Comparison And Contrast Between Agency And Stakeholder Theory
“Agency theory explores how contracts and incentives can be written to motivate individuals to achieve goal congruence” (Anthony, Dearden and Vancil, 1972, p.530). The theory identifies the main criteria for designing incentive contracts or compensation arrangements.
An agency relationship is established when one party (the principal) hires another party (the agent) to carry out a particular service, thereby delegating decision-making authority to the agent. In a corporation, the shareholders are the principals. The agent is the chief executive officer named by the board of directors, acting on behalf of the shareholders; thus, the agent is expected to act in the interest of the shareholders.
The main challenge is motivating agents to increase their productivity to the level they would seek if they were the owners. One of the key tenets of agency theory is that while principals and agents have different preferences or goals, these divergent preferences can be aligned with the help of incentives.
Stakeholder theory is not a formal, unified theory, but more of “a broad research tradition, incorporating philosophy, ethics, political theory, economics, law, and organizational social science” (Solomon, 2007, p.23). Stakeholder theory recognizes that large companies have a far-reaching impact on society; hence they are accountable to many more stakeholders than just their shareholders.
A common feature among all the stakeholders of a company that their relationship with the company involves an exchange: stakeholders provide contributions and expect that the company will fulfil the stakeholders’ expectations through ‘inducements’. Stakeholders include “shareholders, employees, suppliers, customers, creditors, communities in the vicinity of the company’s operations, and the general public” (Solomon, 2007, p.23). Some authors include the environment, animal species and future human generations as stakeholders.
The company manager must maintain support from all these groups, balancing their interests while taking measures to maximize all the stakeholder interests over time.
Thesis Statement: The purpose of this paper is to compare and contrast Agency theory and Stakeholder theory; and to determine which theory offers the most useful insights into corporate behaviour.
Agency and Stakeholder Theories are Based on Essential Moral Principles:
Honouring Agreements and Respecting the Autonomy of Others
Agency theory involves a discussion of moral hazards and agency costs. Agency theory can be applied effectively only if the parties observe four moral principles: “avoiding harm to others; respecting the autonomy of others; avoiding lying; and honouring agreements” (Solomon, 2007, p.25). Only when agents fulfil their basic moral duties as human beings can they involve themselves in maximizing shareholders’ wealth.
Agency theory is interwoven with transaction cost theory. Each views the firm and managerial behaviour using different terminology to describe the same problems and issues. For example, while agency theory confronts moral hazards and agency costs, transaction cost theory assumes that people are often opportunistic. Agency theory analyses the individual agent, while the transaction cost theory looks to the transaction as its unit of analysis. Nonetheless, the ultimate goal of both theories is the same: to persuade company management to work for shareholder’s interests by maximising profit for both the company and the shareholder, rather than to pursue their own self-interest. Thus, agency theory and transaction cost theory are “simply different lenses through which the same problems may be observed and analysed” (Solomon, 2007, p.23).
Stakeholder theory provides a third possible lens.
Stakeholder theory (Freeman, 1984) has become increasingly popular with its concept that stakeholder influence on management contributes beneficially to the performance and valuation of firms. Udayasankar et al. (2005) state that the utility of focusing on stakeholders depends on the extent of protection provided to different stakeholder groups. The authors note that in countries where minority shareholders are given better protection, for example, firm values tend to be higher. Where minority investors have greater rights, they can curb overinvestment in declining industries. Therefore, to achieve an effective system that allows stakeholders to affect the management of firms, it is necessary first to identify such stakeholders through appropriate legislation.
Management literature has advocated and approved the stakeholder theory and its three main distinct but inter-related components: instrumental power, normative validity, and descriptive accuracy. Donaldson and Preston (1995) found that the three aspects are mutually supportive, and that the “normative base of the theory – which includes the modern theory of property rights – is fundamental” (p.65).
The concept of corporate social responsibility is closely related to the broad scope of the stakeholder theory.
