Fluent Essays

To understand the theory, evidence of problems and how to deal with the problems,review this article Address the following questions as you read the article: What corporate finance problem is the article addressing? What method of study (qualitative, quantitative, or mixed study) do the authors use to address the problem? What are the significant findings or ideas of the study? What is the conclusion of the study? Do the findings support the conclusion? What are the strengths and limitations of the study? Make a proposal for future research on the topic that needs to be investigated. Follow this format for the article review assignment: 1. Title 3. Abstract 4. Problem Statement 5. Significance & Purpose 6. Research Method 7. Conclusion & Recommendations: This should briefly state the rationale for your review and any recommendations 8. Critical analysis: Strengths and limitations of the study 9. Proposal for Future Research Literature cited: Use APA style. Agency theory: Review of Theory and Evidence on Problems and Perspectives Brahmadev Panda1 N. M. Leepsa1 Abstract This article intends to review the theoretical aspects and empirical evidences made on agency theory. It is aimed to explore the main ideas, perspectives, prob- lems and issues related to the agency theory through a literature survey. It dis- cusses the theoretical aspects of agency theory and the various concepts and issues related to it and documents empirical evidences on the mechanisms that diminish the agency cost. The conflict of interest and agency cost arises due to the separation of ownership from control, different risk preferences, informa- tion asymmetry and moral hazards. The literatures have cited many solutions like strong ownership control, managerial ownership, independent board members and different committees can be useful in controlling the agency conflict and its cost. This literature survey will enlighten the practitioners and researchers in understanding, analysing the agency problem and will be helpful in mitigating the agency problem. Keywords Agency theory, contractual relationship, conflict of interest, agency issues, agency cost, literature survey Introduction Agency theory revolves around the issue of the agency problem and its solution (Jensen & Meckling, 1976; Ross, 1973). The history of agency problem dates back to the time when human civilisation practiced business and tried to maximise Article Indian Journal of Corporate Governance 10(1) 74–95 © 2017 Institute of Public Enterprise SAGE Publications sagepub.in/home.nav DOI: 10.1177/0974686217701467 http://ijc.sagepub.com 1 School of Management, NIT, Rourkela, India. Corresponding author: Brahmadev Panda, Doctoral Research Scholar, School of Management, NIT, Rourkela–769008, India. E-mail: [email protected] Panda and Leepsa 75 their interest. Agency problem is one of the age-old problems that persisted since the evolution of the joint stock companies. It cannot be ignored since every organ- isation possibly suffered from this problem in different forms. With the change in the time, the agency problem has taken different shapes and the literature has evidence about it. The discussion on the literature of agency theory is very much in need to understand the agency problem, its various forms and the various costs involved in it to minimise the problem. The presence of agency issues has been widely witnessed in different academic fields. The evidences found in different fields like accounting (Ronen & Balachandran, 1995; Watts & Zimmerman, 1983) finance (Fama, 1980; Fama & Jensen, 1983; Jensen, 1986), economics (Jensen & Meckling, 1976; Ross, 1973; Spence & Zeckhauser, 1971), political science (Hammond & Knott, 1996; Weingast & Moran, 1983), sociology (Adams, 1996; Kiser & Tong, 1992), organisational behaviour (Kosnik & Bittenhausen, 1992) and marketing (Bergen, Dutta, & Walker, 1992; Logan, 2000; Tate et al., 2010). The wide existence of the agency problem in differ- ent types of organisations has made this theory as one of the most important theory in the finance and economic literature. The central idea of this article is to inspect and analyse the theoretical and empirical literature on agency theory to find out the answers to certain important questions. These questions are like: What is agency theory? Why does it matter? What is agency problem? What are the types of agency problem? Which factors cause the agency problem? What are the remedies for the problem? What is agency cost? What are the elements of agency cost? and How the agency cost can be controlled? These issues have dominated the finance literature since last many decades. Earlier authors like Eisenhardt (1989), Kiser (1999) and Shapiro (2005) have surveyed and captured the different facets of the agency literature due to its wide popularity. This article is developed in the same line with an extensive work on the theoretical and empirical literature on the various