The Influence of Agency Theory within Corporate Governance
Agency theory has a number of manifestations. Jensen and Meckling’s (1972) innovation was to insist that organisations should be seen as no more than a set of implicit and explicit contracts with associated rights. Alchian and Demsetz (1972) by contrast focused on the ‘team production process’ and the problem of free riding and monitoring within this. Fama (1980) looked to the potential of the managerial labour market to constrain and channel individual executive opportunism. These varied models of the nature of organisational relationships are constructed around a few simple assumptions that Donaldson (1990) characterises as a ‘theory of interest, motivation and compliance’. As with neoclassical economics more generally the basic unit of analysis is taken as the ‘individual’ who is preoccupied with maximising or at least satisficing their utility; conceived typically in terms of a trade-off between work and leisure. It is this combination of assumed autonomy and self-interested motivation that creates the problems within agency relationships; the relationship between a principal and those employed as ‘agents’ to serve their interests.
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As applied to corporate governance it is the shareholder who is cast as the ‘principal’ and the problem, following the separation of ownership and control (Berle and Means 1932), is how the principal can ensure that his ‘agents’ – company directors – serve the shareholders interests rather than their own. Either in the form of ‘shirking’ which in the governance context can be seen in terms of a lack of attention to maximizing shareholder returns, or in terms of ‘self-interested opportunism’ – accruing wealth to themselves rather than shareholders – the principal is vulnerable to the self-interest of their agents. The remedies to this conception of the agency problem within corporate governance involves the acceptance of certain ‘agency costs’ involved either in creating incentives/sanctions that will align executive self interest with the interests of shareholders, or incurred in monitoring executive conduct in order to constrain their opportunism.
As these assumptions have been read onto corporate governance, and informed its reform in recent decades, they have resulted in what are now an almost universal set of techniques and practices designed to control the conduct of executives both within the corporation and externally (Walsh and Seward 1990). Inside the company, boards have essentially two means to exercise control over executives; they can fire them and they can give them incentives – share options, long-term incentive plans. For these levers to work, however, boards must be populated with ‘independent’ non-executives who are willing and able to monitor executive performance, particularly where there are potential conflicts of interest. The growth and development of both the number of non-executives on boards as well as the increased specification of their role and conditions of ‘independence has characterized board reform around the world.
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The separation of the role of chief executive from that of the non-executive chairman has been part of this; in the language of Cadbury it is intended that this ensures that no one individual has ‘unfettered’ powers of decision. The creation of audit, remuneration, and nominations committees all staffed by independent non-executives, is also common and ideally ensures both the proper use of incentives and a high degree of monitoring of executive performance and decision-making. To these internal controls are added a range of external controls. Foremost here has been the focus on enhanced ‘disclosure’, and the ‘transparency’ that this allows, principally of financial performance but recently also of social and environmental performance.
The intention is that the share market is thereby better informed such that all relevant information is impacted into the share-price (Fama 1980, Barker 1998). There is also a market for corporate control that ideally allows for weak management teams to be displaced by strong teams that will run companies to better effect for shareholders. In recent years at least at a policy level there has also been concern that shareholders – in the form of the large institutional investors – taking on their responsibilities as owners through exercising proper scrutiny and influence both publicly and through their private contacts with investors (Roberts et al 2003).
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The model described here of a combination of internal and external controls is what characterises Anglo-American corporations and by early 2001 there was a growing confidence that this model was the best means of ensuring effective governance, and that corporate governance practices in other jurisdictions should and indeed were beginning to converge upon this model (OECD). At this point the scandals of Enron, Worldcom and Tyco broke and these have at least temporarily shaken the confidence in and complacency about the Anglo-American model, and been the stimulus of yet further reform. In the USA the Sarbannes-Oxley act can be read almost as a perfect mirror of the collapse of Enron and perhaps suggests a loss of faith in the self-regulatory capacities of both boards and markets by increasing the criminal liabilities of directors.
In the UK the response has been more muted but has involved the further strengthening of the role of the non-executive within boards (Higgs 2003) and of the monitoring responsibilities of investors in relation to voting and remuneration and activism. I would argue that in many respects these latest reforms merely repeat and reinforce the core assumptions of agency theory – that the problem lies in the self-interested opportunism of executives and can be remedied only through a mixture of increased independent monitoring, sharper sanctions and more appropriately targeted incentives that avoid ‘reward for failure’. In what follows I want to question these assumptions and suggest that they are better seen not as the solution but rather the source of the governance problem.
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References
Alchian, A. & Demsetz, H. Production, Information Costs and Economic Organization, The American Economic Review, 1972, 62 ; 777-95.
Fama, E. Agency problems and the theory of the firm. Journal of Political Economy, 1980, 88 288-307.
Jensen, M. and Meckling W. 1976 Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure The Journal of financial Economics, 3 ,305-360.
Donaldson, L. The Ethereal Hand; organisational economics and management theory, Academy of Management Review, 1990 15(3) 369-81.
Barker, R. (1998) The Market for Information – Evidence from finance directors, Analysts and fund managers, Accounting and Business Research. 29(1):3-20.
Higgs, D. (2003) Review of theRole and Effectiveness of the Non-executive Director, DTI:London.
Walsh, J & Seward, J.(1990) On the efficiency of internal and external corporate control mechanisms. Academy of Management Review, 15(3) 421-58.
Roberts, Barker, R, Sanderson, P and Hendry, J. (2003) “In the Mirror of the Market; the disciplinary effects of company shareholder meetings. IPA conference paper Madrid.
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