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1The Fundamental Agency Problem and Its Mitigation

Article in The Academy of Management Annals ? December 2007

DOI: 10.1080/078559806

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Chapter 1: The Fundamental Agency Problem and Its Mitigation

Dan R. Dalton a; Michael A. Hitt b; S. Trevis Certo b; Catherine M. Dalton a a Kelley School of Business, Indiana University, b Mays College of Business, Texas A&M University, First Published on: 01 December 2007

To cite this Article Dalton, Dan R., Hitt, Michael A., Certo, S. Trevis and Dalton, Catherine M.(2007)'Chapter 1: The Fundamental Agency Problem and Its Mitigation',The Academy of Management Annals,1:1,1 -- 64 To link to this Article: DOI: 10.1080/078559806 URL:

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The Fundamental Agency Problem and Its Mitigation:

Independence, Equity, and the Market for Corporate Control

Dan R. Dalton Kelley School of Business, Indiana University

Michael A. Hitt Mays College of Business, Texas A&M University

S. Trevis Certo Mays College of Business, Texas A&M University

Catherine M. Dalton Kelley School of Business, Indiana University

Abstract A central tenet of agency theory is that there is potential for mischief when the interests of owners and managers diverge. In those circumstances, and for a variety of reasons, managers may be able to exact higher rents than are reasonable or than the owners of the firm would otherwise accord them. While that foundational element of agency theory is secure, other elements derived directly from agency theory are far less settled. Indeed, even after some 75 years of conceptualization and empirical research, the three principal approaches that have long been proposed to mitigate the fundamental agency problem remain contentious. Accordingly, we provide a review of the fundamental agency problem and its mitigation through independence, equity, and the market for corporate control.

 ? The Academy of Management Annals

Introduction

Agency theory is secure among the pantheon of conceptual/theoretical foundations that inform research in corporate governance. Indeed, agency theory not only predates other influential theories, including resource dependence (e.g., Pfeffer & Salancik, 1978; Selznick, 1949; Thompson & McEwen, 1958; Zald, 1969), the resource-based view (e.g., Barney, 1991; Barney, Wright, & Ketchen, 2001; Wernerfelt, 1984), and institutional theory (e.g., DiMaggio & Powell, 1983; Meyer & Rowan, 1977; Oliver, 1991; Rogers, 2003; Scott, 1995), but remains the dominant perspective on which governance research relies.1

A variety of comments may underscore that view. Bratton (2001; see also Bratton, 1989) described Berle and Means' impact on legal scholarship "as a paradigm that dominated the field" and their book, The Modern Corporation and Private Property, as "a singular event in the last century of academic corporate law" (p. 739). Shapiro suggested that agency theory represents a "new zeitgeist" and "the dominant institutional logic of corporate governance" (Shapiro, 2005, p. 279).

Gilson (1996) observed that "the intellectual mission of American corporate governance took the form of a search for the organizational Holy Grail, a technique that bridged the separation of ownership and control by aligning the interests of shareholders and managers" (p. 331). Roe (2005; see also Mizruchi, 2004; Roe, 1994), too, shared a similar perspective that "the core fissure in American corporate governance is the separation of ownership from control" and that "separation is the foundational instability of American corporate governance" (p. 9). Perhaps it is Davis (2005) who provided the most succinct summary of the role of agency theory: "This solution to managerialism became perhaps the dominant theory of the public corporation" (p. 145).

The pivotal notion that focuses this manuscript is the central tenet of agency theory: that there is potential for mischief when the interests of owners and those of managers diverge. In those circumstances, and for a variety of reasons, managers may be able to exact higher rents than would otherwise be accorded them by owners of the firm. While we are confident that this foundation of agency theory is unavoidable and intractable, other elements derived directly from agency theory are far less settled. Indeed, even after some 75 years of conceptualization and empirical research, the three fundamental means of mitigating the agency problem (e.g., independence, equity, and the market for corporate control) remain contentious.

The voluminous research on agency theory was propelled largely by the major challenge of how to solve the fundamental agency problem. How can an organization, through its owners and its stewards, minimize the posited tendency for managers to inappropriately leverage their advantage when managers' interests are not consonant with those of owners?

The Fundamental Agency Problem and Its Mitigation ?

Early on, three principal approaches were developed to minimize the agency problem. One, the "independence" approach, suggested that boards of directors, comprised to be independent of management, can monitor managers and assure that their interests do not diverge substantially from those of owners (Fama, 1980; Fama & Jensen, 1983a, 1983b; Jensen & Meckling, 1976; Mizruchi, 1983; see also Chandler, 1977). Another method, the "equity" approach, proposed that managers with equity in the firm were more likely to embrace the interests of other equity holders and, accordingly, to direct the firm in their joint interests (Fama & Jensen, 1983b; Jensen & Meckling, 1976). Lastly, there was the notion of the "market for corporate control," which set forth the principle that corporate markets may operate to discipline managers who inappropriately leverage their agency advantage. In such cases, self-serving executives may subject the firm to acquisition by other firms (Fama & Jensen, 1983a; Jensen & Ruback, 1983; Manne, 1965). While these three corporate governance approaches are rational in principle, the efficacy of these approaches in practice remains subject to debate.

Accordingly, in subsequent sections of this manuscript, we provide a multidisciplinary overview of agency theory with an emphasis on the three mechanisms through which the fundamental agency problem may be mitigated: (a) independence, (b) equity, and (c) the market for corporate control. In addition, we consider the impact of the current regulatory compliance climate (e.g., Sarbanes-Oxley, the guidelines of the listing exchanges [e.g., NYSE, NASDAQ], the Securities and Exchange Commission [SEC], and the Justice Department) on agency theory and corporate governance.

We do recognize the daunting scope of our project. We did, however, enjoy a substantial advantage as we greatly benefited and borrowed liberally from the reviews and discussions of agency theory that preceded us (e.g., Bradley, Schipani, Sundaram, & Walsh, 1999; Bratton, 1989, 2001; Eisenhardt, 1989; Finkelstein & Hambrick, 1996; Hillman & Dalziel, 2003; Jensen, 1998; Kim & Mahoney, 2005; Mizruchi, 2004; Moe, 1984; Stigler & Friedland, 1983; Walsh & Seward, 1990). Similarly, our task was facilitated by an extraordinary body of work that provided a broad overview of corporate governance (e.g., Corley, 2005; Daily, Dalton, & Cannella, 2003; Daily, Dalton, & Rajagopalan, 2003; Davis, 2005; Denis, 2001; Gaa, 2004; Hambrick, Werder, & Zajac, in press; Hermalin, 2005; Shleifer & Vishny, 1997; Williamson, 2005).

The attention to agency theory provides an imposing literature. Accordingly, the commentary and research on which we rely is representative of that body of work, but is by no means exhaustive. On virtually every point, we could have cited more broadly and credited more examples of outstanding and relevant work. We regret that, in this manuscript, we have not directly represented all of the work contributing to the ubiquity and influence of agency theory. We apologize, too, that we have often sacrificed detail, along with some texture, as we focus largely on the more recent work. We should

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