Agency Theory and Corporate Governance

Abstract

Corporate governance is a broad term used to refer to the processes, policies, regulations, and customs by which a corporation is directed, administered, and controlled. Corporate governance specifies the responsibilities and rights of the various stakeholders in the organization. In a narrow sense, corporate governance articulates the relationship of the company to its immediate stakeholders (e.g., employees, stockholders). In a broader sense, it articulates the relationship of the organization to society. The concept of corporate governance is one of the core areas of economic sociology. The sociological study of corporate governance is often concerned with the relationship not only between principals and agents in a corporation, but also the relationship between all stakeholders and the mediating processes, among these the result in an effective organization.

Most corporations are set up to accomplish something. In some cases, it is to earn enough income so that they can do some good in the world. In other cases, the main motive is profit, particularly in terms of dividends paid out to shareholders who invest in the corporation. In general, shareholders do not invest in corporations for altruistic motives; they want a return on their investment. If the risk is too great to the shareholders, they pull out their investment. To help ensure that the interests of the shareholders are being guarded, corporations put into place various mechanisms to see that their goals are being met. Corporate governance is a broad term used to refer to the processes, policies, regulations, and customs by which a corporation is directed, administered, and controlled. Corporate governance specifies the responsibilities and rights of the various stakeholders in the organization. In a narrow sense, corporate governance articulates the relationship of the company to its immediate stakeholders (e.g., employees, stockholders). In a broader sense, it articulates the relationship of the organization to society. The concept of corporate governance is one of the core areas of economic sociology. This subspecialty of sociology examines economic phenomena from a sociological perspective. Studies of corporate governance are often interdisciplinary in nature, including perspectives from sociology, economics, law, and political science.

Agency Theory. The study of corporate governance originally arose out of agency theory. This is a perspective that attempts to explain the relationship between the principals (e.g., shareholders) and agents (e.g., executives) of an organization. According to agency theory, the principal hires or delegates an agent to perform work. In this kind of relationship, one party acts on behalf of the other party. According to classical agency theory, however, a dilemma arises due to the fact that the interests of the principal and of the agent are not necessarily aligned. For example, a business owner may act as a principal and hire employees to perform various tasks (e.g., make widgets). The interest of the business owner is to expend as little for producing the widgets as possible while selling them to customers for as much money as possible. The interest of the employees, however, is to make as much money as possible for making the widgets.

If the business owner sets up an arrangement with the employees in which they are paid but it is not articulated how much they have to do in order to get paid, the situation in theory becomes one of the business owner expending a great deal of money without getting a great deal of widgets in return. To help make this relationship more tenable (at least from the point of view of the business owner), various mechanisms may be put in place to help ensure that the employees produce value (i.e., working widgets) for their paychecks. This can be done through such incentives as piece rates (i.e., paying based on the number of widgets produced) or commissions, profit sharing (which gives the employees an incentive to make many widgets for a low price because they will reap the rewards along with the business owner), or the implementation of job standards with the negative incentive of being fired if employees do not meet stated expectations. From the perspective of agency theory, the relationship between the principal and the agent is further complicated by the fact that it exists in an environment of information asymmetry, uncertainty, and risk. For example, when the principal hires the agent, he or she only knows what the agent has said about his or her capabilities on a resume, a notoriously imperfect document. However, the agent also does not have as much information about the job or task to be performed as does the principal.

Principal-Agent Relationships. Principal-agent relationships are also characterized by uncertainty and risk. The principal only has a degree of certainty that the agent will be able to adequately learn or perform the task, and the principal accepts a degree of risk that the job will not be done in a manner that will help meet his or her goals because the agents are unable to do the job, shirking their responsibilities, or pursuing their goals in preference to those of the principal. Scholars of corporate governance attempt to deepen agency theory by better understanding the various stakeholders in an organization and the nature of their relationships as well as the facts underlying the diversity of corporate governance systems around the globe. The classical approach to agency theory has focused in large part on the incentives of managers and owners as was the identification of market mechanisms that will allow principals to minimize the potential cost to the agency. Agency theorists have also devoted significant effort to the study of the board of directors in the agency problem. One of the areas of corporate governance that is of interest within the context of agency theory and economic sociology is the degree to which different characteristics of boards of directors (e.g., composition, structure) affect agency costs.

The Nature of Corporate Governance. From a sociological perspective, there are several reasons why agency theory does not adequately explain the nature of corporate governance. One of these is the fact that the relationship between principals and agents and the assumption that ownership of a corporation is dispersed does not take into account the fact that the stakeholders within an organization are frequently diverse (e.g., families, institutional investors, banks) and that each of these groups act as socially constructed interests. Another difficulty with agency theory from a sociological point of view is that it focuses on bilateral contracts between principals and agents while largely ignoring the importance of interdependencies with other stakeholders in the organization. A third problem with agency theory from the perspective of sociology is that the complexity of an organization can only be understood if it is examined in a wider context than from the narrow perspective of shareholders' rights. To overcome these perceived shortcomings, sociologists also examine social relations and organizational embeddedness when analyzing corporate governance.

