AGENCY PROBLEMS AND LEGAL STRATEGIES

Armour, Hansmann, and Kraakman

As Told By: Dominic Lovotti

Main Agency Problem

Agency Problem Arises when the welfare of one party (P) relies on

the performance of another party (A)

What’s the Problem? It takes effort/money to motivate an A to act in

P’s interest instead of A’s interest so there is a loss component to agency relationships.

Why does the Agency Problem occur?

A’s generally have better information than P’s when contracting for the agency relationship

P can do nothing when contracting for A’s performance to ensure that A will act optimally in P’s best interest

As a consequence, A may act opportunistically with or without intending to do so Self-dealing; Shirking

So what does the Agency Problem mean?

There are COSTS to the Agency Relationship.

These costs automatically reduce the value of A’s performance for P.

We call them Agency Costs.

Agency Costs = the direct costs of contracting with A or the indirect costs of monitoring A.

There are 3 Agency Problems in Firms

1) Conflict between a firm’s owners (P) and its hired managers (A).

2) Conflict between minority owners (P) and majority owners (A).

3) Conflict between a firm’s owners (A) and the third parties they contract with (P).

1) Conflict between a firm’s owners (P) and its hired managers (A).

Problem:Assuring managers are responsive to the owners’ interest rather than pursuing their own personal interests.

Special Problem for FirmsMultiple Principals

Differing InterestsCoordination Costs

=1) Owners must delegate more of their

decision-making to their agents.

2) No way to ensure that agent is acting “right.”

2) Conflict between minority owners (P) and majority owners (A).

Problem: Assuring that the noncontrolling owners

interests are not expropriated by the controlling owners.

Also effects:Ordinary and Preferred stockholders &Senior and Junior creditors (when owners after bankruptcy)

3) Conflict between a firm’s owners (A) and the third parties they contract with (P).

Problem:Assuring that the firm does not

expropriate the third parties interest in the firms’ liabilities that are due to them.

Affects:Creditors, Employees, Customers

But Guess What?

The Law Can Reduce Agency Costs

Fore example, there are: Laws that enhance disclosure by agents Laws that create enforcement actions for P

against A Paradoxically, legal action taken for the

benefit of P tends to also benefit A Because P will tend to pay more for an A

when assured that the performance is honest and high quality

But How Does the Law Do It, Dom?

Legal Strategies for Reducing Agency Costs

Regulatory Strategies: Prescriptive, they dictate substantive terms that

govern the agency relationship Tend to focus on constraining A’s behaviors directly Efficacy depends on quality of tribunal that enforces

compliance (integrity, expertise, credibility)

Governance Strategies: Tend to focus on facilitating P’s control of A’s behaviors Efficacy depends on ability of P to exercise the control

rights afforded to them Thus, coordination costs means these are not effective

for multiple principals

Ex Ante and Ex Post Pairings

Agent Constraints

Affiliation Terms

Appointment Rights

Decision Rights

Agent Incentives

Ex Ante Rules Entry Selection Initiation Trusteeship

Ex Post Standards Exit Removal Veto(Ratification)

Reward

Regulatory Strategy:Rules and Standards

Rules: Require or prohibit specific behaviors Generally used where it’s easily foreseeable that the behavior to

be regulated will occur (ex ante)

Standards: Leave the precise determination of compliance to adjudicators Generally used where the agency matters are too complex or

uncertain to regulate before the relationship develops (ex post)

Efficacy is based on enforcement. Rules = only looking for compliance, so quicker enforcementStandards = lots of determinations, so slower/costlier enforcement

Regulatory Strategy: Setting Terms of Entry/Exit

Terms of Entry: Regulate the terms by which a P affiliates with an A Requiring firm disclosures before an investor

purchases stock Requiring purchasers of certain securities to meet a

threshold net worth

Terms of Exit: Allows P to escape affiliation with an opportunistic A Right to withdraw (appraisal right) Right to transfer (sell shares in open market)

Governance Strategies: Selection and Removal

Appointment rights The power to select or remove directors

Key strategy for controlling the firm.

Governance Strategies: Initiation and Ratification

Initiation Decision right that grants P the ability to

initiate management decisions

Ratification Decision right that grants P the ability to

ratify management decisions

Question for class:

These last 4 governance strategies attempt to expand the power of the P (the shareholders) so do you think these really exist in a firm setting?

Governance Strategies: Trusteeship and Reward

Trusteeship Seeks to remove conflicts of interest ex ante Utilizes “low power” incentives (reputation, pride) instead of “high

power” incentives (money) Example: Independent Director

Used to approve self-dealing transactions because of belief that they won’t benefit financially, so they more likely be guided by conscience and concern for reputation

Reward Rewards A for successfully advancing P’s position Sharing Rule: A shares proportionately in P’s success Pay-for-performance: If success for P, then A gets paid

These alter the incentives of the A rather than expand the power of P.

Ex Ante and Ex Post Strategies: Harmony

Agent Constraints

Affiliation Terms

Appointment Rights

Decision Rights

Agent Incentives

Ex Ante Rules Entry Selection Initiation Trusteeship

Ex Post Standards Exit Removal Veto(Ratification)

Reward

While the ex ante strategies specify how an agent must act before the relationship, and the ex post strategies require determination of the quality of an agents actions, the pairs tend to work together harmoniously.

For Example: Rules specify how an agent must act,

while a standard judges the quality of the agent’s actions after he acted.

An entry strategy specifies what must be done before an agent can deal with a principal, while an exit strategy provides a response for the principal to the quality of an agent’s action.

Compliance and Enforcement: Enforcement and Intervention

Regulatory strategies tend to rely on credible institutions for enforcement.

Governance strategies tend to rely on a principal’s intervention to cause agent compliance. Rewards, credible threats, less decision-

making

Compliance and Enforcement: Modes of Enforcement

1) Public Officials All legal and regulatory actions brought by organs of the state.

(Civil/Criminal Actions) (formal) Includes reputational sanctions brought about by disclosure of

investigations (informal)

2) Private Parties acting in their own interest Private lawsuits such as derivative suits and class actions (formal) Includes reputational harm of bad press (informal) Utilizes penalties as mechanism for deterrence of agents ex post

3) “Gatekeepers” – strategically placed private parties conscripted to act in the public interest

Involves conscription of non-corporate actors such as accountants and lawyers in policing the conduct of corporate actors

Generally necessary to most corporate transactions, so shareholders heuristically rely on them to ensure that the managers are acting “right”

Their presence tends to prevent unwanted conduct

Disclosure Fundamental role in controlling agency

costs.

Helps a P determine the terms of entry.

Helps a P determine the extent which they want to remain owners or exit the firm.

Disclosure As a Regulatory Strategy:

Reveals the existence of interested transactions

Gives the shareholder the information needed to decide whether to challenge the transaction

Provides shareholders with information to bring before a court

Disclosure As a Governance Strategy:

Allows principals to assess appropriateness of intervention tactics

Improves principal decision-making Serves to bond the reputations publicly of

the P as an effective monitor of the A

In Summation Governance strategies are more effective for

institutional investors or closely held companies because they have the ability to monitor the A closely.

Regulatory strategies are more effective when coordination costs are high, as in the case of scattered ownership, because they do the most for protecting the many.

The extent to which any of these strategies are effective is based on disclosure. Should disclosure be eroded or selective, a P’s control of an A will be affected negatively.