Agency Problems: A Quick Overview, Part 2

Agency problems are the heart and soul of corporate governance.  In last weeks post we presented a quick overview of the nature of agency problems (see Agency Costs and Corporate Governance, Part 1).  Agency problems are those that arise because the best interests of a firm's owners (the shareholders) often deviate from the best interests of the firms executives.  The term agency occurs because the executives act as agents for the owners.

Today's post gives a quick overview of mechanisms to reduce agency problems.  First, there are internal mechanisms.  Examples include the board of directors, compensation contracts, governance documents, whisleblowing mechanisms,  mutual monitoring and internal auditors.  To mention just two of these, the ideal compensation contracts reward performance - and the measures of performance should be things that matter to the owners, usually share price.  Mutual monitoring occurs as executives observe each other and report problems to superiors.

Now obviously, these mechanisms are imperfect.   Boards are continually struggling with ways to improve governance and the techniques of governance need to evolve with the times and build upon past experience, good and bad.  At one time, options were considered an ideal way to align owners and mangers.  More recently, there have been problems associated with backdating and with the manipulation of earnings to keep options in the money. 

When internal governance mechanisms fail, external forces come to play.  These include lawsuits, regulatory agencies, shareholder activists, external auditors, analysts, journalists, and the market for corporate control.  With regard to the latter, we've argued many times that takeovers or the threat of takeovers can act as a positive force to align the interests of owners and managers.   (See the best takeover defense, don't leave money on the table, and also Joe's recent post entitled M&A Catalyst: Shareholder Activists).

We'll end on a concluding note that actually deserves much more attention than it gets in the literature.  The study of optimal corporate governance is quite different from the study of law.  Optimal governance mechanisms are those that help a firm maximize value.  The study of these techniques requires an understanding of a vast array of statistical techniques and a vast understanding of corporate finance.  While corporate law is certainly important, it is quite a distinct field from the scientific analysis of corporate governance.  More on that in another post.

All the best,

Ralph