Agency theory is concerned with problems that arise where one party (the agent) is expected to act in the interests of another party (the principal), but the agent’s own interests may conflict with the principal’s interests, and the principal cannot fully monitor and discipline the agent. Agency theory is widely referenced in business, economics, and political science, where it is often identified as the “principal-agent problem.” In business applications, the emphasis is usually on “agency costs,” which are the costs borne by either the agent or the principal as a consequence of agency problems.
Agency problems arising from conflicts of interests between the principal and agent are greatest under information asymmetry. Here, the relevant form of information asymmetry is where the agent has more information than the principal regarding opportunities or the agent’s intentions and actions that are pertinent to the principal’s interests. If the principal is not fully aware of the agent’s intentions or actions or is constrained by resources from acquiring the information, then the principal cannot directly monitor the agent’s behavior and ensure the agent is always acting in the principal’s best interest.
An agent’s incentives to act counter to the best interests of the principal may be a consequence of the agent’s inherent personal preferences (e.g., not working sufficiently hard or favoring the interests of other related parties) or adverse incentives such as those arising from bribes, commissions, or poorly structured reward schemes.
In business ethics, irrespective of whether the principal-agent relationship is implied or expressed through a formal contract, it is assumed the agent has a fiduciary duty to the principal. In corporations, directors and other officers of the corporation have a fiduciary duty to the corporation that is usually expressed in statutes or legal codes. The legal treatment of relationships between managers and other stakeholders in the corporation, including shareholders, is more variable. While there may be differences between jurisdictions as to the legal nature and enforceability of the fiduciary duties attaching to an agent, the ethical dimensions and implications of the relationship, such as those pertaining to trust, stewardship, and accountability, may be more generalizable across jurisdictions and markets.
Agency theory is often the source of central tenets in issues concerning corporate governance. In this regard, the most common application of agency theory in relation to business and professional activities pertains to the relationship between corporate management (as agents) and shareholders (as principals). This is particularly evident in the accounting and finance literature, where “corporate management” refers to both directors and executives. The most cited reference in the development of agency theory in the corporate governance context is Jensen and Meckling (1976). This work is informed by problems described in Berle and Means (1932), but the recognition of the agency problem in corporations is much older; Adam Smith discusses concerns about corporate managers (as economic agents who are mere self-interested individuals) in The Wealth of Nations, which was first published in 1776, but it is likely that the relevant ideas were not originated by Smith.
Applications of agency theory in relation to corporate governance are typically focused on shareholders’ interests in the corporation, as represented in the valuation of equity (variously called shares or stock) in the corporation. A major concern in this regard is that, if managers can profit from changes in share prices, the managers have incentives to misrepresent corporate performance or opportunistically manipulate the timing of the release of good and bad news to the market. This may mislead external investors as to the value of the corporation at various points in time in ways that enrich the managers. For example, when executive remuneration (also referred to as executive compensation) includes equity options in the corporation, the executives might obtain financial gains by manipulating the reported performance of the corporation. In this context, an equity option is the right to buy a share in the corporation at a predetermined “exercise price.” This creates an incentive for the prospective option holder to temporarily depress the share price, prior to the option award date, to lower the exercise price of the options. When the share price later recovers, the option holder profits by the difference between the option exercise price and the current market price of the shares.
More generally, central issues addressed in agency theory include agent effort, risk tolerance, and expropriation. These are not limited to the corporate governance context, as demonstrated by some of the examples below.
Managers may spend less effort (shirking) on protecting or serving corporate interests than they would if their actions were fully observable or if their remuneration contracts were more appropriately structured.
Managers may direct corporate assets to nonproductive uses that provide utility to managers from the overconsumption of perquisites (or perks), such as extravagant offices, luxury motor vehicles, and superfluous travel and entertainment expenditures.
An employee may engage in private activities during work hours without the employer’s agreement.
Lessees that are usually responsible for safeguarding leased assets have less interest in protecting and maintaining the assets than the legal owner.
