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Central Power and Light Company: A management ethics case
Pergamon
Journal of Accounting Education, Vol. 15, No. 3, pp. 411-423, 1997 © 1997 Elsevier Science Ltd. All rights reserved Printed in Great Britain 0748-5751/97 $17.00 + 0.00
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Case
C E N T R A L P O W E R A N D LIGHT C O M P A N Y : A M A N A G E M E N T ETHICS CASE 1 Eleanor G. Henry STATE UNIVERSITY
OF NEW YORK
AT OSWEGO
James P. Jennings SAINT LOUIS UNIVERSITY
Abstract: This case considers ethics and agency theory issues presented by an early extinguishment of debt. An electric utility company retired $50 million par of mortgage bonds employing a never-previously-exercised, unique, early retirement provision. This provision allowed the issuer to force early retirement of bonds selling at a premium at par value as opposed to the call price. The case presents the need for financial managers to consider nonfinancial factors in the process of making financial decisions. The case is based on actual class-action litigation brought by the bondholders. The case is directed to a master's level course, an executive development program, or an upper-division undergraduate course in m a n a g e m e n t accounting. © 1997 Elsevier Science Ltd
BACKGROUND Central Power and Light Company is an electrical utility company serving a major midwestern city and surrounding counties. The company's debt has long been rated Baa to Baaa by one of the major bond rating agencies. As is customary in the industry, the company has multiple mortgage bond issues outstanding. All of the bond issues are included under the Master Bond Indenture of 1935. A unique characteristic of utility bond financing is a 'maintenance' provision. The 'maintenance' provision was included in the 1935 master indenture to induce management to make current maintenance expenditures on the major capital assets. During the Great Depression era, bankruptcy and foreclosure were significant concerns. The economic value of collateralized assets presumably would be preserved if the assets were physically well-maintained. The maintenance provision constrains management's annual expenditures for upkeep on capital assets. This provision requires a utility company to spend a minimum percentage of annual revenue on IThis case is based on facts at issue in actual civil litigation. The business ethics issues and essential facts have been retained. All names, dates, and identifying details have been disguised. Thus, if any names used in this case are those of actual firms or individuals, it is purely coincidental. 411
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maintenance o f assets used as collateral for the mortgage bonds. If actual necessary maintenance expenditures are less than the bond indenture maintenance requirement, the indenture provides that the excess must be used to repurchase outstanding mortgage bonds. The indenture further provides that debt retired under the 'maintenance' provision shall be retired at par value. Thus, management is not contractually obligated to pay current market value or pay a call premium to retire debt. In early 1988, Central Power's management observed several developments related to physical plant maintenance expenditures. First, physical plant was at a very high level of maintenance. Future maintenance expenditure could reasonably be reduced with no reduction of the physical condition of plant assets. In fact, several maintenance projects had been recently initiated in response to the ready availability of maintenance funds. Second, no significant increases in peak megawatt output were forecast as a consequence of the low rate of population growth in the company's service area. In addition, various energy conservation programs had caused reduced per-capita electricity consumption. Third, a high level of physical maintenance could be sustained with a reduced level of expenditures as a percentage of annual revenue. Fourth, under the terms of the indenture the minimum required maintenance obligation must be met or debt had to be redeemed.
B O N D R E T I R E M E N T DECISION Cash flow projections prepared by the treasurer and the financial analysis group determined that Central Power had $50 million of excess cash resulting from the decreased need for maintenance expenditures. This cash could be used to retire existing mortgage bonds. Retirement of debt would satisfy the maintenance provision and also allow the corporation to reduce interest expense. The bonds could be retired at par under the 'maintenance' provision of the indenture. Due to differences in maturity dates and stated and current interest rates, several bond issues were selling at a price below par and several were selling above par. Management had the option to use available cash to either purchase bonds in the open market, exercise the call option on a series selling at a premium, or employ the maintenance provision which allowed the company to retire bonds at par. The treasurer further observed that the bond holdings were concentrated among institutional investors committed to holding the bonds to maturity. Consequently, the market for any given series was thin and it could have taken over one year to repurchase $50 million in the open market. The market for the relatively high coupon (stated) rate bonds currently selling at a discount price was especially thin given the bondholders' investment objective.
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After some discussion and review, management decided to retire $50 million par of the $75 million total par value of the Series K First Mortgage Bonds at par under the maintenance provision. The Series K Bonds were selling at 110% of par and had a call price of 103% of par. These bonds normally would be retired at the call price (1) if excess cash were available and (2) if actual maintenance expenditures were at least as large as the contractually-specified percentage of annual revenues. On June 1, 1988, management announced the early retirement of $50 million of the total Series K issue at par value under the terms of the previously never-before-used maintenance provision. The decision was effective on June 30. The market price of the bonds immediately declined from 110% to 100%. On June 2, 1988 Mr. Roger Nelson, an irate bondholder, filed an injunction through his attorney to prohibit Central Power from retiring the bonds at par. On June 10, the court granted an injunction prohibiting Central Power and Light Company from retiring the bonds until the court hearing set for July 20, 1988. RESCISSION On June 29, Central Power's management announced the rescission of the intended retirement of the Series K bonds. Following the June 10 court injunction, the market prices of the bonds moved slowly higher to 107% as of June 28. Following management's rescission of the announced early retirement, the price of the bonds returned to 110% of par. During this time period, less than $500,000 par value or 0.67% of the Series K bonds were traded. On September 12, 1988, Mr. Nelson's attorney filed a class-action lawsuit on behalf of all of the Series K bondholders against Central Power and Light Company. The pleadings set forth a loss of $7.5 million as result of the 'permanent sullying' of the bonds by management's 'demonstrated bad faith' attempt to retire bonds below fair market value through the 'subterfuge of an obscure and never-before-used' indenture provision. TRIAL TESTIMONY At the trial the plaintiff's main witness was Mr. McMullen, a bond portfolio manager for a large insurance company that was one of the plaintiffs in the class action. McMullen testified that he purchased $5 million of the Central Power Series K bonds at the time of issue. At that time he read only the first page of a sixty-page prospectus. He also relied on a report published by a major financial service. Mr. McMullen testified that he was aware of the notice, in large dark type on page one of the prospectus, referencing the maintenance provision. He further testified that he did not read the description of the maintenance provision on page 45 of
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the prospectus. In his opinion, the bondholders lost $7.5 million as result of the announcement. The loss was the par value of the total issue multiplied by the price decline ($75 million×10%). Central Power held that the buyers were, in fact, primarily financial institutions that did have access to the offering prospectus. Exercise of the maintenance provision was well within their contractual rights. Central Power's management admitted this was the first time the provision had been exercised. Further, in their opinion, no loss was incurred because the announced redemption was rescinded. The maximum possible loss was the loss incurred by investors who sold during the one-month period between the announced redemption and the announced rescission. This amount was less than $50,000 ($500,000 tradedx 10%). In fact from the time of the rescission announcement, the bonds yielded the normal yield and price for Baa Utility Bonds. This remained true until the time of the trial in March, 1992.
