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An agency cost is an Economics concept that refers to the costs associated with the relationship between a "principal" (an organization, person or group of persons), and an "agent". The agent is given powers to make decisions on behalf of the principal. However, the two parties may have different incentives and the agent generally has more information. The principal cannot directly ensure that its agent is always acting in its (the principal's) best interests. Pay Without Performance by Lucian Bebchuk and Jesse Fried, Harvard University Press 2004 ( preface and introduction) This potential divergence in interests is what gives rise to agency costs.
Common examples of this cost include:
Though effects of agency cost are present in any agency relationship, the term is most used in business contexts.
The classic case of corporate agency cost is the professional manager—specifically the CEO—with only a small stake in ownership, having interests differing from those of firm's owners.
Instead of making the company more efficient and profitable, the CEO may be tempted into:
Information asymmetry contributes to moral hazard and adverse selection problems.
However, director's duties are difficult to enforce without the involvement of a liquidator. This is in part due to the asymmetry of information between the shareholders and the board (as noted above). In addition, as shareholders are not generally owed directors duties, they do not having standing to enforce them (but notably, some shareholders may have action in minority oppression Dodge v. Ford Motor Company, 204 Mich. 459, 170 N.W. 668 (Mich. 1919)). Similar issues arise with respect to obligations under a contract between the director and the company, given the operation of the privity doctrine. Instead, companies often opt for incentive schemes based on the performance of the company. These schemes provide bonuses to company directors when the company performs well. The director is therefore given an incentive to ensure the proper performance of the company, thereby aligning their interests with that of the shareholders. The costs of paying the bonus is still an agency cost, but the company will profit from paying this cost so long as the avoided residual cost (as defined above), is greater than the bonus.
Another key method by which agency costs are reduced is through legislative requirements that companies undertake Audit of their financial statements.Auditing Standard No 5, pcaobus.org Publicly listed companies must also undertake disclosure to the market. These requirements seek to mitigate the information asymmetry between the board and the shareholders. The requirement to make disclosure reduces monitoring costs, and directors are less able to abuse their position when they will be required to disclose their shortcomings.
In jurisdictions outside the US and UK, a distinct form of agency costs arises from the existence of dominant shareholders within public corporations (Rojas, 2014).
In 2014, the study “Yesterday’s Heroes: Compensation and Creative Risk-Taking,”Cheng, Q., Hong, H., & Scheinkman, J. A. (2014). "Yesterday’s heroes: Compensation and creative risk-taking." Journal of Finance, 69(5), 1883-1936. was published in the Journal of Finance. The authors explained how executive compensation could increase the rate of creative risk-taking, which can lead to better company performance but, at the same time, increase agency costs. The authors used data from the movie industry to illustrate that managers with past successes are more likely to take creative risks and try to bring higher profit returns with higher risks, such as investing in projects with a low probability of success, which can increase agency costs. The paper summarised that the executive compensation design should consider the potential of creative risk-taking and agency costs. Moreover, boards should carefully monitor the activities of managers to ensure that they are acting to achieve the best profit returns for shareholders.
The article “Large shareholders and corporate control”Shleifer, A., & Vishny, R. W. (1986). "Large shareholders and corporate control." The Journal of Political Economy, 94(3), 461-488. was published in the Journal of Political Economy in 1985. The paper provides a theoretical framework that illustrates the role of large shareholders in corporate governance and control. For instance, large shareholders can be crucial in solving agency problems between managers and other shareholders. In addition, they can monitor managers and intervene when necessary in order to protect their profits. Large shareholders can also play an essential role in corporate control. For example, large shareholders hold a significant stake in the company and can therefore influence critical decisions, such as the election of directors and the adoption of significant corporate policies. These decisions could increase the agency cost because large shareholders may decide to get maximum profit for themselves, which is not usually the best decision for the company's long-term survival.
Typically speaking, chiefs and management are paid large salaries in the hope that these salaries deter from participation in high risk business. Yet Enron's board of directors decided to pay its managers in the form of stocks and options. In a very simplistic sense, this meant that managements compensation was pegged to stock performance and would mean any decision they made would be to the benefit of themselves (agents) and principals (shareholders).