In addition to the perspective of the shareholders, sociologists also take into consideration other stakeholders and their interaction within the corporation. It is important that all stakeholders be taken into consideration in order to understand the governance of a corporation. For example, although from the perspective of a shareholder profits and losses may be the highest goal of the organization, management may be concerned about empowering or supporting employees, owners of a family business may be more concerned about its survival than its profitability, and members of the board of directors may be concerned about corporate citizenship and social responsibility. Since corporations have limited resources, the various stakeholders within the corporation must, by necessity, compete for these resources in order to achieve their goals. For example, although the shareholders may be primarily concerned with large dividend checks, some board members may also be concerned with corporate social responsibility as a way to act both as an ethical entity within society as well as out of enlightened self-interest by, for example, not polluting natural resources that it will need in the future and by acting to gain positive publicity and garner a better reputation within the greater community or society with an eye toward increasing sales.

Class Conflict. Because various stakeholders often have differing interests, conflict may arise. Class conflict occurs when the interests of owners and management run counter to the interests of the employees. In particular, there are often conflicts over financial matters regarding employee wages, salaries, insurance, and other remuneration and benefits. From the point of view of management, it is often advantageous to reinvest profits into the organization to better position it to succeed in the future. Employees, on the other hand, would often prefer to invest those same profits in vehicles or projects of their own choosing that are more likely to directly affect their own well-being. As a result, conflict may arise. Tactics such as employee ownership are often employed in an effort to minimize class conflict. Insider-outsider conflict arises when there is a conflict of interest between the organizational insiders (i.e., employees and management) and the corporate outsiders (i.e., owners). Insiders, for example, are more likely than outsiders to support empire building within the organization, dislike organizational restructuring, and develop ways to block external takeovers.

Accountability conflicts arise when there are owners and employees have common interests that are different from those of management within the organization. Management may, from time to time, pursue its own agenda at the expense of both employees and shareholders. In such situations, employees and shareholders have been known to work together to demand greater accountability and greater transparency from management in order to help ensure that their own goals are being met. However, if employees' and shareholders' interests are too different, such coalitions tend to break down, giving management greater autonomy and less accountability, to the detriment of all concerned.

Applications

As discussed above, the study of corporate governance originated as part of agency theory. However, attempts to validate agency theory using empirical data have met with mixed results. Frankforter, Davis, Vollrath, and Hill (2007), however, note that part of the problem may be due to the fact that most studies of agency theory employ secondary analysis rather than collecting primary data. To better determine the usefulness of agency theory regarding determinants of corporate governance, the researchers mailed a survey to the chief executive officer (CEO) and board members of 500 randomly selected, publicly listed corporations in the United States. One hundred thirty-five CEOs and 161 directors responded to the survey (20% response rate). Based on the precepts of agency theory, the researchers tested several hypotheses. First, it was hypothesized that CEOs with higher-order needs motivation would be negatively associated with an agency orientation. It was further hypothesized that CEOs who have a positive association with an agency orientation would have extrinsic motivation, low identification with the organization, low value commitment, low personal power, low involvement situations, high power distance, and work in individualistic cultures. The data analysis validated previous models regarding the psychological and situation factors necessary for a successful agency orientation rather than a stewardship orientation, indicating the usefulness of agency theory in determining governance structures in corporations.

Diversity. Another study done on the nature of corporate governance examined the relationship between diversity on the board of directors and organizational performance. The literature on corporate governance has increasingly stressed the importance of diversity of background characteristics for the success of a board of directors (Davis, 2005). However, previous research has shown mixed results when attempting to validate this assumption. Nielsen, Huse, Minichilli, and Zattoni (2008) suggest that these inconsistencies are due to the fact that although diversity is frequently associated with creativity and innovation, it can also be associated with disagreement and conflict. The researchers further suggest that the inconsistent results may also be due to a lack of study of the intervening processes between board diversity and organizational performance.

To address this lack in the literature, the researchers developed a theoretical framework based on the literature to explain the effects of board diversity on organizational performance (Figure 1). The model examines four factors regarding corporate boards:

• Diversity,
• Processes (i.e., debate and conflict),
• Task performance, and
• Organizational performance.

The model predicts that board diversity influences board processes and that the diversity of demographic characteristics among board members will have multiple and contrasting effects on various mediating constructs and resulting variable impacts on open debate and conflict among board members. In addition, the model predicts that the mediating processes of the board are important factors in the level of its effectiveness in performing its tasks. Further, the model predicts that job-related diversity on the board will indirectly affect the performance of the organization as mediated through the board's processes and task effectiveness.

