CONSTRAINTS IMPOSED ON MANAGERIAL DISCRETION IN PUBLIC CORPORATIONS
- Compiled and Written by Judith Duru, Oladoke Olusegun & Sele Michael (Msc Class, May 2017)
We present constraints to managerial discretion in public corporations analysing the conflicts that exist between the managers and shareholders and the relationship between managerial discretion and public corporation performance. This is carefully done as we break down what managerial discretion is all about as well as the nature of public corporation so that we can create a fit in. We also reflect on how deregulation affects managerial discretion and discuss the mechanics used to control agency problems, that is, the composition of the board of directions.
According to Obaji (2004), Constraints on managerial discretion are the possible conflicts of interest between stakeholders and managers. Managerial discretion is the extent to which managers fail to experience discipline on their behaviours from internal corporate governance e.g. ownership structure and board composition and external control mechanism e.g. product market composition, credit market, market for corporate control and managerial market.
Audretsch and Lehmann (2002), consider that analyzing the relationship between managers and shareholders requires different perspectives in firms belonging to the sector of “new” economy and in firms belonging to more traditional industry. Rajan and Zingales (2000), argue that “new economy” firms need new corporate governance mechanisms to stimulate the innovation potential of human capital. Managerial discretion is an important element of corporate governance mechanism. Since intellectual capital becomes the most important strategic resource for high-tech firms, should high-tech firms arrange different managerial discretion from traditional enterprise.
WHAT IS MANAGERIAL DISCRETION
According to Oliver E. Williamson, he hypothesized (1964) that profit maximization would not be the objective of the managers of a joint stock organization. This theory, like other managerial theories of the firm, assumes that utility maximization is a manager’s sole objective. However it is only in a corporate form of business organization that a self-interest seeking manager can maximize his/her own utility, since there exists a separation of ownership and control. The managers can use their ‘discretion’ to frame and execute policies which would maximize their own utilities rather than maximizing the shareholders’ utilities. This is essentially the principal-agent problem. This could however threaten their job security, if a minimum level of profit is not attained by the firm to distribute among the shareholders.
The basic assumptions of the model are:
- Imperfect competition in the markets.
- Divorce of ownership and management.
- A minimum profit constraint exists for the firms to be able to pay dividends to their share holders.
Managerial discretion has been an important concept in the economics and management literatures, from very different perspectives. In economics, managerial discretion refers to the freedom managers have to pursue their own objectives (pay, power, status and prestige) rather than shareholder interests: high discretion means managers are able to pursue personal objectives without being caught or punished (Williamson, 1963). In the management literature by contrast managerial discretion refers to the choice of actions available to managers in the pursuit of organizational goals: high discretion means managers have low environmental and organizational constraints on their choice of actions, (Hambrick and Finkelstein,1987).
Shen and Cho (2005) usefully integrated both points of view into a single framework which differentiates two aspects of managerial discretion: latitude of objectives and latitude of actions. Latitude of objectives refers to a manager’s freedom to pursue their own objectives rather than those of other stakeholders. Latitude of actions, on the other hand, refers to differing ranges of actions available for managers to pursue organizational objectives.
MEANING OF PUBLIC CORPORATION
A public corporation is that form of public enterprise which is created as an autonomous unit, by a special Act of the Parliament or the State Legislature.
Since a public corporation is created by a Statute; it is also known as a statutory corporation.
The Statute defines the objectives, powers and functions of the public corporation. Power Holding Company of Nigeria (PHCN), Nigeria Ports Authority (NPA), Bank of Industry (BOI), Nigeria National Petroleum Corporation (NNPC) and Federal Radio Corporation of Nigeria (FRCN) etc. are some examples of public corporations, in Nigeria.
Features of Public Corporation:
Following are the salient features of a public corporation:
1. Special Statute: A public corporation is created by a special Act of the Parliament or the State Legislature. The Act defines its powers, objectives, functions and relations with the ministry and the Parliament (or State Legislature).
