Agency cost
An agency cost is an economic concept that refers to the costs associated with the relationship between a "principal", and an "agent". The agent is given powers to make decisions on behalf of the principal. However, the two parties may have different incentives and the agent generally has more information. The principal cannot directly ensure that its agent is always acting in its best interests. This potential divergence in interests is what gives rise to agency costs.
Common examples of this cost include:
- according to the Friedman doctrine, the cost borne by shareholders when corporate management buys other companies to expand its power, or spends money on vanity projects, instead of maximizing the value of the corporation;
- the cost borne by the voters of a politician's district when the politician passes legislation helpful to large contributors to their campaign rather than the voters.
In corporate governance
The relationship between a company's shareholder and the board of directors is generally considered to be a classic example of a principal–agent problem. The problem arises because there is a division between the ownership and control of the company, as a result of the residual loss. In such case, traditional mechanisms of corporate governance such as shareholder activism and proxy contests may be less effective due to the fragmented nature of ownership. The shareholders appoint the board to manage their asset but often lack the time, expertise or power to directly observe the actions of the board. In addition the shareholders may not be placed to understand of the repercussions of the board's decisions. As such, the board may be capable of acting in their own best interests without the oversight of the shareholders. As is noted by Adolf A. Berle, in his now famous work on company law, this issue is exacerbated in companies where each shareholders has only a small interest in the company. Such diversity in shareholder interests makes it unlikely that any one shareholder will exercise proper control over the board.The classic case of corporate agency cost is the professional manager—specifically the CEO—with only a small stake in ownership, having interests differing from those of firm's owners.
Instead of making the company more efficient and profitable, the CEO may be tempted into:
- empire-building ;
- not firing subordinates whose mediocrity or even incompetence may be outweighed by their value as friends and colleagues;
- retaining large amounts of cash that, while wasteful, gives independence from capital markets;
- a maximum of compensation with a minimum of "strings"—in the form of pressure to perform—attached.
- management may even manipulate financial figures to optimize bonuses and stock-price-related options.
Mitigation of Agency Costs
Much of modern company law has evolved in order to limit the effects of agency costs. Company directors in common law jurisdictions owe fiduciary duties to their company. Notably these duties are not owed to the shareholders, but to the company. This is because the company is, in law, a legal person, separate from its shareholders. Breaches of duty by directors have the primary effect of causing losses to the company. The fiduciary duty requires the company director to act with due care and skill, in good faith, in the best interests of the company and without conflicts of interest. In some jurisdictions deliberate breaches of directors duties can result in civil or criminal penalties.However, director's duties are difficult to enforce without the involvement of a liquidator. This is in part due to the asymmetry of information between the shareholders and the board. In addition, as shareholders are not generally owed directors duties, they do not having standing to enforce them. Similar issues arise with respect to obligations under a contract between the director and the company, given the operation of the privity doctrine. Instead, companies often opt for incentive schemes based on the performance of the company. These schemes provide bonuses to company directors when the company performs well. The director is therefore given an incentive to ensure the proper performance of the company, thereby aligning their interests with that of the shareholders. The costs of paying the bonus is still an agency cost, but the company will profit from paying this cost so long as the avoided residual cost, is greater than the bonus.
Another key method by which agency costs are reduced is through legislative requirements that companies undertake audits of their financial statements. Publicly listed companies must also undertake disclosure to the market. These requirements seek to mitigate the information asymmetry between the board and the shareholders. The requirement to make disclosure reduces monitoring costs, and directors are less able to abuse their position when they will be required to disclose their shortcomings.
Concentrated Shareholders
A concentrated shareholder structure can result in small groups that hold a significant proportion of the company’s shares. These shareholders can exercise significant control over the company as well as cause conflicts of interest between concentrated and other shareholders. For instance, concentrated shareholders may prioritise their profits and rights over those of other shareholders, thus increasing agency costs.For example, concentrated shareholders can make decisions that are more beneficial to themselves, such as higher dividend payouts or short-term, high-repayment business decisions. Such decisions may adversely affect the rights of other shareholders or the long-term survival of the company.
