Corporate Governance - Agency TheoryBeyza Oba Spring 2004

Corporate governance; an old problem a new solution

the owner of a business, when contemplating any change, is led by his own interest to weigh the whole gain ..against the whole lost. But the privete interest of the salaried manager, or offical, often draws him in another direction: the path of least resistance, of greater comfort and least risk to himself, is generally that of not striving very energetically for improvement; and of finding plausible excuses for not trying an improvement suggested by others, until its success is established beyond question (Alfred Marshall, 1920)

Seperation of ownership and control in joint-stock company (Berle and Means 1932) allows the firms behaviour to diverge from the profit maximizing, cost minimizing ideal The principal problem rests in the abuse of power by corporate elites; status quo leaves excess power in the hands of senior management, some of whom abuse this in the service of their own interest (Hutton, 1995), the result is damaging for shareholders Corporate governance includes the structures, process, cultures and systems that engender the successfull operation of organisations (Keasey and Wright 1993) and mechanisms to cope with these elements

Agency Theory
Assumptions: Bounded rationality Opportunism Information asymmetry

AT focuses on the relationship and goal incongruance between managers and stockholders
Agency relationships occur when one partner in a transaction (the principal) delegates authority to another (the agent) and the welfare of the principal is affected by the choices of the agent

Agency Theory
The delegation of decision-making authority from principal to agent is problematic in that; 1. The interests of principal and agent will diverge 2. The principal cannot perfectly and costlessly monitor the actions of the agent 3. The principal cannot perfectly and costlessly monitor and acquire the information available to or possesed by the agent

These constitute the agency problem - the possibility of opportunistic behaviour on the part of the agent that works against the welfare of the principal
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Agency costs
Agency costs; incur to protect principals interests and to reduce the possibility that agents will misbehave Monitoring expenditures by principals Bonding expenditures by agents Residual loss of the principal Essential sources of agency problems: Moral hazard; more of the agents actions are hidden from the principal or are costly to observe Adverse selection; the agent posseses information that is, for the principal unobservable or costly to obtain

Risk aversion; as organisations grow managers become risk averse (they would like to protect their position, managers would like to max. chance of success by projects that have already brought success, managers build structures to increase their chances of control)
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Resolving agency problems

Principals and agents resolve agency problems through; Monitoring; observing the behaviour and performance of agents

Bonding; arrangements that penalise agents for acting in ways that violate the interests of principals or reward them for achieving principals goals

Contracts between agents and principals specify the monitoring and bonding arrangements

Why do principals delegate authority to agents?

Size Simplicity of business operations (conceiving opportunity, funding, making and implementing decisions) Decision making situation can overhelm the cognitive capacity of a single individual, decison quality can be impreoved by assigning different parts of the decion to different individuals

What monitoring mechanisms can principals put to minimize agency costs?

Owners seek maximum effort from employees at minimal cost while employees seek to minimise effort and maximise remuneration (i.e. pay and benefits) Monitoring mechanisms; A) Contracts

Principals can monitor agents by collecting information about their behaviour (decisions and actions) behavioural contracts; specify the activities workers should engage in e.g. institutional investors monitor the decisions of of senior managers, board of directors monitor top management...

Principals can monitor consequences of (only partially obseved) agent behaviour outcome based contracts; compensation, rewards, piece rate production, commissions.. When tasks are not highly programmable monitoring performance (output) is more efficient Performance monitoring is problematic in relation to teams, free rider problems

What monitoring mechanisms can principals put to minimize agency costs?

B) Board of directors board is charged with fiduciary responsibility (i.e. legal trustee) of safeguarding the stockholders investment Inside and outside board members The outside board membersprovide objectivity as the board ratifies and monitors the decisions of managers
responsibilities of the board of directors; establish policies and objectives for the firm elect, monitor, evaluate and compensate top managers monitor, approve the financial condition of the firm ensure that regulations are enforced
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What specific bonding mechanisms can agents use to reassure principals?

Principals have an incentive to monitor agents Agents also have an incentive to assure principals that they are behaving in ways consistent with the principals interests Bonding mechanisms take the form of incentives that agents create for themselves Incentive mechanisms should address participation and incentive compatibility, i.e. agents must be induced both to engage in the contract and once engaged to invest effort in those areas which benefit the principal Incentive bondings 1. Compensation package of agents; profit related bonuses, executive share option.. 2. Promotions or other forms of recognition which may enhance their reputations and probability of increased future income
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The role of market discipline

Managerial labour market views the previous associations of managers with success and failure as information about their talents Managers of failing firms may not see a reduction in wages , but will be disciplines as the managerial labour market attaches less value to their services Managers in more sucessful markets may not receive any immediate gain in wages but the success of their firm may increase their value in managerial labour market Capital market and corporate control If managers (agents) of a firm take actions that are viewed by the market as adversly affecting the value of the firms assets, then the price of the assets (i.e. stock price) will likely to drop. Managers in other firms, beleiving that they can profitably manage the assets of the failing firm, may be engaged in a takeover battle. The managers of the troubled firm will loose control of their firm and old high agency cost managers will be replaced by low (?) agency cost managers

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