Limitations Of Agency Theory Finance Essay
Irrespective of the recent well-deserved criticism of Agency Theory I believe it should still play an important role in managerial remuneration. Empirical evidence supports the theory that a conflict of interest exists between shareholders and management.
Throughout recent years one of the more commonly discussed management topics has been executive compensation and in particular the size of bonuses awarded to CEOs and other senior management.
Agency theory can be considered to be the most widely used theory to explain executive compensation. The focus of Agency theory is on ways to make the governance system of corporation’s more efficient so that shareholders’ interests and performance expectations are given every chance to be realised by the Chief Executive Officer (CEO).
An agency problem may arise between managers and shareholders because the principals (the shareholders) cannot adequately monitor the actions taken by the agent (the managers). Subsequently, the agent can have an incentive to pursue their own interests, rather than the bet interests of the principal.
Given the body of evidence, it would be naïve to claim that agency theory has not made a significant contribution to the principal-agent literature. However it does have its limitations and a new approach is needed to use the benefits of agency theory to its fullest.
By realizing agency theory’s limitations, we can add to its strength. Droege, Scott B
A key issue facing agency theory is the reliance that stakeholders have on the board of directors. This has proven to be an unhealthy reliance and the level of independance of some board of direcors can be questioned. This is discussed by Band (xxxx) when he noted that while there is a common perception that the board is independent, this is often fake as noted by Pearce and Zahra who found that over 85% of Fortune 500 industrial companies had Chairmen who had also served as the corporations CEO.
It is well documented that executive compensation packages should be designed to align the interests of senior management with those of the shareholders and thereby reduce the dysfunctional behaviour of managers; this is typically done by rewarding executives for taking decisions and actions that increase shareholder wealth ([26] Mortlock, 2009). Unfortunately, the shareholders (and directors) may have neither complete information about the actions of executives or the expertise to evaluate those actions, making it difficult to base compensation on actions alone. Instead, compensation in practice is often linked to measures that are positively correlated with managerial performance, for instance market share, share price or accounting profit.
Additionally In recent years Boards have become weaker as more power has been distributed to senior management. This has resulted in the decline of the accountability of Directors and a resulting impact in the decline of the monitoring role of Boards.
Corporate Governance – David Band
The board of directors is heavily reliant on the information provided by the CEO.
The recent spate of failures among both financial and non-financial companies has been accompanied by a growing interest in and concern about the compensation of the CEOs of major U.S. corporations. This, in turn, has reignited interest among both academics and financial practitioners about agency theory issues, especially the question of whether or not the total compensation of CEOs is properly scaled in relation to the earnings they generate for the shareholders they serve.
We find that the executive remuneration design derived from a single agency perspective is insufficient. Prospect theory, real option theory and managerial power approach all together would complement agency theory to bring the theory of executive remuneration closer to reality
Adam Notes – Agency Theory or Stewardship theory
Limitations of Agency theory –
Irrespective of the recent well-deserved criticism of Agency Theory I believe it should still play an important role in managerial remuneration. Empirical evidence supports the theory that a conflict of interest exists between shareholders and management.
The board still functions on information provided by the CEO.
While there is a common perception that the board is independent, this is often fake as noted by Pearce and Zahra who found that over 85% of Fortune 500 industrial companies had Chairmen who had also served as the corporations CEO.
In recent years Boards have become weaker as more power has been distributed to senior management. This has resulted in the decline of the accountability of Directors and a resulting impact in the decline of the monitoring role of Boards.
Corporate Governance – David Band
The appropriate remedy for the problem of the potentially self-interested or incompetent managerial team is said to be the monitoring board. But frankly, no one really knows what is the optimal level of option grant: what level of stock option compensation will make an executive risk-neutral like the shareholders, or willing to bite the bullet on layoffs, or willing to accept a premium bid? Even if the stock price falls back, the well-timed executive option exercise is a life-changing experience. More formally, the Black-Scholes option pricing model instructs us that the value of the executive’s stock option will be increasing both in the value of the underlying security and the variance (since stock options are issued “at the money”). So managers with a rich load of options have incentives to get the stock price high by any means necessary, fraud included. In particular, they have incentives to increase the riskiness of the firm, including projects that offer lower expected returns but higher variance. This will reduce the value of the firm for risk-neutral shareholders but has the potential to increase the value of managers’ firm-related investments in cases where the gain in option holdings exceeds the loss to human capital. Managers become risk-preferring. Enron – Jeffrey Gordon
Prospect theory, real option theory and the managerial power approach all together would complement agency theory to bring the theory of executive remuneration closer to reality. On the other hand, theoretically, being the main stream theory of corporate governance, agency theory suggests effective executive remuneration should align managers’ interests with shareholders’ interests in order to minimize agency costs (Florackis, 2005; Bayless,2009). Most remuneration frameworks in the literature have been largely influenced by agency theory. However, notable divergences exist between thepredictions of agency theory and reality. There is a need to extend agency theory with some complementary theories to make executive compensation more realistic.
