The agency theory

Adam Smith, known as father of economics, was highly cynical and pessimistic about the
success of corporation as a model of creating wealth and pursuing economic growth. The
entire idea of dilution of ownership, whereby the owner and manager of funds are two
different groups/persons, was not at all invidious to Smith. Smith had prescience of the
inherent and institutional flaw in the model of corporations. He wrote in his book 'The
Wealth of Nations' (abbreviated name for 'An Inquiry into the Nature and Causes of the
Wealth of Nations') :

'The directors of such companies .... being the managers of other people's money rather than of
their own, it cannot well be expected that they should watch over it with the same anxious
vigilance with which the partners in a private co-partnery frequently watch over their own. Like
stewards of rich man, they are apt to consider attention to small matters as not for their
master's honour and very easily give themselves a dispensation from having it. Negligence and
profusion, therefore, must always prevail, more or less, in the management of the affairs of such
a company ... '

This statement of Smith came in 1776, almost 200 years after incorporation of East India
Company in 1600 - the Company that ruled India and which was the first company to hold
democratic general meeting of shareholders and was later on accused of mis-management
aimed at generating personal gain (in violation of the 'agency theory').

Smith believed so strongly in the power of self interest and the conflicts it generates, that he
was extremely pessimistic about the ability of the joint stock company to survive in any but
the simplest of activities where management's behavior could be easily monitored.

, Without a monopoly a joint stock company cannot long carryon any branch of foreign trade.
To buy in one market, in order to sell, with profit, in another, when there are many competitors
in both; to watch over, not only the occasional variations in the demand, but the much greater
and more frequent variations in the competition, or in the supply which that is likely to get from
other people, and to suit with dexterity and judgment both the quantity and quality of each
assortment of goods to all these circumstances, is a species of warfare of which the operations
are continually changing, and which can scarce ever be conducted successfully, without such
an unremitting exertion of vigilance and attention, as cannot Long be expected from the
directors of a joint stock company' .

Smith had strong surmise about the sustainability of a corporation without it being granted a
state monopoly. Only activities where this model can work, according to Smith, were those that
were easily monitored; Smith implicates this when he says in his words - "which all the
operations are capable of being reduced to what is called a routine, or to such a uniformity of
method as admits of little or no variation ".

Smith was well aware of the benefits of corporations, including their ability to concentrate large
amounts of money into capital-intensive undertakings. But he thought and believed that :
 The costs of agency relationship would always be too high. (Today there is intense
debate in the USA on 'managerial remuneration'.)
 Those costs shall rise with the increase in size of business.
 Bigger a business got, the worse would be waste because of negligence.
 Negligence, profusion and conflict of interest would ruin the corporation as its
business scaled high and it would be predicament for anyone to preclude these costs,
by whatsoever checks, balances, controls and regulations being instituted. (Pending
outcome of investigation, it was negligence and profusion that resided at the bottom
of Sat yam pyramid.)

These agency costs viz. negligence, profusion and conflict of interest, are today reflected in the
form of corporate debacles, be it Enron, World-com or Sat yam. It is sad, but the fact is that
Smith has been proven right hitherto specifically in last decade if one is to go purely on
regression analysis. Smith's prophecy that 'negligence and profusion must always prevail'
made 200 years before, still holds good today. The irony is : it is only now when we realise the
unfathomable truth in his profound statement.
To conclude: Enron brought a sea change in our perspective towards corporate
governance; it had its own lessons to teach and so would Sat yam. Stringent and vigilant
controls would be instituted by regulatory bodies, in the form of codes, rules, audits, and
peer reviews; investigations will be carried out, special committees will be appointed,
white papers will be issued and; significant amount of research would be done in
investigating why this happened, how this happened, could it have been prevented or at
least predicted, what to do to prevent its re-occurrence, who should be held responsible,
how should they be punished, etcetera. However, the fact is and as Smith aptly wrote, this
model of corporation possesses an inherent flaw and this would time and again be
reflected in the form of more Enrons and Sat yams. These are bound to take place in
future, irrespective of checks and balances because of the inherent greed and conflict of
interest