Agency theory: a theory that looks at how to ensure that agents (executives, managers) act in the best interests of the principals (owners, sharehold- ers) of an organization.

ORIGINS

Agency theory addresses the relationship where in a contract ‘one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent’ (Jensen and Meckling, 1976: 308). This happens because of the separation of ownership and control, when the owner of the company or the board of directors (the ‘principals’) have to employ managers (‘agents’) to run the business and need to monitor their performance to ensure they act in the owner’s interest. Economists Alchian and Demsetz (1972) were the first to argue that monitoring the performance of individual work effort is always a cost of any firm and that organizational inefficiencies are created when the flow of information on individual performance is decreased or blocked. This agency theory can happen if there are large teams, unsupervized professionals, or execu- tives of corporations who act autonomously. The main concern of agency theory as proposed by Jensen and Meckling (1976) is how to write con- tracts in which an agent’s performance can be measured and incentivized so that they act with the principal’s interests in mind. Based on the idea that employees (at any level) will have diverse goals, two main agency problems are identified: how to align the conflicting goals of principals and agents, and how to ensure agents perform in the way principals expect them to. These problems can occur when executives or managers make self-interested decisions and manipulate information on performance,

perhaps by moving numbers around or by ‘creative accounting’ to 1 present better performance figures: ‘The problem here is that the princi- pal cannot verify that the agent has behaved appropriately’ (Eisenhardt, 1989: 58). Another example is when a manager decides to buy cheaper and inferior raw material for a product because he benefits personally by

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2 key concepts in organization theory tracts givendifferentconditionsofcertainty, riskaversion, information, agent researchersareconcernedwithexamining theefficiencyofcon- the liquidationofequitybyinvestors(Dalton etal., 2007). Principal– trols behavior throughsuchthreatsasacquisition, hostiletakeover, or alignment ofinterestistheexistenceequity marketwhichcon- public corporations. For example, onespecificmechanismtoensurethe between boardsofdirectors(principals)andthe CEOs(agents)oflarge of governancemechanisms. The focusisusuallytherelationship how anagent’s self-servingbehavior is limitedthroughdifferenttypes where theagentandprincipalhave conflictinggoalsandthenexamine and a ‘principal–agent’ stream. Positivist researcherssearchforsituations agency theoryresearchthatflowsintwostreams: a ‘positivist’ stream weekly productionoutputscomparedtotargets. output controlsmeasureoutputsandgoalachievement, forexample such asattitudestowards patientsandpatientcareinhospitals, while come-based controls?Behavioral controlsmeasureeffectivebehaviors, the mostefficientformsofcontrol–behavior-oriented controlsorout- Another keyquestioninmanagingtheagencyrelationshipiswhatare analysis foragencytheoryfromwhichscholarswillattempttodetermine: because itmaydecreaseprofitsintheshortterm. actually beasoundstrategic moveforsustainable growthofthefirm risk financingalong-termresearchanddevelopmentinitiativethatmay that oftheownersorshareholders. For example, anexecutivemightnot when executivesormanagershave adifferentattitude toward riskfrom due toadeclineinproductquality. Agency problemscanalsooccur this decisionresultsindeteriorating customerrelations andlowerprofits receiving abonusforcuttingcosts. However, thelonger-term impactof packages. This contract betweentheprincipalandagentisunitof senior executivespartownersofthefirmthroughtheircompensation amount andqualityofinformationavailable toprincipalsandmaking tives ormanagersactinthebestinterestsofownersbyincreasing 1989: 58) (e.g. informationisacommoditywhichcanbepurchased).(Eisenhardt, sion), organizations(e.g. goalconflictamongmembers),andinformation assumptions aboutpeople(e.g. self-interest,boundedrationality, riskaver- the mostefficientcontractgoverningprincipal-agentrelationshipgiven The solutiontoeitherofthese In her1989article, Eisenhardtprovidesacomprehensivereviewof agency problems istoensurethatexecu- 31/07/2012 8:23:39PM agency theory 3 31/07/2012 8:23:39 PM

