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ASSIGNMENT 1 – COVER SHEET

21800 Management and Organisations

Assignment Title: Agency Theory explains many of the US-Anglo management and organisational factors that led to the Global Financial Crisis that began in 2007. But I don’t see much attention to challenge Agency Theory so far. We’re therefore likely to repeat the damage. How stupid would that be! What do you think?”

Student Name: Peter Thamin

Student number: 94105982

Date: 11 September 2012

Class day and time: Tuesday, 6pm

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Table of Content

1. Introduction 3

1.1. Proposition 3

2. Review of the Literature 4

2.1. Intentions of Agency Theory 4

2.2. Theory into practice 5

2.2.1 Self-interest and self-fulfilling prophecy 6

2.2.2 Risk-taking, incentives and executive remuneration 7

2.2.3 Profit maximisation and shareholder value 8

3. Implication of the Literature 10

4. Practice Relevance 12

5. Conclusion 15

6. References 16

Introduction

It is without a doubt that Agency Theory is one of the few academic theories in management education that has influenced the world of management practices which was first introduced by Jensen and Meckling (1976). This can be seen by the corporate governance reforms in US-Anglo corporations and the embracement of executive remunerations using incentives to align agent-principal interests. The disclosure of corporate governance structure, and the financial statements of management remuneration practices in annual reports of listed companies are direct evidence of the prominence and popularity of Agency Theory.

From this perspective, it is no surprise to see why people would blame Agency Theory for not only the corporate scandals of the much publicised and spectacular downfall of Enron, Arthur Andersen and WorldCom in the early 2000, but also for the cause of the global financial crisis which eventuated in the collapse of major multinational companies such as Lehman Brothers, and the U.S. government bailouts of the once untouchable Merrill Lynch, Citigroup and AIG.

1 Proposition

I will argue that Agency Theory did not cause the global financial crisis. Although there has been much attention to challenge Agency Theory, from the self-fulfilling prophecy of self-interest, and the promotion of risk-taking behaviours to the desire of maximising profit at all costs, these criticisms are based on incorrect interpretations and misapplication of the theory. The recommendation following from this analysis is that to prevent another crisis, a better insight of what constitutes optimal incentive schemes and what creates the most effective corporate governance at a management level, in line with its strategic objective needs to be established in order to achieve profit sustainability and long-term value creation.

Review of the Literature

There is an enormous amount of literature available covering Agency Theory from economics and finance (Jensen & Meckling 1976, Fama 1980) to other social sciences disciplines such as management education (Ghoshal 2005), organisational behaviour (Eisenhardt 1989), and most notably, corporate governance (Daily, et al 2003). My research aim in this section is to provide a literature review of what is Agency Theory, why was it created and to serve what purpose before outlining the debate of the practicality and impact of the theory in the corporate environment.

1 Intentions of Agency Theory

Agency Theory is the analytical framework used by experts in finance and economics to analyse managers (Jensen & Meckling 1976) with Adam Smith (1776) providing one of the earliest discussions of the problem of the separation of ownership and control in An inquiry into the nature and causes of the wealth of nations (Dalton et al., 2003).

Agency Theory states that managers, who are the agents, act in ways that maximise their self-interest at cost to their principal, the shareholders of the company, who lose value. These agency losses include managers not acting in the best interest of shareholders by simply being lazy, risk avoiding or investing in unprofitable ventures. In Agency Theory, problems occur due to the “separation of ownership and control” and at the heart of Agency Theory, is to protect shareholders who are willing to turn over a significant portion of their wealth to organisations run by managers with divergent interests.

The intention of Agency Theory is to address the potential lack of alignment of goals, preferences and actions between agents and principals (Jensen & Meckling 1976). This can be achieved by: (1) better aligning agency-principal relationship through the use of incentives such as options and shares to encourage executives to take on more risks for the benefit of shareholders; and (2) discipline executives by taking too much unwarranted risk by imposing boards to monitor their performance.