We find that the executive remuneration design derived from a single agency perspective is insufficient. Prospect theory, real option theory and managerial power approach all together would complement agency theory to bring the theory of executive remuneration closer to reality.
Che, Zhang,Xiao and Li
Empirical support for agency theory has been demonstrated in numerous settings. For example, Eisenhardt’s (1988) studies of retail stores show support for agency theory in salaried and commissioned salespeople. Acquisitions and divestitures were the focus of a study by Argawal and Mandelker ( 1 987). Conlon and Parks ( 1 990) examined performance-contingent compensation as the dependent variable and found support for agency theory. Support has been found in interorganizational joint ventures (BalakrishnanandKoza, 1993) and franchising (e.g., Agrawal and LaI, 1995). Although not an exhaustive review, this brief list gives adequate evidence that agency theory has been empirically tested and supported in a variety of contexts from retail sales to manufacturing to joint ventures. Given this body of evidence, it would be naïve to claim that agency theory has not made a contribution to the principal-agent literature. Indeed, it has made a significant contribution. Thus, it is not my intent to discredit agency theory. However, a rational course is to separate the premises and examine them in a new light.
By realizing agency theory’s limitations, we can add to its strength. Droege, Scott B
Agency theory can be considered to be the most widely used theory to explain executive1 compensation. Agency theory, from economics, focuses on ways to make the governance system of a corporation more efficient so that shareholders’ interests and performance expectations are realized by the Chief Executive Officer (CEO).
The failure to find a consistent link between executive compensation and a firm’s performance has motivated some authors to supplement agency theory with other theories originating in psychology and sociology (e.g., Ungson and Steers, 1984; Wiseman and Gomez-Mejia, 1998; Bainbridge, 2005; Gomez- Mejia et al., 2005; and Perkins, 2008).
It should be explicitly mentioned here that it is not our objective to replace agency theory with other theories. Rather, we recommend adding other theoretical lenses, originating in other paradigms, to make our understanding of executive compensation more complete.
While discussing each of the theories, it will become clear that rather than taking a single theory perspective, it is preferable to take a multi-theory approach to explain the complexities of executive compensation. This is also a logical consequence of the use of three paradigms. Under such an approach, different paradigms and theories together serve to explain executive compensation better and more completely than opting for a single theory or paradigm.
Over the last decades, hundreds of studies have been published in the field of executive compensation. Agency theory was found to be the dominant framework. This theory puts forward the relationship between firm performance and executive compensation as one of the mechanisms to reduce agency costs. The inability to find a consistent relationship between performance and executive compensation, however, has given rise to the development of alternative theories. The most popular alternative theories include managerialism theory, institutional theory and contingency theory.
Strong support was found for taking such a multi-theoretical and multi-disciplinary view of executive compensation. The control perspective (agency theory), which has historically been the main perspective, has to be enriched with behavioral, institutional and contingency factors.
Baeten, Xavier; Balkin, David
In the aftermath of the global financial crisis (GFC) governments lost confidence in market fundamentalism and realised the inadequacies of regulatory measures. The purpose of this paper is to outline the proximate causes of the financial crisis of 2007-2009 and to investigate the role of the shareholder wealth maximization (SWM) objective in the GFC. The case studies revealed that unethical behaviour, agency issues, CEO compensation, creative accounting and risk shifting are some of the side effects of SWM. These cases indicate that the assumptions on which SWM are based are questionable. Further, it can be argued that the root cause of the GFC is excessive greed and the single-minded pursuit of SWM.
The global financial crisis (GFC), which had been threatening for some time, began to display its effects in the middle of 2007 and into 2008. Around the world, stock markets have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to develop with rescue packages to bail out their financial systems.
Had all boards of directors being successful in their assigned role of protecting all stakeholders of the firm, rather than just shareholders, then we believe that the GFC would have been avoided.
Most business concern is focused on profit maximisation. However, profit maximisation fails for a number of well-known reasons; it ignores: the timing of returns; the cash flows available to shareholders; and risk.
Without explicitly considering these factors, higher earnings alone do not necessarily translate into higher share prices.
Damodaran (1999) explains that, in the real world, managers perform the decision-making function with four factors or linkages in mind: shareholders, bondholders, society and financial markets. Competitive market conditions place significant pressure on agents and managers who will be tempted to resort to unethical means to portray a positive picture. It is acknowledged that the wealth maximisation objective is not always compatible with a firm’s social obligations, and it usually involves an agency problem which arises when the managers fail to act in the best interests of the shareholders, preferring instead to benefit themselves ([20] Jensen and Meckling, 1976).
