Agency Problem Types From a Corporate Governance Perspective

Agency Problem Types From a Corporate Governance Perspective

Nazih Khalil El-Jor (Lebanese American University, Lebanon)
Copyright: © 2017 |Pages: 17
DOI: 10.4018/978-1-5225-2066-5.ch009
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Abstract

Corporate Governance systems adequately address problems related to accountability and transparency in developed countries. However, in emerging economies these systems are susceptible to exploitation by self-interest-minded individuals entrusted in managing the organization in some cases, by majority shareholders in other cases and at times by third parties from outside the organization. This exploitation falls under the concept of Agency Theory which emerges as a matter of concern that should be dealt with by Corporate Governance systems. Under the Agency Theory, the author classifies the Agency related problems into three types; “Type One”, “Type Two” and “Type Three”. All three types emanate from the separation of ownership and decision making complemented by the natural reality of self-interest requiring thus internal mechanisms of control in order to mitigate the Agency problems along with all Agency related costs. The paper then deals with such mechanisms.
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An Overview Of Agency Theory

One of the simplest and most straight forward concepts of Corporate Governance implies the process by which companies are managed and controlled. A main issue in such a process is the delegation of authority within the governance chain1. As far back as the sixteenth century, Adam Smith brought up the issue of such delegation resulting in the separation of ownership and decision making and the ineffectiveness of such arrangement mainly due to the fact that managers would never handle the interests of shareholders with the same vigilance as they would their own interests leading to waste in resources. The work of Berle and Means (1932) on the same subject serves as the basis for the various debates that place managers in a position to work for their best interests rather than the interests of the organization. These debates have sprung numerous concepts upon which was built the principles for corporate governance. In our chapter, we have limited the framework of corporate governance principles in businesses mainly to the issues pertaining to the “Agency Theory” and its effects of the business’ management thus highlighting the consequences of the separation of ownership (shareholders) and control (management) in modern corporations with private ownerships and the need to implement internal mechanisms of control in order to mitigate the agency conflict(s) along with their related costs and subsequently increase the firm performance.

Jensen and Meckling (1976) define the agency relationship as a contract under which one party (the principal) engages another party (the agent) to perform some service on their behalf. As part of this, the principal will delegate some decision-making authority to the agent. In terms of financial results, the agency problem refers to the conflict of interest arising between creditors, shareholders and management because of differing goals (Investopedia, 2008). The agency problem emanates from the arrangement. Jensen and Meckling criticize theories of the firm as being actually theories of markets in which firms operate, and they advance a theory of firm behavior that focuses on the firm itself. On the other hand, Fama and Jensen (1983) note the narrow set of circumstances under which it is efficient for the functions of decision management, decision control, and residual risk bearing to be combined to the same agents; namely, for small, noncomplex organizations where residual claims are restricted to decision agents, or residual claims are held by other agents with special relationships to decision agents (e.g., family members). Business associates whose goodwill and advice are important to the organization are also potential candidates for holding minority residual claims of organizations that do not separate the management and control of decisions.

Inherent in any principal-agent relationship is the understanding that the agent will act for and on behalf of the principal. The agent assumes an obligation of loyalty to the principal that he will follow the latter’s instructions and will neither intentionally nor negligently act improperly in the performance of the obligation. An agent cannot take personal advantage of the business opportunities the agency position uncovers. A principal, in turn, places trust and confidence in the agent. These obligations bring forth a relationship of trust and confidence between principal and agent.

Theoreticians of the Agency Theory delve on the conflict of interest between the agents (executives) and the principles (shareholders) in which the latter aims at maximizing the profits of their firm while the agents aim at maximizing their personal gain, often at the detriment of the firm. Thus the Agency Theory is based on the shift of interests between those of the executives and those of the shareholders and the study of Agency relationship in private businesses leads to a “Type One” Agency problem between the managers and the owners.

The development of broad types of business endeavors has given rise to numerous forms of associations that brought about, among others, different forms of Agency problems and different systems of governance. A general point of interest to us is the family businesses that are characterized by a concentration of ownership and that have a grave Agency problem often referred to as “Type Two” Agency problem emanating from the conflict of interest between majority and minority shareholders2. Corporate governance mechanisms provide some form of protection for the interests of these shareholders who otherwise are left at the mercy of the decision makers acting to enhance their own benefits.

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