aspects of the agency theory. This article strikes a balance between the theoretical aspects and the empirical evidence in the popular areas of agency theory. Research Design The basic idea of this study is to explore the theoretical and empirical works done on agency theory, its various perspectives and empirical models. This literature survey will aid in finding certain answers to the major issues raised in this article. The design of this literature survey article is based on two approaches. The first approach discusses the theoretical aspects of the concepts, definitions, limitations and issues related to agency theory. The second approach deals with empirical works made on the factors that reduce the agency cost. For this purpose, we have explored various journals, books and chapters available in the online databases like JSTOR, Wiley, Scopus, Science Direct, Springer, SAGE, Taylor & Francis and Emerald to gather the literature on agency theory. This article has searched the articles, working papers and chapters by the keywords such as agency theory, principal–agent problem, agency relationship, 76 Indian Journal of Corporate Governance 10(1) ownership structure, managerial ownership, board structure, governance mech- anisms and agency cost from the online databases. Out of these, we have only selected those articles which are from reputed journals in order to improve the quality of the literature study. Berle and Means (1932) found the research on agency theory in the early 19th century and since then many researches have been done. This article has started the literature survey with Berle and Means (1932) and covered the most prominent works done in the last four decades. Mostly, this article includes articles from 1968 to the recent works in 2015 (Figure 1). Research Questions � What is agency theory? � What is agency problem? � What are the remedies to agency problem? � What is agency cost? � Which factors reduce the agency cost? Research Design Articles Covered Total 75 number of articles have been considered from reputed journals for the review process. Keyword Search Agency theory, agency problem, agency relationship and agency cost. Online Database JSTOR, Wiley, Scopus, Science Direct, Springer, SAGE, Taylor & Francis and Emerald Period Covered Articles from 1968 to 2015 (47 years) Broad Conceptual Framework Figure 1. Summary of Broad Research Framework Source: Developed by the authors. Agency Theory Agency model is considered as one of the oldest theory in the literature of the man- agement and economics (Daily, Dalton, & Rajagopalan, 2003; Wasserman, 2006). Agency theory discusses the problems that surface in the firms due to the separation of owners and managers and emphasises on the reduction of this problem. This theory helps in implementing the various governance mechanisms to control the agents’ action in the jointly held corporations. Berle and Means (1932) in their the- sis found that the modern corporation of the USA was having dispersed ownership, and it leads to the separation of ownership from control. In a joint stock company, the ownership is held by individuals or groups in the form of stock and these share- holders (principals) delegates the authority to the managers (agents) to run the busi- ness on their behalf (Jensen & Meckling, 1976; Ross, 1973), but the major issue is whether these managers are performing for the owners or themselves. Panda and Leepsa 77 Evolution of Agency Theory Adam Smith (1937[1776]) is perhaps the first author to suspect the presence of agency problem and since then it has been a motivating factor for the economists to cultivate the aspects of agency theory. Smith forecasted in his work The Wealth of Nations that if an organisation is managed by a person or group of persons who are not the real owners, then there is a chance that they may not work for the own- ers’ benefit. Berle and Means (1932) later fostered this concern in their thesis, where they analysed the ownership structure of the large firms of the USA and obtained that agents appointed by the owners control large firms and carry the busi- ness operations. They argued that the agents might use the property of the firm for their own end, which will create the conflict between the principals and agents. The financial literature in the 1960s and 1970s described the agency problem in the organisations through the problem of risk-sharing among the cooperating par- ties (Arrow, 1971; Wilson, 1968) involved in the organisations. There are individu- als and groups in the firm having different risk tolerance and their action differs, accordingly. The principal or the owners, who invest their capital and take the risk to acquire the economic benefits, whereas the agents, who manage the firm are risk averse and concerned in maximising their private benefits. Both the principal and agent are having opposite risk preferences and their problem in risk-sharing creates the agency conflict, which