Differences in the objectives of ownership and management lead to agency costs; if these are to be controlled, the shareholders must maintain a strict watch over the functioning of the company. The managers should be rewarded for acting in the interests of the shareholders and the managers should maintain a balance between the interests of the shareholders and other stakeholders. In this context, the GFC highlighted the important influence that incentive structures within financial institutions and other businesses can have on risk-taking and financial performance. In particular, it highlighted the dangers of badly designed remuneration incentive arrangements leading to excessive risk-taking, poor financial performance and a bias towards short-term results at the expense of longer-term financial soundness ([26] Mortlock, 2009).
It is well documented that executive compensation packages should be designed to align the interests of senior management with those of the shareholders and thereby reduce the dysfunctional behaviour of managers; this is typically done by rewarding executives for taking decisions and actions that increase shareholder wealth ([26] Mortlock, 2009). Unfortunately, the shareholders (and directors) may have neither complete information about the actions of executives or the expertise to evaluate those actions, making it difficult to base compensation on actions alone. Instead, compensation in practice is often linked to measures that are positively correlated with managerial performance, for instance market share, share price or accounting profit.
Stock options became an ever greater part of executives’ compensation, “increasing from 27 per cent in 1992 to 60 per cent in 2000. Fixed salary will reduce the risk to the executives and guarantee a standard of living. On the other hand, it may not encourage them to improve their performance in order to maximise shareholder wealth. The use of golden handshake and golden parachute clauses in management contracts may also be driven by managers acting to further their own interests, rather than those of their shareholders.
[25] Matsumura and Shin (2005) characterized conflicts of interest between shareholders and managers as usually arising in three broad areas. First, executives enjoy (as well as exploit) the perquisites provided to them. Second, executives are more risk averse in decision making and aim for better compensation as a trade-off. Lastly, executives are more interested in making decisions that have short-term impacts rather than taking a long-term perspective. By designing executive packages in a way that balances the interests of shareholders and executives, these conflicts can be reduced. The packages should be so designed to motivate the executives, whilst at the same time allowing management to control the amount spent on compensation, based on the performance of the CEOs themselves. [26] Mortlock (2009) notes that the major financial and corporate sector distress seen in the USA and Europe in recent times is partly attributable to poorly designed remuneration incentive arrangements.
An examination of history reveals that a range of practices, unrelated to any major improvement in cash flows and/or profits, have been carried out with the intention of increasing wealth; for example: accounting manoeuvres with deceitful intention and accounting fraud (in the case of Xerox), improper accounting, deviation from accounting principles with deceitful intention, leveraging of shares to raise debt for expensive acquisitions (as in the case of WorldCom), stretching the limits of accounting by misusing its limitations, lack of transparency, intentional projection of a “rosy” picture of performance (in the cases of Enron and Arthur Anderson), massive fraud, accounting scandal (in the case of Peregrine Systems), aggressive acquisition strategies and accounting frauds (in the case of Tyco), diverting business cash into off-shore, family-owned entities, artificial support given to the stock of the company (in the case of Polly Peck), deceitful intention of elite and experienced hands with sophisticated outlets (in the case of BCCI banks) and highly leveraged synthetic financial instruments (in the case of Goldman Sachs).
Creative accounting is the manipulation of financial numbers, usually within the letter of the law and accounting standards, although its use can be unethical and does not provide the “true and fair” view of a company that accounts are supposed to provide ([45] Moneyterms, 2009).
Common to all the cases mentioned above was management’s single-minded focus on SWM. By attempting to grow the company at high speed and by using creative accounting techniques, managers had failed to foresee the detrimental affect these actions would have in the long term.
It is clear that, in light of the side effects of SWM as discussed in Section 4 – particularly their impact during the crisis – the validity of the above assumptions has become questionable. In this regard, [19] Jenkins and Guerrera (2010) argue that the recent SEC attack on Goldman Sachs strikes at the heart of the business model, a model that, as [46] Friedman (1970) states, views the social responsibility of business being to increase its profits. However, as an agent, a manager is bound to act to maximise the wealth of shareholders, rather than to follow an agenda of social responsibility.
It is clear that major issues like unethical behaviour, executive compensation, creative accounting and conflicts of interest, pushed the big entities towards major difficulties and, in many cases, collapse. Though a series of accounting regulations were designed and directed, many giant organisations found convenient loopholes to take advantage of or, if this was not possible, resorted to manipulative means, actions which ultimately contributed substantively to the financial crisis.
