Agency Theory in Corporate Governance: Criticism and Real Application

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Table of Contents

Introduction
Agency Theory Explained
Agency Theory Criticism
Three Other Theories
Discussion
Conclusion
Reference List

Introduction

Corporate governance is an essential phenomenon in the modern world because it has a direct connection to the sustainability of various firms and companies. In general, the given term stands for a set of rules and practices that are used to govern and control the performance of companies. If one wants to understand what this phenomenon is, it is reasonable to consider a hypothetical example. When a firm emerges, it is relatively small, and its founder fully owns it.

However, as it grows, it becomes impossible for the owner to control everything in their business. In this case, it seems suitable to consider delegating some ownership rights to professional specialists. This fact results in the separation of ownership and control, which, in turn, creates corporate governance systems that consist of two distinct groups. The first of them includes shareholders or principals, while the second one comprises managers or agents. The two groups should cooperate to achieve the best outcomes, and Owolabi (2019, p. 2) supports this idea by stating that corporate governance is holding the balance “between individual and communal goals”.

When it comes to such separation, one should emphasize the possible issues that can manifest themselves in several ways. Firstly, principals and agents can have different interests, which is the basis for conflicts between them. Secondly, an agent has a degree of autonomy, which denotes that they cannot consult with a principal before making every decision. This potential scenario means that specific governance procedures are necessary to solve the issues above.

According to the information above, it is impossible to overestimate the significance of corporate governance for individual businesses, and multiple pieces of research prove it. Firstly, Hussain, Rigoni, and Orij (2018, p. 411) have analyzed reports of numerous US-based firms and identified that strict corporate governance has a positive impact on companies’ sustainability. Secondly, Owolabi (2019, p. 1) also mentions that the effectiveness of corporate governance depends on many phenomena, including control mechanisms, compliance with relevant regulations, reliability of financial reports, and others.

The information above denotes that firms should invest in developing their governance structures and procedures. However, the data of publicly traded US firms have shown that more robust corporate governance significantly decreases companies’ innovation abilities and reduces job security (Markus and Swift, 2019, p. 91). It means that effective corporate governance should be moderate to both control business operations and provide managers with appropriate freedom of action.

Since the phenomenon under consideration is complex, it is not a surprise that various approaches exist to explain relationships within it, and agency theory is traditional among them. Even though it is a popular theory, it has faced much criticism in recent decades. Thus, the main task of the given coursework is to explain the reasons for this criticism and compare the theory to three other perspectives. Furthermore, it is reasonable to present an argument for why the agency theory will be relevant in the future of corporate governance.

Agency Theory Explained

To begin with, one should comment on the basics of the agency theory that is simple in its use. The given perspective denotes that there is a principal and an agent, and a contract governs a relationship between them. This agreement stipulates that an agent should perform some service or actions on behalf of a principal. Legal, financial, and moral principles support the existence of the given relationship. In the modern world, this corporate governance theory is one of the most popular ones because it is considered elementary and valid. However, empirical evidence demonstrates that the given approach has both advantages and disadvantages that will be described below.

On the one hand, the most significant advantage of the agency theory has already been presented, and it refers to the simplicity in use. Thus, principals and owners do not need to develop complex mechanisms or establish large bodies to govern their firms. Furthermore, this theory provides agents and managers with relative freedom of action, which often contributes to more productive outcomes.

These results are positive if agents share the principals’ interest, which is possible due to the norms of reciprocity and fairness (Bosse and Phillips, 2016, p. 276). Finally, mechanisms that are present in the given method can lead to lower agency costs, mainly because of a simple governance system and trust between agents and principals (Panda and Leepsa, 2017, p. 74). This positive result means that the profits of an appropriate firm become higher, and this fact is attractive to both agents and principals.

On the other hand, it is necessary to present the disadvantages of the theory under consideration. Firstly, Panda and Leepsa (2017, p. 74) stipulate that the agency perspective results in a problem when there is a conflict of interest between an agent and a principal. This negative effect appears because of the autonomy that is given to agents. In this case, they are free to follow their own interest in some situations because principals do not strictly supervise their actions and decisions. Secondly, one should mention that a higher possibility of financial fraud is another adverse consequence of agency theory.

According to Shi, Connelly, and Hoskisson (2017, p. 1268), this misconduct is caused by external governance mechanisms, including “activist owners, the market for corporate control, securities analysts” and others. Since the external pressure above is limited, it only agitates agents’ intrinsic motivation to participate in financial malpractice (Shi, Connelly, and Hoskisson, 2017, p. 1268). Finally, Pouryousefi and Frooman (2017, p. 163) indicate that it is impossible to benefit from the agency theory “in the absence of ethical behavior”. The success of agency theory significantly depends on the fairness of agents.