DISCUSSION QUESTIONS I. From an agency theory perspective, consider management's responsibility to its shareholders and bondholders. 2. Discuss the ethical conduct of management with regard to the maintenance provision. 3. (Optional) From an agency theory perspective, discuss the ethical behavior of the bondholders represented by Mr. Nelson's actions. 4. (Optional) Discuss the attorney's ethical behavior in filing the classaction suit. 5. (Optional) A moral hazard exists to the extent that parties to a contract may take unfair advantage one another. How does the concept of moral hazard apply to this case?
TEACHING NOTE Introduction
Management accounting courses intend to prepare managers for the decisions they must make. Capital budgeting decisions typically include the allocation of corporate resources not only to new capital projects, but also to the maintenance of existing ones. Although capital budgeting and capital financing are usually treated as distinct and separate issues, in some cases an allocation-of-resources decision implies a change in capital structure. For example, a firm may require additional debt or equity capital to finance a new project. On the other hand, a firm may wish to use surplus funds to repurchase stock or redeem debt.
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In corporations with capital structures containing both debt and equity, management has obligations to both shareholders and debtholders. Stockholders anticipate the rewards of dividends and appreciated stock prices. Bondholders expect timely payments of interest and the eventual return of principal at the end of the contract period, subject to any call provisions. Bond covenants are designed to protect bondholders against the potential management decisions that might jeopardize their invested capital (Jensen & Meckling, 1976; Barnea et al., 1985, 8 6 9 3 ) . Call provisions often establish premiums as protection against early retirement. Maintenance provisions, such as those found in utility bond indentures, provide assurance that the assets used as collateral will not be impaired through neglect or misuse. Bond covenants are contractual agreements accepted by bondholders from management and the shareholders of a company. Bond covenants also may benefit shareholders (Barnea et al., 1985, 86). Call provisions provide for early retirement of debt and reduction of interest expense. Covenants, in general, serve as disclosures of management's options and intentions in the firm's formal policy toward bondholders (Barnea et al., 1985, 140-141). Disclosures of this nature contribute to resolving any conflict of interest between shareholders and bondholders. The Central Light and Power Company case presents an ethical dilemma for management in deciding whether to retire the Series K bonds in accordance with the contract provisions for retirement at par value. Early retirement of debt prevents allocation of corporate resources to unnecessary maintenance. Thus, resources could be allocated to other projects to satisfy the stockholders' expectations. On the other hand, early retirement at par value was not consistent with the bondholders' expectations. The Series K bond covenant specified a call premium of 103 percent. The primary ethical issue at Central Power and Light centers on management and the conflicting provisions for retirement of debt under the master bond indenture and the Series K covenant. A second ethical issue involves the bondholders regarding impairment of their investment and any damages they may have suffered. We define ethics as standards of behavior. An agency theory framework is especially useful in examining ethical issues because it prescribes a degree of ethical conduct and specifies to whom an agent owes these duties. To examine the ethical questions, this case uses an agency theory framework in the Jensen and Meckling tradition integrated with common law agency concepts. Common law prescribes rights and duties for both parties in a contractual relationship. The party who procures the services of another (the principal) is expected to perform the contract and provide
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fair compensation. The party engaged under the contract (the agent) has obligations of loyalty, obedience, and information in acting on the behalf of the principal. All parties to a contract are expected to act in good faith and deal fairly. This teaching note first explains the relationship of agency theory commonly used in the economics, finance, and accounting literature to the legal theory of agency. Second, it discusses each of the case questions in terms of the agency standard of behavior. Third, it outlines suggested readings and source material necessary to prepare students for a discussion of the ethical issues relevant to this case.
Agency Theory and the Law of Agency The law of agency has its roots in the legal system and body of common law that evolved in England following the Norman Conquest of 1066. The law originally applied to the master-servant relationships of the land barons and tenants of the late Middle Ages. Over the next several centuries, modern corporations replaced feudal estates. Stockholders and creditors assumed the role held by masters as owners of the capital inputs. Professional agents evolved from servants as parties through whom multiple owners might conduct the affairs of an enterprise. In either agency theory or law of agency, the unit of analysis is the agreement that is made between contracting parties. The economics, finance, and accounting literature emphasizes the self-interested nature of the agent and principal. The law of agency also recognizes self-interest as the primary motivation in human behavior. Justice Holmes (1841-1935) was one of the first to extract the philosophical principles and concepts underlying the body of common law. The Common Law (Holmes, 1881) was a comprehensive attempt to uncover the reasons that explained and justified a rule of law. Under the influence of contemporary theorists, including Charles Darwin (Howe, 1963, xxi-xxvii), Holmes accepted the notion that man was motivated by the instinct for survival. Self-preference or self-interest is a necessary element for survival. Thus, Holmes argued that any moral code or philosophy of law must be consistent with an assumption of selfinterest. The purpose of the law is prevention of specific acts to increase the general welfare of all people (Holmes, 1881, 40). Laws not only make certain actions illegal, but also specify sanctions for infractions. By imposing penalties, the law economizes on self-interest. Acting in selfinterest requires one to obey the law to avoid penalties. Obeying the law increases the general social welfare. The economics, finance, and accounting literature depart from the law of agency on the issue of fiduciary duties of an agent. This body of
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literature generally focuses on explaining existing contracts or on formulating contracts, monitoring activities, or incentive systems to obtain maximum efficiency. Jensen & Meckling (1976, 308) define an agency relationship as one in which the agent is expected to act on behalf of the principal. With that exception, few references are made to the specific standards of behavior for agents contained in the law of agency. In his observations regarding self-interest, Holmes attempted to describe an element of realism present in the body of law. However, common law and the law of agency have idealistic objectives also. A legal agency relationship is characterized by its fiduciary responsibilities. Fiduciary duties are imposed to protect the principal's property and interests. A contemporary interpretation is summarized in Justice Cardoza's statement of 1926 (Dunfee et al., 1984, 631): " M a n y forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the marketplace. N o t honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of the courts of equity when petitioned to undermine the rule of undivided loyalty by the 'disintegrating erosion' of particular exceptions ... Only thus has the level of conduct for fiduciaries been kept at a higher level than that trodden by the crowd" (FN M e & h a r d v. Salman, 164 N.E. 545, 546 [N.Y. 1926]). An agent is expected to act for the benefit of its principal in all matters regarding the agency relationship (Dunfee et al., 1984, 631). Other duties include those of loyalty to the principal, obedience to the principal's instructions, and the exercise of reasonable care and skill in performance of the task. The duties of information and accounting require the agent to inform the principal of all facts and events related to the agency and to provide an accounting of all money and property entrusted by the principal. These duties provide a standard of behavior and form a basis of expectations in one's dealings with an agent. Many writers take the position that ethics cannot be enforced. For example, Noreen (1988) argues that unethical behavior is often not observable and cannot be enforced by external sanctions. Thus, internal sanctions are necessary to enforce a code of ethics. In contrast to Noreen, we find that external sanctions for unethical behavior exist as demonstrated in the law of agency. Penalties under the law for violation of the fiduciary standards range from surrender of compensation or property to criminal penalties of fines and imprisonment. Under common law, violation terminates the agency relationship and forfeits the agent's compensation. Sanctions also may be imposed on agents if principals suffer damages and initiate a civil suit.
