In our continuing series, Corporate Governance Expert David Beatty offers insights into the agency problem.
The Agency Problem
Why do institutions so favor shareholder influence over outcomes of the companies’ director elections for example. The reason goes back to Michael Jensen, very famous Harvard professor, who created something he called the agency problem. And that is if you separate the manager from the owner, somebody else owns it but doesn’t show up for work, you make the fundamental proposition that those people will try and skew things pretty much in their interests. So I’m the CEO, you own the company, I get paid to run it, and I decide I need seats at a basketball game. I decide I should take my customers out to a five-star restaurant for dinner. I decide I need a second corporate jet. I’m making these decisions with less than a full exposure to the equity that my owner is. And these are called agency costs. And the basic presumption is that managers will lie, steal, and chill.
I know that’s an exaggeration but if you think about it that way, you leave them alone, they will lie, cheat, and steal. We need to have some influence, say the owners, over these kinds of practices. And we do that through the board of directors. This is called the shareholder value system where we as independent directors are going to oversee the work of management and pay careful attention to management emoluments, management benefits, management’s perks and requisites.
Agency costs drive the shareholders to believe that they can do a better job of overseeing the companies than the board of directors might because they get to vote the board of directors in, and they can vote out the ones that don’t seem to be effective. Sounds persuasive. But recently, there’s another theory that’s risen in the recent markets and the growth of activism is called the principal’s costs.
There are costs to being a publicly traded company, costs that relate to defending short-termism, costs that relate to defending activism, which has permeated all the markets, big, medium, small, nano caps in most countries around the world. And these are real costs. They not only cost out of pocket money for your lawyers and your defense teams and your consultants to advise you beforehand. They cost you 20% to 30% maybe even 50% of your top management’s time, which is perhaps the scarcest resource in any corporation.
So a new theory has emerged that you’ve got to relate the total costs, the costs of the agency, and the cost of the capital together, the principal costs, and come to some balance. And if you do that, you might come out with a very different point of view on dual class shares than if you didn’t do that. And I think that it is a very productive way to think about how to bring a company public with the least cost to the shareholders and to the future of the corporation.
David Beatty is an adjunct professor and Conway chair of the Clarkson Centre for Business Ethics and Board Effectiveness at the Rotman School of Management. Over his career, he has served on more than 39 boards of directors and been chair of nine publicly traded companies. He was the founding managing director of the Canadian Coalition for Good Governance (2003 to 2008). A version of this article will also appear in the Winter 2017 edition of Rotman Management, published by the University of Toronto’s Rotman School of Management.