To better comprehend the significance and intentions of Agency Theory, it is important to realise the context of when the theory was first introduced and to address what purpose. Michael Jensen and William Meckling in 1976 challenged the way corporations were being managed implying executives were serving their own interests rather than those of the owners. This was during the times of stagflation of the 1970s in the U.S., coupled by a decade of lacklustre stock market performance and the domination of the Japanese in high tech industries (Dobbin & Jung 2010, Jensen et al., 2004). Agency Theory’s intention was to identify what went wrong and what could go wrong due to misalignment of interests and what can be done to minimise this cost. Applying Agency Theory in this context is economically plausible.

2 Theory into practice

So, based on what has been provided, did Agency Theory really brought down the economy and caused the corporate scandals and the recent financial crisis? The answer is “No”. Agency Theory did not cause the financial failures of US-Anglo corporations. I will defend my position and challenge critics of Agency Theory by covering the controversial topics of: (1) self-interest and self-fulfilling prophecy, (2) risk-taking, incentives and executive remuneration, and (3) profit maximisation and shareholder value. This is from the viewpoint that Agency Theory has been widely misinterpreted and misused by both academics and practitioners.

1 Self-interest and self-fulfilling prophecy

Ghoshal (2005), who has been the most critical voice in management academia believes that Agency Theory’s related models of human behaviour (i.e., rational, self-interested, utility-maximizing homo economicus) has set a very significant but negative influence on the practice of management. His concern was that if you assume people are self-interested and use this conclusion to manage people (instead of the more positive self-seeking assumption) then this will likely to enhance self-serving behaviour among people which becomes a self-fulfilling prophecy. He then goes on to say, “Why then do we feel surprised by the fact that executives in Enron, Global Crossing, Tyco, and scores of other companies granted themselves excessive stock options, treated their employees very badly, and took their customers for a ride when they could?” (Ghoshal 2005, p.76). The global financial crisis would have definitely been in Ghoshal’s list of failures caused by Agency Theory.

What Ghoshal is concerned about is the self-fulfilling prophecy of the theory and there is some evidence to support this concern (Ferraro et al., 2005). However, I believe this to be an overly literal use of Agency Theory which is misinterpreted and misrepresented.

Utility is a representation of preferences and preferences reflect whatever desire a person happens to have, whether it be egoistic or altruistic, selfish or selfless (Heath 2009, The Economist 1998). What creates the need for incentives in Agency Theory is not that managers have egoistic preferences, but merely they have different preferences which need to be aligned.

The central proposition of Agency Theory is not that people are self-interested, but rather that “rational self-interested people always have incentives to reduce or control conflicts of interest so as to reduce the losses these conflicts engender. They can then share the gains.” (Jensen 1994, p. 15).

2 Risk-taking, incentives and executive remuneration

In Agency Theory, risk-taking is synonymous with stock options which have become a major part of executive remunerations (Hall & Liebman 1998). It comes to no surprise that the recent financial crisis has accelerated the debate on this topic, especially when equity-based pay of U.S. CEOs has risen from 1% prior to 1985 to 66% in 2001 (Hall 2003, cited in Nyberg, et al, 2010).

It can be said that stock options encourage risk-taking behaviours (Dobbin & Jung 2010, Sanders & Hambrick 2007) because it offers great upside rewards with little downside risk, which motivates corporate leaders to pursue short-term strategies that provide immediate boost to stock values rather than build companies that will thrive over the long run.

In a similar vein, critics such as Frey and Osterloh (2005) blame this type of compensation for misconduct by CEOs to the detriment of the company and society which exacerbates income inequality and a decline in organisational citizenship. Other studies (Sahlman 2009, Tarraf 2011) have shown that it is the aggressive lending tactics by banks due to their incentive structure which has caused the recent financial crisis.

There are indeed ethical issues of equity, fairness and justice of executive compensations especially when income inequality between CEO/worker pay is on a staggering rise from 42-1 in 1982 to 301-1 in 2003 (Matsumura & Shin 2005). Furthermore, people have the right to feel outraged when CEOs are receiving extravagant bonuses when company performances are suffering. For example, Dick Fuld, the CEO of Lehman Brothers earned $34m in both cash and equity rewards when the company collapsed into bankruptcy (Murphy 2011). I also agree that excessive risk-taking can be an unintended consequence of Agency Theory.

