Adam Smith was a Scottish economist and philosopher, also known as ”The Father of Economics”. Smith wrote two classic works, one of them called The Wealth of Nations, which is considered the first modern work of economics.
“The directors of companies, being the managers of other people’s money rather than their own, cannot well be expected to watch over it with the same anxious vigilance with which (they) watch over their own. ”
– Adam Smith, The Wealth of Nations, 1776.
I use this quote as a segway to talk to my students about the economical framework that underpins corporate governance. There are numerous theories, but the one I focus on the agency theory.
Here are some key considerations:
- Agency theory identifies the agency relationship where one party, the principal, delegates work to another party, the agent. In the context of a corporation, the owners are the principal and the directors are the agent.
- The work of Jensen and Meckling (1976) and Jensen (1983) was important to the development of agency theory.
- Much of agency theory as related to corporations is set out in the context of ownership and control
The principal and the agent have access to different levels of information; in practice, this means that the principal is at a disadvantage because the agent will have more information.
Ultimately, the agency theory says: corporate governance mechanisms (controls, checks, limitations, audits etc) are the monitoring devices to ensure that the agency problems are minimized.
Blair (1996): “Managers must be monitored and institutional and institutional arrangements must provide some checks and balances to make sure they do not abuse their power”
Here are two important definitions.
Agency Problem: self-interested executives have the opportunity to take actions that benefit themselves, with shareholders and stakeholders bearing the cost of these actions
- Agency problems can be mitigated with monitoring mechanisms, right incentives, contract design, debt financing etc
Agency costs: The sum of incentive, monitoring, and enforcement costs as well as any residual losses incurred by principals because it is not possible for principals to guarantee 100% compliance through monitoring arrangements.
We spend some time discussing some examples of agency costs – e.g. situations when executives make investment, financing, and operating decisions that better themselves at the expense of other parties related to the firm.
They may choose to slack or shirk with low effort, spending insufficient time and effort on building shareholder value. Some use expensive perquisites such as company private jets or even inflate their own compensation by manipulating financial results or engaging in fraudulent activities to increase bonuses or stock prices. Some managers will overinvest in particular areas of the business that they control or pursue uneconomic acquisitions (“empire building“). Risk lovers will demonstrate excessive risk-taking to increase short-term results and bonuses. Risk avoiders, on the contrary, will not invest in profitable new projects, therefore avoiding risks of potentially losing their jobs. Finally, CEOs may intentionally fail to groom successors so they will appear “indispensable”.
Do capital markets respond to the agency problem? In general, yes. Investors demand better reporting and transparency, set out rules for accountability and audit. The legislative examples will include things like a requirement on the number of independent directors on the board, separation of Chairman and CEO roles and other legislative and regulatory mandates. Many firms proceed to write and endorse corporate governance codes, principles, and trainings. All of these measures will feed into what we currently understand as corporate governance.
Disclaimer: my course is based on Larcker and Tanyan “Corporate Governance Matters” textbook, so I make sure my definitions are aligned with theirs. I also include links to demonstrate theoretical concepts using real-life examples.