Data were collected using a survey instrument. The final sample included 279 Italian firms with at least 50 employees. The response rate for the survey was 15%. Data analysis suggested that job-related diversity among board members had a positive impact on the level of open debate among board members. Open debate, in turn, had a positive impact on the performance of both service and control tasks of the board. However, diversity among board members was not found to have a significant relationship with conflict, although conflict had a negative impact on the performance of both service and control tasks for the board. The effectiveness of board service tasks had a positive effect on the performance of the organization. However, there was no correlation between board control tasks and organizational performance.

Conclusion

From a sociological point of view, corporate management is much more than setting up a board of directors and developing and instituting policies and procedures for the smooth running of the organization. Corporate governance needs to be concerned with the rights and responsibilities of all stakeholders within the organization from the chair of the board of directors to the lowest hourly worker on the floor. To be most effective and efficient, corporate governance policies and procedures also need to take into account the needs as well as the resources that all stakeholders bring to the corporation. This will allow the development of policies and procedures that will be most efficient and effective from the perspective of all stakeholders and that will advance the goals of all involved parties. More research is needed to better understand the relationship between the structures and processes of corporate governance and the effectiveness of the organization.

Terms & Concepts

Agency Theory: A theory that attempts to explain the relationship between the principals (e.g., shareholders) and agents (e.g., executives) of an organization. According to agency theory, the principal hires or delegates an agent to perform work. Agency theory is concerned with explaining the mechanisms and costs of resolving conflicts and of aligning interests between principals and agents.

Board of Directors: Individuals elected by the shareholders of a corporation to oversee the management of the organization. The board of directors has legal responsibility for the activities of the corporation. A board of directors acts as an intermediary governing body between the shareholders of the organization and its management.

Conflict: A situation in which one party believes that its interests are negatively affected by another party.

Corporate Governance: A broad term used to refer to the processes, policies, regulations, and customs by which a corporation is directed, administered, and controlled. Corporate governance specifies the responsibilities and rights of the various stakeholders in the organization. In a narrow sense, corporate governance articulates the relationship of the company to its immediate stakeholders (e.g., employees, stockholders). In a broader sense, it articulates the relationship of the organization to society.

Corporation: A common form of business organization that is chartered by an individual state. Corporations are considered entities that are separate from their owners (thereby giving the owners limited liability, or protection from being personally liable in case the organization is sued) and are accorded a number of legal rights. Corporations have different tax liabilities than do unincorporated partnerships.

Ethics: In philosophy, ethics refers to the study of the content of moral judgments (i.e., the difference between right and wrong) and the nature of these judgments (i.e., whether the judgments are subjective or objective).

Motivation: An internal process that gives direction to, energizes, and sustains an organism's behavior. Motivation can be internal (e.g., I am hungry, so I eat lunch) or external (e.g., the advertisement for the ice cream cone is attractive, so I buy one).

Return on Investment (ROI): A measure of the organization's profitability or how effectively it uses its capital to produce profit. In general terms, return on investment is the income that is produced by a financial investment within a given time period (usually a year). There are a number of formulas that can be used in calculating ROI. One frequently used formula for determining ROI is (profits-costs) / (costs) x 100. The higher the ROI, the more profitable the organization.

Risk: The quantifiable probability that a financial investment's actual return will be lower than expected. Higher risks mean both a greater probability of loss and a possibility of greater return on investment.

Secondary Analysis: A further analysis of existing data typically collected by a different researcher. The intent of secondary analysis is to use existing data in order to develop conclusions or knowledge in addition to or different from those resulting from the original analysis of the data. Secondary analysis may be qualitative or quantitative in nature and may be used by itself or combined with other research data to reach conclusions.

Shareholder: An individual who owns shares of stock in a corporation. Shareholders have rights to declared dividends and to vote on certain company matters, including the election of the board of directors.

Social Responsibility: The philosophy that an individual, corporation, government, or other entity has the obligation to contribute the welfare of the community of which it is a part. Social responsibility includes taking into account the impact of one's decisions or actions on others, in particular those who are disadvantaged.

Society: A distinct group of people who live within the same territory, share a common culture and way of life, and are relatively independent from people outside the group. Society includes systems of social interactions that govern both culture and social organization.

Stakeholder: A person or group that can affect or be affected by a decision or action. In manufacturing, for example, stakeholders may include the organization's employees, suppliers, distributors, and stockholders.

Survey: (a) A data collection instrument used to acquire information on the opinions, attitudes, or reactions of people. (b) A research study in which members of a selected sample are asked questions concerning their opinions, attitudes, or reactions are gathered using a survey instrument or questionnaire for purposes of scientific analysis; typically the results of this analysis are used to extrapolate the findings from the sample to the underlying population. (c) To conduct a survey on a sample.