However, this is exactly what the theory is trying to achieve. In other words, Agency Theory states that incentives using stock options are a powerful tool in motivating people to create shareholder value which should not be used indiscriminately. The problem with stock options is that, although it is a great motivator of risk-taking, they do not necessarily always motivate smart or successful risk-taking (Sanders & Hambrick, 2007). Besides designing better incentives schemes, there is a need to promote the ethical view that the right thing to do is to maximise shareholder value.

Viewed as a whole, it is the misapplication of incentives due to the complexity of derivatives (Hall 2000), along with other issues such as executives having immense power which they use to pay themselves large amounts of money that are insufficiently related to performance (Bebchuk & Fried 2006), and the failure of corporate governance to mitigate risk (Tarraf 2011) that is the problem, not the theory. However, the unintended consequences used to question Agency Theory’s validity deserve closer scrutiny for future research.

3 Profit maximisation and shareholder value

The impact of corporate scandals and the recent financial crisis and the entrenched culture of profit maximisation have also resulted in critics challenging the legitimacy of Agency Theory. With developments closer to home, it can be seen that even during economic prosperity, our major banks are cutting jobs despite posting record profits (Johnston 2012), in their quest to make shareholders happy.

In Grossman’s (2005) assessment of refining the role of corporations, he has attributed the collapse of Enron as a result of the management’s desire to maximise profit at all costs which led to a culture of corruption, resulting in management and employees acting irresponsibly. Likewise, Grossman and others (Tarraf 2011, Jensen et al., 2004, Dobbin & Jung 2010) have noted that managers who seek to act in a socially responsible manner by adopting a long term approach to profit maximisation has either been criticised or left behind by demanding institutional investors, who are impatient.

Therefore, the above situation has caused managers to be under immense pressure to beat analysts’ expectations, which has led many to resort to aggressive accounting and financial fraud. Obviously, critics of Agency Theory will assume this is what also caused the global financial crisis as we have created a culture of profit maximisation largely driven by the pressures of financial markets, to increase shareholder wealth.

It is undeniable that shareholders do play an important role in Agency Theory and their interests should be protected. This is an implicit assumption in a capitalist economy. Whether we agree with it or not, protecting the interest of shareholders benefits everyone. A buoyant stock market increases the likelihood of foreign direct investment (this is most critical in developing nations), improves employment opportunities and safeguards superannuation funds. As owner and risk bearers of the company, shareholders have the right to be protected.

However, there is a lot of misconception and misinterpretation on the objective of profit maximisation and shareholder value in Agency Theory. Professor of Finance at INSEAD, Theo Vermaelen, sums up the definition of what constitutes shareholder value well. He states that “shareholder value is defined as the present value of free cash flows from now until infinity, discounted at a rate that reflects the risks of these cash flows. So, maximising shareholder value is not the same thing as maximising short-term profits, earnings per share or manipulating stock prices through accounting fraud. The Enron disaster, in which all shareholders lost their money, has nothing to do with excessive focus on shareholder value.” (n.d., para. 3).

Another misconception is that in pursuit of maximising shareholder value, Agency Theory disregards the interest of other stakeholders. This is not true. Simply put, a firm cannot maximise shareholder value if it ignores the interest of other stakeholders (Jensen 2001). In fact, companies are increasingly recognising the need to implement sincere corporate social responsibility (CSR) programs (Grossman 2005) which is in line with the doctrine of Agency Theory. This is to attract increased business, customers, investor support and hence shareholder value creation.

Implication of the Literature

Ghoshal’s (2005) criticism that bad management theories are destroying good management practices is pessimistic at best. Surely, not all corporate scandals are attributed to ex-MBA students applying Agency Theory into practice which is what Ghoshal was implying. As students, we have the ability to distinguish what is a good theory and what constitutes a bad theory. We also have the ability to realise the theories limitation and main propositions so our voices were definitely being ignored in Ghoshal’s article.