2. Separate Legal Entity: A public corporation is a separate legal entity with perpetual succession and common seal. It has an existence, independent of the Government. It can own properly; can make contracts and file suits, in its own name.
3. Capital provided by the Government: The capital of a public corporation is provided by the Government or by agencies controlled by the government. However, many public corporations have also begun to raise money from the capital market.
4. Financial Autonomy: A public corporation enjoys financial autonomy. It prepares its own budget; and has authority to retain and utilize its earnings for its business.
5. Management by Board of Directors: Its management is vested in a Board of Directors, appointed or nominated by the Government. But there is no Governmental interference in the day-to-day working of the corporation.
6. Own Staff: A publication corporation has its own staff; whose appointment, remuneration and service conditions are decided by the corporation itself.
7. Service Motive: The main objective of a public corporation is service-motive; though it is expected to the self-supporting and earn reasonable profits.
8. Public Accountability: A public corporation has to submit its annual report on its work. Its accounts are audited by the Comptroller and Auditor General of Nigeria. Annual report and audited accounts of a public corporation are presented to the Parliament or State Legislatures.
MANAGERIAL DISCRETION IN PUBLIC CORPORATIONS
Managerial discretion, which refers to executives’ ability to affect important organizational outcomes, is a function of the task environment the internal organization, and managerial characteristics. Managerial discretion occurs in public corporations when owners of organization or governments enjoy exclusive control rights over managers. When there exist non-owner control over managers, managerial discretion may produce a favourable effect on corporate performance, if the objective functions of managers is relatively more in line with profit maximization rather than to the non-owner controlling party.
Public corporation is not suitable in industries where long-term growth is slow, where internally-generated funds outstrip the opportunities to invest them profitably or where downsizing is the most productive long-term strategy. The public corporation is a social invention of vast historical importance. Its genius is rooted in its capacity to spread financial risk over the diversified portfolio of millions of individuals and institutions and to allow investors customize risk to their unique circumstances. By diversifying risks that would otherwise be borne by owner-entrepreneurs and by facilitating the creation of a liquid market for exchanging risks, the public corporation lowers the cost of capital.
CONSTRAINTS ON MANAGERIAL DISCRETION
The degree of discretion that senior executive managers have in setting objectives is limited by both external and internal constraints. External constraints arise from the active market in company shares while internal constraints arise from the role of nonexecutive board members and stakeholders, trying to align the managers’ and the owners’ interests by the rules shaping corporate governance.
There are five sources of external constraint on managerial behaviour in any system of corporate control. Those who potentially hold this power are:
1. Holders of large blocks of shares who use or threaten to use their voting power to change management or their policies if they become dissatisfied.
2. Acquirers of blocks of shares sold by existing shareholders unhappy with the performance of management.
3. Bidders in the takeover process who promise to buy all the voting shares of the enterprise.
4. Debtors/Investors, particularly in times of financial distress, who act to protect their interests in the company.
5. External regulators and auditors.
In outsider systems, external control is exercised mainly through the workings of the stock market rather than voting.
The influence of the workings of the stock market on managerial discretion assumes that a fall in the share price will make management more vulnerable to shareholder activism either in selling shares or in voting at shareholder meetings.
Other external constraints on managerial behaviour are the need to comply with company law, independent auditing of accounts and the lodging of company accounts with the regulators.
The organizational structure of the company, there are groups who may be able to influence management to change policies.
The first of these are the non-executive directors, who are appointed to the boards of UK companies to oversee the behaviour of the executive directors. However, they are normally appointed by the executive managers and, therefore, may not be independent in their actions or effective in constraining executive directors. They are often few in number and can be outvoted by executive directors. One of the objectives of corporate governance reform in the UK is to make non-executives more effective. In the German system the supervisory board plays this role by influencing the management board, but its membership is more wide-ranging.
