AGENCY THEORY

Agency theory suggests that the firm can be viewed as a nexus of contracts (loosely defined) between resource holders. An agency relationship arises whenever one or more individuals, called principals, hire one or more other individuals, called agents, to perform some service and then delegate decision-making authority to the agents. The primary agency relationships in business are those (1) between stockholders and managers and (2) between debtholders and stockholders. These relationships are not necessarily harmonious; indeed, agency theory is concerned with so-called agency conflicts, or conflicts of interest between agents and principals. This has implications for, among other things, corporate governance and business ethics. When agency occurs it also tends to give rise to agency costs, which are expenses incurred in order to sustain an effective agency relationship (e.g., offering management performance bonuses to encourage managers to act in the shareholders' interests). Accordingly, agency theory has emerged as a dominant model in the financial economics literature, and is widely discussed in business ethics texts.

Agency theory in a formal sense originated in the early 1970s, but the concepts behind it have a long and varied history. Among the influences are property-rights theories, organization economics, contract law, and political philosophy, including the works of Locke and Hobbes. Some noteworthy scholars involved in agency theory's formative period in the 1970s included Armen Alchian, Harold Demsetz, Michael Jensen, William Meckling, and S.A. Ross.

CONFLICTS BETWEEN MANAGERS AND
SHAREHOLDERS

Agency theory raises a fundamental problem in organizations—self-interested behavior. A corporation's managers may have personal goals that compete with the owner's goal of maximization of shareholder wealth. Since the shareholders authorize managers to administer the firm's assets, a potential conflict of interest exists between the two groups.

SELF-INTERESTED BEHAVIOR.

Agency theory suggests that, in imperfect labor and capital markets, managers will seek to maximize their own utility at the expense of corporate shareholders. Agents have the ability to operate in their own self-interest rather than in the best interests of the firm because of asymmetric information (e.g., managers know better than shareholders whether they are capable of meeting the shareholders' objectives) and uncertainty (e.g., myriad factors contribute to final outcomes, and it may not be evident whether the agent directly caused a given outcome, positive or negative). Evidence of self-interested managerial behavior includes the consumption of some corporate resources in the form of perquisites and the avoidance of optimal risk positions, whereby risk-averse managers bypass profitable opportunities in which the firm's shareholders would prefer they invest. Outside investors recognize that the firm will make decisions contrary to their best interests. Accordingly, investors will discount the prices they are willing to pay for the firm's securities.

A potential agency conflict arises whenever the manager of a firm owns less than 100 percent of the firm's common stock. If a firm is a sole proprietorship managed by the owner, the owner-manager will undertake actions to maximize his or her own welfare. The owner-manager will probably measure utility by personal wealth, but may trade off other considerations, such as leisure and perquisites, against personal wealth. If the owner-manager forgoes a portion of his or her ownership by selling some of the firm's stock to outside investors, a potential conflict of interest, called an agency conflict, arises. For example, the owner-manager may prefer a more leisurely lifestyle and not work as vigorously to maximize shareholder wealth, because less of the wealth will now accrue to the owner-manager. In addition, the owner-manager may decide to consume more perquisites, because some of the cost of the consumption of benefits will now be borne by the outside shareholders.

In the majority of large publicly traded corporations, agency conflicts are potentially quite significant because the firm's managers generally own only a small percentage of the common stock. Therefore, shareholder wealth maximization could be subordinated to an assortment of other managerial goals. For instance, managers may have a fundamental objective of maximizing the size of the firm. By creating a large, rapidly growing firm, executives increase their own status, create more opportunities for lower- and middle-level managers and salaries, and enhance their job security because an unfriendly takeover is less likely. As a result, incumbent management may pursue diversification at the expense of the shareholders who can easily diversify their individual portfolios simply by buying shares in other companies.

Managers can be encouraged to act in the stockholders' best interests through incentives, constraints, and punishments. These methods, however, are effective only if shareholders can observe all of the actions taken by managers. A moral hazard problem, whereby agents take unobserved actions in their own self-interests, originates because it is infeasible for shareholders to monitor all managerial actions. To reduce the moral hazard problem, stockholders must incur agency costs.

COSTS OF SHAREHOLDER-MANAGEMENT CONFLICT.

Agency costs are defined as those costs borne by shareholders to encourage managers to maximize shareholder wealth rather than behave in their own self-interests. The notion of agency costs is perhaps most associated with a seminal 1976 Journal of Finance paper by Michael Jensen and William Meckling, who suggested that corporate debt levels and management equity levels are both influenced by a wish to contain agency costs. There are three major types of agency costs: (1) expenditures to monitor managerial activities, such as audit costs; (2) expenditures to structure the organization in a way that will limit undesirable managerial behavior, such as appointing outside members to the board of directors or restructuring the company's business units and management hierarchy; and (3) opportunity costs which are incurred when shareholder-imposed restrictions, such as requirements for shareholder votes on specific issues, limit the ability of managers to take actions that advance shareholder wealth.