In response to increasing environmental, social and political challenges, environmental and social groups lobby companies to comply with moral and ethical requirements and thereby accommodate the interests of all the company’s stakeholders. Thus, companies must adhere to ethical behaviour, whether or not it is profitable. Quinn and Jones (1995) term this approach non-instrumental ethics,
On the other hand, companies have “a legal and fiduciary obligation to shareholder wealth maximization” (Solomon, 2007, p.25). Therefore the business cannot base its operations solely on ethics, but must find a way to succeed in both arenas.
In their Report to Society, 2004, the Rio Tinto Company illustrates their approach to social responsibility, noting that the company’s commitment to sustainable development has become compelling from a business perspective. They cite evidence that companies like theirs which maintain high levels of social, economic and environmental performance attract the best people as management and employees.
Adherence to high standards of ethics also improves the motivation and commitment of employees while achieving continued loyalty of their customers, strong relationships with other stakeholders, and stronger corporate reputation. All these factors help to increase shareholder value (Solomon, 2007).
Agency Theory: Divergent Goals of Principals and Agents;
“Agency theory assumes that all individuals act in their own self-interest” (Anthony et al, 1972, p.530). Agents are assumed to be satisfied not only by their financial compensation but also by the various perquisites and privileges they can claim on the basis of their agency relationship. Shareholder theory assumes that principals (shareholders) are interested only in the financial returns they receive from investing in the firm.
Agents and principals also diverge as to their tolerance for risk.
Agency theory assumes that managers opt for more wealth rather than less, but that the marginal utility or satisfaction from acquiring more wealth decreases as they obtain more wealth. Agents usually depend on the fortunes of the firm for their own financial wealth and their human capital. Therefore, agents are assumed to be risk averse.
Many owners of company stocks diversify their wealth by owning shares in several companies. Owners are interested in the expected value of their investment, and consequently are risk neutral.
Information asymmetry occurs when the principal does not have adequate information about the agent’s performance, and is uncertain about the extent to which the agent’s efforts contributed to the company’s financial results (Anthony et al, 1972).
There are two main control mechanisms for dealing with the problems of divergent principal and agent objectives and information asymmetry: monitoring the agent’s actions and reducing the degree to which increases in the agent’s welfare come at the cost of reducing the principal’s benefits.
Incentive contracting provides another monitoring device. For example, Columbia Broadcasting System (CBS) included a protection clause in CEO Les Moonves’ employment contract, agreeing to pay him $5 million if CBS were sold to another company. A few months after Moonves arrived at CBS, Westinghouse purchased CBS, which triggered the clause. Other types of incentive plans for agents of the corporation include CEO Compensation and Stock Ownership Plans, and Business Unit Managers and Accounting-Based Incentives (Anthony et al, 1972).
Significantly, none of these incentive arrangements ensure that the managers attain their goals. The reasons lie in the differences in risk preferences, the asymmetry of information, and the costs of monitoring. Even an efficient system of incentive alignments would result in a divergence of preferences, termed the residual loss. Anthony et al (1972) state that agency costs include the incentive compensation costs, the monitoring costs and the residual loss.
Corporate scandals involving corruption by companies’ agents result from divergent goals, information asymmetry, and insufficient monitoring of agents, and can be analysed according to the stakeholder, public management and agency theories.
Agency Theory Results in Failure of Corporate Governance
Global concern has been expressed about the limitations of the current systems of corporate governance. English-speaking countries such as Britain, Australia and others have similar systems. In Germany, the distance between ownership and control is far less than in the United States. Japan’s system of corporate governance is considered to be mid-way between those of Germany and the United States, and differs from. The international comparisons indicate varied approaches to the problem of corporate governance, ensuring that managers act in shareholders’ interest (Crowther and Jatana, 2005).