There is no value to focus on one aspect of the assumptions of Agency Theory, and ignore what the theory is trying to achieve. Human behaviour is far too complex to be generalised, but the question is whether the self-interest generalisation is useful for its intended purpose for graduate students to learn about the theory, or is it completely off the mark. If we assume that self-interest means everyone is inherently greedy, cunning and untrustworthy, then there is a good case to refute Agency Theory as it is plainly wrong. But this is not what self-interest is implying. In my view, it should make no difference if we replace “self-interest” to “self-seeking” as suggested by Ghoshal, or use “self-actualisation” based on Maslow’s needs hierarchy theory (Maslow 1943, cited in McShane et al., 2010), as it still does not change the central proposition of the theory that due to the separation of ownership, agent-principal interests should be better aligned to achieve the greatest good for everyone.

There are indeed unintended consequences of Agency Theory. But blaming Agency Theory for the financial turmoils of the past decade due to excessive risk taking, ineffective incentive plans and extravagant CEO remuneration (Sahlman 2010, Sanders & Hambrick 2007, Tarraf 2011, Dobbin & Jung 2010) misses the point of what the theory is trying to achieve. That is, according to Agency Theory, mechanisms that align the interests of managers with those of shareholders increase the value of the firm. We must then ask ourselves, do mortgage brokers (acting as agents) prior to the financial crisis, that originated the loans without making a strong effort to evaluate whether the borrower could pay off the loan is actually working in the best interest of shareholders? Does paying CEOs such as Dick Fuld $34m in the year Lehman Brothers collapsed really had the intention of creating firm value? Are the outcomes of the above two examples and many others congruent with what Agency Theory is trying to accomplish? The answer is an irrefutable “No”. It is in fact more accurate to contend that it is the existence of agency problems that are the root cause of the financial instability, and it is often the interest of shareholders that are forgotten, or the voices that Agency Theory is trying to protect all along.

With regards to profit maximisation, Agency Theory does not state that “the social responsibility of business is to increase its profits” (Friedman 1970) as many of the critics would have led us to believe. In fact, studies by McWilliams and Siegel (2001) reveal that there is some level of CSR that will maximise profit while satisfying the demand for CSR from other stakeholders. What the theory implies however is that if companies are involved in CSR programs, it has the fiduciary responsibility in announcing the intentions to the market, so the voices of investors are not ignored. And if, CSR programs do offer better returns to shareholders, then according to Agency Theory and the voices of financial experts, companies are encouraged to become more involved in assessing and shaping company policies and practices in the promotion of CSR programs.

Finally, Agency Theory as widely believed, does not promote short-term profit maximisation at the expense of long-term value creation. This is not what the theory stands for as it does not in anyway, create shareholder value. The accountability rests upon the management to implement strategies that are able to support its long-term sustainability and value creation.

Practice Relevance

When reviewing the literature and the implications of the literature in defending my position, it was important that I assess Agency Theory’s conceptual appeal, practical application and the depth of research and evidence available.

Conceptual Appeal

Agency Theory’s conceptual appeal is that when managers have equity in their firm, they are more likely to embrace the interest of other shareholders. According to McShane et al (2010), money or equity in this case, is much more than an object of compensation to organisational objectives. Money is a symbol of achievement and status, a reinforcer and motivator and a supporter of self-concept. Therefore, I find the conceptual appeal of Agency Theory is that it is intuitive and effective. It is intuitive because people will work harder if there is more to gain and it is effective because it has the ability to change people’s behaviour and objectives or preferences. Based on this, I view Agency Theory as a great motivational drive to create shareholder value. Unfortunately, this can also be a cause for misinterpretation and abuse where morals and ethics are not high within a person’s values hierarchy.

Practical Application

The practical application of Agency Theory is that it is an extremely simple theory, in which large corporations are reduced to two participants and the interest of each are assumed to be both clear and consistent. The practicality of the theory is evident by the backing of institutional investors. The rise of their aggregate shareholdings in the U.S. from 16% in 1965 to 57% by 1994 (Useem 1996) where it remains at that level today (Fox & Lorsch 2012), and the important role they have come to play in corporate governance and shareholder activism, suggests they have embraced the notion that the objective of companies is to maximise profit and increase shareholder value.

