2.2.5 Remedies for minimising agency problems

The problems attached to the separation of ownership and control and in particular the agency problems can be minimised in several ways. These remedies do of course cohere with one and another, but can separately be referred to as:

For the purpose of understanding the theoretical framework of this study further (see III in figure 2.1a), the remedies are briefly explained below, with special attention for the disclosure remedy in section 2.4 further down, since the comply or explain principle itself can be regarded as a disclosure.

By aligning the interests of the agents and principals (i) the agency problems should decrease. In the event that the principal has shares in the company he manages, he has the same interests as the shareholders: a high share value and good market valuation of the company. The agent shall act to achieve these joint goals. According to the convergence-of-interests hypothesis a uniformly positive relationship between management ownership and market valuation exists (Short and Keasey 1999, p. 80). Morck, Shleifer and Vishny argue: "As their stake rises they pay a larger share ofthe costs ofdeviation from value-maximization, so they are motivated not to squander corporate wealth" (Morck, Shleifer et al. 1988, p. 293).

On the other hand, based on the entrenchment hypothesis this market valuation can be adversely affected for a particular range of high ownership stakes (the 5% to 25% range).1 Through those high ownership stakes the manager has such voting power or influence that he is more or less free from control and can safeguard his own employment with the firm with an attractive salary (Morck, Shleifer et al. 1988, p. 295). To sum up, and leaving the discussion about the desired level of management ownership out of it, by aligning the interests of agents and principals the agency problems should decrease.

Through disclosure (ii) of all relevant information by principals and more importantly by the agents, information asymmetry and as a consequence thereof opportunistic behaviour can be avoided. Transparency as complete as possible is a goal to aim for. (Mandatory) disclosure can help reduce the agency costs (for example the monitoring costs) and the use of corporate assets by principals for self-interested purposes (Mahoney 1995, p. 1048) (for more information on the disclosure remedy see section 2.4). A third remedy for agency problems is commitment (iii). Due to contracts between the agents and the principals, they are committed to one and another. The parties involved have to behave in line with their contracts (for example the employment contract between the manager and the company) and opportunistic behaviour can be avoided ex ante by the strict agreements laid down in these contracts. By means of such contracts the separation of functions (iv) can be arranged. Fama and Jensen state that the separation of risk-bearing functions from decision functions is common in organisations because of the acknowledged benefits of specialisation in management or in risk bearing (Fama and Jensen 1983, p. 2). They ground their research on the separation of ownership and control and claim that the decision process has four steps: initiation, ratification, implementation and monitoring (Fama and Jensen 1983, p. 4). To control agency problems the ratification and monitoring of decisions (decision control) must be separated from the initiation and implementation of decisions (decision management) (Fama and Jensen 1983, p. 5). Otherwise phrased: the decision management and decision control must not be combined in one agent and the decision managers (the agents who initiate and implement decisions) are not the major residual claimants who hold a major share of the wealth effects of their decisions (the principals/shareholders).

Monitoring, supervision or control (v) is mentioned as the fifth solution. Fama and Jensen define monitoring or supervision with regard to companies as: "Measurement ofthe performance ofdecision agents and implementation of reward' (Fama and Jensen 1983, p. 4). Or more specifically: "It includes efforts on the part of the principal to 'control' the behaviour of the agent through budget restrictions, compensation policies, operating rules, etc." (Jensen and Meckling 1976, p. 6). Alchian and Demsetz, as frontrunners in this matter, argued for the specialised role of a monitor to check the input performance of team members for the purpose of reducing shirking (Alchian and Demsetz 1972, p. 781). Although taking into consideration that Alchian and Demsetz only discuss the role of an internal supervisor, the need for and the specialised role of ' the supervisor' have been recognised since then. Monitoring is by turns seen as a solution or a problem (Mertens 2006, p. 5). Various developments regarding monitoring occurred in recent years. Monitoring by the private sector gained importance and since the nineties western governments are withdrawing from supervision more and more (Leeuw and Willemsen 2006, p. 2109).

Society internationalised and the power of the markets and their participants increased. Due to the withdrawal of the government and the growing influence of the market participants, society became more 'horizontal' or 'flat'.This development resulted in a growing desire for hierarchical relations (i.e. monitoring), especially after the decline of traditional norms and values and after the corporate scandals (Vermaat 2000, p. 8). Monitoring became that much of a trend, that just having a monitor could be considered an asset (Leeuw and Willemsen 2006, p. 2109). Nevertheless, in the years thereafter various failures of this fifth solution were visible as well, for example too much supervision (unnecessary, incident driven or overlapping supervision) (Leeuw and Willemsen 2006, p. 2109) (Peij 2005, p. 21) (Coffee 1991, p. 1329) (Baarsma 2005, p. 19) or more recently possible insufficient supervision before the financial crisis.

All of the remedies explained briefly above help solve and decrease agency problems. Implementing one of the five remedies in companies is not sufficient; combinations are necessary to decrease agency problems. The best combinations to be made depend on company characteristics (one size does not fit all): such as size and structure, the applicable legislation and corporate culture. Over time the attention given to specific remedies and the importance assigned to specific remedies changed. Berle, Means, Jensen and Meckling stressed the separation of ownership and control in their work and from their viewpoint alignment, commitment and the separation of functions are of great importance to diminish agency problems. In several western countries those remedies are nowadays quite explicitly laid down in legislation/regulation or in agreements.2 Nevertheless, attention should nowadays constantly be drawn to disclosures about and monitoring of the level to which those rules are applied - and likewise to the comply or explain principle - to ensure that companies, their directors and advisors comply with the rules and agreements and as a consequence thereof agency problems are minimised as much as possible.

To determine the theoretical framework in this multidisciplinary study the judicial view of the existence of firms and the relationship between agency problems and possible legal remedies are of importance too; hence law and economics converge. Some of the above remedies have long been incorporated in legislation or are part of the core legal characteristics of a firm. To make the theoretical framework of this study comprehensive the next two subsections provide a more judicial explanation of the characteristics of a firm, the agency problems and possible remedies (see I, II and III in figure 2.1a).