Whilst in theory the concept was sound, it meant that Enron management could now deceive the markets for their own monetary gain, and they did just that. Higher management decided to take on high debt and risky activities, leaving these transactions 'off the books' and essentially meaning Enron was falsifying information. Enron had reached the point where it was overstating profits by $1.2 billion and eventually lead to its collapse.
In Enron collapse it also took down its accounting counterpart firm, Arthur Andersen, who were certifying Enron books to be clean, when they very obviously weren't. In the case of Arthur Andersen again reiterating the power of the principal-agent problem, where the accounting firm (principal) trusts and follows orders from the chiefs (agents), who benefit greatly from the business of a large company like Enron.
The collapse of the two giants shook Wall street, and finance around the globe, leading to Enron CEO Jeffrey Skilling being sentenced to serve 24 years in prison, as a result of various counts of conspiracy, fraud and insider trading. To this day, the Enron scandal still remains as one of the key studies of the principal-agent problem.
Another potential example of the agency-cost problem (which also gives rise to questions of corporate social responsibility) arose with respect to the James Hardie Scandal, where James Hardie Industries sought to avoid payment of settlements to those former employees suffering from by asbestos related illnesses. Ultimately, the shareholders were almost unanimous in voting in favor of a compensation scheme for the victims. The interests of the shareholders may have favored funding the compensation scheme earlier than the directors were willing to. This divergence in interest, even where it address an issue of corporate social responsibility rather than strictly monetary concerns, could be considered an example of agency cost.
Further difficulties may arise where the interests of one shareholder conflicts with that of another. In the legal dispute Dodge v Ford Motor Co, Henry Ford sought to take Ford Motors in a direction that was disagreeable to one of the minority shareholders, Mr Dodge. Mr Ford's aggressive expansion policies (including his goals of reducing prices and increasing employee wages) were perceived by Mr Ford to be for the long-term benefit of the company, but they prevented dividends being paid in the short term. This was beneficial to long-term shareholders, such as Mr Ford, but Mr Dodge may not have held his shares for long enough to reap the benefit. As such, he brought a successful action in minority oppression in order to force the payment of dividends by the Ford Motor Co. Mr Dodge's inability to receive a dividend without litigation is another example of agency cost.
Because bondholders know this, they often have costly and large ex-ante contracts in place prohibiting the management from taking on very risky projects that might arise, or they will simply raise the interest rate demanded, increasing the cost of capital for the company.
Labour is sometimes aligned with stockholders and sometimes with management. They too share the same risk-averse strategy, since they cannot diversify their labour whereas the stockholders can diversify their stake in the equity. Risk averse projects reduce the risk of bankruptcy and in turn reduce the chances of job-loss. On the other hand, if the CEO is clearly underperforming then the company is in threat of a hostile takeover which is sometimes associated with job-loss. They are therefore likely to give the CEO considerable leeway in taking risk averse projects, but if the manager is clearly underperforming, they will likely signal that to the stockholders.
In 1995, the paper “The Provision of Incentives to Firms”Prendergast, C. (1999). "The provision of incentives in firms." Journal of Economic Literature, 37(1), 7-63. was published in the Journal of Economic Literature and comprehensively reviewed the literature on providing incentives to firms. The authors pointed out that incentives are crucial for employee motivation and improving firm performance. Moreover, incentives can take many forms, including performance-based compensation, promotions, and career development opportunities. The paper also identifies factors that can influence the effectiveness of incentives in firms, such as incentive programmes, the characteristics of the workers subject to the programmes, and the level of competition in the labour market. In the end, the authors concluded that incentives could effectively improve firm performance. However, the design of each incentive programme is critical to its success. For instance, incentive programmes must be carefully structured to meet the interests of employees and managers. Published in the Journal of Business Research in 2015, the paper “The Impact of HR Practises on Labour Agency Costs”Mihailova, I. (2018). "The effect of HRM practices on labour agency costs." Journal of Applied Economics and Business Research, 8(3), 132-145. examines the relationship between human resource management (HRM) practises and labour agency costs. The authors claim that, by providing for the interests of both employees and managers, HR systems can help reduce labour agency costs. Moreover, every company sector increases its interest by increasing company profit. Furthermore, by emphasising communication, employee engagement, and training can help build trust between employees and managers, which can lead to higher employee engagement and lower employee turnover. In conclusion, the paper stated that HR practises for reducing labour agency costs could work significantly. However, this will depend on various factors, such as strategies and employee characteristics.
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