The second of these groups are the owners or shareholders, who can exercise their authority at meetings of the company or informally with management. Directors are elected at the annual general meeting of the company. Dissatisfied shareholders can vote against the re-election of existing executive directors or seek to get nominees elected. They can also vote against resolutions proposed by the executive of the company, such as those relating to executive remuneration. In the past this has rarely happened as shareholders have been passive rather than active in company affairs and sell under-performing shares. However, in the UK institutional shareholders have become more active in organizing coalitions to either influence management behind the scenes or forcing votes at annual general meetings.
A third group that can influence executive managers are the stakeholders within the company. These include employees of the firm as well as customers, suppliers, lenders and the local community. They may do this by expressing their criticisms concerns either directly to the executives or indirectly by informing shareholders, the media and outside experts or commentators. Investment banks and stockbrokers offer advice to shareholders on the potential future earnings of the company, and such comments may help to influence attitudes toward incumbent managers.
THE RELATIONSHIP BETWEEN MANAGERIAL DISCRETION, PUBLIC CORPORATION PERFORMANCE AND CORPORATE GOVERNANCE
The relationship between managerial discretion and public corporation is assumed that government own exclusive rights to control and monitor the managers. More studies indicate that the absence of external control Mechanism, an increase in managerial discretion implies a decrease in control by the owners; the result of which is more operating leeway, for undesirable behaviour on the part of the managers. As a result, a negative relationship between managerial discretion and a public corporation performance is expected.
Corporate governance is the system of rules, practices and processes by which a company is directed and controlled. Corporate governance essentially involves balancing the interests of a company's many stakeholders, such as shareholders, management, customers, suppliers, financiers, government and the community. Since corporate governance also provides the framework for attaining a company's objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.
The ownership and control of firms are pronounced and vary dramatically across organizations. Therefore, one of the questions that arise when considering whether or not corporate governance affects performance includes whether or not owner-controlled firms are more profitable than manager-controlled firms? A priority, it is not clear whether or not concentrated ownership and control will improve performance. On the one hand, concentrated ownership by providing better monitoring incentives should lead to better performance. On the other hand, it might also lead to the extraction of private benefits by controlling block-holders (A block-holder is the owner of a large amount of a company's shares and/or bonds, or block) at the expense of minority shareholders. These issues are central to the debate surrounding corporate governance practices, particularly since concentrated holdings are the primary means of control. A common feature of large public corporations is the separation of ownership and control between the principal and the agent (Fama and Jensen, 1983).
Therefore, whether or not the agency problem arising from the separation of ownership and control is a serious one and does concentrated ownership effectively overcome these problems in public corporation is present. The principle-agent model suggests that managers are less likely to engage in strictly profit maximizing behaviour in the absence of strict monitoring by shareholders. Therefore, if owner-controlled firms are more profitable than manager-controlled firms, it would seem that insider systems have an advantage in that they provide better monitoring which leads to better performance. The vast majority of empirical studies, turns out, do to favour the beneficial effects of enhanced monitoring as a result of higher ownership concentration.
A central weakness and source of waste in the large public corporation is the conflict between shareholders and managers over the pay-out of free cash flow that is, cash flow in excess of that required to fund all investment projects with positive net present values when discounted at the relevant post of capital. For a company to operate efficiently and maximize value, free cash flow must be distributed to shareholders rather than retained. But this happens infrequently, as senior managers have few mechanisms to compel distribution.
Managers-stockholders; conflicts are introduced by considering the fact that, in addition to his fixed wage, the manager derives utility form both retaining control and investing new project: A common determinant of capital structure arises from manager-shareholders’ conflicts. Managers and shareholders have different objectives. In particular, managers tend to value investment more than shareholders do. Graham (2000) holds that debt financing can increase a firm’s value by reducing the costs associated with the conflict.