Hull (2009) argues that the inappropriateness of extant incentive schemes led to a short-term focus in the managerial decision making. Given this situation, in February 2009, US President Barack Obama introduced new restrictions on executive compensation for institutions that receive financial assistance from the government, by limiting cash compensation to US$500,000; similarly, the US’s Financial Stability Board released a set of principles aimed to ensuring effective governance of compensation and the effective alignment of compensation with prudent risk taking. These developments in turn suggest that the SWM objective is neither self-regulatory nor flawless in nature.
As we have discussed in this paper, the reasons for the burst of this financial bubble are many. However, most of the factors are (directly or indirectly) linked to the pursuit of SWM. The above discussion has shown that each factor had in common the desire to increase the value of owners’ wealth. It appears reasonable to argue that, by forgetting the importance of ethics and deviating from accounting principles, the greed paid off.
Risk shifting and dysfunctional behaviour are some of the side effects and flaws in an SWM-based system that is not self-regulatory.
Because of a strong focus on profit maximisation or even SWM, the corporate decisions that led to the economic downturn were never balanced with any “good citizen” approach. But value maximisation alone is no longer sufficient in today’s competitive global business environment; organisations need to focus on objectives that have long-term benefits rather than short-term value. By taking stakeholders and society into consideration a firm will truly begin to create sustainable wealth; while the corporate objective function is dominated by SWM this cannot take place. Yahanpath, Noel
Supporters of agency theory underscore, among its positive features, the realism with which it describes relationships among individuals in a company(Eisenhardt, 1989). The firm is no longer considered as a single, monolithic actor but the complex set of interactions among several individuals. The firm is now presented as a nexus of contracts between principals and agents (Maitland, 1994; Shankman,1999).
Typically, there are different goals and interests among individuals involved in an agency relationship. Agency theory presupposes that individuals are opportunistic, that is, they constantly aim to maximize their own interests (Bohren, 1998). Thus, there is no guarantee that agents will always act in the best interests of principals. Rather, there is a constant temptation for agents to maximize their own interests, even at the expense of principals.
Under conditions of incomplete information and uncertainty prevalent in business settings two kinds of problems arise: adverse selection and moral hazard (Eisenhardt, 1989, p. 58). Adverse selection refers to the possibility of agents misrepresenting their ability to do the work agreed; in other words, agents may adopt decisions inconsistent with the contractual goals that embody their principals preferences. Moral hazard, on the other hand, refers to the danger of agents not putting forth their best efforts or shirking from their tasks.
This divergence between the interests of the principal and the agent unavoidably generates costs. Agency costs are residual costs that result in a failure to maximize the principal_s wealth. These may be incurred by the principal – through measures to control the agent_s behaviour – or by the agent – through efforts to demonstrate his commitment to the principal_s goals.
The whole point behind agency theory is to come up with mechanisms that ensure an efficient alignment of interests between agent and principal, thereby reducing agency costs (Shankman, 1999, p.321).
Principals are thus challenged to design contracts that protect their interests and maximize their utility in case of conflict. These contracts are based on several assumptions regarding agents (self-interest, limited rationality, risk aversion), organizations (goal conflict between members) and information (asymmetrical) (Shankman, 1999, p. 332).
Supporters of agency theory underscore, among itspositive features, the realism with which it describes relationships among individuals in a company (Eisenhardt, 1989). The firm is no longer considered as a single, monolithic actor but the complex set of interactions among several individuals.
Methodologically, agency theory subscribes to individualism: its basic unit of analysis is the human being fully constituted as an individual and bereft of any social dimension. In every endeavour individual agents seek above all their own utility (utilitarianism) or pleasure (hedonism), the satisfaction of their own desires. They form groups not to fulfil any requirement of their proper flourishing as human beings but only to further their particular interests (contractualism).
Outside of this, agents do not subscribe to any moral imperative; they willingly engage in immoral conduct whenever convenient. Acting morally would be reasonable only if it presented a greater economic incentive in terms of utility and pleasure than the contrary (Bohren, 1998).
Joan Fontrodona, Alejo Jose´ G. Sison
The recent spate of failures among both financial and non-financial companies has been accompanied by a growing interest in and concern about the compensation of the CEOs of major U.S. corporations. This, in turn, has reignited interest among both academics and financial practitioners about agency theory issues, especially the question of whether or not the total compensation of CEOs is properly scaled in relation to the earnings they generate for the shareholders they serve.
Our null hypothesis, consistent with the popular assumption in the media, is that the secular growth of CEO compensation has become increasingly misaligned with the earnings results that CEOs have produced for shareholders. Surprisingly, our initial findings, drawing on secular trends among S&P 500 firms, appear to show that our hypothesis does not hold, and that, over an extended period of time, CEOs have not received compensation that is out of line with the their companies’ earnings trends.
Zhao, Kevin M; Baum, Charles L; Ford, William F