A synopsis of agency problems that exist in a firm setting and the legal strategies utilized to balance the shifting power of the principal/agent relationship in the firm setting

1. AGENCY PROBLEMS AND
LEGAL STRATEGIES
Armour, Hansmann, and
Kraakman
As Told By: Dominic Lovotti

2. 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.

3. 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

4. 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.

5. 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).

6. 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.

7. Special Problem for Firms
Multiple Principals
Differing Interests
Coordination Costs
=
1) Owners must delegate more of their decision-
making to their agents.
2) No way to ensure that agent is acting
“right.”

8. 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)

9. 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

10. But Guess What?

11. 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

12. But How Does the Law Do It,
Dom?

13. 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

14. Ex Ante and Ex Post Pairings
Agent
Constraint
s
Affiliation
Terms
Appointme
nt Rights
Decision
Rights
Agent
Incentives
Ex Ante Rules Entry Selection Initiation Trusteeship
Ex Post Standards Exit Removal Veto
(Ratification
)
Reward

15. 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 enforcement

16. 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)

17. Governance Strategies:
Selection and
Removal
 Appointment rights
 The power to select or remove directors
 Key strategy for controlling the firm.

18. 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

19. 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?

20. 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

21. Ex Ante and Ex Post Strategies:
Harmony
Agent
Constraint
s
Affiliation
Terms
Appointme
nt 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.

22. 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.

23. 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

24. 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)
1) 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
2) “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”

25. 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.

26. 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

27. 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

28. 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.