Agency Problem - Corporate
Governance
Dr Surbhi Kapur
Introduction
• CG- a system in which businesses are directed and managed.
• The purpose-
• to protect the shareholders and stakeholders of the company,
• to ensure its long-term existence,
• to ensure that the businesses carry out their activities in a healthy way in the light of certain
principles to prevent corporate scandals.
• The most fundamental role in ensuring that corporate governance fulfills its objectives
falls to the board of directors, which is responsible for corporate governance.
• It is extremely important that boards of directors are aware of their responsibilities and
fulfill their duties in a way that protects the interests of shareholders- or beyond?
Agency Problem
• Conflicts of interest
• Between corporate ‘insiders,’ such as controlling shareholders and top managers, and
‘outsiders,’ such as minority shareholders or creditors.
• These conflicts all have the character of what economists refer to as ‘agency
problems’ or ‘principal-agent’ problems.
• Whenever the welfare of one party, termed the ‘principal’, depends upon actions
taken by another party, termed the ‘agent.’
• The problem lies in motivating the agent to act in the principal’s interest rather than
simply in the agent’s own interest.
Information Asymmetry
• the agent commonly has better information than does the principal
about the relevant facts;
• the principal cannot easily assure himself that the agent’s
performance is precisely what was promised.
• As a consequence, the agent has an incentive to act opportunistically,
skimping on the quality of his performance, or even diverting to
himself some of what was promised to the principal.
Ctnd…
• Agency costs: the value of the agent’s performance to the principal
will be reduced, either directly or because, to assure the quality of
the agent’s performance, the principal must engage in costly
monitoring of the agent.
• The greater the complexity of the tasks undertaken by the agent, and
the greater the discretion the agent must be given, the larger these
‘agency costs’ are likely to be- coordination costs- multiple principals-
heterogeneous preferences;
Three generic agency problems
• the conflict between the firm’s owners (principals) and its hired managers (agents);
• Challenge- to ensure that the managers are responsive to the owners’ interests rather than
pursuing their own personal interests
• the conflict between owners who possess the majority or controlling interest
(agents) in the firm and the minority or noncontrolling owners (principals);
• the conflict between the firm itself—including, particularly, its owners—and the
other parties with whom the firm contracts, such as creditors, employees, and
customers;
• May entail expropriating creditors, exploiting workers, or misleading consumers
Legal Strategies
• Law can play an important role in reducing agency costs; deploying
substantive law to mitigate the vulnerability of principals to the
opportunism of their agents
• Rules and procedures that enhance disclosure by agents or facilitate
enforcement actions brought by principals against dishonest or
negligent agents.
Legal Strategies
‘agent-constraining’ and ‘principal-empowering’
Regulatory Governance
Strategies Strategies
Regulatory Strategies
• Are prescriptive: they dictate substantive terms that govern the content of the principal-
agent relationship;
• Constrain the agent’s behavior directly.
• Depend for efficacy on the ability of an external authority—a court or regulatory body—
to determine whether or not the agent complied with particular prescriptions.
• This requires good-quality regulatory institutions + effective disclosure mechanisms to
ensure that information about the actions of agents can be ‘verified’ by the regulator.
Governance Strategies
• By contrast, governance strategies seek to facilitate the principals’ control over their
agent’s behavior;
• Coordination costs between principals will make it more difficult for them either to
monitor the agent so as to determine the appropriateness of her actions, or to
decide whether, and how, to take action to sanction nonperformance.
• High coordination costs thus render governance strategies less successful in
controlling agents, and regulatory strategies will tend to seem more attractive.
Rules and standards
• constrains agents by commanding them not to make decisions, or undertake
transactions, that would harm the interests of their principals.
• Rules, which prescribe specific behaviors ex ante are commonly used in the corporate
context to protect a corporation’s creditors and public investors.
• E.g., statutes universally include creditor protection rules- bankruptcy;
• standards-based regulation relate to the company’s internal affairs, as when the law
requires directors to act in ‘good faith’- leave discretion for adjudicators to determine ex
post whether violations have occurred.
Setting the terms of entry and exit
• Regulating the terms on which principals affiliate with agents;
• The law can dictate terms of entry by, for example, requiring agents to
disclose information about the likely quality of their performance
before contracting with principals.
• Alternatively, the law can prescribe exit opportunities for principals,
such as awarding to a shareholder the right to sell her stock; right to
withdraw; right to transfer;
Governance Strategies
• Selection and removal- appointment rights—the power to select or remove
directors (or other managers)—are key strategies for controlling the
enterprise; These strategies are at the very core of corporate governance.
• Initiation and ratification- decision rights, which grant principals the power
to initiate or ratify management decisions;
• Trusteeship and reward: incentive strategies- reward strategy, which
rewards agents for successfully advancing the interests of their principals;
pay-for-performance regime (e.g., ESOPs); independent directors
COMPLIANCE AND ENFORCEMENT
• Legal strategies are relevant only to the extent that they induce compliance.
• In this regard, each strategy depends on the existence of other legal institutions—
such as courts, regulators, and procedural rules—to secure enforcement of the
legal norms.
• Public enforcement- legal and regulatory actions brought by organs of the state;
includes- reputational sanctions that may accompany the disclosure that a firm is
under investigation; e.g., SEBI in India, self-regulatory and quasi-regulatory
authorities, such as national stock exchanges
Ctnd…
• Private enforcement: encompasses civil lawsuits brought by private parties,
such as shareholder derivative suits and class action;
• informal, or reputational, sanctions imposed by private parties, which might take the
form of lower share prices, a decline in social standing, or a personal sense of shame
• Gatekeeper control involves the conscription of noncorporate actors, such as
accountants and lawyers, in policing the conduct of corporate actors.
• exposing the gatekeepers to the threat of sanction for participation in corporate
misbehavior, or for failure to prevent or disclose misbehavior.
• delegated intervention: principals do not themselves engage in scrutiny of the agent, but
leave this to the gatekeeper.
Disclosures
• plays a fundamental role in controlling corporate agency problems and
reducing agency costs.
• For e.g., prospectus disclosure forces agents to provide prospective
principals with information that helps them to decide upon which terms, if
any, they wish to enter the firm as owners.
• Periodic financial disclosure and ad hoc disclosure—for example, of
information relevant to share prices, and of the terms of related party
transactions—also permits principals to determine the extent to which
they wish to remain owners, or rather exit the firm.
Thank you