Agency Theory
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Agency theory Agency theory refers to the agency relationship, in which one party (the principal) appoints another party (the agent) to fulfill a certain duty. Agency theory describes this relationship using the metaphor of the contract (Jensen & Meckling, 1976). The agency problem appears when: (a) there is a conflict between the wishes and objectives of the agent and those of the principal; and (b) it is sufficiently costly and difficult for the principal to verify what the agent actually does.
There is a risk sharing between the principal and the agent which have different attitudes towards risk. They would prefer different solutions for the same problem because, in general, the principal is risk-averse, while the agent assumes a higher degree of risk in solving a problem.
The agency relationship If both parties want to maximize their own utility functions (or profits), than it is probable that the agent will not entirely follow the interests of the principal. Also, it is impossible to insure a convergence of both parties’ interests without any cost borne by either party. The agency relationship is characterized by divergence of interests and the existence of the following specific costs: 1. Monitoring costs borne by the principal; 2. Assurance costs borne by the agent; and 3. A residual loss, which may be calculated as the decrease in the value of the principal’s wealth, as a consequence of diverging interests with the agent. Also, breaking the relationship with the agent can also be regarded as an associated cost.
Shareholders and mandate •
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Shareholders act as principals only in theory. In practice, shareholders are diverse groups of people and organizations with diverse interests. The directors have a moral obligation towards them directly, although the latter do not always know the former’s intentions. In addition, shareholders have their own duty to the company (most important to vote in some key moments), which explains why they may choose not to play the role of principal. Corporate law considers that directors have a legal obligation to the company as a legal (fictitious) entity, and shareholders usually benefit from a successful mandate. Managers have no obligation to the shareholders, because they are employees of the company. Thus, they have a duty to their employer, in this case a legal entity represented by the Board of Directors.
M o d e l s a n d p r a c t i c e s o f c o r p o r a t e g o v e r n a n c e ( C
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)
Private benefits •
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Shareholders may benefit indirectly (residual interests) or directly (as private benefits) from their status. Private benefits are customized, they are not shared with other shareholders. From the perspective of shareholders, there is a compromise (tradeoff) between direct and indirect benefits. Private benefits can harm the company, in which case they will reduce indirect benefits (profits, equity prices and dividends). Individual shareholders can be agents of the company (when looking at the firm as a principal), when they collect private benefits from interacting with the company. Therefore, the economic entity as a whole may be interested to interact with shareholders whose private benefits are not harmful and are aligned with company business goals (such as business partners or managers who receive shares in the company). For minority shareholders, the majority owner is an agent for protecting their own investment.
M o d e l s a n d p r a c t i c e s o f c o r p o r a t e g o v e r n a n c e ( C
o n f . d r . V o i c u D r a g o m i r
)
“Good” and “bad” shareholders •
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There is an agency issue in respect of the shareholders involvement. They can be considered “good” when they actively monitor and require the long-term increase of company value, or “bad” in the following situations: Some shareholders seek only personal gain. For example, whenever public companies are run by people close to the political sphere, and to which the company’s money is redirected to support political expenditure. Some shareholders may take advantage of the close relationship with the managers, in order to receive payments and benefits from the company, which could drive the firm even to bankruptcy.
In these situations, the agency conflict may be reduced by restricting the interference which some shareholders may have in business operations and with the company’s managers.
M o d e l s a n d p r a c t i c e s o f c o r p o r a t e g o v e r n a n c e ( C
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Corporate law requires that managers seek “profit for the shareholders” in order to attract new investors to become shareholders and existing ones to invest more. This rule is a benchmark for the actions of managers who run the company. The penalties for breaking this rule vary by jurisdiction and the nature of the offence.
M o d e l s a n d p r a c t i c e s o f c o r p o r a t e g o v e r n a n c e
Law experts consider that the survival of the firm and the return for shareholders are two complimentary goals, where dividend distribution and rising share prices are just two components of this equation.
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Return for the shareholders (I) •
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This rule is only a general goal, since it does not specify how to run the business, the profit targets or how to redistribute these returns. Business losses are a normal consequence of economic activity, and they are not civil or criminal offences.
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Return for the shareholders (II) •
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The “profit for shareholders” rule provides a control mechanism, since shareholders can legally become monitors of the company, and offers them an incentive to incur certain costs of monitoring.
Firm profitability influence its stock market valuation. A small constant value of the company will reduce its long-term survival chances and will transform it into a takeover target. A value in an uptrend will enable the company to use equity-based financing, which is cheaper overall. This rule does not say how much should be allocated to shareholders as dividends or share buy-backs, and how much profit should be distributed to other parties. From the perspective of long-term survival, it is considered that there should be a tradeoff between market value and fair distribution of resources to all business partners and the society.
M o d e l s a n d p r a c t i c e s o f c o r p o r a t e g o v e r n a n c e ( C
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)