is broadly covered under the agency theory. Ross (1973) and Mitnick (1975) have shaped the theory of agency and came up with two different approaches in their respective works. Ross regarded the agency problem as the problem of incentives, while Mitnick considered the problem occurs due to the institutional structure, but the central idea behind their theories is similar. Ross identified the principal–agent problem as the consequence of the compensation decision and opined that the problem does not confine only in the firm, rather it prevails in the society as well. The institutional approach of Mitnick helped in developing the logics of the core agency theory and it was possibly designed to understand the behaviour of the real world. His theory propagated that institutions are built around agency and grow to reconcile with the agency. Alchian and Demsetz (1972) and Jensen and Meckling (1976) defined a firm as a ‘set of contracts between the factors of production’. They described that firms are the legal fictions, where some contractual relationships exist among the per- sons involved in the firm. Agency relationship is also a kind of contract between the principal and agent, where both the party work for their self-interest that leads to the agency conflict. In this context, principals exercise various monitoring activities to curb the actions of the agents to control the agency cost. In the prin- cipal–agent contract, the incentive structure, labour market and information asymmetry plays a crucial role and these elements helped in building the theory of ownership structure. Jensen and Meckling (1976) portrayed the firm as a black box, which operates to maximise its value and profitability. The maximisation of the wealth can be achieved through a proper coordination and teamwork among the parties involved in the firm. However, the interest of the parties differs, the conflict of interest arises, and it can only be relegated through managerial ownership and control. The self-interested 78 Indian Journal of Corporate Governance 10(1) parties also knew that their interest can only be satisfied if the firm exists. Hence, they perform well for the survival of the firm. Same way, Fama (1980) advocated that the firms can be disciplined by the competition from the other players, which monitors the performance of the entire team and the individual persons. Fama and Jensen (1983) made a study on the decision-making process and the residual claimants. They segregated the firm’s decision process into two catego- ries such as decision management and decision control, where agents are the key players in the process. In the non-complex firms, the decision management and decision control are the same but in complex firms, both exists. In those complex firms, the agency problem arises in the management decision process because the decision-makers who initiate and implement the decisions of the firm are not the real bearer of the wealth effects of their choices. They inferred that these agency problems are necessary to be controlled for the survival of the firm. Grossman and Hart (1983) made an interesting tale on the divergence of risk preference between the principal and agents. They explained that the consumption of the principal gets affected by the agent’s output. The agent’s level of effort affects the firms’ output, where the principals desire for the higher level of effort from agents. Hence, the principal should trade-off the agent’s behaviour with a proper payment structure, for which they used an algorithmic model to figure out an optimal incentive structure. The incentive structure is affected by the agents’ attitude towards the risk and information quality possessed by the principals and no incentive problem arise if the agent is risk neutral. Eisenhardt (1989) categorised the agency theory into two models such as the positivist agency model and principal–agent model (Harris & Raviv, 1978). Both of these models are based upon the contractual relationship between the principal and agent but principal–agent model is more mathematical. Principal–agent model explains that principals are risk-neutral and profit seekers, while agents are risk averse and rent seekers. Positive agency theory explains the causes of agency problem and the cost involved in it. This theory proposes two propositions. First proposition explains that if the outcome of the contract is incentive based, then the agents act in the favour of principal. Second, if the principal is having information about the agents, then the action of the agents will be disciplined. Criticism of Agency Theory Perrow (1986) criticised that positivist agency researchers have only concentrated on the agent side of the ‘principal and agent problem’, and opined that the prob- lem may also happen from the principal side. He observed that this theory is unconcerned about the principals, who deceive, shirk and exploit the agents. Furthermore, he added