In the absence of efforts by shareholders to alter managerial behavior, there will typically be some loss of shareholder wealth due to inappropriate managerial actions. On the other hand, agency costs would be excessive if shareholders attempted to ensure that every managerial action conformed with shareholder interests. Therefore, the optimal amount of agency costs to be borne by shareholders is determined in a cost-benefit context—agency costs should be increased as long as each incremental dollar spent results in at least a dollar increase in shareholder wealth.

MECHANISMS FOR DEALING WITH
SHAREHOLDER-MANAGER CONFLICTS

There are two polar positions for dealing with shareholder-manager agency conflicts. At one extreme, the firm's managers are compensated entirely on the basis of stock price changes. In this case, agency costs will be low because managers have great incentives to maximize shareholder wealth. It would be extremely difficult, however, to hire talented managers under these contractual terms because the firm's earnings would be affected by economic events that are not under managerial control. At the other extreme, stockholders could monitor every managerial action, but this would be extremely costly and inefficient. The optimal solution lies between the extremes, where executive compensation is tied to performance, but some monitoring is also undertaken. In addition to monitoring, the following mechanisms encourage managers to act in shareholders' interests: (1) performance-based incentive plans, (2) direct intervention by shareholders, (3) the threat of firing, and (4) the threat of takeover.

Most publicly traded firms now employ performance shares, which are shares of stock given to executives on the basis of performances as defined by financial measures such as earnings per share, return on assets, return on equity, and stock price changes. If corporate performance is above the performance targets, the firm's managers earn more shares. If performance is below the target, however, they receive less than 100 percent of the shares. Incentive-based compensation plans, such as performance shares, are designed to satisfy two objectives. First, they offer executives incentives to take actions that will enhance shareholder wealth. Second, these plans help companies attract and retain managers who have the confidence to risk their financial future on their own abilities—which should lead to better performance.

An increasing percentage of common stock in corporate America is owned by institutional investors such as insurance companies, pension funds, and mutual funds. The institutional money managers have the clout, if they choose, to exert considerable influence over a firm's operations. Institutional investors can influence a firm's managers in two primary ways. First, they can meet with a firm's management and offer suggestions regarding the firm's operations. Second, institutional shareholders can sponsor a proposal to be voted on at the annual stockholders' meeting, even if the proposal is opposed by management. Although such shareholder-sponsored proposals are nonbinding and involve issues outside day-to-day operations, the results of these votes clearly influence management opinion.

In the past, the likelihood of a large company's management being ousted by its stockholders was so remote that it posed little threat. This was true because the ownership of most firms was so widely distributed, and management's control over the voting mechanism so strong, that it was almost impossible for dissident stockholders to obtain the necessary votes required to remove the managers. In recent years, however, the chief executive officers at American Express Co., General Motors Corp., IBM, and Kmart have all resigned in the midst of institutional opposition and speculation that their departures were associated with their companies' poor operating performance.

Hostile takeovers, which occur when management does not wish to sell the firm, are most likely to develop when a firm's stock is undervalued relative to its potential because of inadequate management. In a hostile takeover, the senior managers of the acquired firm are typically dismissed, and those who are retained lose the independence they had prior to the acquisition. The threat of a hostile takeover disciplines managerial behavior and induces managers to attempt to maximize shareholder value.

STOCKHOLDERS VERSUS CREDITORS: A
SECOND AGENCY CONFLICT

In addition to the agency conflict between stockholders and managers, there is a second class of agency conflicts—those between creditors and stockholders. Creditors have the primary claim on part of the firm's earnings in the form of interest and principal payments on the debt as well as a claim on the firm's assets in the event of bankruptcy. The stockholders, however, maintain control of the operating decisions (through the firm's managers) that affect the firm's cash flows and their corresponding risks. Creditors lend capital to the firm at rates that are based on the riskiness of the firm's existing assets and on the firm's existing capital structure of debt and equity financing, as well as on expectations concerning changes in the riskiness of these two variables.

The shareholders, acting through management, have an incentive to induce the firm to take on new projects that have a greater risk than was anticipated by the firm's creditors. The increased risk will raise the required rate of return on the firm's debt, which in turn will cause the value of the outstanding bonds to fall. If the risky capital investment project is successful, all of the benefits will go to the firm's stockholders, because the bondholders' returns are fixed at the original low-risk rate. If the project fails, however, the bondholders are forced to share in the losses. On the other hand, shareholders may be reluctant to finance beneficial investment projects. Shareholders of firms undergoing financial distress are unwilling to raise additional funds to finance positive net present value projects because these actions will benefit bondholders more than shareholders by providing additional security for the creditors' claims.

