AGENCY THEORY

JUNE 2014

CHAPTER ONE: INTRODUCTION

1.1 Historical background
An agency relationship arises between two (or more) parties when one, designated as the agent,
acts for, on behalf of, or as representative for the other, designated the principal, in a particular
domain of decision problems. Agency theory looks at how to ensure that agents (executives,
managers) act in the best interests of the principals (owners, shareholders) of an organization
(Jensen and Meckling, 1976).
While the agent/principal dilemma in a corporate context had been pondered as early as the 18th
century by Adam Smith and many of its key concepts were developed in literature on the firm,
organizations, and on incentives and information - a separate theory of agency did not emerge
until the early 1970s when Stephen A. Ross and Barry M. Mitnick, working independently, each
presented a theory of agency. Ross presented his paper entitled The Economic Theory of Agency:
The Principal's Problem at the annual meeting of the American Economic Association in
December 1972. This paper outlined agency as a universal principle and not just a theory of the
firm. Even so, the rather brief paper limited its scope to the problem of incentive and laid out a
model for inducing the agent to produce maximum gains for the principal.

By contrast, Mitnik's paper, entitled Fiduciary Rationality and Public Policy: The Theory of
Agency and Some Consequences and presented at the annual meeting American Political Science
Association in 1973, laid out a much more general theory of agency with possible application to
numerous societal contexts. Mitnick identified the problems of agency as 1) the principal's
problem, 2) the agent's problem, 3) policing mechanisms and incentives. The principal's problem
is to motivate the agent to act in a manner that will achieve the principal's goals. Examples of
motivational tools are financial incentives, prospect of sanctions, and supplying information to
activate norms (such as loyalty or obedience) and preferences that coincide with the principal's
goals. The agent's problem is that he may be faced with decisions to act either in the principal's
interest, his own interest, or some compromise between the two when they do not coincide.

Policing mechanisms are mechanisms and incentives intended to limit the agent's discretion,
such as surveillance or specifically directed tasks. Incentive systems are mechanisms that offer
rewards to the agent for acting in accordance with the principal's wishes, such as bonuses and
increased pay (positive incentives) or fear of reprisals (negative incentives). The problem with
policing and incentives is that they create costs for the principal; this creates a potential paradox
in that it is only rational to implement policing and incentive mechanisms if the increased return
to the principal's objective outweighs the cost of policing and incentives. Mitnick concluded by
noting that he had created only a basic framework around which to further develop agency
theory.
1.2 Seminal Paper
In 1976, Michael C. Jensen and William H. Meckling came up with a seminal paper titled:
Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. As part of a
broader theory of the firm, this paper further explored agency costs and its sources. Like Mitnick,
Jensen and Meckling identified monitoring the agent's actions as a source of agency cost, but
they also identified at least two other sources: bonding costs borne by the agent (such as bonding
against malfeasance, contractual limitations on his power, which limits his ability to take full
advantage of profitable opportunities, foregoing certain nonpecuniary benefits, etc.), and the
wealth loss borne by the principal when the agent's actions do not maximize his welfare (referred
to as residual loss). While the previous agency theory literature had focused on how to
structure incentives and the principal/agent relationship to maximize the principal's welfare,
Jensen and Meckling presumed the parties largely resolve these issues. Instead Jensen and
Meckling investigated the incentives faced by each of the parties and the elements entering into
the determination of the equilibrium contractual form characterizing the relationship between the
manager (i.e., agent) of the firm and the outside equity and debt holders (i.e., principals).
To that end, they compared the management behaviors found in two different firm structures:
one where the manager owns 100% of the firm versus when the manager sells an equity share to
outsiders. In the former structure, the owner/manager will act to maximize the firm's welfare
because the full benefit of this maximization will accrue to him. Maximization occurs when the
marginal utility of each dollar expended is equal to the nonpecuniary benefits (such as office size
and appointments, respect from staff, ability to choose and control staff, etc.) and the marginal
utility of each after-tax dollar. However, when the owner/manager sells, say, a 20% equity stake
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to outside shareholder, agency costs will arise from the divergence of interests between the
manager and the shareholders. For instance, since his wealth interest has been reduced to 80%,
he will be inclined to expend resources such that one dollar spent equals the marginal utility of
80 cents of purchasing power - a reduction equal to his reduction in the share of the wealth. This
cost can be mitigated, but probably not eliminated, by the shareholders incurring monitoring
costs. As the manager's fractional ownership falls, his fractional outcome on ownership falls as
does his incentive to seek out new profitable ventures; and his incentive to extract rents or
perquisites rises, as do the monitoring costs to curb such tendencies. Jensen and Meckling
conclude that these agency costs are inevitable when there is a separation of ownership and
control, and that to call these costs inefficiencies is appropriate only if comparing to an ideal
world where principal and agent interests could be aligned at zero cost.
1.3 Critiques to the Seminal Paper
Jensen and Eugene F. Fama (1983) further explored the separation of ownership and control
particularly in large, complex organizations. Central to their paper Separation of Ownership and
Control is the theory of how decision processes are divided. Generally speaking, the decision
process has four steps: 1) initiation of proposals of resource utilization and structuring of
contracts, 2) ratification (choosing which initiatives will be implemented, 3) implementation of
ratified decisions and 4) monitoring the performance of the decision agents and implementation
of rewards.
Fama and Jensen (1983) hypothesized that because the decision managers in such organizations
do not bear the major wealth effects of their decisions, an effective system implies, almost by
definition, that the control (ratification and monitoring) of decisions is to some extent separate
from the management (initiation and implementation) of decisions. The control decisions tend
to be retained by those who bear the major risk, referred to as residual claimants.

