Agency Problems and Legal

Strategies

Commercial law
Class VI
Alessandro Pomelli
Subject to copyright. Do not reproduce or circulate without the Author’s consent
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 Corporate Interests

• The interests of which corporate

constituencies should be maximized by
companies?

• Those of the shareholders? Creditors?

Employees? Suppliers? Customers?

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 Ultimate Goal of Corporate Law:
Corporate Welfare (Stakeholder Value)
Maximization

The authors of our textbook argue that the ultimate goal

of the corporate law should be that of maximizing the
aggregate welfare of all who explicitly or implicitly
engage in contractual dealings within the firm
(shareholders, directors) and with the firm (managers,
workers, creditors, suppliers, customers), i.e. all the
stakeholders.

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But should the interests of the shareholders,
who are unprotected residual claimants, be
treated as are those of other stakeholders,
such as creditors or employees, who
conversely are protected by law and contract?

In case of conflict, what interests should

prevail?

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 First (Intermediate) Goal of
Corporations Law
 The first intermediate goal of corporate law, which is
pursued by providing to business people a corporate
form having the 5 core features we studied so far, is:
1. To reduce transaction costs among the corporate
constituencies by facilitating both contracting and
coordination among all the factors of production
(capital, labor) by means of a dedicated corporate legal
entity, which becomes a stable, long-lasting
counterparty for all providers of inputs (shareholders,
creditors, workers..)

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 Second (Intermediate) Goal of
Corporate Law
2. The next intermediate goal of corporate law
is to solve at low cost the multiple conflicts of
interest that arise from the multiple “agency
relationships” that are established within and
with the firm.
– This makes sure that all the corporate
constituencies may effectively work together for
the common good.
– In order to understand this point, we need to
understand what an agency relationship is and
what problems and costs it poses.
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 Agency Relationship
 In legal terms, an agency relationship arises out of a
specific contract, the “agency contract”, under which
the agent is delegated by the principal to perform some
predetermined activities on behalf of the latter

 In economic terms, an agency relationship arises

whenever (it is irrelevant whether by a formal agency
contract or otherwise) somebody (who becomes the
“principal”) relies on actions taken by somebody else
(who becomes the “agent”) in order to enhance his (the
principal’s) welfare.
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 Agency Relationships in the Corporate Context
1.Shareholders (principals) v directors/managers
(agents)
– It stems from delegation of management (one of the core
features of the corporate entity)
2.Majority shareholders (agents) v minority
shareholders (principals)
– It stems from the majority principle applicable within the
corporate form (as opposed to unanimity in partnerships)
– The majority always wins out, the minority always loses out but
the money of the minority, too, is at stake. This is tantamount
to saying that the majority is de facto delegated to (indirectly)
manage the assets of the minority.

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3. Company (agent) v corporate constituencies, such as
employees, suppliers, voluntary and involuntary
creditors in general, customers (principals)
– Employees, suppliers and creditors in general are
respectively owed wages, prices of goods and services,
return of money lent to the company or damage awards.
• Such payments must be made out of the corporate assets, which
are managed directly by directors and officers and indirectly by the
shareholders by appointing the former.
• This means that the company becomes the agent of all these
creditors for the repayment of the debts.
– Customers invest money relying on the delivery and quality
of products and services they buy from companies
• Delivery and quality depend on actions taken by corporate
managers

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 Agency Costs
• If an agency relationship gives rise to potential
agency problems, potential agency problems
in turn give rise to potential agency costs.
• What are they?
• What is the role of the law then?

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 Legal Strategies: Regulatory and
Governance
According to the Authors of our Textbook, legal
strategies (“methods of deploying substantive
law to mitigate the vulnerability of principals to
the opportunism of their agents”) for controlling
agency problems can be first divided in:

1. Regulatory strategies
and
2.Governance strategies
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Regulatory strategies are prescriptive
– Once and for all companies, they directly dictate the
substantive terms that will govern the agency
relationship regardless of the subjective
preferences of the principals.

Governance strategies are based on principal’s

active participation and intervention
– They confer on principals the right and power to
control their agents and take defensive measures in
case agents do not advance their interests.

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• What are the advantages of regulatory
strategies?
• What are the disadvantages of regulatory
strategies?
• What are the advantages of governance
strategies?
• What are the disadvantages of governance
strategies?

