AGENCY theory is part of the topic of corporate governance. It involves the problem of directors controlling a company while the shareholders own the company. From this arises the problem whereby directors may not always act in the best interest of the shareholders and stakeholders.
In a corporation there is a web of contractual relations among different interest groups with a stake in the company, with a third group such as the creditors, which may also be involved. Shareholders may have conflicts with the managers (the directors) and also with the bank creditors since their individual priorities vary.
Managers seek profits that increase their own wealth, power and reputation, while shareholders are more interested in a slow and steady growth of the company over time, providing them with dividends. Creditors want to ensure that the loans they extend are paid.
Agency theory identifies points of conflict among corporate interest groups. Banks wish to reduce risk, while shareholders want to reasonably maximize profits. Managers are concerned with their ability to turn profits to show to their directors. These relationships create costs in that each group tries to control the others.
One of the major insights of agency theory is the concept of costs of maintaining the division of labor among shareholders, managers and creditors. Managers have the advantage of information since they know the firm up close, and thus can use this to enhance their own reputations at the expense of the shareholders. Profit-seeking in risky ventures may alienate banks and other sources of finance.
Monitoring and limiting managers sometimes entail costs to the firm.
Corporate governance holds that firms are basically units of conflict rather than unitary profit-seeking machines. This conflict is directly built into the structure of the corporation. If one accepts the premise of agency theory, i.e., that corporations are actually groups of connected fiefs, each fief having its own interest and culture and view the firm differently, one can assume that managers will behave in such a way as to maximize their own profit and reputation, even at the expense of shareholders.
Agency theory holds that problems arise because of differences of goals of the principal and agent. Agency theory, in relation to corporate governance, explains the actions of the various interest groups. Historically, companies used to be owned and managed by the same people. Expansion and growth, however, necessitated a larger number of investors to provide the necessary finance leading to the concept of limited liability and the development of stock markets where people could buy and sell shares. In the stock market, people who bought and sold shares did not need to take any interest in running the firm.
This job was delegated to the managers (agent), resulting in separation of goals.
The separation between ownership and control and the resulting conflict of interest, known as the “principal-agent problem,” is the key area of corporate governance focus.
The principal needs to find ways of ensuring that the agent acts in their best interest. As a result of several high-profile corporate collapses (Enron, et al.) there has been a great debate about the power of the board of directors and how shareholders and stakeholders can ensure that the board does not abuse their power. This led to the enactment of legislations to improve the control that shareholders and stakeholders can exercise over the board of directors, and the current emphasis on good corporate governance.
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