In my view, the major difference between Agency Theory and the popular theory such as Stakeholders Theory (Freeman 1984) is in its practicality. Although Stakeholders Theory is morally, ethically and politically correct, the implementation is impractical and flawed. For example, maximising stakeholder value in my view could mean paying workers above competitive salaries, charging customers at cost and paying suppliers before payments are due. The problem is that if you do this in a competitive market, you will soon be driven out of business. The popularity of Agency Theory is that it is directive and flexible. It is directive because it provides managers with a clear focus which is to create firm and shareholder value, and it is flexible because the implicit assumption in creating shareholder value is to also incorporate the interest of all stakeholders. That is, shareholder value cannot be maximised with disgruntled customers and employees or with inferior products.

However, it is important to note that applying Agency Theory in overvalued shares will not reduce agency problem, but will in fact make it worse. Therefore, Finance academics need to not only teach the desirability of value maximisation, but also the dangers of over-valuation and provide strategies on how best to deal with this with the financial markets. One way in dealing with this is to resist the temptation of “cooking the books” and have a more transparent dialogue with investors.

Research and evidence

A good theory comes from engagement with problems in the world, not gaps in the literature with ideas “articulated, organized, and connected in a way that suggests new directions for researchers” (Rindova 2008, p. 300).

The depth of research of Agency Theory in corporate governance (Daily et al., 2003), organisational theory (Eisenhardt 1989), CEO and firm performance (Bebchuck & Fried 2006), culture (Kulik 2005), management education (Ghoshal 2005, Donaldson 2002) and corporate social responsibility (Grossman 2005, McWilliams and Siegel 2001) to name just a few, brings us one step closer to the truth through empirical facts and revolution of knowledge (Popper 1965, cited in Shareef 2007). In summary, Agency Theory has generated a peripheral volume of constructive debate with empirical evidence for and against the effectiveness of Agency Theory. Although there appears to be more empirical evidence against the effectiveness of Agency Theory, it appears that the theory is winning more converts than ever before.

Limitation and further discussion

Like any other theory, Agency Theory has its limitations. The limitations arise from the unintended consequences and the misapplication of the theory which can further increase the agency problem. In order for us to avoid another financial crisis, an effective use of the theory needs to be promoted and the outcome further researched. This should include but not limited to understanding the effects of:

• Establishing remuneration committees which has the “remuneration philosophy” of maximising long-term value creation in line with its vision and corporate strategy;

• Creating well-designed remuneration packages to attract and retain executives at the lowest cost (Jensen et al., 2004);

• Encouraging remuneration committees to fully understand the cost and incentive implications of options (Hall 2000), so they are in a better position to ensure its option programs are actually accomplishing its goals;

• Encouraging managers to be confident of what drives long-term value in their organisation, not what drives analysts’ expectations and avoid playing the earnings game;

• Increasing monitoring and improving corporate governance effectiveness such as appointing boards with the right kinds of knowledge and expertise (Mcdonald et al., 2004); and

• Making boards more accountable by giving shareholders more power to replace directors (Bebchuck and Fried 2006).

Conclusion

The intense scrutiny of Agency Theory has become more important now than ever as a result of corporate scandals and the global financial crisis. Its popularity and extensive application has added fuel to the fire on the validity and effectiveness of Agency Theory.

Although it is difficult to quantify with accuracy, it could be possible that Agency Theory may have played a role in the recent economic crisis, but this paper argues that it is not the theory, but the misinterpretation, misapplication and the unintended consequences of the theory that is the root cause of the problem.

In judging whether US-Anglo organisations are serious about reforming itself, CEO pay and corporate governance remains the critical test. The ability of executives to assure long-term value creation and maximising shareholders’ wealth is a fundamental concern for corporate managers, shareholders and for the field of management and organisation studies in preventing another crisis from happening again. To date, the results are far from encouraging.

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