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REGULATORY STRATEGIES IN DETAIL

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 Agent Constraints: Rules
• Mandatory rules that prescribe ex ante a
certain behavior or the omission of a certain
behavior on the part of the agents.
• They are the most severe and least flexible
legal strategy.
• They aim at protecting those that cannot
obtain easy protection otherwise

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 Agent Constraints: Standards
• Standards do not impose any specific behavior
in detail, but rather state a code of conduct, a
benchmark against which one or another
behavior will be evaluated ex post

• Standards are flexible and adaptable over

time by way of judge-made law

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 Affiliation Terms: Entry
• While agent constraints (i.e., rules and
standards) regulate the agency relationship
after it is formed….
• ….The “entry” strategy regulates the initial
terms and conditions on which an agency
relationship can be established.
• Agent constraints may strengthen public
reliance on the entry terms

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 Affiliation Terms: Exit

• The “exit” strategy is based on letting the

principal terminate the agency relationship by
leaving the company or otherwise cancelling
its contractual relationship with it.

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GOVERNANCE STRATEGIES IN DETAIL

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 Agent Incentives: Trusteeship
• Conferral of oversight powers on individuals
or authorities, internal or external to the
corporation, that are likely to be super partes
• For they are not personally exposed to, or
interested in, the outcome of the agency
relationship, they may well deserve trust from
the principals.

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 Agent Incentives: Reward

• Creating personal incentives for the agent to

act in the interest of the principal by aligning
the interest of the former with that of the
latter

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 Appointment Rights: Selection
and Removal
• Allocation to the principals of the rights to select,
appoint and remove their agents (at will, for a just
cause, etc.)
• Selection and appointment rights give rise to the
agency relationship
– They must be read in conjunction with some entry terms
• Removal rights terminate the agency relationship
– They must be read in conjunction with some exit terms

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 Decision Rights: Initiation and
Ratification
• Assignment to the principals of the right/power to
make proposals and resolve on major corporate issues
outside the province of the management
– This occurs when preliminary action by management, albeit
possible, is not strictly required.
• Assignment to the principals of the right to ratify or
object to resolutions proposed or taken by the
management
– This occurs when the proposal must be made by
management but for it to become effective it must then be
ratified by the shareholders, who can veto it.
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 Enforcement
• Legal strategies are useful only if they induce
compliance
• Compliance is induced if the target of a rule of
law knows he/she will face detrimental
consequences in case of non-compliance
• Compliance is assured by the prospect of the
enforcement of the rule of law where it is
violated, if and only if enforcement is
perceived to be effective
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 Modes of Enforcement
In the corporate world there are three types
of enforcement, depending on the nature and
quality of the enforcer:

1.Public enforcement

2.Private enforcement

3.Gatekeeper control
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 Public Enforcement
It is performed by organs of the state:
Criminal prosecutors
Market authorities / regulators: Italy’s Consob, US
Securities and Exchange Commission (SEC), UK Financial
Conduct Authority (FCA), France’s Autorité des marchés
financiers (AMF)

It is justified by the relevance of public interests at

stake or the inability of the parties affected by
others’ wrongdoing to vindicate their rights.

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 It mainly supports regulatory strategies and gives rise
to penalties administered by courts and/or market
regulators
– varying from criminal sanctions administered by courts of law
(imprisonment and monetary penalties), civil sanctions
administered by courts of law (claim for damages,
indemnification),and administrative sanctions administered
by market authorities (monetary penalties, disqualification).
• Reputational damages may also ensue by giving publicity
to the misconduct
 It may also back up governance strategies
– Ex.: Enforcement of mandatory disclosure of information
ahead of a shareholders’ meetings

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 Private Enforcement
 It occurs upon the initiative of private parties, those
directly affected by the violation of the law or by any
wrongdoing.

 It is the most prominent means of out-of-court

enforcement of governance strategies.

– Ex.: Shareholders may take the initiative to remove directors

because dissatisfied with their performance or the breach of
their fiduciary duties (loyalty, care, good faith…) by
exercising their right to vote them out of office.
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 But it can also take place in court, where a judge
adjudicates the issue, and in such a case it
supplements regulatory strategies.

– Ex.: Shareholders may sue managers in court for damages

in a derivative action or in a class action for violation of
duty of loyalty or duty of care.

 Sanctions vary from payment of damages to

termination of office and reputational damages.
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 Gatekeeper Control
• It is performed by noncorporate, independent
and qualified professionals who are equipped
and paid to check on the agents on behalf of
the principals.
• It is a form of trusteeship, too (see supra).
• Gatekeepers are usually delegated by the law
the power to scrutinize ex ante sensitive
corporate transactions or actions

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• There also are gatekeepers whose function is
not mandated by the law and yet are routinely
tasked by companies with scrutinizing ex ante
other types of sensitive corporate transactions
– Example: Credit rating agencies

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• It supplements both regulatory strategies and
governance strategies to the extent it eases
public enforcement and private enforcement
• Gatekeeper role is thus strengthened by way
of criminal, administrative, civil and
reputational sanctions imposed on the
gatekeepers themselves

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