Models and practices of corporate governance (Conf. dr.

Voicu Dragomir)

Agency
Theory

Agency theory
Agency theory refers to the agency relationship, in which one
party (the principal) appoints another party (the agent) to
fulfill a certain duty.
Agency theory describes this relationship using the metaphor of
the contract (Jensen & Meckling, 1976).
The agency problem appears when: (a) there is a conflict
between the wishes and objectives of the agent and those of
the principal; and (b) it is sufficiently costly and difficult for
the principal to verify what the agent actually does.
There is a risk sharing between the principal and the agent which
have different attitudes towards risk. They would prefer
different solutions for the same problem because, in general,
the principal is risk-averse, while the agent assumes a higher
degree of risk in solving a problem.

The agency relationship

If both parties want to maximize their own utility functions (or
profits), than it is probable that the agent will not entirely
follow the interests of the principal. Also, it is impossible to
insure a convergence of both parties interests without any
cost borne by either party. The agency relationship is
characterized by divergence of interests and the existence of
the following specific costs:
1. Monitoring costs borne by the principal;
2. Assurance costs borne by the agent; and
3. A residual loss, which may be calculated as the decrease in the
value of the principals wealth, as a consequence of diverging
interests with the agent. Also, breaking the relationship with
the agent can also be regarded as an associated cost.

 Shareholders act as principals only in theory. In practice,

shareholders are diverse groups of people and organizations
with diverse interests. The directors have a moral obligation
towards them directly, although the latter do not always know
the formers intentions.
In addition, shareholders have their own duty to the company
(most important to vote in some key moments), which
explains why they may choose not to play the role of principal.
Corporate law considers that directors have a legal obligation
to the company as a legal (fictitious) entity, and shareholders
usually benefit from a successful mandate.
Managers have no obligation to the shareholders, because
they are employees of the company. Thus, they have a duty to
their employer, in this case a legal entity represented by the
Board of Directors.

Models and practices of corporate governance (Conf. dr. Voicu Dragomir)

Shareholders and mandate

 Shareholders may benefit indirectly (residual interests) or

directly (as private benefits) from their status. Private benefits
are customized, they are not shared with other shareholders.
From the perspective of shareholders, there is a compromise
(tradeoff) between direct and indirect benefits. Private benefits
can harm the company, in which case they will reduce indirect
benefits (profits, equity prices and dividends).
Individual shareholders can be agents of the company (when
looking at the firm as a principal), when they collect private
benefits from interacting with the company. Therefore, the
economic entity as a whole may be interested to interact with
shareholders whose private benefits are not harmful and are
aligned with company business goals (such as business partners
or managers who receive shares in the company).
For minority shareholders, the majority owner is an agent for
protecting their own investment.

Models and practices of corporate governance (Conf. dr. Voicu Dragomir)

Private benefits

 There is an agency issue in respect of the shareholders

involvement. They can be considered good when they
actively monitor and require the long-term increase of
company value, or bad in the following situations:
1. Some shareholders seek only personal gain. For example,
whenever public companies are run by people close to the
political sphere, and to which the companys money is
redirected to support political expenditure.
2. Some shareholders may take advantage of the close
relationship with the managers, in order to receive
payments and benefits from the company, which could drive
the firm even to bankruptcy.
In these situations, the agency conflict may be reduced by
restricting the interference which some shareholders may have
in business operations and with the companys managers.

Models and practices of corporate governance (Conf. dr. Voicu Dragomir)

Good and bad shareholders

 Corporate law requires that managers seek profit for the

shareholders in order to attract new investors to become
shareholders and existing ones to invest more. This rule is a
benchmark for the actions of managers who run the company.
The penalties for breaking this rule vary by jurisdiction and the
nature of the offence.
Law experts consider that the survival of the firm and the
return for shareholders are two complimentary goals, where
dividend distribution and rising share prices are just two
components of this equation.
This rule is only a general goal, since it does not specify how
to run the business, the profit targets or how to redistribute
these returns. Business losses are a normal consequence of
economic activity, and they are not civil or criminal offences.

Models and practices of corporate governance (Conf. dr. Voicu Dragomir)

Return for the shareholders (I)

 The profit for shareholders rule provides a control

mechanism, since shareholders can legally become monitors of
the company, and offers them an incentive to incur certain
costs of monitoring.
Firm profitability influence its stock market valuation. A small
constant value of the company will reduce its long-term survival
chances and will transform it into a takeover target. A value in
an uptrend will enable the company to use equity-based
financing, which is cheaper overall.
This rule does not say how much should be allocated to
shareholders as dividends or share buy-backs, and how much
profit should be distributed to other parties. From the
perspective of long-term survival, it is considered that there
should be a tradeoff between market value and fair distribution
of resources to all business partners and the society.

Models and practices of corporate governance (Conf. dr. Voicu Dragomir)

Return for the shareholders (II)