The validity of agency theory is based on the relationship between the principal and the agent. Crowther and Jatana (2005) challenge the validity of the theory, stating that there can be no relationship between the principal and the agent. Particularly in the modern world, most managers are almost as impermanent as shareholders, so there is no loyalty to the business from anyone involved in the firm’s functions. Under the principal-agent contract, the shareholder looks towards growth in share value, and the manager towards current rewards; neither has much farsightedness interest in the future of the business. The managers are not interested in stewardship, but instead seek to manage the finances of the firm for immediate benefit, sharing those benefits with the owners. Both parties have little consideration for the other stakeholders. Crowther and Jatana (2005) argue that relying on agency theory to manage a business leads to excesses and corruption by agents and senior level management, and a breakdown of corporate governance.
Enron Energy-Producing Corporation and other Companies: Corporate Scandals Resulting from Breakdown of Governance Relations
Almost all the corporate scandals that destabilized American businesses from late 2001 through 2002 have been traced to a “break-down of the governance relation between shareholders, the board, and the senior executives” (Heath and Norman, 2004, p.2). Thus, stakeholder theory, the company’s corporate governance, and public management are the key elements in explaining the corporate crimes.
The scandal surrounding Enron Corporation, an American energy-producing and trading company based in Houston, Texas, is one of the biggest white collar crimes in American history. After the corporate crimes came to light in October 2001, they ultimately resulted in the bankruptcy of the company, as well as the dissolution of Arthur Andersen, one of the five largest audit and accountancy partnerships in the world. Thus, Enron was not only the largest American bankruptcy reorganization of that time, but was also the biggest audit failure (Sterling, 2002).
“Enron” is used symbolically here to represent the wave of corporate scandals that rocked American business from late 2001 to the end of 2002. These included leading firms such as “Arthur Andersen, WorldCom, General Electric, Tyco, Qwest, Adelphia, Halliburton, Global Crossing, AOL, Time-Warner, Merrill Lynch, Health South and, of course, Enron” (Heath and Norman, 2002, p.2).
Since shareholders are given extensive status and control under corporate law, and their interests are taken into consideration by the firm’s management, supporters of the Stakeholder theory tend to defend shareholder rights as a very minimum. Stakeholder theorists who take shareholders’ rights into account have largely attempted to limit or circumscribe those rights in order to provide for the rights or interests of other stakeholder groups.
Examining the case of Enron should make us reconsider this assumption, however, since shareholders during that era could not be sure that senior management considered all their interests. There are lessons to be learned from this case for those with a vested interest in the system of shareholder-focused capitalism: “investors, brokerages, auditors, financial regulators, legislators, and so on” (Heath and Norman, 2002, p.2).
These stakeholders reacted swiftly to the Enron bankruptcy and audit. Authorities attempted hastily to identify flaws in the governance relation that had allowed the occurrence of the most conspicuous wrong-doings. They proposed to patch up the flaws, frequently in the form of revised regulations or voluntary codes to prevent or discourage the occurrence of similar scandals in the future. Almost all the post-Enron reforms undertook to strengthen the accountability of corporate executives to their boards and their shareholders.
Heath and Norman (2002) argue that stakeholder theorists who opposed the dominant shareholder-focused conception of the firm, stood to gain even more important lessons. First, stakeholder theorists underestimated the importance of shareholder interests and shareholder control for promoting the interests of other stakeholders of the firm. Hence, each of the stakeholders of Enron was negatively impacted when the company’s senior managers “conspired against the interests of the shareholders, and when investors lost confidence in the company” (p.3).
Second, issues of governance and corporate law need to receive greater attention among those who promote stakeholder theory, or who advocate a shift from the shareholder-focused conception of the firm. Heath and Norman (2002) believed that there should be an integration of the interests of shareholders and other stakeholders. They studied the relevance of agency problems to governance in general, and to the governance of firms based on stakeholder theory.
The corporate scandals which occurred during the Enron era were essentially due to “a failure of these firms and their shareholders to protect themselves against agency problems” (Heath and Norman, 2002, p.3). Senior executives or agents acted against the interests of the principals or shareholders by exploiting information asymmetries and conflicts of interest on the board. They evidently had a reasonable expectation of evading punishment. The authors investigated whether governance relations in firms that operated on the stakeholder theory could be safeguarded from comparable agency problems. Their cautioned that any restructuring of corporate law and corporate governance to encourage stakeholder management could leave firms vulnerable to both the internal fraud of Enron and the extensive inefficiencies of companies such as Ontario Hydro or British Steel.
