The origin of agency cost and corporate governance

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The origin of agency cost

The agency cost is an inexorable result of the development of corporate structure. Since the industrial revolution in 18th century, business structures have developed into three types, namely sole proprietorship, partnership and corporation in time order (Walter, 2005). He pointed out that it reflects the scale-up of company and the social division of labour. With the birth of a corporation, the owners delegate the running to more professional individuals. The former is shareholders or principals, and the latter is managers or agents. Compared with shareholders, managers have more access to information and resource of the company. As the insider of the corporation, their decision-making is everyday affairs, which would be also tedious work. According to Sanford’s view (1983), the action from managers is assumed to be unable to be all monitored by shareholders, and it is also assumed that managers’ decision will influence the performance of company and profit of the shareholders. Under these two assumption, it is difficult to motivate the agents to work on behalf of principals rather than that of themselves, that is the agent problem or the principal-agent conflict. Then the loss in this conflict is called agency cost, which has been defined by Jensen in 1976. As a result, it seems that the appearance of this cost is unavoidable.

In general, the causes that can affect the agency cost would be divided into three parts. Lambert (2012) claims that information asymmetry is the first one, which means that managers know more information and spend more money without the allowance of owner in the presence of ethical dilemma. And the goal conflict and the inconsistency in the incentive mechanism is also associated with the cost (Boivie, 2011). The whole profit that comes from the manager’s hard-working goes to the shareholder, while the manager just has the limited salaries from the company. At the same time, managers can live in the lap of luxury when they are leaders in the company, while all the cost will be paid by the shareholders.

Three different ways

Considering the factors above, most scholars suggested that strong corporate governance can minimise the cost and negative effects on corporate performance (eg Shleifer, 1997), but the specific opinions have some differences. As for ownership structure, Jensen and Meckling (1976) conclude that the higher the level of managers’ share ownership is, the lower the cost is. However, the finding from Fama (1983) is a little different. When the proportion is over one point, the situation varies totally. In recently research, it is important to maintain a proper radio (Davidson, 2003), according to same evidences and data analysis. La Porta (1998) thinks that the agent problem in the whole world is how to control the interest of minor shareholders will not be impaired by major shareholders. The past finding seems to be consistent with present research which finds that managers who also are major shareholders would aggravate the conflict between the two camps (Faccio, 2012). And the finding from Pagano (1999) and Nager (2002) conclude that it is a good way to have several major shareholders, because mutual supervision can make a difference.

From another perspective of corporate governance, the board size and independence also is essential parts to be considered. The board size is measured the number of directors, including the insiders who have positions in the company and outsiders. And the board independence is measured by the number of outsiders, because the insiders have more potential to be influenced by the affairs in the company. Based on this, the board of directors plays two roles in minimising the agency cost. One is to give some advice to the managers, and another is to monitor the behaviours of managers (Fama, 1983). Some scholars think that the advantage of larger board is stronger ability to give and collect the information subsequently. However, the disadvantage is more obvious. The difficult accordance between board members will cause more useless waste in time and money, so that managers would be looselyregulated. Recently, more academic evidence appears to support this view that there is a negative relationship between the board size and agency cost. Some similar research are made in the world. For example, both analysing nearly 500 UK companies by Conyon in 1998 and discussing the Switzerland’s firms by Loderer in 2002 support it, while Beiner (2006) find no relation between the board size and agency cost. A finding is that the number of board size should not be greater than eight (Jensen, 1993), which means that if the number is under 8, it can be increased and vice versa. As for the independence, almost all scholars claims that it is effective to control the agency cost, because outsiders will have no conflict between the two groups. An evidence from Klein (2002) showed that it is negatively associated with the financial fraud and earning management, which is an intentional behaviour to make the financial report better seemingly.

The third way to minimise the cost is to design the reasonable contrast about managerial salaries, which is common to see in most companies but do not have a definite conclusion. Surveys conducted by Depken (2006) in US have shown that managerial salaries and agency cost are directly related, while Firth (2008) have found that there is a negative relationship. The reason why the conclusions are different is that managers is powerful in the widely held corporation and the high level of managerial salaries is one kind of expression in the agent problem. According to this reason, if the purpose of salaries design is to link the interest of managers and shareholders together, it is a good way to relieve this problem and minimise the cost. For example, managerial salaries would depend on the corporate performance, such as the share price or the annual financial report. Another way could be considered is to give them more employee share options rather than money award, which means that managers have the right to buy the corporate share on very favourable terms. They would not just pay attention to the annual salaries and the consumption for their life.

A case study

Tyco international Ltd is a multinational corporation which was discovered that a few senior executives, specially the CEO L.Dennis Kozlowski, the CFO Mark Swartz, and the Legal Director Mark Belnick, haven been charged by grand larceny with hundreds of millions of dollars. (news from CNN in 2005) It means that the shareholders of this corporation incur the agency cost in this company corruption. After a series of intensive investigation, above 60 senior managers have been dismissed and the whole board has been replaced. To explore the reason why so large amounts of agency cost appear, the weak board should the most important one.

It is well-known that the shareholder vote the board of directors, and board is considered as the boss of CEO and has responsibility to advise and monitor the upper management level. But during the time of Kozlowski, the whole board has been reigned by senior managers though some disgraceful way, such as bribery or deception. In theory, the member of directors should both insiders and outsiders. But unfortunately, the majority are insiders and the part of outsiders have business relationship with the company. For example, Director Josh Berman provided some legal aid with a reward of 360000 dollars every year and Director Frank Walsh got a fat commission of 20 million dollars by arranging meetings between Tyco and some financial companies. Strictly speaking, these kind of directors were insiders rather than outsiders in the board. Due to this reason, the Tyco board was rated as weak. ( In this case, two key programs were carried out by Kozlowski, which were called a compensation committee approved relocation program and the key employee loan program. The former was to make sure senior managers have enough money to have a new house for life despite of never being granted by the board, the latter was misused as their own personal loans rather than its original goal to help managers to pay taxes. (Tyco Press Release) In the end, shareholders paid a high price on this two programs.

After the exposure, Tyco hired a new CEO named Breen to replace the former one. He point out that the whole board need to be resigned, because the first thing to do is rebuild the board independence. And a professor from an universty came this company to help to develop the corporate governance system, such as the policies and regulations. And every employee were asked to join the ethics studying and pass the ethics test.

The most effective way

In this essay, three ways have been discussed, which are to optimize ownership structure of company, to control the board size and independence, and to design reasonable salary contract. Though the case in Tyco, it is shown that maintain the independence of the board is the most important way to control managerial behaviours. And the other ways should be build on the independence. Even if a company has the perfect structure and policies but without independent outsider directors to monitor the managers, it is impossible to minimise the agency cost.

If the board has been independent, there are several suggestion to strengthen the effects. Firstly,