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Agents may face more severe penalties if a fiduciary duty has been incorporated in legal statutes. Two examples are the Securities Acts of 1933 and 1934 and the Foreign Corrupt Practices Act of 1977. The Securities Acts prescribe reporting and disclosure standards. The Foreign Corrupt Practices Act requires a system of internal controls and reporting standards such that the information system of a firm will detect payments of bribes or other irregularities. Underlying these Acts is the duty of management (the agent) to provide information and accounting to the owners and potential investors (the principals). To the extent that ethics is defined as standards of behavior, the fiduciary duties o f an agent provide a basis for discussion of ethical versus unethical behavior in the contractual agency framework. We do not invoke personal value systems, try to apply the golden rule, or derive a universal ethical code. Although our framework may be consistent with some of these, this teaching note draws no parallels and does not make comparisons.
Case Discussion Questions
Management's responsibility." obligations of agents to principals. An agency relationship is typically defined as a contract in which the agent is delegated authority to act on behalf of the principal (Jensen & Meckling, 1976). At Central Power and Light, management has been engaged to act on behalf of the corporation's stockholders. In this agency relationship, management is the agent and the stockholders are principals. The firm also has entered into a contract with bondholders who have entrusted debt capital to the firm. Thus, management is also an agent of the bondholders in a second contractual relationship. Financial agency theory recognizes a potential conflict of interests for management. Acting on behalf of stockholders implies that management will conduct profitable operations to maximize the wealth of its stockholders. Consequently, management is expected to control discretionary costs, such as maintenance and interest expense. Covenants in bond indentures help ensure that management does not make decisions that increase stockholder wealth at the expense of bondholders (Jensen & Meckling, 1976; Barnea et al., 1985, 141). An example at Central Power and Light is the bond covenant to maintain the company assets that serve as collateral for the bonds. Management may not neglect maintenance to benefit shareholders through improved earnings and dividends. In the case of a bond default, the value of the bondholders' assets would be protected. There is a presumption that the maintenance provision is reasonable. If the provision amount exceeds actual maintenance, management is induced to reduce debt at par and avoid overspending on maintenance.
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The terms of the bond indenture give management several discretionary alternatives that allow it to control interest expense. Bonds can be purchased on the open market, although a thin market makes this difficult. The bonds are also callable. Series K bondholders are subject to the provision that establishes a call price of 103% of par. Thus, if contract rates of interest exceed market rates, management may use excess cash to retire the bonds. These bonds would normally be retired at the call price if excess cash were available and the required maintenance expenditures were high enough not to trigger the maintenance provision. However, the necessary maintenance expenditures were less than the contractually-specified percentage of revenues. Accordingly, the bond indenture provided for retirement at par under the maintenance provision. Thus, management could not exercise the call provision and act in the full interest of the shareholders. Stockholders would always prefer to retire the bonds at the least cost. Consequently, management acted in the interests of its principals (shareholders) in deciding to retire Series K bonds selling at a premium. To the extent that management acted within the contractual constraints of the bond agreement, it did not violate its obligations to the bondholders.
Ethical conduct of management. At Central Power, management is an agent in the contract with the bondholders who are principals with respect to this relationship. At the heart of any contract or agency relationship is the obligation to act in good faith and deal fairly. An agent has a duty of loyalty to the principal he represents (Anderson et al., 1992, 769-771). He also has a duty to inform the principal of facts related to the agency. Because the agent is engaged to obtain his expertise, the agent is expected to have superior information about the task. Information asymmetry results when the agent does not fully disclose his private information to the principal. Principals and agents are each assumed to act in self-interest. Principals maximize the utility of wealth. Agents are assumed generally to maximize the utility of wealth, leisure, and perquisites. The assumption of economic self-interest suggests that an agent may not always act in the fullest interests of its principal and may shirk his duties. This may occur in spite of the duties of loyalty and information. The problem of shirking is referred to as the moral hazard in an agency relationship. If an agent acts in self-interest at the expense of the principal, he acts opportunistically. Moreover, he violates his fiduciary duty to act for the benefit of the principal. Although it must be fair to both parties, Central Power management represents the shareholders in its dealings with the bondholders. Thus selfinterest is interpreted in a broader context and includes the self-interest of the shareholders. Management attempted to maximize shareholder wealth
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at the expense of the bondholders. Because the maintenance provision had never been used in the 50-year period since its inception, the bondholders apparently did not believe it had any legal substance. Thus, they had inappropriate information with respect to management's options and intentions. With several options available with regard to the maintenance provision, management selected the alternative that produced the greatest savings in interest. Thus, wealth would have been transferred from bondholders to shareholders if a court injunction had not been obtained. Whether or not management acted unethically regarding the bondholders is debatable. The answer depends on whether or not the prospectus provided full disclosure of information to the bondholders regarding management's options and intentions. A second consideration involves the expected degree of comprehension on the part of the reader, how much can be expected of a sophisticated investor, and whether these bondholders should be classified as sophisticated.