Because of these problems, the basic concepts of stakeholder theory may best be achieved by strategies ensuring a shareholder-focused governance structure in the firm. This emphasized the significance of using the stakeholder theory to improve organizational behaviour.
The Failure of Corporate Governance in the Case of Parmalat Dairy Foods Co.
Initially, a standard accounting fraud was revealed in the Parmalat group, a global frontrunner in the dairy food business, based in Italy. Eventually the company collapsed, acknowledging extensive holes in its financial statements and seeking bankruptcy protection in December 2003. Several billion euros were found to be missing from the firm’s accounts. This sensational collapse resulted in doubts regarding the quality of accounting and financial reporting standards, “as well as the Italian corporate governance system” (Melis, 2005, p.478).
Melis (2003) indicates that information-supply agents within Parmalat were not held accountable for carrying out their work. The agents include the board of directors, the board of statutory auditors, the internal control committee, the senior management and the external auditing firm. It was confirmed that there was “lack of a monitoring structure making corporate insiders accountable in the presence of a corporate governance system characterised by a controlling shareholder” (Melis, 2005, p.487).
Based on the typical Italian roles of the ownership and control structure, with respect to the controlling shareholder’s role, and of the board of statutory auditors, it may appear that Parmalat is a specifically Italian corporate governance case. Additionally, the controlling shareholder held the positions of Chairman and CEO of Parmalat Finanzaria, which resulted in an extensive accumulation of powers. Although this state of multiple positions is uncommon among listed large Italian companies, the Italian code of best practice does not recommend separating the two positions, so Parmalat formally complied with the code.
On an international level, Italian corporate governance is not of the highest standard, but the standards themselves were not entirely at fault in the Parmalat case. Parmalat’s corporate governance structure failed to comply with some of the key existing Italian corporate governance standards of best practice, such as the presence of independent directors, particularly on the board’s internal control committee.
These ineffective monitors appear to suggest that the Parmalat case is supports the need for a global corporate governance standard. While the Parmalat case pertains more to the Italian context, its corporate governance problems cannot be disregarded on grounds of being country-specific, since the same conditions can appear in other firms around the world (Melis, 2005, p.487).
The Utility of Agency Theory and Stakeholder Theory
Although agency theory is considered a failure when applied to corporate governance, numerous studies validate agency theory predictions in other contexts, such as a firms’ public stock offering to raise new capital, setting up a franchise, strategy for developing new product technology, and labour union transactions.
A firm’s diversification strategy is likely to reduce the firm’s value when it offers stock to raise new capital, because diversified firms trade at a discount. This is in contrast to their single-segment peers. Earlier studies found a significant link between greater shareholder wealth and focused strategy for many leading United States firms, state Bowrin, Sridharan, Navissi and Braendle (2006).
While diversification within a firm can lead to a reduction in value, managers encourage corporate diversifications because their private benefits, including incentives and non-financial such as perquisites, privileges and power, were related to diversified portfolio.
Setting up a franchise is regarded as an efficient way to minimize the agency problems of shirking. Since franchisees are compensated out of the residual claims of their individual units (what is left after paying all expenses), they normally bear the costs of shirking either entirely or to a great extent.
While agency theory has empirical support, new research studies investigate the theory’s utility for newer variants of organizational structures. New studies also analyse the applicability of agency theory compared to other theories. For example, corporate diversifications are examined using stewardship theory, which is led by strategic management, rather than agency theory, which is led by organizational economics (Bowrin et al, 2006).