Managers can also increase the firm's level of debt, without altering its assets, in an effort to leverage up stockholders' return on equity. If the old debt is not senior to the newly issued debt, its value will decrease, because a larger number of creditors will have claims against the firm's cash flows and assets. Both the riskier assets and the increased leverage transactions have the effect of transferring wealth from the firm's bondholders to the stockholders.

Shareholder-creditor agency conflicts can result in situations in which a firm's total value declines but its stock price rises. This occurs if the value of the firm's outstanding debt falls by more than the increase in the value of the firm's common stock. If stockholders attempt to expropriate wealth from the firm's creditors, bondholders will protect themselves by placing restrictive covenants in future debt agreements. Furthermore, if creditors believe that a firm's managers are trying to take advantage of them, they will either refuse to provide additional funds to the firm or will charge an above-market interest rate to compensate for the risk of possible expropriation of their claims. Thus, firms which deal with creditors in an inequitable manner either lose access to the debt markets or face high interest rates and restrictive covenants, both of which are detrimental to shareholders.

Management actions that attempt to usurp wealth from any of the firm's other stakeholders, including its employees, customers, or suppliers, are handled through similar constraints and sanctions. For example, if employees believe that they will be treated unfairly, they will demand an above-market wage rate to compensate for the unreasonably high likelihood of job loss.

AGENCY VERSUS CONTRACT

Although the notions of agency and contract are closely intertwined, some academics bristle at the suggestion they are essentially the same. Specifically, they point out a number of unique features of agency versus contractual relationships. There are two major sets of differences. First, agents are usually retained not for any particular or discrete set of tasks, but for a broad range of activities, which may change over time, that are consistent with basic objectives and interests set forth by the principals. In this instance principals must be concerned to some degree about agents' personal attitudes, dispositions, and other characteristics that are usually not a concern in contractual agreements. Principals hire out broad objectives to be fulfilled instead of specific tasks. Second, in an agency relationship there is typically much less independence between agent and principal than between contracting parties. Typically this also means that the principal-agent relationship is more hierarchical and power-driven than a contractual relationship, and included in this power is greater latitude for principals to reward, punish, and control agents.

A conventional view holds that agency is a special application of contract theory. However, some argue that the reverse is true: a contract is a formalized, structured, and limited version of agency, but agency itself is not based on contracts.

AGENCY AND ETHICS

Since agency relationships are usually more complex and ambiguous (in terms of what specifically the agent is required to do for the principal) than contractual relationships, agency carries with it special ethical issues and problems, concerning both agents and principals. Ethicists point out that the classical version of agency theory assumes that agents (i.e., managers) should always act in principals' (owners') interests. However, if taken literally, this entails a further assumption that either (a) the principals' interests are always morally acceptable ones or (b) managers should act unethically in order to fulfill their "contract" in the agency relationship. Clearly, these stances do not conform to any practicable model of business ethics.

A familiar real-life example is large corporations' layoff dilemma. Conventional wisdom holds that investors are rewarded when companies thin their employment rosters because operating costs are lowered, in theory leading to greater profits. This expectation is often made explicit in news reporting surrounding a downsizing episode; the reports highlight whether investors seem pleased or displeased with an announcement of a mass layoff, and the often-stated assumption is that corporate management has undertaken the layoffs in part, if not in whole, to please shareholders and enhance their wealth. In this instance it is obvious that shareholders' interests are advanced to the detriment of at least one other constituency, namely the employees. In such cases, observers question whether it is ethical to serve the principals' interests when those actions harm a large number of people, and whether the benefits shareholders receive are commensurate with the harm inflicted on the laid-off employees.

Along the same lines, others have noted that traditional agency theory makes little mention of what obligations, moral or otherwise, principals have to their agents. The emphasis lies almost exclusively on what agents should or must do for the principals, relying, in turn, on a vague assumption that principals will compensate agents adequately—even more than adequately—for their services. Some ethics scholars argue that principals have obligations as well. In the example above, some would argue that not only is it unethical to harm employees to obtain improvements (often marginal) in shareowners' wealth, but also that the shareholders have moral obligations directly to the employees as an extension of the ethical employer/employee relationship (i.e., not to harm them arbitrarily, among other obligations). This ethical problem is only complicated by the reality that, as noted above, principals are often institutions rather than individuals.

Meanwhile, consistent with the conventional formulation of the theory, agents are seen as having ethical duties to the principals. If managers act in self-interest—a rather negative assumption—and it fails to serve the best interests of the shareholders, they may, according to some views, have fallen short on their ethical responsibilities.

In a larger sense, some see the traditional agency model as a simplistic, even deceptive, justification for traditional economic power relationships, specifically that large wealth holders can extract concessions from weaker economic beings. Certain scholars have argued that from a broader social perspective, there are many kinds of principal-agent relations, and included among these is the fact that shareholders may be seen as agents to managers, employees, and the broader society.