Eisenhardt (1989) provides a comprehensive review of agency theory research that flows in two
streams: a positivist stream and a principalagent stream. Positivist researchers search for
situations where the agent and principal have conflicting goals and then examine how an agents
self-serving behavior is limited through different types of governance mechanisms. The focus is
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usually the relationship between boards of directors (principals) and the CEOs (agents) of large
public corporations. For example, one specific mechanism to ensure the alignment of interest is
the existence of the equity market which controls behavior through such threats as acquisition,
hostile takeover, or the liquidation of equity by investors (Dalton et al., 2007). Principalagent
researchers are concerned with examining the efficiency of contracts given different conditions
of certainty, risk aversion, information, etc. The focus is usually more theoretical, more
mathematical, and broader in terms of application (e.g. contracts with employees, suppliers,
clients). Eisenhardt argues that agency theory provides a unique, realistic, and empirically
testable perspective on the organizational problems of cooperative effort.

Supporters of agency theory underscore among its positive features, the realism with which it
describes relationships among individuals in a company (Eisenhardt, 1989). The firm is no
longer considered as a single, monolithic actor but the complex set of interactions among several
individuals. The firm is now presented as a nexus of contracts between principals and agents
(Shankman, 1999; Martland, 1994).

Typically, there are different goals and interests among individuals involved in an agency
relationship.

Agency theory presupposes that individuals are opportunistic, that is, they

constantly aim to maximize their own interests (Bohren, 1998). Thus, there is no guarantee that
agents will always act in the best interests of principals. Rather, there is a constant temptation
for agents to maximize their own interests, even at the expense of principals.

Under conditions of incomplete information and uncertainty prevalent in business settings two
kinds of problems arise: adverse selection and moral hazard (Eisenhardt, 1989).

Adverse

selection refers to the possibility of agents misrepresenting their ability to do work agreed; in
other words, agents may adopt decisions inconsistent with the contractual goals that embody
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their principals preferences. Moral hazard, on the other hand, refers to the danger of agents not
putting forth their best efforts or shirking from their tasks.

The whole point behind agency theory is to come up with mechanisms that ensure an efficient
alignment of interests between agent and principal, thereby reducing agency costs (Shankman,
1989). Here it coincides fully with what Coase (1937) had set as the purpose of the firm.
Principals are thus challenged to design contracts that protect their interests and maximize their
utility in case of conflict. These contracts are based on several assumptions regarding agents
(self-interest, limited rationality, risk aversion), organizations (goal conflict between members),
and information (asymmetrical) (Shankman, 1989).