To optimise corporate behaviour, the theory of ownership structure for the firm integrates aspects of the theory of agency, property rights, and finance, reasoning that if the interests of owners and managers are not the same, corporate inefficiencies and subsequent costs to the firm may result. The scholars’ analysis reveals new implications in relation to the definition of the firm, the differences between ownership and control, corporate social responsibility, corporate objective function, “the determination of an optimal capital structure, the specification of the content of credit agreements, the theory of organizations, and the supply side of the completeness of markets problems” (Jensen and Meckling, 1976, p.305).
On the other hand, the adverse implication of Agency theory is that managers in non-profit and governmental organizations may lack the motivation for aligning their goals with those of the owner or principal if they are not provided with incentive compensation.
Further, the components of the Agency theory cannot be quantified, for example estimating the cost of information asymmetry would not be possible.
Additionally, the Agency theory to a great extent oversimplifies the relationship between superiors and subordinates. Anthony et al (1972) reiterates that the model uses only a few elements while not taking other essential factors into consideration, such as: the personalities of the participants, motives unrelated to finance, agents who are not risk averse, the principal’s trust in the agent, the agent’s level of capability, and other reasons.
It is increasingly likely that companies that focus on creating value for stakeholders by maximizing value for communities, employees, environmental impacts, and other factors, may actually create more financial value for shareholders. Therefore, neglecting the requirements of stakeholders can lead to a decline in financial profits and ultimately result in corporate failure.
A contrasting aspect to this concept is that satisfying the needs of a diverse group of stakeholders may not necessarily lead to achieving the ultimate goal of maximising shareholder wealth.
In the long-term, both agency theory and stakeholder theory have the same objectives. Only by taking into consideration both stakeholders’ and shareholders’ interests can “companies achieve long-term profit maximization and ultimately, shareholder wealth maximization” (Solomon, 2007, p.29).
Requirement for a Combined Agency-Stakeholder Theory and Conclusion
This paper has highlighted Agency and Stakeholder theories of the firm. Both theories offer useful insights into corporate behaviour, but each has its limitations. The interests of principals and agents diverge mainly because of their different utility functions. This can result in direct conflict regarding the use of resources.
Agency theory focuses on the divergent interests of managers and stakeholders. On the other hand, Hill and Jones’ (1992) stakeholder-agency theory takes into consideration the causes of conflict between managers and stakeholders as a result of disequilibrium conditions. Further, stakeholder-agency theory also indicates theoretical adjustment mechanisms that integrate management and stakeholder interests.
The core issue in the debate between agency and stakeholder theories of the firm consists of two competing views of the firm. Due to the sharply contrasting assumptions and processes of the approaches, agency and stakeholder theories are frequently considered to be polar opposites.
According to Shankman (1999), however, agency theory can be incorporated within a general stakeholder theory of the firm. After analysing the assumptions of agency theory, the author argues that the combined theory must include a recognition of stakeholders; uphold a moral minimum placing the four moral principles as essential and unaffected by the interests of any stakeholders, including shareholders; and infuse trust, honesty and loyalty into the agency relationship as an offshoot of agency theory’s inherently contradictory assumptions about human nature. The author uses empirical hypotheses to substantiate his argument that stakeholder theory is the logical conclusion of agency theory.
Laplume, Sonpar and Litz (2008) reported an extensive increase in the prominence of stakeholder theory in the last fifteen years. Shareholders’ theory being another version for agency theory, it is important to integrate these theories with stakeholder theory to obtain best practices in corporate governance. This was seen in the examples of Enron and Parmalat, as well as other corporate scandals, where further monitoring of the company’s agents was crucially required.
The authors recommend:
further empirical research across a wider range of organizations,
more qualitative research to investigate the cognitive aspects of managers’ response to stakeholders’ expectations, and
greater focus on the stakeholders’ theory emphasising the positive outcomes related to stakeholder management, and
a broader perspective on firm performance and focus on the roles of various agents, with extensive monitoring and regular evaluation of their work.
Therefore, we conclude that to obtain the most useful insights into corporate behaviour, it is necessary to use a combination of agency and stakeholder theories, incorporating the former concept into the latter, as suggested by Shankman (1999).
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