In jurisdictions outside the US and UK, a distinct form of agency costs arises from the existence of dominant shareholders within public corporations.
In 2014, the study “Yesterday’s Heroes: Compensation and Creative Risk-Taking,” was published in the Journal of Finance. The authors explained how executive compensation could increase the rate of creative risk-taking, which can lead to better company performance but, at the same time, increase agency costs. The authors used data from the movie industry to illustrate that managers with past successes are more likely to take creative risks and try to bring higher profit returns with higher risks, such as investing in projects with a low probability of success, which can increase agency costs. The paper summarised that the executive compensation design should consider the potential of creative risk-taking and agency costs. Moreover, boards should carefully monitor the activities of managers to ensure that they are acting to achieve the best profit returns for shareholders.
The article “Large shareholders and corporate control” was published in the Journal of Political Economy in 1985. The paper provides a theoretical framework that illustrates the role of large shareholders in corporate governance and control. For instance, large shareholders can be crucial in solving agency problems between managers and other shareholders. In addition, they can monitor managers and intervene when necessary in order to protect their profits. Large shareholders can also play an essential role in corporate control. For example, large shareholders hold a significant stake in the company and can therefore influence critical decisions, such as the election of directors and the adoption of significant corporate policies. These decisions could increase the agency cost because large shareholders may decide to get maximum profit for themselves, which is not usually the best decision for the company's long-term survival.
Modern Examples
, a U.S. energy giant operated for decades trading large and highly demanded commodities. However, 2001 saw the fall of the giant as a result of poor management, and a deeply rooted principal-agent problem.Typically speaking, chiefs and management are paid large salaries in the hope that these salaries deter from participation in high risk business. Yet Enron's board of directors decided to pay its managers in the form of stocks and options. In a very simplistic sense, this meant that managements compensation was pegged to stock performance and would mean any decision they made would be to the benefit of themselves and principals.
Whilst in theory the concept was sound, it meant that Enron's management could now deceive the markets for their own monetary gain, and they did just that. Higher management decided to take on high debt and risky activities, leaving these transactions 'off the books' and essentially meaning Enron was falsifying information. Enron had reached the point where it was overstating profits by and eventually lead to its collapse.
In Enron's collapse it also took down its accounting counterpart firm, Arthur Andersen, who were certifying Enron's books to be clean, when they very obviously weren't. In the case of Arthur Andersen again reiterating the power of the principal-agent problem, where the accounting firm trusts and follows orders from the chiefs, who benefit greatly from the business of a large company like Enron.
The collapse of the two giants shook Wall street, and finance around the globe, leading to Enron's CEO Jeffrey Skilling being sentenced , as a result of various counts of conspiracy, fraud and insider trading. To this day, the Enron Scandal still remains as one of the key studies of the principal-agent problem.
Another potential example of the agency-cost problem arose with respect to the James Hardie Scandal, where James Hardie Industries sought to avoid payment of settlements to those former employees suffering from by asbestos related illnesses. Ultimately, the shareholders were almost unanimous in voting in favor of a compensation scheme for the victims. The interests of the shareholders may have favored funding the compensation scheme earlier than the directors were willing to. This divergence in interest, even where it address an issue of corporate social responsibility rather than strictly monetary concerns, could be considered an example of agency cost.
Further difficulties may arise where the interests of one shareholder conflicts with that of another. In the legal dispute Dodge v Ford Motor Co, Henry Ford sought to take Ford Motors in a direction that was disagreeable to one of the minority shareholders, Mr Dodge. Mr Ford's aggressive expansion policies were perceived by Mr Ford to be for the long-term benefit of the company, but they prevented dividends being paid in the short term. This was beneficial to long-term shareholders, such as Mr Ford, but Mr Dodge may not have held his shares for long enough to reap the benefit. As such, he brought a successful action in minority oppression in order to force the payment of dividends by the Ford Motor Co. Mr Dodge's inability to receive a dividend without litigation is another example of agency cost.