Ethical behavior of the bondholders (optional question). Because the provision for retirement was stated in the master bond indenture, and more importantly in the offering statement, investors should have known of this possibility. In an efficient financial market, this information should be reflected in a lower bond purchase price. Moreover, institutional investors who held the bulk of Central Power's bonds are recognized as sophisticated investors. The 1933 Securities Act exempts limited offerings to accredited investors from the lengthy registration process (Afterman, 1995, 26). These individuals are expected to understand the implications of bond covenants. However, before the announced retirement, the Series K bonds were selling at prices well in excess of the call price. From this one might infer that the bondholders did not anticipate a possible call much less a maintenance clause bond redemption. The injunction initiated by Nelson and the class-action suit might be justified on the basis of inadequate information. However, because less than 1% of the bonds traded prior to the class-action suit, it is difficult to argue that Series K bondholders sustained losses in trading impaired bonds. Because the bond rating did not decline and the bond price returned to its previous premium amount, it is difficult to argue that the bonds were impaired. Without actual losses or impairment of assets, a class-action suit has little apparent legal or ethical basis. Nelson probably faced financial losses. If he believed that management did not perform its fiduciary duties in the prospectus for the Series K bonds, Nelson did not act unethically in filing for an injunction. However, pursuing the issue with a class-action lawsuit may indicate unethical behavior on the part of the bondholders. Moral hazard also may apply to principals (Dees, 1992, 35-36) who may be untruthful or exploit an agent.
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The bondholders are principals with respect to Central Power. If they suffered no losses or impairment of assets, they acted unethically in bringing suit.
Ethical behavior of the attorney (optional question). The first duty of an attorney is to his client. An attorney is an agent and must act in the interests of his client. Although there were few losses, management may have acted in bad faith which has implications for future dealings with bondholders. Their interests may have been protected by a lawsuit. If the lawsuit was initiated because there was a 'deep pocket' (the financial resources of Central Light and Power), the attorney acted unethically. Moral hazard (optional question). Principals and agents are each assumed to act in self-interest. Principals maximize the utility of wealth. Agents are generally assumed to maximize the utility of wealth, leisure, and perquisites. The assumption of economic self-interest suggests that an agent may not always act in the fullest interests of its principal and may shirk his duties. This may occur in spite of the duties of loyalty and information owed to the principal. The problem of shirking is referred to as the moral hazard in an agency relationship. In this case, management is an agent both of the stockholders and of bondholders of Central Light and Power. Management has acted in the interests of its stockholders. Bond covenants are designed to protect bondholders from exploitation by management and the stockholders. It has been shown that no covenants were violated and bondholders suffered few if any losses. Accordingly, bondholders do not appear to be victims of the moral hazard. On the contrary, the bondholders appear to have taken advantage of their theoretically weaker position in the agency relationship by bringing suit against management and the stockholders. To this extent, they may not have acted in good faith. Dees (1992, 35-36) points out that principals also can exploit agents to extract more profit. In a society in which attorneys' fees are some percentage of the damages awarded, plaintiffs (bondholders) have nothing to lose by bringing suits to court. Implementation of the Case in the Classroom This case is intended for a management accounting course at the M.B.A. level, for an executive development course, or for an upper-division undergraduate course. However, it also may be appropriate for a secondsemester Business Law or Financial Management course. Students may have been exposed to agency theory (Jensen & Meckling, 1976) in an upper-division microeconomics course in an M.B.A. or graduate program. However, many management accounting and financial management textbooks describe the basic principles. Whether or not students have had prior exposure to agency theory in accounting, finance,
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or economics, a basic Business Law text will provide a presentation of agency theory as covered by the law. Each of nearly one dozen Business Law texts that we examined contained at least two chapters on Agency. The annotated bibliography provided here may be used as a resource for either students or instructors. Some of these materials could be put on reserve in the library for common student use. Most upper-division undergraduate business students will have a background in finance and accounting. Accounting majors will have completed Intermediate Accounting. Accordingly, the assumption that they will have a basic understanding of bonds, bond covenants, and redemption of debt seems reasonable. With respect to the discussion questions, we emphasize the importance of Questions 1 and 2. The additional questions are provided to increase the flexibility and degree of challenge. To provide students with sufficient time to digest the case facts, consult additional sources or references, and prepare an analysis, we suggest using this as an outside project. Acknowledgement--We would like to thank five anonymous reviewers and the participants at the 1996 AAA Management Accounting Conference for their helpful comments and suggestions. We are grateful also to the Emerson Electric Center for Business Ethics at Saint Louis University for its support and encouragement.
REFERENCES Afterman, A. (1995). SEC Regulation of Public Companies. Englewood Cliffs, NJ: PrenticeHall. This volume provides a comprehensive overview of the SEC and the federal regulations that it administers. It describes the procedures necessary for a public offering, registration, and reporting and the accountant's role. Coverage also includes the regulation of corporate insiders, proxy rules and takeover regulation, SEC small business initiatives, and foreign issuers and international offerings. Anderson, R., Fox, I., & Twomey, D. (1992). Business Law. Cincinnati, Ohio: South-Western Publishing Co. Four chapters of this text are devoted to defining agency relationships, creation and termination of agency, duties and rights of principals and agents, and employment as agency. Barnea, A., Haugen, R., & Senbet, L. (1985). Agency Problems and Financial Contracting. Englewood Cliffs, NJ: Prentice-Hall. In addition to defining problems and costs in agency relationships, this study examines complex financial contracts as solutions. Attention is directed to callable debt and the value of accounting information in constructing enforceable contracts. This publication is an independent study in the Foundations of Finance Series. Dees, J. (1992). Principals, agents, and ethics. In N. Bowie and R. Freeman (Eds.) Ethics and Agency Theory (pp. 25-72). New York: Oxford University Press, Inc. The background for principal-agent analysis is presented along with a discussion of the concepts and assumptions. Ethical dimensions are specifically addressed. Dunfee, T., Gibson, F., Blackburn, J., Whitman, D., McCarty, F., & Brennan, B. (1984). Modern Business Law. New York: Random House, Inc. Chapter 25 (pp. 613-643) of this text presents the fundamental principles of agency relationships and the fiduciary duties of agents.
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Holmes, O.W., Jr. (1881). The Common Law, ed. Mark DeWolfe Howe. (1963). Cambridge, MA: The Belknap Press of Harvard University Press. This book contains the eleven lectures that Holmes prepared on the significance of the common law as a model for contemporary law. The editor's introduction is very helpful in identifying common themes that were developed in Holmes' later works. Howe, M. (1963). Introduction. In The Common Law, O.W. Holmes, Jr., ed. M. Howe. Cambridge, MA: The Belknap Press of Harvard University Press. Jensen, M., & Meckling. W. (1976). Theory of the firm: managerial behavior, agency costs, and ownership structure. J. Financial Economics, 3, 305-360. This landmark article was one of the first to use the common law concepts of agency to analyze the modern corporation and the relationship between holders of debt and equity. Ethics are not addressed per se, but the authors acknowledge the importance of a legal framework to define and support contractual relationships. Noreen, E. (1988). The economics of ethics: a new perspective on agency theory. Accounting, Organizations and Society, •3(4): 359-369. This article explores the usefulness of various mechanisms in enforcing ethical behavior including religion, genetics, conscience, and behavioral norms.
