3.3.1 Agency theory

The agency theory is concerned with the separation of ownership and control (Jensen and Meckling 1976), which has become necessary due to the expansion of capitalism in the nineteenth and the start of the twentieth century. The capital requirements of these new large companies were becoming so high that they grew beyond the means of a single owner. Although the owners preferred to stay the single shareholder, they could not meet the increasing financial obligations anymore and were forced to take in new capital providers (Berle and Means 1932: 2-7). The owners in this growing shareholder base acted like principals by delegating executive tasks to managers (agents). Agents perform services on behalf of the principals, such as decision-making. Jensen and Meckling view the company as a nexus of contracts or a form of legal fiction, in which respect the contract between the principal and agent is one of such contracts (1976: 310-311). The relationship between principals and agents is named the agency relationship.

The underlying model of man in an agency theory framework is the Resourceful, Evaluative, Maximising Model (REMM) later described by Jensen and Meckling (1994). The view on this kind of man is that of a rational human being who pursues utility maximisation and self-interest. Utility can be generated by pecuniary benefits, but also by non-pecuniary benefits, such as ‘the attractiveness of the secretarial staff, the level of employee discipline, the kind and amount of charitable contributions, personal relations (love, respect, etc.) with employees, a larger than optimal computer to play with, purchase of production inputs from friends, etc.’ (Jensen and Meckling 1976: 312). A less visible appearance of non-pecuniary benefits is the pursuit of growth or empire-building to increase management’s prestige at the expense of company profits (Stano 1976: 677). These non-pecuniary benefits, which are not strictly necessary for the company to exist, are referred to as perquisites. When a manager is the single owner of the whole company, he will make decisions that maximise his own utility. A rational manager will spend profits of the company on perquisites as long as his marginal increase in utility generated by the consumption of the perquisites is larger than the marginal decrease in utility generated by the loss of profit. In this case of a single owner manager there is no divergence of interests, because the utility curves of the owner and the manager naturally coincide.

When the owner/manager decides to take in other capital providers – for reasons described above in this subsection – the utility curves of the manager and owners start to diverge. The new shareholders derive no utility from the perquisites, but they do have to pay for them by enjoying lower profits. The manager still enjoys the full wealth effects of his private benefits, but only bears a small part of the costs. The situation deteriorates when the manager’s stake in the company falls further and his part of the profits declines in proportion. To compensate his loss of wealth, he will increase the company’s spending on perquisites at the expense of the shareholders. The problem depicted here is the agency problem. The decision of the agent to maximise his own utility instead of the utility of the principal causes a loss of welfare for the principal, referred to as residual loss (Jensen and Meckling 1976: 308). However, the residual loss and the agency problem are not only concerned with agent’s spending on perquisites. Although being one of the most obvious examples of the agency problem, Jensen and Meckling claim that the reduced incentive for the agent to ‘devote significant effort to creative activities such as searching out new profitable ventures’ is the most important implication of the agent’s declining equity stake (1976: 313).

To curb the agent’s resource expenses on non-pecuniary benefits and to let the agent behave in the interest of the principal, the principal has the possibility to establish monitoring and other controlling mechanisms. ‘Auditing, formal control systems, budget restrictions, and the establishment of incentive compensation systems which serve to more closely identify the manager’s interest with those of the outside equity holders’ are examples of how protection of shareholder interests and alignment of agent-principals interests can be implemented (Jensen and Meckling 1976: 323). Monitoring tasks of the board often discussed in literature are monitoring the CEO and strategic implementation, planning CEO succession and appraising top management performance (Hillman and Dalziel 2003: 384-385). The formal control systems are conceptualised by Fama and Jensen with the introduction of decision management and decision control (1983: 302-304). Decision management comprises initiation and execution of corporate decisions, while decision control comprises ratification and monitoring of these. Fama and Jensen advise the strict separation of decision management and decision control, when decision management is not carried out by the residual risk bearer (i.e. the principals or shareholders). Executive directors in a unitary board structure and a management board in a dual board structure are responsible for decision management, independent NEDs and independent supervisory board members are responsible for decision control (Maassen and Van den Bosch 1999: 34-35). In complex companies hierarchical partition of the decision process must be part of the formal control systems as well, since the necessary approval of higher management of decisions of lower management makes it difficult for agents at all levels to take actions that are not beneficial to the shareholders (Fama and Jensen 1983: 310).

In order to reach maximum alignment of principal/agent interests, incentive compensation schemes can be deployed by (1) requiring board members to become equity holders; (2) threatening dismissal for poor performance; and (3) structuring salaries, bonuses and stock options so as to provide big rewards for superior performance and big penalties for poor performance (Jensen and Murphy 1990: 139-140). Stewart developed a leveraged equity purchase plan (LEPP) to let board members meet the requirement to become equity holders (1990: 127-129). The LEPP comprehends a corporate programme that enables a director to become a significant equity holder by allowing him to borrow the major part of the investment from the company and requiring him to finance the remainder by drawing on his personal funds. This is a strong incentive to act in accordance with shareholders’ interests, because ‘[n]othing makes directors think like shareholders more than being shareholders” (Minow and Bingham 1995: 497). Barkema and Gomez-Mejia have established a three pillar comprehensive framework to understand the structuring of salaries, bonuses and stock options (1998: 140-142). It appears from their research that performance is not the only determinant of executive (performance-based) pay. The three pillars of this framework are (1) the determination of criteria that go beyond performance and consider among others company size, peer compensation, individual characteristics of board members and their role; (2) the governance structure of the company; and (3) contingencies such as market growth, industry regulation, national culture and tax system.

In addition to monitoring and incentive compensation, the principal can allow the agent to make bonding costs in order to guarantee that he would limit his activities that harm shareholders’ wealth (Jensen and Meckling 1976: 325-326). Examples are the contractual obligation to have the financial statements audited by an audit company and contractual limitations on the power of management to engage in certain projects. Both examples of bonding involve financial consequences for the shareholder: the fees for the audit company in the first example and the imposed costs of the smaller ability of management to participate fully in certain profitable opportunities.

The sum of monitoring costs, bonding expenditures and the residual loss is defined as agency costs (Jensen and Meckling 1976: 308). In an agency theory framework it is the principal’s aim to align the interests of principals and agents, to protect shareholders from expropriation by agents and to minimise these agency costs. The interaction with on the one hand monitoring costs and on the other hand residual losses requires principals to determine an optimal level of monitoring. A rational acting principal will intensify monitoring as long as the marginal increase in monitoring costs is smaller than the induced decrease in residual losses. All these agency theory mechanisms described here are focused on maximisation of shareholder’s wealth. This is also the central idea behind the composition of the board in an agency theory framework, which is described below.