A theory concerning the relationship between a principal (shareholder) and an agent of the
principal (company's managers).
A conflict of interest arising between creditors, shareholders and management because of
differing goals.
For example, an agency problem exists when management and stockholders have
conflicting ideas on how the company should be run.
In political science and economics, the principal–agent problem or agency dilemma treats
the difficulties that arise under conditions of incomplete and asymmetric information when
a principal hires an agent, such as the problem that the two may not have the same interests,
while the principal is, presumably, hiring the agent to pursue the interests of the former.
Various mechanisms may be used to try to align the interests of the agent in solidarity with
those of the principal, such as piece rates/commissions, profit sharing, efficiency wages,
performance measurement (including financial statements), the agent posting a bond, or fear
of firing.
The principal–agent problem is found in most employer/employee relationships, for example,
when stockholders hire top executives of corporations. Numerous studies in political science
have noted the problems inherent in the delegation of legislative authority to bureaucratic
agencies.
As another example, the implementation of legislation (such as laws and executive directives)
is open to bureaucratic interpretation, which creates opportunities and incentives for the
bureaucrat-as-agent to deviate from the intentions or preferences of the legislators. Variance
in the intensity of legislative oversight also serves to increase principal–agent problems in
implementing legislative preferences.
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 debt holders
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 debtas 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
placingrestrictive 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