that the agents are unknowingly dragged into work with the perilous working environment and without any scope for encroachment, where principals act as opportunistic. He believed in another way that humans are noble and work ethically for the betterment of the firm. This argument persisted in the finance literature and has become a prominent theory known as stewardship theory (Donaldson, 1990). Panda and Leepsa 79 Many authors like Wiseman and Gomez-Mejia (1998), Sanders and Carpenter (2003) and Pepper and Gore (2012) have criticised the positive agency theory (Eisenhardt, 1989) on various grounds and they propounded a different agency theory called behavioural agency theory. These behavioural agency theorists argued that standard agency theory only emphasises on the principal and agent conflict, agency cost and the realignment of both the parties’ interest to minimise the agency problem. The behavioural agency model recommended some modifi- cations like agent’s motivation, risk averseness, time preference and equitable compensation. The argument was that the agents are the main component of the principal–agent relationship and their performance mostly depends upon their ability, motivation and perfect opportunity. Behavioural agency model (Wiseman & Gomez-Mejia, 1998) is essentially different from the positive agency model (Eisenhardt, 1989) by three aspects. The first difference is that the behavioural agency model assesses the association between the agency cost and agent’s performance, while the positive agency model emphasises on the principal and agent relationship and the cost incurred due to it. Second, the behavioural agency model theorises the agents as the bound- edly rational, anti-risk/loss takers and they trade-off between the internal and external benefits, while the positive agency model assumes the agents as logical and reward seekers. Third, behavioural agency model finds a linear relationship between the agent’s performance and motivation, while agency model focuses on the principal’s objective and agency cost. Limitation of Agency Theory Though agency theory is very pragmatic and popular, it still suffers from various limitations and this has been documented by many authors like Eisenhardt (1989), Shleifer and Vishny (1997) and Daily et al. (2003). The theory assumes a contrac- tual agreement between the principal and agent for a limited or unlimited future period, where the future is uncertain. The theory assumes that contracting can eliminate the agency problem, but practically it faces many hindrances like infor- mation asymmetry, rationality, fraud and transaction cost. Shareholders’ interest in the firm is only to maximise their return, but their role is limited in the firm. The roles of directors are only limited to monitor the managers and their further role is not clearly defined. The theory considers the managers as opportunistic and ignores the competence of the managers. Types of Agency Problem The firm is based on the limited or unlimited contractual relationship (Alchian & Demsetz, 1972) between the two interested parties and they are known as the principal and agent. The principal is the person who owns the firm, while agents manage the business of the firm on behalf of the principal. These two parties reside under one firm but have different and opposite goals and interest, so there exists a conflict and this conflict is termed as the agency problem. With the 80 Indian Journal of Corporate Governance 10(1) changes of time, the agency problem is not only limited to the principal and agent, rather it has gone beyond and covered other parties like creditors, major share- holders and minor shareholders. 11111111111111111111111111111111111111 000000000111 Type - I Principal/owners Agent/Managers Type - II Majority Owners Minority Owners Type - III Owners Creditors Figure 2. Types of Agency Problem Source: Authors’ research. The economic and finance researchers have categorised the agency problem into three types, which are depicted in the figure 2. The first type is between the principal and agents, which arises due to the information asymmetry and variances in risk- sharing attitudes (Jensen & Meckling, 1976; Ross, 1973). The second type of con- flict occurs between the major and minor shareholders (Gilson & Gordon, 2003; Shleifer & Vishny, 1997) and it arises because major owners take decisions for their benefit at the expense of the minor shareholders. The third type of the agency prob- lem happens between the owners and creditors; this conflict awakes when the own- ers take more risky investment decision against the will of the creditors. Type—1: Principal–Agent Problem The problem of agency between owners and managers in the organisations due to the separation of ownership from control was found since the birth of large corpo- rations (Berle & Means, 1932). The owners assign the task to the managers to manage the firm with a hope that managers will work