Journal of Accounting Education, Vol. 15, No. 3, pp. 411-423, 1997 © 1997 Elsevier Science Ltd. All rights reserved Printed in Great Britain 0748-5751/97 $17.00 + 0.00
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Case
C E N T R A L P O W E R A N D LIGHT C O M P A N Y : A M A N A G E M E N T ETHICS CASE 1 Eleanor G. Henry STATE UNIVERSITY
OF NEW YORK
AT OSWEGO
James P. Jennings SAINT LOUIS UNIVERSITY
Abstract: This case considers ethics and agency theory issues presented by an early extinguishment of debt. An electric utility company retired $50 million par of mortgage bonds employing a never-previously-exercised, unique, early retirement provision. This provision allowed the issuer to force early retirement of bonds selling at a premium at par value as opposed to the call price. The case presents the need for financial managers to consider nonfinancial factors in the process of making financial decisions. The case is based on actual class-action litigation brought by the bondholders. The case is directed to a master's level course, an executive development program, or an upper-division undergraduate course in m a n a g e m e n t accounting. © 1997 Elsevier Science Ltd
BACKGROUND Central Power and Light Company is an electrical utility company serving a major midwestern city and surrounding counties. The company's debt has long been rated Baa to Baaa by one of the major bond rating agencies. As is customary in the industry, the company has multiple mortgage bond issues outstanding. All of the bond issues are included under the Master Bond Indenture of 1935. A unique characteristic of utility bond financing is a 'maintenance' provision. The 'maintenance' provision was included in the 1935 master indenture to induce management to make current maintenance expenditures on the major capital assets. During the Great Depression era, bankruptcy and foreclosure were significant concerns. The economic value of collateralized assets presumably would be preserved if the assets were physically well-maintained. The maintenance provision constrains management's annual expenditures for upkeep on capital assets. This provision requires a utility company to spend a minimum percentage of annual revenue on IThis case is based on facts at issue in actual civil litigation. The business ethics issues and essential facts have been retained. All names, dates, and identifying details have been disguised. Thus, if any names used in this case are those of actual firms or individuals, it is purely coincidental. 411
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maintenance o f assets used as collateral for the mortgage bonds. If actual necessary maintenance expenditures are less than the bond indenture maintenance requirement, the indenture provides that the excess must be used to repurchase outstanding mortgage bonds. The indenture further provides that debt retired under the 'maintenance' provision shall be retired at par value. Thus, management is not contractually obligated to pay current market value or pay a call premium to retire debt. In early 1988, Central Power's management observed several developments related to physical plant maintenance expenditures. First, physical plant was at a very high level of maintenance. Future maintenance expenditure could reasonably be reduced with no reduction of the physical condition of plant assets. In fact, several maintenance projects had been recently initiated in response to the ready availability of maintenance funds. Second, no significant increases in peak megawatt output were forecast as a consequence of the low rate of population growth in the company's service area. In addition, various energy conservation programs had caused reduced per-capita electricity consumption. Third, a high level of physical maintenance could be sustained with a reduced level of expenditures as a percentage of annual revenue. Fourth, under the terms of the indenture the minimum required maintenance obligation must be met or debt had to be redeemed.
B O N D R E T I R E M E N T DECISION Cash flow projections prepared by the treasurer and the financial analysis group determined that Central Power had $50 million of excess cash resulting from the decreased need for maintenance expenditures. This cash could be used to retire existing mortgage bonds. Retirement of debt would satisfy the maintenance provision and also allow the corporation to reduce interest expense. The bonds could be retired at par under the 'maintenance' provision of the indenture. Due to differences in maturity dates and stated and current interest rates, several bond issues were selling at a price below par and several were selling above par. Management had the option to use available cash to either purchase bonds in the open market, exercise the call option on a series selling at a premium, or employ the maintenance provision which allowed the company to retire bonds at par. The treasurer further observed that the bond holdings were concentrated among institutional investors committed to holding the bonds to maturity. Consequently, the market for any given series was thin and it could have taken over one year to repurchase $50 million in the open market. The market for the relatively high coupon (stated) rate bonds currently selling at a discount price was especially thin given the bondholders' investment objective.
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After some discussion and review, management decided to retire $50 million par of the $75 million total par value of the Series K First Mortgage Bonds at par under the maintenance provision. The Series K Bonds were selling at 110% of par and had a call price of 103% of par. These bonds normally would be retired at the call price (1) if excess cash were available and (2) if actual maintenance expenditures were at least as large as the contractually-specified percentage of annual revenues. On June 1, 1988, management announced the early retirement of $50 million of the total Series K issue at par value under the terms of the previously never-before-used maintenance provision. The decision was effective on June 30. The market price of the bonds immediately declined from 110% to 100%. On June 2, 1988 Mr. Roger Nelson, an irate bondholder, filed an injunction through his attorney to prohibit Central Power from retiring the bonds at par. On June 10, the court granted an injunction prohibiting Central Power and Light Company from retiring the bonds until the court hearing set for July 20, 1988. RESCISSION On June 29, Central Power's management announced the rescission of the intended retirement of the Series K bonds. Following the June 10 court injunction, the market prices of the bonds moved slowly higher to 107% as of June 28. Following management's rescission of the announced early retirement, the price of the bonds returned to 110% of par. During this time period, less than $500,000 par value or 0.67% of the Series K bonds were traded. On September 12, 1988, Mr. Nelson's attorney filed a class-action lawsuit on behalf of all of the Series K bondholders against Central Power and Light Company. The pleadings set forth a loss of $7.5 million as result of the 'permanent sullying' of the bonds by management's 'demonstrated bad faith' attempt to retire bonds below fair market value through the 'subterfuge of an obscure and never-before-used' indenture provision. TRIAL TESTIMONY At the trial the plaintiff's main witness was Mr. McMullen, a bond portfolio manager for a large insurance company that was one of the plaintiffs in the class action. McMullen testified that he purchased $5 million of the Central Power Series K bonds at the time of issue. At that time he read only the first page of a sixty-page prospectus. He also relied on a report published by a major financial service. Mr. McMullen testified that he was aware of the notice, in large dark type on page one of the prospectus, referencing the maintenance provision. He further testified that he did not read the description of the maintenance provision on page 45 of
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the prospectus. In his opinion, the bondholders lost $7.5 million as result of the announcement. The loss was the par value of the total issue multiplied by the price decline ($75 million×10%). Central Power held that the buyers were, in fact, primarily financial institutions that did have access to the offering prospectus. Exercise of the maintenance provision was well within their contractual rights. Central Power's management admitted this was the first time the provision had been exercised. Further, in their opinion, no loss was incurred because the announced redemption was rescinded. The maximum possible loss was the loss incurred by investors who sold during the one-month period between the announced redemption and the announced rescission. This amount was less than $50,000 ($500,000 tradedx 10%). In fact from the time of the rescission announcement, the bonds yielded the normal yield and price for Baa Utility Bonds. This remained true until the time of the trial in March, 1992.