Bibliography

Aguilera, R. V. (2004). Corporate governance. Retrieved Octaober 11, 2008, from http://www.business.uiuc.edu/Aguilera/pdf/Aguilera&Yip-Cha05-2004.pdf

Davis, G. F. (2005). New directions in corporate governance. Annual Review of Sociology, 31(1), 143–162. Retrieved October 11, 2008, from EBSCO online database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=17647372&site=ehost-live

Elsig, M. (2011). Principal-agent theory and the World Trade Organization: Complex agency and "missing delegation." European Journal of International Relations, 17(3), 495–517. Retrieved November 7, 2013, from EBSCO online database SocINDEX with Full Text. http://search.ebscohost.com/login.aspx?direct=true&db=sih&AN=65151471

Frankforter, S. A., Davis, J. H., Vollrath, D. A., & Hill, V. (2008). Determinants of governance structure among companies: A test of agency theory predictions. International Journal of Management, 24(3), 454–462. Retrieved October 3, 2008, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=26757487&site=ehost-live

Hoskisson, R. E., Arthurs, J. D., White, R. E., & Wyatt, C. (2013). Multiple agency theory: An emerging perspective on corporate governance. In D. M. Wright, D. S. Siegel, K. Keasey, & I. Filatotchev (Eds.), The Oxford handbook of corporate governance. New York, NY: Oxford University Press.

Nielsen, S., Huse, M., Minichilli, A., & Zattoni, A. (2008). Board diversity and firm performance: An empirical investigation of the mediating effects of board processes and task performance. Academy of Management Proceedings, 1-6. Retrieved October 3, 2008, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=33625430&site=ehost-live

O'Kelly, C., & Wheeler, S. (2012). Internalities and the foundations of corporate governance. Social & Legal Studies, 21(4), 469–489. Retrieved November 7, 2013, from EBSCO online database SocINDEX with Full Text. http://search.ebscohost.com/login.aspx?direct=true&db=sih&AN=84342949

Shapiro, S. P. (2005). Agency theory. Annual Review of Sociology, 31(1), 263–284. Retrieved October 11, 2008, from EBSCO online database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=17647366&site=ehost-live

Weik, E. (2011). Institutional entrepreneurship and agency. Journal for the Theory of Social Behaviour, 41(4), 466–481. Retrieved November 7, 2013, from EBSCO online database SocINDEX with Full Text. http://search.ebsco-host.com/login.aspx?direct=true&db=sih&AN=67460943

Suggested Reading

Aguilera, R. V., Filatotchev, I., Gospel, H., & Jackson, G. (2007, May). An organizational approach to comparative corporate governance. Costs, contingencies, and complementarities. Organization Science, 19(3), 381–495. Retrieved October 11, 2008, from: papers.ssrn.com/sol3/papers.cfm?abstract%5Fid=955043

Bandsuch, M., Pate, L., & Thies, J. (2008). Rebuilding stakeholder trust in business: An examination of principle-centered leadership and organizational transparency in corporate governance. Business and Society Review, 113(1), 99–127. Retrieved October 3, 2008, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=30101077&site=ehost-live

Catlaw, T. J. (2007, September). Frederick Thayer: Remembering the original theorist of governance. Administrative Theory and Praxis, 29(3), 460–464. Retrieved October 3, 2008, from EBSCO online database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=26561917&site=ehost-live

Foss, N. J., & Klein, P. G. (2007, Oct). Organizational Governance (draft). Retrieved October 11, 2008, from web.missouri.edu/~kleinp/papers/08061.pdf

Hassan, H., Islam, S. M. N., & Rashid, K. (2018). Corporate governance, agency theory and firm value advanced econometric analysis and empirical evidence. New York, NY: Nova Science Publishers.

Homayoun, S., & Homayoun, S. (2015). Agency theory and corporate governance. International Business Management, 9(5), 805–815. Retrieved October 29, 2018, from https://www.medwelljournals.com/abstract/?doi=ibm.2015.805.815

Jiraporn, P., & Gleason, K. C. (2007). Capital structure, shareholder rights, and corporate governance. Journal of Financial Research, 30(1), 21–33. Retrieved October 3, 2008, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23894222&site=ehost-live

Pacces, A. M. (2013). Rethinking corporate governance: The law and economics of control powers. Abingdon, England: Routledge. Retrieved November 7, 2013, from EBSCO online database eBook Collection (EBSCOhost). http://search.ebscohost.com/login.aspx?direct=true&db=nlebk&AN=530202&site=ehost-live

Simpson, J., & Taylor, J. (2013). Corporate governance, ethics, and CSR. London, England: Kogan Page. Retrieved November 7, 2013, from EBSCO online database eBook Collection (EBSCOhost). http://search.ebscohost.com/login.aspx?direct=true&db=nlebk&AN=505804&site=ehost-live