Agency problems and corporate governance | Cheat Sheet Law

The principal is the one who hires and delegates authority, whereas, the agent is the one the one who

performs and makes decisions upon the orders of the principal. Thus, there exists an information

asymmetry or conflict of interest between the two. The three generic agency problems that arises in

business firms are between:

1. Firms owners and its hired managers

Here the owners are the principals, and the managers are the agents. The problem here lies in

assuring that the managers are responsive to the owners’ interests rather than pursuing their

own personal interests.

2. Majority and minority shareholders

The noncontrolling owners can be though of as the principals and the controlling owners as

agents. The difficulty here lies in assuring that the former is not expropriated by the latter.

While this problem is most conspicuous in tensions between majority and minority

shareholders, it appears whenever some subset of a firm’s owners can control decisions

affecting the class of owners as a whole. Thus, if minority shareholders enjoy veto rights in

relation to particular decisions, it can give rise to a species of this second agency problem.

Similar problems can arise between ordinary and preference shareholders, and between senior

and junior creditors in bankruptcy (when creditors are the effective owners of the firm).

3. Owners and the other parties

The third agency problem involves the conflict between the firm itself including, particularly,

its owners and the other parties with whom the firm contracts, such as creditors, employees,

and customers. Here the difficulty lies in assuring that the firm, as agent, does not behave

opportunistically toward these various other principals such as by expropriating creditors,

exploiting workers, or misleading consumers.

Strategies for reducing agency costs:

1. REGULATORY STRATEGY

Herein the substantive terms that govern the content of the principal-agent relationship are

dictated. Thereby, constraining the agent’s behaviour directly.

- RULES AND STANDARDS

regulatory strategies constrain agents by commanding them not to make decisions, or

undertake transactions, that would harm the interests of their principals. Lawmakers can

frame such constraints as rules, which require or prohibit specific behaviors, or as general

standards, which leave the precise determination of compliance to adjudicators after the

fact.

Rules are used to protect a corporation’s creditors and public investors. corporation

statutes universally include creditor protection rules such as dividend restrictions,

minimum capitalization requirements, or rules requiring action to be taken following

serious loss of capital. Few jurisdictions rely solely on the rules strategy for regulating

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The principal is the one who hires and delegates authority, whereas, the agent is the one the one who performs and makes decisions upon the orders of the principal. Thus, there exists an information asymmetry or conflict of interest between the two. The three generic agency problems that arises in business firms are between:

Firms owners and its hired managers Here the owners are the principals, and the managers are the agents. The problem here lies in assuring that the managers are responsive to the owners’ interests rather than pursuing their own personal interests.
Majority and minority shareholders The noncontrolling owners can be though of as the principals and the controlling owners as agents. The difficulty here lies in assuring that the former is not expropriated by the latter. While this problem is most conspicuous in tensions between majority and minority shareholders, it appears whenever some subset of a firm’s owners can control decisions affecting the class of owners as a whole. Thus, if minority shareholders enjoy veto rights in relation to particular decisions, it can give rise to a species of this second agency problem. Similar problems can arise between ordinary and preference shareholders, and between senior and junior creditors in bankruptcy (when creditors are the effective owners of the firm).
Owners and the other parties The third agency problem involves the conflict between the firm itself including, particularly, its owners and the other parties with whom the firm contracts, such as creditors, employees, and customers. Here the difficulty lies in assuring that the firm, as agent, does not behave opportunistically toward these various other principals such as by expropriating creditors, exploiting workers, or misleading consumers. Strategies for reducing agency costs:
REGULATORY STRATEGY Herein the substantive terms that govern the content of the principal-agent relationship are dictated. Thereby, constraining the agent’s behaviour directly.

RULES AND STANDARDS regulatory strategies constrain agents by commanding them not to make decisions, or undertake transactions, that would harm the interests of their principals. Lawmakers can frame such constraints as rules, which require or prohibit specific behaviors, or as general standards, which leave the precise determination of compliance to adjudicators after the fact. Rules are used to protect a corporation’s creditors and public investors. corporation statutes universally include creditor protection rules such as dividend restrictions, minimum capitalization requirements, or rules requiring action to be taken following serious loss of capital. Few jurisdictions rely solely on the rules strategy for regulating

complex, intra-corporate relations, such as, for example, self-dealing transactions initiated by controlling shareholders. Standards are also used to protect creditors and public investors, but the paradigmatic examples of standards-based regulation relate to the company’s internal affairs, as when the law requires directors to act in ‘good faith’ or mandates that self-dealing transactions must be ‘entirely fair’.

SETTING THE TERMS OF ENTRY AND EXIT The law can dictate terms of entry by, for example, requiring agents to disclose information about the likely quality of their performance before contracting with principals. Alternatively, the law can prescribe exit opportunities for principals, such as awarding to a shareholder the right to sell her stock or awarding to a creditor the right to call a loan.

GOVERNANCE STARETEGY This strategy is used to facilitate the principal’s control over the agent’s behaviour.

SELECTION AND REMOVAL Appointment rights- this is the power to select or remove directors which is the key strategy for controlling the enterprise.
INITIATION AND RATIFICATION expands the power of principals to intervene in the firm’s management. These are decision rights, which grant principals the power to initiate or ratify management decisions.
TRUSTEESHIP AND REWARD rewards agents for successfully advancing the interests of their principals. Done in two ways:

Sharing rule- motivates loyalty by tying the agent’s monetary returns directly to those of the principal.
Pay for performance regime- in which an agent, although not sharing in his principal’s returns, is nonetheless paid for successfully advancing her interests.

TRUSTEESHIP STRATEGIES It seeks to remove conflicts of interest ex ante to ensure that an agent will not obtain personal gain from disserving her principal. This strategy assumes that, in the absence of strongly focused or ‘high-powered’ monetary incentives to behave opportunistically, agents will respond to the ‘low-powered’ incentives of conscience, pride, and reputation, and are thus more likely to manage in the interests of their principals. Refer PPT for enforcement part.

Agency problems and corporate governance, Cheat Sheet of Law

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