The information above has demonstrated that the same principles of the agency theory lead to both positive and negative outcomes. Thus, the provided autonomy results in both product performance and the potential for financial fraud. At the same time, the absence of various governance mechanisms and reporting systems is suitable for all the parties, but it results in the fact that principals cannot monitor agents’ actions. This phenomenon, in turn, can lead to the fact that agents follow their own interests or behave unethically in some cases. The given scenario is known as opportunistic behavior when agents work against the welfare of principals.

Agency Theory Criticism

According to the information above, there is no doubt that agency theory is a controversial phenomenon. All the disadvantages justify the criticism that has reached the given perspective over the past decades. The ideas that will be presented below are going to explain that the critical points of view are based on multiple aspects. They include theoretical implications, the role of a board of directors, financial issues, ethical considerations, and others. This criticism will show that it is necessary to consider other corporate governance theories to identify their potential impact on the firm’s performance and sustainability.

Narrow Theoretical Scope

Firstly, one of the main reasons that doubt the effectiveness of the agency approach refers to its narrow theoretical scope. There is a significant number of research articles concerning the effectiveness of the agency theory, but they often draw attention to a limited set of conditions and concomitant factors. It refers to the fact that the essential part of research only analyses the use of the given approach in the context of developed countries, including the US and the UK. However, when it comes to smaller businesses in both developed and developing nations, the results can be significantly different.

Vargas-Hernández and Cruz (2018) support the idea above by focusing on the Mexican market. The researchers consider the case of Megacable, Mexico’s largest internet and telephony provider, and show that the agency perspective can help achieve faster growth. It is possible because of “the distribution of rights and responsibilities among the different participants of the company” (Vargas-Hernández and Cruz, 2018, p. 67).

At the same time, the scholars stipulate that in Mexico, small and medium enterprises that are owned by family members represent a significant part of all businesses. In this context, it is a typical case when agents and principals are relatives, which can result in some issues. For example, low-skilled individuals can become agents, and it leads to general incompetence and potential fraud (Vargas-Hernández and Cruz, 2018, p. 62). There is little research on the topic, and it is challenging to answer how to address the issue. Consequently, agency theory criticism is based on the fact that it is not explained how it is possible to benefit from the perspective under consideration in all environments.

Board of Directors Structure

Secondly, one should state that the board of directors stands for another source of criticism. This body acts as an intermediary between principals and agents, and “it is responsible for ratifying and evaluating strategic decisions” (Vargas-Hernández and Cruz, 2018, p. 62). Consequently, it necessarily implies the performance and sustainability of a firm or company. Even though Yusof (2016, p. 156) argues that the conduct of directors determines the effectiveness of the body, it is reasonable to draw attention to its structure. The presence of independent or external directors is useful for a company as they tend to perform their functions impartially, which is possible because they are given the director’s compensation.

Thus, one can say that the board of directors is a supervisory body of principals who hire specialists to make the shape the activity of agents. When the directors perform their functions diligently, the company’s performance improves. However, criticism emerges when it comes to the fact that directors, both internal and external, require additional remuneration. That is why critical points of view stipulate that the agency theory loses its advantages because it is necessary to invest in the creation of other bodies to monitor the activity of individuals.

Financial Issues

Thirdly, the financial side also represents an essential aspect of the problem under consideration. As has been mentioned above, it manifests itself in the necessity to reward directors, which implies higher governance costs. It means that owners should spend more to contribute to the better performance of their businesses. However, relevant financial issues also characterize a direct principal-agent relationship without any intermediaries. It refers to the fact that principals can use economic incentives to make their agents work better (Vargas-Hernández and Cruz, 2018, p. 61). Furthermore, Vargas-Hernández and Cruz (2018, p. 61) emphasize a direct connection between the expected amount of remuneration and the company’s profit. Thus, if a firm owns more, agents also want to obtain higher compensation.

The information above represents a significant basis of agency theory criticism. It is so because the given perspective aims at reducing agency costs, which has been mentioned above. However, the case with economic incentives demonstrates that it is challenging to achieve this result. It relates to the fact that money remains the most effective way to influence individual activity. Thus, one can suppose that if agents do not receive the desired amount of remuneration, the agency theory will not be useful. This fact demonstrates that it is a typical scenario when agents and principals have different interests.

In this case, money is considered the only asset that can be utilized by principals to shape and direct the activity of agents. Consequently, the idea behind the notions above is that the agency theory faces criticism because it requires extra financial resources to be an effective governance system.

Ethical Considerations

In addition to that, it is reasonable to draw attention to criticism that is based on moral issues. As has already been mentioned, the effectiveness of the agency perspective significantly depends on the fairness of agents, which draws essential attention to their ethics. Thus, severe problems for companies arise when agents pursue their own ends. However, this situation becomes even more substantial, considering the following aspect.

