Agency theory

Another perspective on the inter-personal and inter-organizational conflicts of interest is that of agency theory. In modern corporate governance literature, agency theory and associated agency costs provide the theoretical foundation for describing most governance issues related

to human capital and its deployment (Thomsen 2008). This thesis adheres to this assumption and uses agency theory as a theoretical foundation. Therefore, a thorough outline of the basic tenets of the agency theory and its extensions is given in the following.

Although several scholars acknowledge that it may be hard to distinguish transaction cost economics’ issues from those of agency theory (Williamson 1996, Gilson, Mnookin 1985), it is noted that agency theory uses as its unit of analysis the individual, whereas transaction cost economics analyzes the transaction itself (Solomon 2004, Williamson 1996). As this thesis is ultimately concerned with the incentives and actions of the individual, more specifically the board member, agency theory takes the predominant position as a theoretical foundation for this thesis.

4.3.1 Fundamental agency theory

Following Ross’ (1973) first description of the principal-agent relation, Jensen and Meckling (1976) build the first theoretical exposition on the agency problem.

Agency theory seeks to explain the incentive issues arising with the separation of ownership and control, or using Fama and Jensen’s (1983b) more precise term; the separation of decision control and decision management where important decision agents do not bear substantial share of the wealth effects of their decisions.

The literature on agency theory concerns itself with the principal (the owner/decision controller) and the agent (the decision manager), who face an available surplus (from the interaction), who have a conflict of interests and who have an information asymmetry between them (Hendrickse 2003). The agent acts on behalf of the principal and the agent is assumed to have the information advantage. The principal, on the other hand, is assumed to be the claimant to the surplus generated in the interaction, lest the amount of compensation agreed a priori between the parties.

A classic and simple example of the principal-agent problem is that of the doctor-patient: the doctor (the agent) has the information needed to treat the patient (the principal) who is willing to pay for the doctor’s services (surplus to be generated if the offered sum is higher than the doctor’s reservation price). The patient is unable to control the doctor’s efforts, as their relationship is informatively asymmetrical.(Culyer,Newhouse 2000).

4.3.2 The extended agency problem

In modern, large corporations, the agency problem is vastly more complex. The extended agency problem as a term refers to the multitude of agency problems found in firms with shareholders, a board of directors and with several layers of management (Thomsen 2008). In

practice, complexity is attained by the introduction of limited liability ownership and the opening of corporate ownership to the public¹² (Solomon 2004).

In public listed companies, the shareholders are the owners. Unable and unwilling to run the business on a daily basis, shareholders elect a board of directors to oversee and control the company’s operations. The board in turn hires the executive management, who should ultimately be acting on behalf of the company’s owners; the shareholders. The board is thus agents to their principals, the shareholders, and the board also serves as principals to the executive management, who in turn are agents to the board and to the shareholders (Hendrickse 2003). The board of directors is carefully examined in section 4.8.

The various agency problems come with agency costs, defined as the costs of structuring, monitoring and bonding a set of contracts among agents with conflicting interests (Fama, Jensen 1983b), and as the cost of aligning the agent’s incentives with those of the principal’s (Jensen, Meckling 1976, Stiglitz 1989) .

4.3.3 Contracts

The firm as a whole can generally be seen as a nexus of contracts (Jensen, Meckling 1976), which – among other purposes – serve to mitigate the outlined agency problems by specifying which tasks are transferred to agents and at which compensation (Fama, Jensen 1983b).

The existence of asymmetrical information is one of the characteristics of an agency problem (Hendrickse 2003, Mankiw 2008). In the decision process when hiring and controlling an agent, information asymmetry can arise at two separate stages: before signing the contract and/or after signing the contract (Thomsen 2008).

When a contract is entered into by a principal and an agent, the contract should ideally be complete contingent, meaning the agent’s effort and the outcome of this is known and can be observed and verified by everyone. In most cases, when entering into a contract some characteristics are not observable to everyone, but the outcome of them is; for example, a manager’s skill set might not be observable to the principal at the time of signing the contract, but the outcome of his actions can be. As an example, the owner (the principal) may know that a future manager is financially educated, but not if he is a hard-working manager who deploys his financial knowledge to his work efforts. Such a situation forms the basis for a complete contract, which then entails ex-ante informational asymmetry.

12 This view is derived from the “Fisherian Separation Principle”, which is the notion that capital markets are the reason separation of control and management exists at all.

If the outcome depends on other circumstances and skills than the ones contracted for with the agent, the contract is incomplete, reflecting informational asymmetry ante as well as ex-post, because now the full characteristics as well as the outcome are unknown to some degree.

This means that the outcome obtained from the agent’s efforts might be a result of all other things than the characteristics the agent was hired on and the effort he chose to put into the work. (Fama, Jensen 1983b, Hendrickse 2003, Mallin 2010).

A good example of employment contracts that in hindsight clearly should have been characterized as “incomplete” is the many publically lauded investment managers in the years leading to 2008: they were thought of as being hard-working financial wizards, whose dedicated efforts resulted in incredible returns on the portfolios they managed. In return, they negotiated astronomical salaries and incentive plans for themselves. It turned out, however, that when markets stalled, so did their funds: most of the upside could be ascribed to business cycle effects and to un-diversified risk-taking.

4.3.4 Ex-ante information asymmetry – hidden characteristics

The possible informational asymmetry before a principal contracts with an agent is labeled a hidden characteristics problem. The principal can observe whether the agent accepts the contract drafted by the principal, but not his motivation to do so. The principal may use methods to infer certain things about the agent’s characteristics (education, past results, hobbies and so forth), but cannot always exactly determine the qualities of the agent (Thomsen 2008, Solomon 2004).

Several applications of the hidden characteristics problem are found in the extended agency problem (see section 4.3.2). When the shareholders elect a board, they want to be sure the individual director has the qualities needed to govern the corporation effectively on their behalf. They cannot, however, completely know all the details of the prospective director’s qualities and his motivation for running for the election. Informational asymmetry therefore exists ex-ante.

In the extended agency problem, the elected board members face the same obstacles when hiring top management, who in turn will have to hire middle management; thus, the hidden characteristics problem is one of (possible) importance in all principal-agent relations throughout the corporation’s control chain. (Hendrickse 2003, Mallin 2010)

4.3.5 Ex-post information asymmetry – moral hazard

The result of ex-post information asymmetry is regularly characterized as “moral hazard” – the agent, knowing that the principal cannot fully observe her effort, but only the outcome of the combined effort and other circumstances, chooses to deliver an effort that does not (necessarily) maximize the owner’s value(Hendrickse 2003). Holmström (1979) describes this as “[…] moral hazard may arise when individuals engage in risk sharing under conditions such that their privately taken actions affect the probability distribution of the outcome” and may be the result of the agent’s attempt to benefit from the principal’s inferior information set (Beaver 1989).