Agency Theory Term Paper

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Agency Theory and Executive Compensation

An Analysis of Agency Theory and Aligning Executive Stock Options with Corporate Objectives

According to Jensen and Meckling (1976), any medium- or large-sized firm today is not directly managed by its owners (the shareholders) but rather by "hired hands" that is, professional managers. Presumably, these professionals are capable and diligent agents of the owners, but these professionals' interests are not always the same as the shareholders' interests. Shareholders want their agents to maximize the value of the firm. The professional managers want to maximize their own welfare. They, for example, may want to create an organization with a great many employees as a way of wielding more power and getting more remuneration (there is a correlation between top executive pay and the size of the organization). This "agency problem" is addressed by modern firms in a variety of ways. Firms are often counseled to deal with this problem by better aligning the executive's rewards with that of the firm. One popular way to do that is to give executives stock options, making them owners as well as agents. If a significant part of one's remuneration is from company stock, the reasoning goes, executives ought to act in the stockholders best interests. To determine the efficacy of this assertion, this paper will a) review the literature on organizational behavior and business law as it pertains to "agency theory"; b) provide a discussion of the extent to which it should be argued that the "remedy" of executive compensation through stock options (or other forms of firm ownership) is effective today; and c) other alternatives modern firm should use to address the "agency problem" today. A summary of the research, salient findings and relevant recommendations will be provided in the conclusion.

Review and Discussion

Background and Overview. According to Black's Law Dictionary (1990), "agency" refers to "a relationship between two persons, by agreement or otherwise, where one (the agent) may act on behalf of the other (the principal) and bind the principal by words and actions" (p. 62). The term also refers to a legal relationship in which one person acts for or represents another by latter's authority, either in the relationship of principal and agent, master and servant, or employer or proprietor and independent contractor (Black's, 1990).

Within this general theory, there are a number of individual behaviors that firms must take into account when devising appropriate compensation packages. For example, Lynch and Perry (2002) point out that, "Agency theory suggests that managers are more risk-averse than owners and must be compensated for undertaking risky projects" (p. 279). Stock firms, for instance, frequently provide their executives with some level of compensation in the form of stock options, thereby providing incentives for increased risk bearing (Fields & Tirtiroglu, 1991). Likewise, Datta and Garven (1988 cited in Fields & Tirtiroglu) maintained that the distributional form also affects risk bearing, as the employees of direct writers have exclusive contracts with one firm. This arrangement, then, provides an incentive for agents to contract only with a low risk firm based on the contractual requirement that they produce business for one firm. This reasoning is congruent with empirical evidence provided by Chung and Charoenwong (1991), who determined that growth companies were more likely to be riskier enterprises than their non-growth counterparts; therefore, managers require greater compensation for assuming this additional risk.

Agency theory also suggests that managers' compensation should reflect how well (or poorly) a company is performing; in this regard, the research to date has indicated that total compensation increases with company performance. As a result, agency theory also maintains, and prior studies have confirmed, that size, growth opportunities, and performance are associated with total compensation (Lynch & Perry, 2002). Likewise, in his book, Trust and Loyalty in Electronic Commerce: An Agency Theory Perspective, Karake-Shalhoub (2002) reports that in an examination of organizational behavior using a contractual framework, agency theory maintains that cooperative effort within organizations is frequently constrained by opportunistic behavior on the part of organizational members, and incentive systems and control structures can help mitigate problems associated with such behavior.

