Agency Theory and Corporate Governance1

Background: Moral Hazard and the Agency Problem

Beginning with Berle and Means (1932, The Modern Corporation and Private Property, Harcourt,
Brace & World) it has been argued that a decentralized system of shareholders cannot properly constrain
corporate managers to act in the shareholders’ interests. Instead, managers act in their own self-interest
(they are opportunistic). This has led to an entire literature on incentives that align managerial behavior
with the interests of shareholders. It is also the theory underlying the use of such incentives in corporate
America.

More generally, the incongruence between shareholders and management is an example of what is
known as a principal-agent problem. In such a situation there is a separation of ownership and control.
This often results in a conflict of interest between the principal (owner) and the agent (who directly
controls the activity). For example, upper management may be more interested in perquisites than
ensuring that profit-maximizing activities are taken to their logical end. To rectify this, principals can
create a contract that induces the agent to take costly actions that are in the interest of the principal,
without monitoring. That is, incentive contracts are used to overcome a phenomenon known as moral
hazard (hidden action). Conversely, if monitoring is not too costly the principal can substitute some
monitoring activities (e.g., audits, analysts, and rating agencies) for financial incentives.

1
This case was prepared for the Giving Voice to Values program by Daniel G. Arce, Ph.D., Department of Economics, School of Economic,
Political and Policy Sciences, The University of Texas at Dallas and Mary C. Gentile, Ph.D.

This material is part of the Giving Voice to Values curriculum collection (www.GivingVoiceToValues.org).
The Aspen Institute was founding partner, along with the Yale School of Management, and incubator for Giving Voice to Values (GVV).
Now Funded by Babson College.
Do not alter or distribute without permission. © Mary C. Gentile, 2010
1
 Moral Hazard Examples in Principal-Agent Relationships
Principal Agent Effort
Profit
Stockholders Management
maximization
Managers Workers Work effort
Stockholders CPAs Audit effort
Insurance Care to avoid
Policy Holder
Company loss.
Client Lawyer Settlements
Cultivation
Landowner Sharecropper
Efforts

The idea underlying an incentive contract is that the higher a fixed wage (salary) is, the less incentive
there is for management to undertake activities that are in the interest of the firm but contrary to
management’s well-being. Hidden action implies an information asymmetry between absentee
shareholders and management that opportunistic executives can take advantage of. To overcome moral
hazard the principal can commit to a certain payment contingent upon observing a desired outcome, but
she cannot directly observe the actions taken by agent. An example is a contract with a lower fixed
component (salary) and a higher variable component that is an imperfect measure of the agent’s long-
term actions (e.g., stock options). Bonus payments contingent upon some observed outcome (e.g.,
earnings) can also be used to align shorter-term incentives. From this perspective, the firm can be
viewed as a nexus of contracts that reflect the (moral) hazards that each participant faces.

In this way, the principle-agent model is viewed as the “official story” in that it is the dominant
paradigm of the theory of corporate governance that is taught within MBA programs.2 Further, the
operationalization of agency theory is regarded by the popular press as the intellectual foundation for the
shareholder value movement in Corporate America, resulting in a tripling of CEO compensation from
1980-1994, and a further doubling by 2001 (primarily through stock options).

Agency and Corporate Governance

Daniel is one of a group of founding scientists of a biotechnology firm that has recently gone public with
a successful IPO. After the IPO he is now the Director of Product Development, but also finds himself
in the unfamiliar territory of the compensation committee of the firm. A new board member on the
compensation committee has raised the issue of instituting an incentive component of pay for
management that is tied explicitly with the firm’s market performance. Her argument is that such a
package will allow the firm to remain competitive in the market for managerial talent in the
biotechnology industry. This argument is made in the context of the various rationales for incentive pay
outlined above. Daniel is less sanguine, noting that the firm has successfully made it this far without
such a program. Further, he feels that as the firm deals with products that are related to public
health/safety, this responsibility should remain management’s first priority. In addition, he feels that the
2
The term “official story” originates from, Bebchuck, L and J. Fried (2004). Pay without Performance, Cambridge, MA:
Harvard University Press.

This material is part of the Giving Voice to Values curriculum collection (www.GivingVoiceToValues.org).
The Aspen Institute was founding partner, along with the Yale School of Management, and incubator for Giving Voice to Values (GVV).
Now Funded by Babson College
Do not alter or distribute without permission. © Mary C. Gentile, 2010
2
firm’s success has been due to research that is motivated by resolving health issues, rather than being
motivated by products that provide the highest profit margin. Daniel feels that the human benefits of his
firm’s activities should be the primary motivator, and that profits will follow. He is therefore against the
notion that executive behavior must somehow be incentivized to create a culture of shareholder
maximization. Daniel is in favor of retaining a culture that emphasizes the firm’s historical competitive
advantage  which is developing innovative products that serve the public trust  rather than acting so as
to maximize one’s incentive package. Daniel believes in a pro-management perspective rather than a
stylized approach that overemphasizes the potential for opportunism.

Discussion Questions
 What’s at stake for the key parties, including those with whom Daniel disagrees?
 What are the main arguments Daniel is trying to counter? That is, what are the reasons and
rationalizations you need to address?
 What levers/arguments can Daniel use to influence those with whom he disagrees?
 What is Daniel’s most powerful and persuasive response to the reasons and rationalizations he
needs to address?

Revised 02/28/2010

This material is part of the Giving Voice to Values curriculum collection (www.GivingVoiceToValues.org).
The Aspen Institute was founding partner, along with the Yale School of Management, and incubator for Giving Voice to Values (GVV).
Now Funded by Babson College
Do not alter or distribute without permission. © Mary C. Gentile, 2010
3