DISCUSSION QUESTIONS I. From an agency theory perspective, consider management's responsibility to its shareholders and bondholders. 2. Discuss the ethical conduct of management with regard to the maintenance provision. 3. (Optional) From an agency theory perspective, discuss the ethical behavior of the bondholders represented by Mr. Nelson's actions. 4. (Optional) Discuss the attorney's ethical behavior in filing the classaction suit. 5. (Optional) A moral hazard exists to the extent that parties to a contract may take unfair advantage one another. How does the concept of moral hazard apply to this case?
TEACHING NOTE Introduction
Management accounting courses intend to prepare managers for the decisions they must make. Capital budgeting decisions typically include the allocation of corporate resources not only to new capital projects, but also to the maintenance of existing ones. Although capital budgeting and capital financing are usually treated as distinct and separate issues, in some cases an allocation-of-resources decision implies a change in capital structure. For example, a firm may require additional debt or equity capital to finance a new project. On the other hand, a firm may wish to use surplus funds to repurchase stock or redeem debt.
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In corporations with capital structures containing both debt and equity, management has obligations to both shareholders and debtholders. Stockholders anticipate the rewards of dividends and appreciated stock prices. Bondholders expect timely payments of interest and the eventual return of principal at the end of the contract period, subject to any call provisions. Bond covenants are designed to protect bondholders against the potential management decisions that might jeopardize their invested capital (Jensen & Meckling, 1976; Barnea et al., 1985, 8 6 9 3 ) . Call provisions often establish premiums as protection against early retirement. Maintenance provisions, such as those found in utility bond indentures, provide assurance that the assets used as collateral will not be impaired through neglect or misuse. Bond covenants are contractual agreements accepted by bondholders from management and the shareholders of a company. Bond covenants also may benefit shareholders (Barnea et al., 1985, 86). Call provisions provide for early retirement of debt and reduction of interest expense. Covenants, in general, serve as disclosures of management's options and intentions in the firm's formal policy toward bondholders (Barnea et al., 1985, 140-141). Disclosures of this nature contribute to resolving any conflict of interest between shareholders and bondholders. The Central Light and Power Company case presents an ethical dilemma for management in deciding whether to retire the Series K bonds in accordance with the contract provisions for retirement at par value. Early retirement of debt prevents allocation of corporate resources to unnecessary maintenance. Thus, resources could be allocated to other projects to satisfy the stockholders' expectations. On the other hand, early retirement at par value was not consistent with the bondholders' expectations. The Series K bond covenant specified a call premium of 103 percent. The primary ethical issue at Central Power and Light centers on management and the conflicting provisions for retirement of debt under the master bond indenture and the Series K covenant. A second ethical issue involves the bondholders regarding impairment of their investment and any damages they may have suffered. We define ethics as standards of behavior. An agency theory framework is especially useful in examining ethical issues because it prescribes a degree of ethical conduct and specifies to whom an agent owes these duties. To examine the ethical questions, this case uses an agency theory framework in the Jensen and Meckling tradition integrated with common law agency concepts. Common law prescribes rights and duties for both parties in a contractual relationship. The party who procures the services of another (the principal) is expected to perform the contract and provide
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fair compensation. The party engaged under the contract (the agent) has obligations of loyalty, obedience, and information in acting on the behalf of the principal. All parties to a contract are expected to act in good faith and deal fairly. This teaching note first explains the relationship of agency theory commonly used in the economics, finance, and accounting literature to the legal theory of agency. Second, it discusses each of the case questions in terms of the agency standard of behavior. Third, it outlines suggested readings and source material necessary to prepare students for a discussion of the ethical issues relevant to this case.
Agency Theory and the Law of Agency The law of agency has its roots in the legal system and body of common law that evolved in England following the Norman Conquest of 1066. The law originally applied to the master-servant relationships of the land barons and tenants of the late Middle Ages. Over the next several centuries, modern corporations replaced feudal estates. Stockholders and creditors assumed the role held by masters as owners of the capital inputs. Professional agents evolved from servants as parties through whom multiple owners might conduct the affairs of an enterprise. In either agency theory or law of agency, the unit of analysis is the agreement that is made between contracting parties. The economics, finance, and accounting literature emphasizes the self-interested nature of the agent and principal. The law of agency also recognizes self-interest as the primary motivation in human behavior. Justice Holmes (1841-1935) was one of the first to extract the philosophical principles and concepts underlying the body of common law. The Common Law (Holmes, 1881) was a comprehensive attempt to uncover the reasons that explained and justified a rule of law. Under the influence of contemporary theorists, including Charles Darwin (Howe, 1963, xxi-xxvii), Holmes accepted the notion that man was motivated by the instinct for survival. Self-preference or self-interest is a necessary element for survival. Thus, Holmes argued that any moral code or philosophy of law must be consistent with an assumption of selfinterest. The purpose of the law is prevention of specific acts to increase the general welfare of all people (Holmes, 1881, 40). Laws not only make certain actions illegal, but also specify sanctions for infractions. By imposing penalties, the law economizes on self-interest. Acting in selfinterest requires one to obey the law to avoid penalties. Obeying the law increases the general social welfare. The economics, finance, and accounting literature depart from the law of agency on the issue of fiduciary duties of an agent. This body of
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literature generally focuses on explaining existing contracts or on formulating contracts, monitoring activities, or incentive systems to obtain maximum efficiency. Jensen & Meckling (1976, 308) define an agency relationship as one in which the agent is expected to act on behalf of the principal. With that exception, few references are made to the specific standards of behavior for agents contained in the law of agency. In his observations regarding self-interest, Holmes attempted to describe an element of realism present in the body of law. However, common law and the law of agency have idealistic objectives also. A legal agency relationship is characterized by its fiduciary responsibilities. Fiduciary duties are imposed to protect the principal's property and interests. A contemporary interpretation is summarized in Justice Cardoza's statement of 1926 (Dunfee et al., 1984, 631): " M a n y forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the marketplace. N o t honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of the courts of equity when petitioned to undermine the rule of undivided loyalty by the 'disintegrating erosion' of particular exceptions ... Only thus has the level of conduct for fiduciaries been kept at a higher level than that trodden by the crowd" (FN M e & h a r d v. Salman, 164 N.E. 545, 546 [N.Y. 1926]). An agent is expected to act for the benefit of its principal in all matters regarding the agency relationship (Dunfee et al., 1984, 631). Other duties include those of loyalty to the principal, obedience to the principal's instructions, and the exercise of reasonable care and skill in performance of the task. The duties of information and accounting require the agent to inform the principal of all facts and events related to the agency and to provide an accounting of all money and property entrusted by the principal. These duties provide a standard of behavior and form a basis of expectations in one's dealings with an agent. Many writers take the position that ethics cannot be enforced. For example, Noreen (1988) argues that unethical behavior is often not observable and cannot be enforced by external sanctions. Thus, internal sanctions are necessary to enforce a code of ethics. In contrast to Noreen, we find that external sanctions for unethical behavior exist as demonstrated in the law of agency. Penalties under the law for violation of the fiduciary standards range from surrender of compensation or property to criminal penalties of fines and imprisonment. Under common law, violation terminates the agency relationship and forfeits the agent's compensation. Sanctions also may be imposed on agents if principals suffer damages and initiate a civil suit.