Risk tolerance: In situations where an agent utilizes the resources of a principal, the agent may incur little to no downside risk because all losses are the burden of the principal, but the agent benefits more from upside risks through performance bonuses. This is seen when shareholders bear the residual risks by providing financial capital that corporate managers use at their discretion. Managers may exhibit a risk tolerance that differs from the shareholders’ risk tolerances because of the uneven distribution of risk. This agency problem is a manifestation of moral hazard. Conversely, a consequence known as the “agency cost of debt” emerges when the cost of debt increases because management engages in projects or behaviors that benefit shareholders more than bondholders, for example, taking on riskier projects that offer a high payoff may benefit shareholders but the higher risk the probability of default on debt obligations.
A manager purchases (sells) an asset at an inflated (deflated) price from (to) a party in which the manager has a vested interest. This is direct expropriation.
Financial planners are expected to act in the best interests of clients but may have financial inducements to recommend products that are not best suited to the client’s risk and return preferences. Although indirect, this can be regarded as expropriation because the agent is enriched by their actions but at the client’s expense.
A shareholder’s short-term liquidity needs may be best served by high dividend distributions that can reduce the corporation’s ability to invest in profitable opportunities or create liquidity problems for the corporation, thus adversely affecting the value of the corporation (conflicting with the interests of some other shareholders) or the future survival or growth of the corporation. This conflicts with the interests of the corporation as an entity and may conflict with the interests of other shareholders.
Some corporations have controlling shareholders and minority shareholders. Controlling shareholders can usually determine board membership and thus appoint executives and influence management decisions. Through these means, controlling shareholders can act against the interests of the corporation as an entity or against the interests of other shareholders. For example, a controlling shareholder might use their power to have family members appointed to managerial positions when they are not the best choices for such roles (nepotism), facilitate the expropriation of corporate assets, or cause the corporation to invest in projects that enrich the controlling shareholder or related parties but which are not the best investment options in terms of corporate value (a form of expropriation known as tunneling).
Because potential agency problems create uncertainty for principals as to agents’ behaviors, market forces (including those in capital markets, managerial labor markets, and product markets) may provide incentives for the principals and agents to agree to monitoring arrangements designed to reduce that uncertainty. If markets fail in this regard, there may be regulatory responses intended to reduce the uncertainty if it is perceived by regulators that this is in the public interest. This is the basis for many regulations that are associated with information asymmetry, including restrictions on “insider trading” of shares, and corporate disclosure requirements and related audit and assurance requirements.
The regulation of corporate financial reports to shareholders is intended to reduce the information asymmetry problem by requiring management to report on their financial performance and stewardship. Requirements for independent audits of those reports are intended to reduce the uncertainty that attaches to the corporate financial reports, which are prepared and presented by management. The multilateral relationships between managers, shareholders, the corporation, and auditors give rise to a complex set of agency issues. In most jurisdictions, the auditor is effectively chosen by management; in jurisdictions requiring shareholder ratification, the auditor selection process and contract negotiation are nonetheless controlled by the board of directors (or its equivalent). The auditor has contractual and statutory obligations to the corporation and its shareholders but is chosen by directors who oversee the auditor’s contractual and remuneration arrangements. In addition, the auditor engages closely with corporate employees, including executives, in the conduct of the audit. The processes for selecting and remunerating auditors, and their working relationships with officers and employees of the corporation, are threats to auditor independence, which is fundamental to their role in alleviating the uncertainties attaching to the corporate financial reports provided by management. This concern receives substantial attention in the codes or standards concerned with the ethical conduct of auditors.
Applications of agency theory are broadly concerned with economic consequences and contracting behavior that are examined in the context of rational expectations. The ethical implications of agency theory are largely concerned with agents’ breaches of their duties to principals. Agency theory informs many discussions and debates in business and professional ethics and has substantially influenced developments in corporate regulation.