he has a strong incentive to take on the riskier investment. You on the other hand, would be unhappy because if Steve were unsuccessful, then you would lose all your money you lent him.

Tools to Help Solve Moral Hazard Net Worth and Collateral Monitoring and Enforcement of Restrictive Covenants Financial Intermediation

Net Worth and Collateral When borrowers have more at stake because their net worth is high or the collateral they have pledged to the lender is valuable

A Solution that High Net Worth and Collateral Provides to the Moral Hazard Problem Make the debt contract incentive compatible incentive-compatible: having the incentives of both parties to a contract in alignment

Monitoring and Enforcement of Restrictive Covenants Restrictive covenants are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behavior

Forms of Covenants to discourage undesirable behavior to encourage desirable behavior to keep collateral valuable to provide information

Covenants to discourage undesirable behavior Function in two forms: - restricting the use of money so that it can only be used on certain criteria - barring the use of the capital so it can not be used for certain purposes.

Covenants to encourage desirable behavior. Require a firm to maintain certain good business practices, such as minimum holdings and insurance.

Covenants to keep collateral valuable Require proper protection of the asset, an example would be homeowners insurance as part of a mortgage

Covenants to provide information Require the provision of information by the borrower to the lender, making it easier to monitor the firm.

Corporate Scandal of 2002 Moral hazard and principal-agent problem. How Tyco and WorldCom got into trouble?

Characteristics Agent: Greedy CEOs and CFOs Principal: corporate workers and investors Lax Monitoring: insufficient auditing Lack of leadership Strong incentives for committing fraud Consider their companies as piggy banks

International Tyco CEO Kozlowski was accused of looting $170 million for extravagant lifestyle from Tyco and obtaining $430 million by fraud in the sale of company shares. Often asked the board for loan and forgiven later. Both CEO and CEFO conspired to falsify the financial statements to inflate stock.

WorldCom CEO Bernard Ebbers was under pressure due to margin calls because the his WorldCom's stock was declining. Asked the boards for personal loan and guarantee of 400 millions. CFO Scott Sullivan also cooked the book to boost the WorldCom's stock Internal audit uncovered 3.8 billions of the fraud. The SEC launched investigation and WorldCom declared bankruptcy.

Consequences Stocks became worthless Thousand of workers were out of job and lost pension Investors lost money CEOs and CFOs were convicted for fraud and theft, each was sentenced 25 years or more Corporate oversight and accounting reforms were initiated and enforced Other example: Enron, Adelphi, Global Crossing, etc.