for the benefit of the own- ers. However, managers are more interested in their compensation maximisation. The argument on the agent’s self-satisfying behaviour is based on the rationality of human behaviour (Sen, 1987; Williamson, 1985), which states that human actions are rational and motivated to maximise their own ends. The misalignment of interest between principal and agent and the lack of proper monitoring due to diffused ownership structure leads to the conflict, which is known as principal– agent conflict. Type—2: Principal–Principal Problem The underlying assumption of this type of agency problem is the conflict of inter- est between the major and minor owners. Major owners are termed as a person or group of person holding the majority of the shares of a firm, while minor owners are those persons holding a very less portion of the firm’s share. The majority owners or blockholders are having higher voting power and can take any decision in favour of their benefit, which hampers the interests of the minor shareholders (Fama & Jensen, 1983). This kind of agency problem prevails in a country or company, where the ownership is concentrated in the hands of few persons or with Panda and Leepsa 81 the family owners, then the minority shareholders find it difficult to protect their interests or wealth (Demsetz & Lehn, 1985). Type–3: Principal–Creditor Problem The conflict between the owners and creditors arise due to the projects undertaken and the financing decision taken by the shareholders (Damodaran, 1997). The shareholders try to invest in the risky projects, where they expect higher return. The risk involved in the projects raise the cost of the finance and decreases the value of the outstanding debt, which affects the creditors. If the project is success- ful, then the owners will enjoy the huge profits, while the interest of the creditors is limited as they get only a fixed rate of interest. On the other hand, if the project fails, then the creditors will be enforced to share some of the losses and generally this problem persists in these kinds of circumstances. Causes of Agency Problem The agency problem between the principal and agent in the firms has certain causes and these are described by Chowdhury (2004) in his study. He has pointed out several reasons for the occurrence of the agency problem like separation of the ownership from control, differences in risk attitudes between the principal and agents, short period involvement of the agents in the organisation, unsatisfactory incentive plans for the agents and the prevalence of information asymmetry within the firm. These causes of the agency problem are often found in the listed firms between the principal and agent, major owners and minor owners, and owners and creditors (Barnea, Haugen, & Senbet, 1985). Table 1. Different Causes of the Agency Problem Causes of Agency Problem Explanation Type of Agency Problem Separation of Ownership from Control The separation of ownership from control in the large organisations leads to loss of proper monitoring by the owners on the managers, where managers use the business property for their private purpose to maximise their welfare. Type-I Risk Preference The parties involved in the organisations are having different risk perceptions and struggle to reconcile with their decisions. This conflict arises between the owners and managers and owners and creditors. Type-I and III Duration of Involvement The managers work for the organisations for a limited period, whereas the owners are the inseparable part of the firms. Hence, the agents try to maximise their benefit within their limited stay and then flow to another firm. Type-I (Table 1 Continued) 82 Indian Journal of Corporate Governance 10(1) Causes of Agency Problem Explanation Type of Agency Problem Limited Earnings Both the managers and creditors of the firm are the significant stakeholders of the firm, but they are having only limited earnings as managers are concerned for their compensation, while creditors look for the interest amount only. Type-I and III Decision-making Mostly, the majority shareholders take the decision in the firms due to high voting rights, while the minority shareholders only follow it. Type-II Information Asymmetry Managers look after the firm and are aware about all the information related to the business, while owners depend upon the managers to get the information. So the information may not reach to the owners exactly in the same manner. Type-I Moral Hazard Managers work for the owners in good faith, where the owners utilise their knowledge and skill in the risky projects, which the managers are not aware of the risk attached to the investment decision for which they suffer. Type-I Retention of Earnings The majority owners take the decision to retain the earnings of the firm for future profitable risky projects instead of distributing the profits as dividends to all the shareholders. Due to which the minority