Yusof (2016, p. 156) stipulates that “who owns the firm’s matter for the firms’ strategies, objectives and performance”. It denotes that an owner’s identity can be one of the most significant advantages of a company. At the same time, if agents fail to follow high moral standards, the productive outcomes of the given phenomenon disappear. That is why this piece of criticism can both reduce the effect of the existing advantages and create additional problems, including, for example, financial fraud.

Other Issues

Finally, one should comment on a few more factors that contribute to agency theory criticism. On the one hand, it relates to the issue that has already been discussed. The given perspective significantly relies on the fact that principles and agents have the same interest. As practice shows, however, opposite scenarios are often, and when the agent’s self-interest overweighs that of a principal, appropriate problems for the company arise. On the other hand, one should stipulate that the agency approach is simplistic in practice. It relates to the fact that many modern companies have complex governance structures, and the agency theory fails to reflect these systems with numerous relationships within them.

The information above has shown that agency theory has multiple reasons for criticism. These issues refer to various fields, and each of them can substantially decrease the performance of a company or firm. There exist two possible solutions to the situation under consideration. On the one hand, firms can accept the risks of the given approach and do their best to minimize the potential harmful effects. On the other hand, it is possible to replace the agency theory with an alternative variant. Numerous corporate governance theories support the effectiveness of the latter step. Consequently, three additional theories will be described below to compare them to the agency perspective.

Three Other Theories

As has been mentioned above, no single theory can be sufficient to describe corporate governance. Furthermore, the agency perspective faces much criticism, which supports the idea to consider other approaches that can be useful to explain corporate governance relationships within a firm. That is why three theories, including stewardship, stakeholder, and institutional ones, will be presented further to determine whether they offer some significant advantages in comparison with the agency method.

Stewardship Theory Explained

The given perspective focuses on the fact that managers can act as stewards. According to Madlhani (2017, p. 13), this theory “acknowledges the existence of a relationship built upon trust between the shareholder and management”. It denotes that managers are considered trustworthy individuals, which allows them to act as stewards. Furthermore, Madlhani (2017, p. 13) stipulates that the perspective is useful for a firm because it is not required to split the dual role of CEO and chairman.

This duality makes it possible for the company to save some agency costs. In addition to that, the stewardship theory envisages that monitoring and financial compensations are not necessary because stewards have the same interest as shareholders (Chrisman, 2019, p. 1052). Consequently, shareholders only have the possibility to use their skills and expertise to influence company strategy (Madlhani, 2017, p. 10). As for the effectiveness of the given perspective, Joslin and Müller (2016, p. 613) indicate that it leads to more successful projects.

The positive results above are possible because of the assumption that stewards are self-actualizing and other-serving rather than self-interested (Chrisman, 2019, p. 1052). It means that these individuals tend to subsume their personal opinions to meet corporate objectives. As a result, managers and owners have shared goals, which contributes to the overall better performance of a business (Zhang et al., 2018, p. 88).

This information addresses some of the agency theory’s essential issues, including opportunistic behavior and high agency costs. Thus, the stewardship perspective seems to be more effective compared to agency one because the former means that stewards are willing to meet the specified goals without excessive financial remuneration. That is why the two approaches are considered alternative and even competing perspectives (Schillemans and Bjurstrøm, 2019, p. 1). However, this scenario is idealistic because it is a rare case when managers are ready to follow corporate goals without regard to their personal interests. That is why one can conclude that the given theory lacks realism and relevance to identify corporate governance relationships, which mitigates the impact of its advantages.

The Basics of Stakeholder Theory

The stakeholder perspective represents an alternative look at what makes firms exist and operate. Since the previous theories focused on generating shareholder value, the given approach states that it is also essential to benefit stakeholders. In the research field, there are many definitions of this term. According to Miles (2017, p. 24), stakeholders can be individuals, groups, or even entities that have an opportunity to influence the company’s performance and be impacted by its activity. This ambiguous definition reflects complex relationships that are the basis of the theory under consideration.

Collective efforts of all stakeholders are determined to influence the value creation, and the most productive outcomes are achieved when stakeholders have shared goals with a company (Freudenreich, Lüdeke-Freund, and Schaltegger, 2019, para. 15). Lange and Bundy (2018, p. 365) support this idea and emphasize that the given approach has a strong moral foundation because it is necessary to consider the interests of various people and entities.

At the same time, this approach faces a portion of criticism. Firstly, it is because of the ambiguity of its central concept (Miles, 2017, p. 39). If it is challenging to present a clear and concise definition of stakeholders, it is not a surprise that the basics of this approach also face some doubts. Secondly, this perspective stipulates that the primary purpose of any company is to meet stakeholders’ needs (Narbel and Muff, 2017, p. 1357).

