Agency Costs and the Design of Corporate Governance Mechanisms
The separation of ownership and control in modern corporations creates agency costs. Corporate governance mechanisms represent institutional responses to this fundamental problem, and their effectiveness varies predictably with firm characteristics and market conditions.
The Agency Problem Defined
Managerial Discretion
Managers possess discretion that can be exercised in shareholders' interests or their own. Empire building, excessive compensation, and resistance to value-enhancing takeovers exemplify agency costs.
Monitoring Costs
Shareholders face collective action problems in monitoring management. Dispersed ownership means that no individual shareholder captures sufficient benefits from monitoring to justify the costs.
Governance Mechanisms
Board Independence
Independent directors theoretically provide monitoring without the conflicts that afflict inside directors. Empirical evidence on effectiveness is mixed, suggesting that independence alone is insufficient without appropriate incentives and expertise.
Executive Compensation
Equity-based compensation aligns managerial and shareholder interests but creates its own distortions. Stock options may encourage excessive risk-taking; restricted stock may promote excessive caution. Optimal compensation design remains contested.
Market for Corporate Control
The threat of hostile takeover disciplines management by creating consequences for poor performance. However, defensive measures—poison pills, staggered boards—can insulate management from this discipline.
Comparative Governance
Concentrated vs. Dispersed Ownership
Different ownership structures create different agency problems. Concentrated ownership reduces manager-shareholder conflicts but creates controlling shareholder-minority shareholder conflicts. Governance mechanisms must be tailored accordingly.
Legal Origins
Common law and civil law jurisdictions have developed different governance approaches, reflecting different solutions to agency problems. Neither system is uniformly superior; each represents a locally optimal response to specific institutional conditions.
Conclusion
Effective corporate governance requires understanding the specific agency costs present in particular contexts and selecting mechanisms calibrated to address those costs. One-size-fits-all approaches inevitably fail.