Critics of agency theory mostly focus on the assumptions of the theory (Brenman, 1994; Perrow,
1986). These assumptions are individualism, utilitarianism and contractualism regarding agents.
For De George (1992), they are sufficient to render agency theory applied to firms incompatible
any ethical theory. Duska (1992) admits that they may provide a plausible explanation of the
firm; nonetheless, it would be better to adopt non-egoistic assumptions. For similar reasons,
Koford and Penno (1992), on the one hand, and Wright et al. (2001), on the other have all
proposed to relax the force of these assumptions. One way of doing so has been explored out by
Aoki (1984) who like Evan and Freeman (1983) has studied the relationship of agents to multiple
principals apart from just shareholders.

CHAPTER TWO: EMPIRICAL REVIEW

Researchers in several disciplines have undertaken empirical studies of agency theory. These
studies mirrored the two streams of theoretical agency research: the positivist stream and
principal-agent stream (Eisenhardt, 1989).

One of the earliest studies was conducted by Amihud and Lev (1981). These researchers
explored why firms engage in conglomerate mergers. They established that conglomerate
mergers were not in the interests of stockholders because stockholders can diversify directly
through their stock portfolio. In contrast, conglomerate mergers were attractive to managers who
have fewer avenues available to diversify their own risk. Specifically, these authors linked
merger and diversification behavior to whether to whether the firm was owner controlled or
manager controlled. Consistent with agency theory arguments (Jensen & Meckling, 1976),
manager-controlled firms engaged in significantly more conglomerate acquisitions and were
more diversified.
Along the same lines, Walking and Long (1984) studied mangers resistance to takeover bids.
Their sample included 105 large U.S. corporations that were targets of takeover attempts
between 1972 and 1977.

They found out that resistance to takeover bids was not in the

stockholders interests, but in the interests of managers because they can lose their jobs during a
takeover. Consistent with agency theory (Jensen & Meckling, 1976), the authors found that
managers who have substantial equity positions within their firms (outcome-based contracts)
were less likely to resist takeover bids.

Kosnik (1987) examined another information mechanism for managerial opportunism, the board
of directors. Kosnik studied 110 large U.S. corporations that were greenmail targets between
1979 and 1983. Using both hegemony and greenmail was actually paid (paying greenmail is
considered not in the stockholders interests). As predicted by agency theory (Fama & Jensen,
1983), boards of companies that resisted greenmail had a higher proportion of outside directors
and a higher proportion of outside director executives.

In a similar vein, Argawal and Mandelker (1987) examined whether executive holdings of firm
securities reduced agency problems between stockholders and management. Specifically, they
studied the relationship between stock and stock option holdings of executives and whether
acquisition and financing decisions were made consistent with the interests of stockholders. In
general, managers preferred lower risk acquisitions and lower debt financing. Their sample
included 209 firms that participated in acquisitions and divestitures between 1974 and 1982.
Consistent with agency ideas of Jensen & Meckling (1976), executive security holdings
(outcome-based contract) were related to acquisition and financing decisions that were more
consistent with stockholder interest. Executive stock holdings appeared to coalign managerial
preferences with those of stockholders.

Eccles (1985) used agency theory to develop a framework for understanding transfer pricing.
Using interviews with 150 executives in 13 large corporations, he developed a framework based
on notions of agency and fairness to prescribe the conditions under which various sourcing and
transfer pricing alternatives are both efficient and equitable. Prominent in his framework is the
link between decentralization (arguably a measure of task programmability) and the choice
between cost (behavior-based contract) and market (outcome-based contract) transfer pricing
mechanisms.