However, Schaltegger, Hörisch, and Freeman (2019, p. 191) stipulate that the problem arises since the firm’s activity only creates benefits for a single group of stakeholders. Thus, it is almost impossible to meet the interests of all stakeholders at the same time. Finally, the perspective under consideration relies on regulation to minimize the adverse effects of market failures (Narbel and Muff, 2017, p. 1363). It denotes that those stakeholders who create the externalities should bear their cost, which results in unhealthy segregation within a business.

When compared to agency theory, the stakeholder perspective is peculiar because it focuses on meeting stakeholders’ needs instead of increasing shareholder value. Since there are various groups of stakeholders, it is challenging to meet the multiple interests of each of them. Consequently, the agency approach seems to be more realistic when it becomes necessary to describe the principles of corporate governance and various relationships that comprise it.

Institutional Theory Explained

As distinct from the previously described approaches, the institutional perspective draws attention to the external environment and how it can influence firms’ corporate governance. Thus, the institutional environment refers to history, culture, capital markets, political systems, and others. Even though these phenomena do not have a direct impact on a business, they can influence governance relationships. Miras- Rodríguez, Martínez- Martínez and Escobar-Pérez (2018, p. 4) state that the approach under consideration helps understand firm strategies and managerial choices.

Ferri (2017, p. 24) explains that companies should draw significant attention to different institutional settings because they imply various rules, norms, and values. Furthermore, it is necessary to consider the institutional environment “to illuminate the issue of regulatory effectiveness in changing corporate behaviour” (Chiu, 2019, p. 87). Chiu (2019, p. 85) also argues that this perspective is common in the UK. In addition to that, Briano-Turrent and Rodríguez-Ariza (2016, p. 63) stipulate that multiple institutional factors positively influence corporate governance ratings in developing countries.

However, one should stipulate that the effectiveness of the institutional approach implies a few limitations. On the one hand, the given method does not draw significant attention to the internal structure of organizations, focusing on its environment (Dolan and Connolly, 2018, p. 139). Thus, the firm’s performance is determined by the rules and norms that are present in a particular environment. On the other hand, the effectiveness of the institutional perspective depends on the level of rule-based trust in society. Alon and Hageman (2017, p. 155) say that when it is high, companies are less likely to suffer from corruption irrespective of the environment.

Discussion

As has been mentioned, all the theories above can be used to describe the principles of corporate governance, and none of them is free from limitations. That is why there arises a question of which perspective is more relevant in the modern world. The following information will try to prove that the traditional agency perspective is still valid and appropriate in the field of corporate governance.

Firstly, one of the leading agency theory advantages refers to the fact that it implies a clear and straightforward governance structure that comprises principals and agents. There is no need to establish large bodies that will make it possible to rule businesses. At the same time, the perspective under consideration draws attention to the fact that principals and agents can have different interests concerning some issues, which can result in opportunistic behavior. Its possible adverse effect is mitigated with the help of financial remuneration systems. This perspective requires essential economic resources, but this fact reflects the real state of affairs. Consequently, this theory is more relevant than the stewardship perspective because the latter is based on an idealistic view that there is a constant consensus between owners and managers.

Secondly, the agency approach is also suitable for current conditions because it does not aim at meeting all stakeholder’s needs. When it comes to governing a business, it can comprise multiple stakeholder groups, and each of them implies its appropriate interests. It is impossible to satisfy their needs without harming a company. That is why the focus should be placed on achieving the best outcomes, which is possible by meeting the corporate goals. It has been described that principals are one of the main factors that determine the successful performance of a firm. Thus, agents act as useful tools to reach the specified targets, which means that the agency perspective is relevant since it allows to achieve positive outcomes.

Thirdly, the agency approach is more relevant than the institutional one because the latter draws attention to the external conditions of business. There is no doubt that this environment is essential, but it is more reasonable to focus on internal relationships. Alon and Hagemann (2017, p. 155) support this idea by mentioning that trust between individuals is significant for determining the effectiveness of the institutional approach. Thus, it is more useful to consider the real relationships between various agents and principals to understand the main concepts that represent the basics of corporate governance structures.

Conclusion

Corporate governance is a complicated and essential phenomenon that describes how various companies are ruled. Since it has a complex nature, multiple theories try to explain how corporate governance works. Each of them implies its own assumptions and limitations that are the basis for criticism. Even though each perspective has some defects, it is possible to compare all of them to identify one that is more relevant than the others.

The given method has demonstrated that the agency perspective is appropriate in the modern world. Even though the presented approach is highly criticized, it is still useful because it is based on working and straightforward principles. Furthermore, the given theory relies on financial compensation, which allows achieving the most productive results.

Reference List

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