According to agency theory, there will be a fundamental disparity in the availability and quality of information, and opportunism represents yet another opportunity for consummation of service exchanges. Karake-Shalhoub suggests that the concept of inequitable access to and quality of information
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implies that one of the partners in the agency relationship enjoys a greater quantity and/or quality of information; however, both parties have incomplete information and are making decisions under uncertain conditions (Karake-Shalhoub, 2002). "The information domain is usually circumscribed by the nature and quality of service delivered," Karake-Shalhoub says, and "In most instances, the information asymmetry is in favor of the service provider" (p. 109). This point is made by Gomez-Mejia and Tosi, who note that:

In agency theory, the organization is seen as a nexus of implicit and explicit contracts among participants such as owners, employees, managers, other suppliers of capital, and so forth who make contributions to the organization and in return receive payments from it. Owners are seen as principals who contract with and are dependent on the actions of the manager (the agent). The term "contract" is used to mean the agreement between the principal and the agent that specifies the rights of the parties, ways of judging performance, and the payoffs for them. The costs of this relationship are called 'agency costs.' These costs include, at least, losses to the principal because the agent does not act in the principal's interests and the cost of monitoring the activities of the agent. (p. 170).

Agency costs are an important consideration in stock valuation because management's willingness to redistribute cash flow back to shareholders at some point by investing in the firm itself shows that agency costs are under control and that the firm must be a good investment (Westphal & Zajac, 2001).

Because agents are able to control organizational resources and are more likely to know about the tasks that they perform for the principal, an inherent information asymmetry exists that provides agents with an advantage over the principal (Pratt and Zeckhauser, 1985). According to Gomez-Mejia and Toris, the principal will generally attempt to offset this asymmetry by developing control measures and corporate structures that are designed to prevent the agent from making decisions to divert resources away from the principal's interests. In his book, Changing Organizations: Business Networks in the New Political Economy, Knoke (2001) reports that, "Agency theory is the predominant explanation among finance economists for executive compensation and its relation to firm performance. It originated as a general perspective on using incentives to gain control over organizational actors' behavior (Jensen and Meckling 1976)" (p. 264).

Agency theory emphasizes risk-sharing among cooperating parties; in this regard, an agency relationship is a "contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent" (Jensen & Meckling 1976, p. 308). An agent is paid for her services and retains some control or autonomy over her specific actions undertaken to achieve the principal's goal. Some common examples are the major entertainers and sports agents who are retained by movie stars and athletes to secure the best possible contracts from studios and team owners (Knoke, 2001).

In a business setting, the shareholders (principals) accomplish the same end by contracting through the board of directors with a CEO and top management team (agents) to operate the company in order to maximize profits, thereby increasing the shareholders' wealth. "In most theoretical versions," Knoke advises, "because principals lack the agent's skills and knowledge (information asymmetry), they cannot accurately assess the quality of an agent's performance" (p. 265). In fact, even board members who enjoy daily interactions in many instances, more directly than most shareholders with the manager-agents, do not have the same intimate, day-to-day knowledge of company operations and managerial performances; in addition, any self-interested agent will typically pursue personal goals that do not fully coincide with a principal's goals (Knoke, 2001). As a result, an agent is always on the alert to opportunities to improve his or her own position by channeling efforts into those activities that may not produce the optimal value desired by the principal. In this regard, Knoke writes: "For example, instead of maximizing the firm's current earnings and share value, a CEO may prefer to increase the company's long-term revenue or market share by spending resources on costly pet projects and corporate acquisitions that reduce the stock price" (p. 264).

Clearly, the typical firm is characterized by asymmetrical access to and quality of the information being used to make management decisions at any given time. The quality of this information, then, depends on who is receiving it and who is communicating it; if managers assert a privileged position to take advantage of an opportunity to improve their own position, firms should be shocked, perhaps, but not surprised: "In the jargon of agency theory, moral…

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Aggarwal, R., & Rivoli, P. (1990). Fads in the initial public offering market? Financial

Management, 19, 45-57. In Dhatt et al., p. 44.

Amihud, Y., & Lev, B. (1981). Risk reduction as a managerial motive for conglomerate mergers. Bell Journal of Economics, 605-17. In Baek & Pagan, p. 30.

Baek, H.Y., & Pagan, J.A. (2002). Executive compensation and corporate production efficiency: A stochastic frontier approach. Quarterly Journal of Business and Economics, 41, 27.

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