Another related study was conducted by Sanda et al. (2005), who examined corporate
governance mechanisms and the financial performance of organizations in Nigeria. The authors
looked at board size (defined as number of board members), board composition (defined as
proportion of external board members), and top management experience (defined in terms of
whether the CEO comes from another country). Their sample consisted of all companies listed
on the Nigerian stock exchange. Their results regarding board composition were found to
partially and positively influence organizations financial performance. They also reported that
small size was effective up to certain numbers, after which it becomes ineffective. This implies
that large boards (with more than ten members) are not very efficient. They further found that
organizations with international CEOs who are part of the board outperformed those which did
not have international CEOs.
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Mori and Olomi (2012) explored and examined the effects of the governing board on the social
and financial performance of Microfinance institutions (MFIs) in Kenya and Tanzania. The first
phase of the study explored MFI board members awareness and perception of their roles and
how this affected their participation in the board and their influence on it. The second phase
examined the effect of specific board member characteristics (external representation,
international source, education, and gender) on the economic and social performance of the MFI
through a survey of 337 board members in Kenya and Tanzania. The pilot study established that
although MFI board members were largely aware of their roles, a few are either not aware or
assertive enough, and this impacts the extent of their influence. Contrary to expectations, less
educated, female, and local directors bring about superior financial and social performance of
MFIs.
A study conducted in Kenya by Ongore & KObonyo (2011) examined the interrelations among
ownership, board and manager characteristics and firm performance in a sample of 54 firms listed at
the Nairobi Stock Exchange (NSE). Using PPMC, Logistic Regression and Stepwise Regression, the
paper presents evidence of significant positive relationship between foreign, insider, institutional and
diverse ownership forms, and firm performance. However, the relationship between ownership
concentration and government, and firm performance was significantly negative. The role of boards
was found to be of very little value, mainly due to lack of adherence to board member selection
criteria. The results also show significant positive relationship between managerial discretion and
performance. Collectively, these results are consistent with pertinent literature with regard to the
implications of government, foreign, manager (insider) and institutional ownership forms, but
significantly differ concerning the effects of ownership concentration and diverse ownership on firm
performance.

Letting, Aosa and Machuki (2012), examined the relationship between board diversity and
financial performance of firms listed in the Nairobi Stock Exchange. The population of the study
consisted of firms listed in the Nairobi Stock Exchange (NSE) as at 31st December, 2010. As at
this date, the number of firms was forty-seven (47), which operated in various sectors of the
Kenyan economy. All these firms were included in the study, hence a census survey. Data on
boards age, gender, educational qualifications, study specialization, and board specialization as
well as the companies financial performance were obtained from the companies using a
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structured questionnaire. Using the Ordinary Least Squares (OLS) regression, the results showed
that there is a weak positive association between board diversity and financial performance.
Overall, the results indicated a statistically not significant effect of board diversity on financial
performance except for the independent effect of board study specialization on dividend yield.
The results partially concur with agency and resource dependency theories of corporate
governance as well as similar empirical studies.
Kiruri (2013) examined the effects of ownership structure on bank profitability in Kenya.
The study used a descriptive study design. Data was drawn from all the registered banks by the
Central Bank of Kenya. According to the central bank of Kenya, there were 43 licensed commercial
banks in Kenya. Primary data was obtained through a questionnaire that was structured to meet

the objectives of the study. The study used annual reports that were available from their websites
and in the Central bank of Kenya website.
The study found that ownership concentration and state ownership had negative and significant
effects on bank profitability while foreign ownership and domestic ownership had positive and
significant effects on bank profitability. The study concluded that higher ownership
concentration and state ownership lead to lower profitability in commercial banks while higher
foreign and domestic ownership lead to higher profitability in commercial banks. These findings
were consistent with the agency relationship hypothesized by Jensen & Meckling (1976). State
ownership would be deemed inefficient due to the lack of capital market monitoring which according
to the Agency theory would tempt managers to pursue their own interest at the expense of the
enterprise.

Barako et al. (2006) studied the relationship between corporate governance attributes and
voluntary disclosure in Kenyan listed companies. The authors examined the extent to which
board composition (defined as the percentage of external board members) and the existence of
board audit committees affect company disclosure (defined as the release of financial and nonfinancial information through annual reports above mandatory requirements). Their results in
regard to board composition revealed a negative relationship between the existence of external
board members and voluntary disclosure, which implied that external board members do not
matter much when it comes to convincing companies to reveal information.

In summary, there is support for the principal-agent hypotheses linking contract form with
information

systems,

outcome

uncertainty,

outcome

measurability,

time

and

task

programmability. Moreover, this support rests on research using a variety of methods including
questionnaires, secondary sources, laboratory experiments and interviews.