Other key points to why Manager/Shareholder conflict abounds in Public corporations are;
1. The agency view of the corporation suggests that the decision rights of the corporation should be entrusted to a manager to act in shareholders' interest. Agency costs mainly occur when ownership is separated, or when managers have objectives other than shareholder value maximization.
2. Typically, the CEO and other top executives are responsible for making decisions about high-level policy and strategy. Shareholders, on the other hand, are individuals or institutions that legally own shares of corporation stock. Shareholders typically concede control rights to managers.
3. There are various conflicts of interest that can impact manager's decisions to act in shareholders' interests. Management may, for example, buy other companies to expand power. Venturing onto fraud, they may even manipulate financial figures to optimize bonuses and stock-price-related options.
4. Contemporary discussions of corporate governance argue that corporations should respect the rights of shareholders and help shareholders to exercise those rights. Disclosure and transparency are intimately intertwined with these goals.
THE RELATIONSHIP BETWEEN THE BOARD OF DIRECTORS AND THE MANAGEMENT IN MANAGERIAL DISCRETION
The relationship between the board of directors and the management cannot be described as just being that of a relationship between an employee and his or her manager. Though the board oversees the decisions taken by the management and ratifies them along with acting as the final arbiters of the strategic direction and focus that the company is heading into, the relationship goes beyond that. For instance, the board of directors is responsible for the actions of the management and hence not only does the board need to monitor the management, the management needs to take the board into confidence about its decisions. Hence, the relationship can be described as being symbiotic with each with each serving in an ecosystem called the organization. The point here is that neither the management nor the board can exist without each other and hence both need each other to survive and flourish.
Another aspect to the relationship between the board and the management is that more often than not, there is a significant representation of the management in the board. This means that the other board members have to study the decisions taken by these members carefully so that there are no agency problems, conflicts of interest and asymmetries of information.
Only when the board and the management coexist together in a harmonious manner can there be true progress for the organization. For this to happen, there must be a provision for having independent directors and those directors that are not affiliated to the management. The point here is that unless there is objectivity and separation of the directors belonging to the management and those from outside can there is a semblance of avoidance of conflict of interest.
The third aspect of the relationship between the board and the management is the role played by institutional investors or directors from large equity houses and mutual fund companies. These directors bring to the table rich and varied expertise and experience in running companies and hence their input is crucial to the working of the company. It is for this reason that many regulators insist on having a certain percentage of the board as independent directors and another percentage from institutional shareholders. The reason for this is the fact that unless there is a process of due diligence and oversight over the actions of the management, the management can take unilateral decisions that are not always in the best interests of the company.
Managerial discretion, which refers to executives’ ability to affect important organizational outcomes, is a function of the task environment the internal organization, and managerial characteristics.
A public business corporation establishes a compensation committee consisting of outside directors that sets the salaries, incentive bonuses, and other forms of compensation of the top-level executives of the organization. An outside director is one who has no management position in the business and who, therefore, should be more objective and should not be beholden to the chief executive of the business.
This is good in theory, but it doesn’t work out that well in practice — mainly because the top-level executive of a large public business typically has the dominant voice in selecting the persons to serve on its board of directors. Being a director of a large public corporation is a prestigious position, to say nothing of the annual fees that are substantial at most corporations
Finally, the relationship between the board and management is somewhat strained whenever the company is not doing well. This happens because the board has a top view of the organization and the management has a deeper insight. Hence, to be fair to the management, they are the ones who have to run the organization and so they cannot be constrained by what the board dictates sitting on its perch. This is the classic problem that many companies face especially when they are not doing well and the remedy for this is to take the board into confidence about the complexities of the day to day operations and apprise them of the nuances and subtleties of running the organization.
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The Compilation of this work was carried out by Masters of Sciences student of University of Abuja, Business Administration (16/17) department as part of their presentation work in a Comparative Management course.
The Compilation of this work was carried out by Masters of Sciences student of University of Abuja, Business Administration (16/17) department as part of their presentation work in a Comparative Management course.