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Agents may face more severe penalties if a fiduciary duty has been incorporated in legal statutes. Two examples are the Securities Acts of 1933 and 1934 and the Foreign Corrupt Practices Act of 1977. The Securities Acts prescribe reporting and disclosure standards. The Foreign Corrupt Practices Act requires a system of internal controls and reporting standards such that the information system of a firm will detect payments of bribes or other irregularities. Underlying these Acts is the duty of management (the agent) to provide information and accounting to the owners and potential investors (the principals). To the extent that ethics is defined as standards of behavior, the fiduciary duties o f an agent provide a basis for discussion of ethical versus unethical behavior in the contractual agency framework. We do not invoke personal value systems, try to apply the golden rule, or derive a universal ethical code. Although our framework may be consistent with some of these, this teaching note draws no parallels and does not make comparisons.
Case Discussion Questions
Management's responsibility." obligations of agents to principals. An agency relationship is typically defined as a contract in which the agent is delegated authority to act on behalf of the principal (Jensen & Meckling, 1976). At Central Power and Light, management has been engaged to act on behalf of the corporation's stockholders. In this agency relationship, management is the agent and the stockholders are principals. The firm also has entered into a contract with bondholders who have entrusted debt capital to the firm. Thus, management is also an agent of the bondholders in a second contractual relationship. Financial agency theory recognizes a potential conflict of interests for management. Acting on behalf of stockholders implies that management will conduct profitable operations to maximize the wealth of its stockholders. Consequently, management is expected to control discretionary costs, such as maintenance and interest expense. Covenants in bond indentures help ensure that management does not make decisions that increase stockholder wealth at the expense of bondholders (Jensen & Meckling, 1976; Barnea et al., 1985, 141). An example at Central Power and Light is the bond covenant to maintain the company assets that serve as collateral for the bonds. Management may not neglect maintenance to benefit shareholders through improved earnings and dividends. In the case of a bond default, the value of the bondholders' assets would be protected. There is a presumption that the maintenance provision is reasonable. If the provision amount exceeds actual maintenance, management is induced to reduce debt at par and avoid overspending on maintenance.
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The terms of the bond indenture give management several discretionary alternatives that allow it to control interest expense. Bonds can be purchased on the open market, although a thin market makes this difficult. The bonds are also callable. Series K bondholders are subject to the provision that establishes a call price of 103% of par. Thus, if contract rates of interest exceed market rates, management may use excess cash to retire the bonds. These bonds would normally be retired at the call price if excess cash were available and the required maintenance expenditures were high enough not to trigger the maintenance provision. However, the necessary maintenance expenditures were less than the contractually-specified percentage of revenues. Accordingly, the bond indenture provided for retirement at par under the maintenance provision. Thus, management could not exercise the call provision and act in the full interest of the shareholders. Stockholders would always prefer to retire the bonds at the least cost. Consequently, management acted in the interests of its principals (shareholders) in deciding to retire Series K bonds selling at a premium. To the extent that management acted within the contractual constraints of the bond agreement, it did not violate its obligations to the bondholders.
Ethical conduct of management. At Central Power, management is an agent in the contract with the bondholders who are principals with respect to this relationship. At the heart of any contract or agency relationship is the obligation to act in good faith and deal fairly. An agent has a duty of loyalty to the principal he represents (Anderson et al., 1992, 769-771). He also has a duty to inform the principal of facts related to the agency. Because the agent is engaged to obtain his expertise, the agent is expected to have superior information about the task. Information asymmetry results when the agent does not fully disclose his private information to the principal. Principals and agents are each assumed to act in self-interest. Principals maximize the utility of wealth. Agents are assumed generally to maximize the utility of wealth, leisure, and perquisites. The assumption of economic self-interest suggests that an agent may not always act in the fullest interests of its principal and may shirk his duties. This may occur in spite of the duties of loyalty and information. The problem of shirking is referred to as the moral hazard in an agency relationship. If an agent acts in self-interest at the expense of the principal, he acts opportunistically. Moreover, he violates his fiduciary duty to act for the benefit of the principal. Although it must be fair to both parties, Central Power management represents the shareholders in its dealings with the bondholders. Thus selfinterest is interpreted in a broader context and includes the self-interest of the shareholders. Management attempted to maximize shareholder wealth
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at the expense of the bondholders. Because the maintenance provision had never been used in the 50-year period since its inception, the bondholders apparently did not believe it had any legal substance. Thus, they had inappropriate information with respect to management's options and intentions. With several options available with regard to the maintenance provision, management selected the alternative that produced the greatest savings in interest. Thus, wealth would have been transferred from bondholders to shareholders if a court injunction had not been obtained. Whether or not management acted unethically regarding the bondholders is debatable. The answer depends on whether or not the prospectus provided full disclosure of information to the bondholders regarding management's options and intentions. A second consideration involves the expected degree of comprehension on the part of the reader, how much can be expected of a sophisticated investor, and whether these bondholders should be classified as sophisticated.