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CHAPTER THREE: CONCLUSION, GAPS AND SUGGESTIONS FOR

FUTHER RESEARCH
3.1 Conclusion
Agency theory reestablishes the importance of incentives and self-interest in organizational
thinking (Perrow, 1986). Agency theory reminds us that much of organizational life, whether we
like it or not, is based on self-interest. The theory also emphasizes the importance of a common
problem structure across research topics. Agency theory also makes two specific contributions to
organizational thinking. The first is the treatment of information. In agency theory, information
is regarded as a commodity: it has a cost, and it can be purchased. This gives an important role
to formal information systems, such as budgeting, MBO, and boards of directors and informal
ones, such as managerial supervision, which is unique in organizational research.

The

implication is that organizations can invest in information systems in order to control

opportunism (Eisenhardt, 1989).

The publicly held business corporation is an awesome social invention. Millions of individuals
voluntarily entrust billions of dollars, Euros, shillings, etc., of personal wealth to the care of
managers on the basis of a complex set of contracting relationships which delineate the rights of
the parties involved. The growth in the use of the corporate form as well as the growth in market
value of established corporations suggests that at least up to the present, creditors and investors
have by and large not been disappointed with the results, despite the agency costs inherent in the
corporate form (Jensen & Meckling, 1976).

Agency costs arc as real as any other costs. The level of agency costs depends among other
things on statutory and common law and human ingenuity in devising contracts. Both the law
and the sophistication of contracts relevant to the modern corporation are the products of a
historical process in which there were strong incentives for individuals to minimize agency costs.
Moreover, there were alternative organizational forms available, and opportunities to invent new
ones. Whatever its shortcomings, the corporation has this far survived the market test against
potential alternatives (Eisenhardt, 1989).

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3.2 Research Gaps

Most of the researches in agency theory focus on the international context with rather few ones
addressing local agency issues. Majority of the studies done are either improvements on existing
studies or similar issues on a different context. The local studies focus on board composition and
ownership structure and its effects on performance. Perrow (1986) and others have criticized
agency theory for being excessively narrow and having few testable implications. Although
these criticisms may be extreme, they do suggest that research should be undertaken in new
areas.

If firms choose among alternative control mechanisms and these are not taken into account
explicitly, we would expect to see significant unobserved firm heterogeneity. The unobserved
firm characteristics are likely to be even more important, if, for example, the nature of the
decision process influence agency costs as suggested by Jensen and Fama (1983).

3.3 Suggestions for further research

For future research in this area, there are currently three key areas which appear to be vastly underexplored. International research into corporate boards and discipline from the market for corporate
control has been forthcoming. However, there appears to be very little research carried out involving
many of the other governance mechanisms which control agency problems. While disclosure
requirements particularly with respect to executive compensation differ across international markets,
more research could be conducted into effectiveness of the other mechanisms discussed above in
various countries. Such studies would perhaps allow a greater understanding of which aspects of our
own markets influence the effectiveness of these devices in disciplining management for divergences
from the interests of their shareholders.

Secondly, greater distinction must be made in the treatment of certain variables when empirical
testing is carried out. This should particularly be the case for research into block shareholders.
Empirical studies generally still refer to block holders as one group. Without such distinctions, we
are not able to gain a full understanding of why exactly certain investor types, or director types,
contribute to either better or worse monitoring of management.

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Finally, the recent work of Cho (1998), Hermalin and Weisbach (1998) and Himmelberg et al.
(1999) examines the potential problems of past empirical research, in its failing to control for
endogenity. These studies have since found that corporate governance characteristics of
companies are inter-dependent, and previous research which fails to control for this is at best
misspecified. This calls into question how many other previous studies are misspecified in their
treatment of governance variables as exogenous.

Despite its faults, with respect to agency conflicts, the modern corporation appears to be the most
popular form of corporate organization. Perhaps this can largely be attributable to the evolution
of governance mechanisms designed to limit the scope of these problems. However, these
devices must continue to evolve, and greater research may be required to understand exactly
what works, when it works, where it works, and most importantly why it works.

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