shareholders lose their earnings. Type-II Source: Authors’ research. Table 1 describes the different causes behind the agency conflict and the relation between the cause and the type of the agency problem. The persistence of the agency problem in every organisation has made the researchers find out the real causes and its remedies. Jensen and Meckling (1976) opined that the agency prob- lem can be mitigated if the owner–manager will manage the firm, otherwise this problem will persist as ownership and control differs (Ang, Cole, & Lin, 2000). Remedies to Agency Problem The study of agency problem and its remedies is an ongoing research in both the corporate and academic world. Eisenhardt (1989) highlighted that a proper gov- ernance system can relegate the agency conflict. He recommended two proposals to minimise the agency problem. The first one is to have an outcome-based con- tract, where the action of the agents’ can be checked. Second, the principal needs to form a strong information structure, where the principal is aware of all the information about the agents’ action and they cannot misrepresent the principals. (Table 1 Continued) Panda and Leepsa 83 Several researchers have documented certain remedies to the agency problem, which are cited below: Managerial ownership: Granting of stocks to the agents increases their affilia- tion to the firm. Jensen and Meckling (1976) described that managerial ownership makes the manager work as the owner in the organisation and concentrate on the firm performance. By this, the interest of the owners’ and managers’ interest aligns. Executive compensation: An inadequate compensation package may force the managers to use the owners’ property for their private benefit. A periodic com- pensation revision and proper incentive package can motivate the managers to work harder for the better performance of the firm (Core, Holthausen, & Larcker, 1999) and by which the owners can maximise their wealth. Debt: Increase in the debt level in the firm discipline the managers. The peri- odic payment of the debt service charges and principal amount to the creditors can make the managers more cautious regarding taking inefficient decisions that may hamper the profitability of the firm (Frierman & Viswanath, 1994). Labour market: The effective managers always aspire for better opportunity and remuneration from the market and the market estimate the manager’s ability by their previous performance (Fama, 1980). For this reason, the managers have to prove their worth in the firm by maximising the value of the firm and this increases the effectiveness and efficiency of the managers. Board of directors: The inclusion of more outside and independent directors in the board (Rosenstein & Wyatt, 1990) may diligently watch the actions of the managers and help in making the alignment of the interest among the owners and managers. Blockholders: A strong owner or concentrated ownership or the blockholders can closely monitor the behaviours of the managers and can control their activities to improvise the value of the firm (Burkart, Gromb, & Panunzi, 1997). Dividends: The profit distribution as dividends leads to decline in the agency conflict (Park, 2009). Dividend distribution decreases the internal funds, so the firm has to attract external funds to finance. For which, the managers need to make the firm perform better in order to allure the market participants. Dividend payout also resolves the agency conflict between the inside and outside share- holders (Jensen, 1986; Myers, 2000). Market for corporate control: The poor performing firm may be taken over by an efficient firm and the acquiring firm may eradicate the inefficient man- agement (Kini, Kracaw, & Mian, 2004), which penetrates the managers to per- form efficiently. Agency Cost Agency theory has brought forward the concept of agency conflict and the cost that arises out of it (Jensen & Meckling, 1976). Agency costs are one of the internal costs attached with the agents that occur due to the misalignment of the interest between the agent and principal. It embraces the cost of examining and picking up a suitable agent, collecting of information to fix performance benchmarks, watching to control 84 Indian Journal of Corporate Governance 10(1) the agent’s action, bonding costs and the loss due to the inefficient decisions of the agents. Jensen and Meckling (1976) described the agency cost as the aggregate of the monitoring cost, bonding cost and residual loss (Figure 3). These elements of the agency cost are described below. Agency Cost Monitoring Cost Bonding Cost Residual Loss Figure 3: Elements of Agency Cost Source: Jensen and Meckling (1976). Monitoring Cost Monitoring cost involves the cost associated with the monitoring and assessing of the agent’s performance in the firm. The various expenditures covered under the monitoring cost are the payment for watching, compensating and evaluating the agent’s behaviour. …