DISCUSSION Another study, by O’Reilly and Main (2010), also questions the lack also questions by O’Reilly and Main (2010), Another study, Research using the concept of agency theory is quite broad and exten- the concept of agency theory is Research using here is however, the scope of this book, sive and a full review is beyond opinion, to Eisenhardt’s In contrast a look at some recent studies. the incentive alignment prediction of (2010) argue that Nyberg et al. been empirically proven in studies of CEO far, so agency theory has not, In their study of 2,166 US firms with (who are agents) compensation. the authors attempt to refine the concept of data from 1992 to 2004, ‘equity ownership that leads managers as defined financial alignment, shareholder interests’ firm to embrace who share ownership of their of empirical support for linking executive pay with firm performance. manage- They believe executive pay may be more likely a function of than an instru- more of a behavioral that is, ment power and influence; in a 2003 database Based on a study of 306 firms mental phenomenon. agency they argue that provided by an executive compensation firm, incentive theory may be a useful lens by which to study governance and are better at but that the ideas of reciprocity and influence alignment, com- explaining why boards of directors sometimes design non-optimal ‘norms The authors found that pensation packages for their executives. obligated the expectation that another will be of reciprocity’ – that is, ‘when the ‘social influence’ – that is, 684) – and when you help them (p. actions are appro- which attitudes and tacitly or explicitly, group signals, in 686) – appear distinctly priate and acceptable and which are not’ (p. etc. The focus is usually more theoretical, more mathematical, and and more mathematical, more theoretical, focus is usually The etc. suppliers, with employees, contracts of application (e.g. broader in terms realis- theory provides a unique, Eisenhardt argues that agency clients). on the organizational problems testable perspective and empirically tic, 72). effort (1989: of cooperative to predict organizational performance. and examine its ability 1030), (p. ‘CEO return,’ of variable Along with their newly conceptualized the percentage change in total firm-specific CEO wealth ‘as defined they found a statistically significant 1036), during a given fiscal year’ (p. return and shareholder return such positive relationship between CEO from doing firms do create financial alignment and gain on average, that, create CEO-shareholders via long-term use of equity- ‘when they so, executives to maintain based pay and policies that encourage/require 1041). which they work’ (p. equity positions in the firms for Cunliffe.indd 3 Cunliffe.indd 4

4 key concepts in organization theory the implementationofarange ofexecutiveactions’(p. 736). their results ‘suggest thatprincipalswithdifferinginterests caninfluence each ofthesenegativeorpositiverelationshipstobelessso. Clearly, cal competitiveactions, andmixedownershipstructurescaninfluence increase intransient institutionalownershipleadstoanincreaseintacti- tional ownershipleadstoadecreaseinstrategic competitiveactions, an increase instrategic competitiveactions, anincreaseintransient institu- other words, anincreaseindedicatedinstitutionalownershipleadsto executives aresignificantlyrelatedtofirmownershipstructures. In data from1997to2006andfoundthatcompetitiveactionstakenby actions ofexecutives. They lookedatasampleof investors withdifferenthorizons, mightinfluencethecompetitive returns. Connellyetal. (2010)askhowprincipals, suchasinstitutional of $1258inCEO’totalcashcompensation(p. 700). ‘every $1000theboardmemberreceivesisassociatedwithanincrease tion forthecommitteechairleadstohigherrates of CEOpay, suchthat the issueofboardcompensationcommitteeswherehighercompensa- and tegic competitiveaction, different timehorizonscanleadtocompetingcompetitiveactions: persed portfoliooffirms’withashorterhorizon(p. 723). And thetwo tional investorsthat ‘acquire lessconcentrated equitystakesinadis- firms andhave extendedinvestmenthorizons’and transient institu- tional investorsthat ‘acquire concentrated equitypositionsinafew tional investorscanbecategorizedintotwotypes: dedicatedinstitu- especially whenconsideringinstitutionalinvestors. Typically institu- agents have diversegoals, principalsalsohave heterogeneousinterests, only along-termoutlook, butConnellyetal. (2010)arguethatjustas tion andresourcesthatcouldimprovefirmperformance. Inastudyof outside directorshipsarequitevaluable intermsofaccesstoinforma- outsider directorshipsallowed. Yet, embeddednessscholarsarguethat over thepastfewdecadesinlegalrestrictions onthenumberof with theequityinvestmentcommunityasrepresented bythegrowth torship, theirfirmsdonotbenefit. This argumentseeminglyholdssway agency theoryscholarsarguethatwhenaCEO holdsanoutsidedirec- was askedinastudybyGeletkanyczandBoyd(2011). A numberof are theydistracted fromtheirinternalresponsibilities? This question When CEOsholdpositionsonBoardsofDirectorsforotherfirms, Agency theorytendstoassumeinvestors tactical competitiveaction, whichfocusesonlong-termsustainablegrowth, whichvalues short-termearningsand are anhomogeneous Fortune 500 firmswith set with stra- 31/07/2012 8:23:40PM agency theory 5 31/07/2012 8:23:40 PM Academy of experiences list, Geletkanycz and Geletkanycz list, when a firm Fortune 1000 Fortune FURTHER READING FURTHER , 14: 57–74. 14: , Environment–Organization Interaction, Stakeholder Theory, and Transaction Cost and Transaction Environment–Organization Interaction, Stakeholder Theory, Management Review Cai et al. (2011) researched the question of whether US firms that are (2011) researched the Cai et al. Boyd (2011) found that, in isolation, neither argument was adequate. adequate. argument was neither in isolation, that, Boyd (2011) found ‘that a contingency perspective They proposed acute challenges, it is in both the firm’s and its CEO’s personal interest personal its CEO’s and firm’s it is in both the acute challenges, serv- gains from outside board relevant to deploy the organizationally aligns with when outside board service Firms do benefit 336). ice’ (p. it provides of the firms; imperatives and environmental the strategic and exposure to strategic environmental scanning CEOs with improved alternatives. Eisenhardt K (1989) Agency theory: An assessment and review. An assessment and review. Agency theory: Eisenhardt K (1989) See also: Economics data from 460 firms in the 1987 460 firms in data from more socially responsible might pay their CEOs less. In a complex study, In a complex study, pay their CEOs less. more socially responsible might along with hypothesis’ of agency theory, ‘overinvestment they tested the over- The explanation’ of stakeholder theory. ‘conflict resolution the socially responsible that if corporate investment hypothesis purports such initiatives are a do not maximize firm value, ‘initiatives (CSR) problem would arise The agency 160). resources’ (p. of valuable waste in CSR activities simply to improve because managers would over-invest in an attempt to increase their bargain- their reputation as good citizens an increase in CSR initia- Thus, ing position in regard to compensation. The conflict in CEO compensation. tives would lead to an increase depends on the interest ‘firm value that resolution explanation purports stakeholder management will, and firms that practice of all stakeholders, CEOs 160). outperform others that do not’ (p. other things being equal, decrease conflict and to increase their would tend to take lower pay to increase in CSR initiatives would while an as virtuous, appearance CSR would an increase in Thus, decrease conflicts between stakeholders. 1,946 (2011) studied Cai et al. lead to a decrease in CEO compensation. with US firms with data from 1996 to 2010 that indeed showed firms This negative pay. lower CEO on average, more CSR activities having, consistent with relationship between CEO pay and CSR initiatives was the over- not the conflict-resolution explanation of stakeholder theory, investment hypothesis of agency theory. Cunliffe.indd 5 Cunliffe.indd 6

