WHAT IS A CONFLICT OF INTEREST IN FINANCE?

A Company is owned by Shareholders but run and managed by Directors/Managers. Generally, both these stakeholders float in the same boat and increased financial statements’ margins & Revenues will have a positive impact on both. Shareholders’ wealth is maximized and directors retain their jobs and are sometimes rewarded with bonuses.

However, there lies a risk, the risk of Shareholders’ wealth not being maximized by directors, instead, digging their own money. This leads to a conflict of interest and it deteriorates future prospects of the company.

Agency problem, in other words, conflict of interest arises when directors make decisions in their own interests. These decisions often compromise their objectivity, which is the maximization of Shareholders’ wealth.

This issue is increasing day by day and has affected many companies recently even some to the extent of liquidation. I will talk about those companies in detail. Let’s first know when and why a conflict of interest may arise.

WHEN AND WHY CONFLICT OF INTEREST ARISES

Following are some of the situations where conflict of interest arises;

EXCESS REMUNERATIONS

Shareholders invest money in a company, directors get paid for managing the company. The decision as to how much salaries should be paid is made by senior directors, in large quoted companies, a remuneration committee. Directors would want to receive big salaries and shareholders on the other hand appreciate increased profit and dividends.

The profit figure arrives after remunerations have been deducted, hence, the higher the remunerations lower will be the profit and consequently, lower dividends. This leads to a conflict of interest, with directors demanding excessive salaries at the expense of shareholders’ wealth.

CREATIVE ACCOUNTING

This is common in situations where bonuses of managers are attached to the level of profit the company makes. Profit figure is taken from the income statement and these figures can be manipulated by managers to receive their bonuses. They can do this by setting up depreciation policies that favor them, Overstating revenues or other income.

They can also understate the cost of sales & other expenses. Profit for the period will increase and bonuses awarded to managers.

But what about Shareholders?!
This obviously will damage their wealth. The company will not be able to pay dividends due to virtual and paper profit only. If exposed, it will affect the reputation of the company and the share price will decrease drastically. No investor would want to invest and no lender would risk their money. Its ultimate result will most probably be the cessation of the company due to a lack of capital and goodwill.

TAKEOVER BIDS

When a company is interested in buying another company, it offers a good deal of money which is beneficial for shareholders. They will receive more than the market price of their shares. But, the managers will not be willing to accept the offer. They will be worried about their position in the company as they might lose their jobs or demote.

Also, there will be a parental effect, and the company’s operations being controlled & monitored by the parent company. NO director likes that!

EMPIRE BUILDING

Empire Building is the opposite of Takeover Bids. In the Empire building, the company itself buys other entities thus becoming the parent. The more companies it acquires, the more power the directors exercise. They will interfere in decisions regarding subsidiaries. Everybody loves power and directors are no exception.

Shareholders, on the other hand, might not be interested in buying some companies. Specifically, companies with increased risk exposure and/or no satisfactory past results. Hence, another conflict of interest to deal with.

OFF-BALANCE SHEET FINANCE – GEARING STRUCTURE

Gearing structure is one of the most important decisions to make for a company. Excess gearing will make the company a riskier entity to invest in and low gearing will mean that the company isn’t taking advantage of the cheap source of capital available. Finding and keeping that optimal point of gearing is a cornerstone for the company’s capital structure. Now, shareholders and directors might have different approaches to gearing. Aggressive shareholders will acknowledge high level of gearing due to cheap interest rates which consequently, will increase profitability and dividends. But, increased gearing would restrict directors’ decisions regarding operational and investment decisions of the company and can threaten its going concern.

The collapse of a company can create far more dire consequences for directors than for a well-diversified investor.

UNETHICAL ACTIVITIES

These are activities that add value to shareholders’ wealth using unethical means. Some of which are using cheap/child/slave labor and employees working under dreadful conditions. It costs the company low hence increasing profitability & dividends. But, directors, being members of reputed organizations and employees themselves, will not be willing to accommodate it. Hence, a conflict of interest that might affect their objectivity will arise.

The above are some cases in which conflicts of interest might arise. There are other situations too and these are just few extracts. It is vital for a company’s success to identify and resolve these issues. Some strategies to adopt are as follows;

How To Resolve Conflict Of Interest?

Resolving this sensitive issue is subjective and many factors should be considered before implementing new policies and strategies. In addition, implementation is one thing, it also needs to be monitored closely to see if it’s working.

However, there are some strategies that are generally adopted to cope with conflict of interest. Some of them are as follows;

REMUNERATION LINKED TO PROFIT

Bonuses of directors and managers are linked to minimum profit levels and they will only be awarded bonuses when the target is achieved. This motivates them to take decisions that increase profitability. This, however, could lead to managers manipulating financial statements figures for their bonuses. And, managers taking decisions to increase short-term profits at the expense of long-term goals.

EXECUTIVE SHARE OPTION SCHEME

In the Executive share option scheme, managers are rewarded with shares in the company. They might be given the opportunity of buying shares of the company at a lower price in the future or instead of cash bonuses, they will be offered free shares. This eradicates conflict of interest in that the directors also become shareholders and their wealth will be maximized with an increase in Share price and/or dividends. Thus creating a goal-congruent workplace.

Conflict of interest is subjective and any policy established should reflect the following.

1- Define who the interested persons are.
2- Details of the underlying conflict of interest. ( its inception and causes )
3- How your organization values financial elements?
4- Assess the organization’s procedures for identifying and inspecting conflicts of interest.
5- Identify the people & committees responsible for handling conflicts of interest.
6- State clearly what happens in case of policy violations.

It is important to ponder over the above list as it gives an insight into setting up efficient policies and strategies.

Some of the real-life examples of conflict of interest in the corporate world are;

BLACKROCK
JP MORGAN