2.2.7 Legal strategies to decrease agency problems

The remedies for the agency problem described above in section 2.2.5 (see III in figure 2.1a) are absorbed in legal strategies to help reduce the agency problem. These strategies, consciously or unconsciously, short or long ago, implemented in (international) corporate law, are assessed further below and will be referred to in the remainder of this study when the comply or explain principle is discussed in more detail in section 2.4.

Corporate law in general - or more specifically the legal strategies absorbed in corporate law - plays a large role in reducing agency problems, the attached costs and in protecting the interests of the principals (Kraakman, Armour et al. 2009, p. 35) (Kraakman, Davies et al. 2004, p. 22). The table below presents ten generally accepted legal strategies, among which four regulatory strategies and six governance strategies.

The regulatory strategies mentioned in table 2.2.7 deal with the protection of parties in the case of contractual or pre-contractual relationships with or within the firm; they regulate the contents of the agent-principal relationship, its formation and dissolution. Rules and standards constrain agents not to make decisions or take actions that are not in line with the interests of the principals. Rules prohibit, constrain or require (ex ante) specific behaviour of agents. Standards leave the precise determination of compliance with these standards to after the facts (ex post).

The affiliation terms dictate: "the terms on which principals affiliate with agents rather than - as with rules and standards - the terms on which the principal-agent relationship develops internally" (Kraakman, Armour et al. 2009, p. 40). Affiliation terms of entry mean that the law can require agents to disclose information about themselves before contracting with the principals: for instance the duty to disclose information to a bank before receiving a loan or the duty to publish the annual accounts or the articles of association of a firm. The entry strategy makes it possible to screen out the opportunistic agents before business is done with them. The exit strategy allows the principals to escape ex post from those opportunistic agents they contracted with. For example, they have the right to withdraw the value of their investments. Withdrawal rights are not universal rights and in many jurisdictions they do not exist (Kraakman, Armour et al. 2009, p. 41). Nevertheless, in some jurisdictions and for certain legal persons it can be determined in the articles of association that the shareholders under certain circumstances have the right to dissolve the company. They can thus withdraw the value of their investments before any further opportunistic behaviour occurs (Kraakman, Armour et al. 2009, p. 41). Another and more common exit strategy is the right of transfer. Shareholders have the right to sell their shares and can do so massively when opportunistic behaviour occurs (e.g. in Enron).

As clarified above, the regulatory strategies govern the contents of the agent-principal relationship. The other group of legal strategies - the governance strategies - do cohere with the elements of hierarchy and dependency that characterise the principal-agent relationship. These strategies tend to protect the principals indirectly, for instance by increasing their powers or by arranging the principals' incentives (Kraakman, Armour et al. 2009, p. 42). Selection or removal rights - that is the appointment rights - are important governance strategies to control the firm and to deal with the three important agency relationships within the firm.1 Within these three relationships various kinds of appointment and removal rights should be determined to prevent, control or punish opportunistic behaviour of the agents. The rights can be laid down in legislation, articles of association or employment contracts, all for the purpose of arranging hierarchical and dependency issues clearly within the firm. The second governance strategy - the decision rights - gives the principals the power to initiate or ratify management decisions. An initiative by principals to propose a management decision is quite rare; because of the separation of ownership and leadership in a firm the decision-making authority is delegated to the agent by the principal (Kraakman, Armour et al. 2009, p. 42). However, due to increasing shareholders' activism nowadays shareholders tend to propose decisions more often than before.2 The ratification or veto of management decisions by principals - an ex post corporate strategy - takes place in the event of important and fundamental decisions, such as mergers or amendments to the articles of association. The agents prepare the grounds for these changes, however at the end of the day the principals have - if necessary - the right to veto changes they do not agree upon or that are possibly not in their interests. To conclude, trusteeship and reward are corporate strategies that alter the incentives of the agents (incentive strategies) (Kraakman, Armour et al. 2009, p. 43). The trusteeship strategy tries to achieve that opportunistic behaviour by the agents is not rewarded, and agency problems should thus be avoided ex ante. It is believed that: "in the absence of strongly focused - or 'high powered'- monetary incentives to behave opportunistically, the agents will respond to 'low-powered' incentives of conscience, pride and reputation, and are thus more likely to manage in the interests oftheir principals" (Kraakman, Armour et al. 2009, p. 43).

The reward strategy implies that the agent is rewarded whenever he acts successfully in the interests of the principal. According to this strategy two types of reward exist: (i) the sharing rule and (ii) the pay-for-performance regime. The sharing rule involves that the principals' monetary returns are directly linked to the rewards of the principal (for example a pro rata distribution of dividends). Under the pay-for-performance regime the agent is also paid for acting successfully in the interests of the principal, however he does not share in the principal's profits directly. The implementation of the basic set of legal strategies (the four regulatory and six governance strategies) within legal systems or companies, as clarified briefly above, helps decrease the agency problems and provides a large role for corporate law in doing so (Kraakman, Armour et al. 2009, p. 37). Some strategies have long since been laid down in legislation and other strategies - such as agent constraints through standards - have gained extra attention after the corporate scandals.

Because of the length of this section and for the purposes of a clear overview, a short synopsis of section 2.2 is provided below. Moreover, in anticipation of what is stated below, this section briefly applies the theory elaborated upon above to the comply or explain principle.