An agency cost is an economic 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:
according to the Friedman doctrine, the cost borne by shareholders (the principals) when corporate management (the agent) buys other companies to expand its power, or spends money on vanity projects, instead of maximizing the value of the corporation;
the cost borne by the voters of a politician's district (the principals) when the politician (the agent) passes legislation helpful to large contributors to their campaign rather than the voters.Investopedia explains 'Agency Costs'
Though effects of agency cost are present in any agency relationship, the term is most used in business contexts.
Sources of the costs
Professor Michael Jensen and the late Professor William Meckling of the Simon School of Business, University of Rochester wrote an influential paper in 1976 titled "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure". Professor Jensen also wrote an important paper with Eugene Fama of University of Chicago titled "Agency Problems and Residual Claims". These works categories agency costs into three main sources:
Monitoring costs: Costs borne by the principal to mitigate the problems associated with using an agent. They may include gathering more information on what the agent is doing (e.g., the costs of producing financial statements or carrying out audits) or employing mechanisms to align the interests of the agent with those of the principal (e.g. compensating executives with equity payment such as stock options); Bonding costs: Costs borne by the agent to build trust with their principal, such as costs associated with obtaining insurance, posting performance bonds, and other forms of financial assurance. Bonding costs may include contractually limiting the agent's decision making powers, or increasing the transparency of the agent's decision. In theory, agents will only take on bonding costs where the marginal benefit of these costs are equal to or greater than the marginal cost to the agent. Bonding costs may reduce the steps that a principal will need to take to monitor the agent. Therefore, the agent's acceptance of these costs may produce a higher utility outcome for both parties. In practice, bonding costs are nearly impossible to measure. Residual loss: The costs that arise where the agent acts contrary to the best interests of the principal. It has been argued that the problem of residual loss is particularly acute in firms where ownership is separated from management, such as publicly traded corporations. In these firms, managers have control over the firm's resources but are not the ultimate owners, which can create a misalignment of incentives. One way to mitigate the problem of residual loss is through the use of performance-based compensation, which ties managerial compensation to the performance of the firm. This creates an incentive for managers to act in the best interests of the owners and to maximise the value of the firm's assets.
In corporate governance
The relationship between a company's shareholder and the board of directors is generally considered to be a classic example of a principal–agent problem. The problem arises because there is a division between the ownership and control of the company, as a result of the residual loss. In such case, traditional mechanisms of corporate governance such as shareholder activism and proxy contests may be less effective due to the fragmented nature of ownership. The shareholders appoint the board to manage their asset but often lack the time, expertise or power to directly observe the actions of the board. In addition the shareholders may not be placed to understand of the repercussions of the board's decisions. As such, the board may be capable of acting in their own best interests without the oversight of the shareholders. As is noted by Adolf A. Berle, in his now famous work on company law, this issue is exacerbated in companies where each shareholders has only a small interest in the company. Such diversity in shareholder interests makes it unlikely that any one shareholder will exercise proper control over the board.
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: empire-building (i.e. increasing the size of the corporation, rather than the size of its profits,The Art of Capital Restructuring: Creating Shareholder Value Through Mergers ... By H. Kent Bake, p.60-1 "which usually increases the executives' prestige, perks, compensation", etc., but at the expense of the efficiency and thus value of the firm); not firing subordinates whose mediocrity or even incompetence may be outweighed by their value as friends and colleagues;Bebchuk and Fried, Pay Without Performance (2004), p.16 retaining large amounts of cash that, while wasteful, gives independence from capital markets; a maximum of compensation with a minimum of "strings"—in the form of pressure to perform—attached. management may even manipulate financial figures to optimize bonuses and stock-price-related options.
Information asymmetry contributes to moral hazard and adverse selection problems.
Mitigation of agency costs Much of modern company law has evolved in order to limit the effects of agency costs. Company directors in common law jurisdictions owe fiduciary duties to their company.Corporations Act 2001 (Australia) s 180 - 181; Companies Act 2006 (UK) s 174 - 175; Dodge v. Ford Motor Company, 204 Mich. 459, 170 N.W. 668 (Mich. 1919). Notably these duties are not owed to the shareholders, but to the company. This is because the company is, in law, a legal person, separate from its shareholders.Salomon v A Salomon & Co Ltd UKHL 1 Breaches of duty by directors have the primary effect of causing losses to the company. The fiduciary duty requires the company director to act with due care and skill, in good faith, in the best interests of the company and without conflicts of interest. In some jurisdictions deliberate breaches of directors duties can result in civil or criminal penalties.Corporations Act 2001 (Australia) s 184
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 oppressionDodge 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 audits 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.
Concentrated shareholders
A concentrated shareholder structure can result in small groups that hold a significant proportion of the company’s shares. These shareholders can exercise significant control over the company as well as cause conflicts of interest between concentrated and other shareholders. For instance, concentrated shareholders may prioritise their profits and rights over those of other shareholders, thus increasing agency costs. For example, concentrated shareholders can make decisions that are more beneficial to themselves, such as higher dividend payouts or short-term, high-repayment business decisions. Such decisions may adversely affect the rights of other shareholders or the long-term survival of the company.
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.
Modern examples Enron, a U.S. energy giant operated for decades trading large and highly demanded commodities. However, 2001 saw the fall of the giant as a result of poor management, and a deeply rooted principal-agent problem.