6 key concepts in organization theory O’Reilly CA andMainBGM(2010)Economicpsychologicalperspectiveson Nyberg AJ, FulmerIS, GerhartBandCarpenterMA(2010) Agency theoryrevisited: Jensen MCandMeckling WH (1976) Theory ofthefirm: Managerialbehavior, agency Geletkanycz MAandBoydBK(2011)CEOoutsidedirectorshipsfirmperform- Cai Y, Jo HandPan C(2011) Vice orvirtue? The impactofcorporate socialrespon- Alchian AA andDemsetzH(1972)Production, informationcosts, andeconomic tion theorybutisusuallyattributedtothewritings ofthe19th-century The conceptofalienationdevelopedwellbefore theadventoforganiza- Eisenhardt K(1989) Agency theory: An assessmentandreview. Dalton DR, HittMA, CertoSTandDaltonCM(2007) The fundamentalagency Connelly BL, Tihanyi L, CertoSTandHittMA(2010)Marchingtothebeatofdif- CEO returnandshareholderinterestalignment. costs, andownership structure. Journal ance: A reconciliationofagencyandembeddednessviews. Management Review CEO compensation: A reviewandsynthesis. 53(5): 1029–1049. 19(3): 675–712. lack ofcontrol. their actions,societyandsurroundings,resulting infeelingsofa Alienation: sibility onexecutivecompensation. organization. control. problem anditsmitigation: Independence, equity, andthemarketforcorporate Academy ofManagementJournal ferent drummers: The influenceofinstitutionalownersoncompetitiveactions. , 54(2): 335–352. Academy ofManagement Annals the estrangementandseparationofpeoplefromthemselves, American EconomicReview , 14: 57–74. REFERENCES Journal ofFinancial Economics , 53(4): 723–742. ORIGINS Journal ofBusinessEthics , 62: 777–795. , 1(1): 1–64. Industrial andCorporateChange Academy ofManagementJournal Academy ofManagement , 104: 159–173. , 3: 305–360. Academy of , , 31/07/2012 8:23:40PM