Ethical behavior of the bondholders (optional question). Because the provision for retirement was stated in the master bond indenture, and more importantly in the offering statement, investors should have known of this possibility. In an efficient financial market, this information should be reflected in a lower bond purchase price. Moreover, institutional investors who held the bulk of Central Power's bonds are recognized as sophisticated investors. The 1933 Securities Act exempts limited offerings to accredited investors from the lengthy registration process (Afterman, 1995, 26). These individuals are expected to understand the implications of bond covenants. However, before the announced retirement, the Series K bonds were selling at prices well in excess of the call price. From this one might infer that the bondholders did not anticipate a possible call much less a maintenance clause bond redemption. The injunction initiated by Nelson and the class-action suit might be justified on the basis of inadequate information. However, because less than 1% of the bonds traded prior to the class-action suit, it is difficult to argue that Series K bondholders sustained losses in trading impaired bonds. Because the bond rating did not decline and the bond price returned to its previous premium amount, it is difficult to argue that the bonds were impaired. Without actual losses or impairment of assets, a class-action suit has little apparent legal or ethical basis. Nelson probably faced financial losses. If he believed that management did not perform its fiduciary duties in the prospectus for the Series K bonds, Nelson did not act unethically in filing for an injunction. However, pursuing the issue with a class-action lawsuit may indicate unethical behavior on the part of the bondholders. Moral hazard also may apply to principals (Dees, 1992, 35-36) who may be untruthful or exploit an agent.
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The bondholders are principals with respect to Central Power. If they suffered no losses or impairment of assets, they acted unethically in bringing suit.
Ethical behavior of the attorney (optional question). The first duty of an attorney is to his client. An attorney is an agent and must act in the interests of his client. Although there were few losses, management may have acted in bad faith which has implications for future dealings with bondholders. Their interests may have been protected by a lawsuit. If the lawsuit was initiated because there was a 'deep pocket' (the financial resources of Central Light and Power), the attorney acted unethically. Moral hazard (optional question). Principals and agents are each assumed to act in self-interest. Principals maximize the utility of wealth. Agents are generally assumed to maximize the utility of wealth, leisure, and perquisites. The assumption of economic self-interest suggests that an agent may not always act in the fullest interests of its principal and may shirk his duties. This may occur in spite of the duties of loyalty and information owed to the principal. The problem of shirking is referred to as the moral hazard in an agency relationship. In this case, management is an agent both of the stockholders and of bondholders of Central Light and Power. Management has acted in the interests of its stockholders. Bond covenants are designed to protect bondholders from exploitation by management and the stockholders. It has been shown that no covenants were violated and bondholders suffered few if any losses. Accordingly, bondholders do not appear to be victims of the moral hazard. On the contrary, the bondholders appear to have taken advantage of their theoretically weaker position in the agency relationship by bringing suit against management and the stockholders. To this extent, they may not have acted in good faith. Dees (1992, 35-36) points out that principals also can exploit agents to extract more profit. In a society in which attorneys' fees are some percentage of the damages awarded, plaintiffs (bondholders) have nothing to lose by bringing suits to court. Implementation of the Case in the Classroom This case is intended for a management accounting course at the M.B.A. level, for an executive development course, or for an upper-division undergraduate course. However, it also may be appropriate for a secondsemester Business Law or Financial Management course. Students may have been exposed to agency theory (Jensen & Meckling, 1976) in an upper-division microeconomics course in an M.B.A. or graduate program. However, many management accounting and financial management textbooks describe the basic principles. Whether or not students have had prior exposure to agency theory in accounting, finance,
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or economics, a basic Business Law text will provide a presentation of agency theory as covered by the law. Each of nearly one dozen Business Law texts that we examined contained at least two chapters on Agency. The annotated bibliography provided here may be used as a resource for either students or instructors. Some of these materials could be put on reserve in the library for common student use. Most upper-division undergraduate business students will have a background in finance and accounting. Accounting majors will have completed Intermediate Accounting. Accordingly, the assumption that they will have a basic understanding of bonds, bond covenants, and redemption of debt seems reasonable. With respect to the discussion questions, we emphasize the importance of Questions 1 and 2. The additional questions are provided to increase the flexibility and degree of challenge. To provide students with sufficient time to digest the case facts, consult additional sources or references, and prepare an analysis, we suggest using this as an outside project. Acknowledgement--We would like to thank five anonymous reviewers and the participants at the 1996 AAA Management Accounting Conference for their helpful comments and suggestions. We are grateful also to the Emerson Electric Center for Business Ethics at Saint Louis University for its support and encouragement.
REFERENCES Afterman, A. (1995). SEC Regulation of Public Companies. Englewood Cliffs, NJ: PrenticeHall. This volume provides a comprehensive overview of the SEC and the federal regulations that it administers. It describes the procedures necessary for a public offering, registration, and reporting and the accountant's role. Coverage also includes the regulation of corporate insiders, proxy rules and takeover regulation, SEC small business initiatives, and foreign issuers and international offerings. Anderson, R., Fox, I., & Twomey, D. (1992). Business Law. Cincinnati, Ohio: South-Western Publishing Co. Four chapters of this text are devoted to defining agency relationships, creation and termination of agency, duties and rights of principals and agents, and employment as agency. Barnea, A., Haugen, R., & Senbet, L. (1985). Agency Problems and Financial Contracting. Englewood Cliffs, NJ: Prentice-Hall. In addition to defining problems and costs in agency relationships, this study examines complex financial contracts as solutions. Attention is directed to callable debt and the value of accounting information in constructing enforceable contracts. This publication is an independent study in the Foundations of Finance Series. Dees, J. (1992). Principals, agents, and ethics. In N. Bowie and R. Freeman (Eds.) Ethics and Agency Theory (pp. 25-72). New York: Oxford University Press, Inc. The background for principal-agent analysis is presented along with a discussion of the concepts and assumptions. Ethical dimensions are specifically addressed. Dunfee, T., Gibson, F., Blackburn, J., Whitman, D., McCarty, F., & Brennan, B. (1984). Modern Business Law. New York: Random House, Inc. Chapter 25 (pp. 613-643) of this text presents the fundamental principles of agency relationships and the fiduciary duties of agents.
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Holmes, O.W., Jr. (1881). The Common Law, ed. Mark DeWolfe Howe. (1963). Cambridge, MA: The Belknap Press of Harvard University Press. This book contains the eleven lectures that Holmes prepared on the significance of the common law as a model for contemporary law. The editor's introduction is very helpful in identifying common themes that were developed in Holmes' later works. Howe, M. (1963). Introduction. In The Common Law, O.W. Holmes, Jr., ed. M. Howe. Cambridge, MA: The Belknap Press of Harvard University Press. Jensen, M., & Meckling. W. (1976). Theory of the firm: managerial behavior, agency costs, and ownership structure. J. Financial Economics, 3, 305-360. This landmark article was one of the first to use the common law concepts of agency to analyze the modern corporation and the relationship between holders of debt and equity. Ethics are not addressed per se, but the authors acknowledge the importance of a legal framework to define and support contractual relationships. Noreen, E. (1988). The economics of ethics: a new perspective on agency theory. Accounting, Organizations and Society, •3(4): 359-369. This article explores the usefulness of various mechanisms in enforcing ethical behavior including religion, genetics, conscience, and behavioral norms.