Agency Theory Essay

In the corporate form of business organization, an agency relationship problem exists. In agency theory, the agency relationship problem results from a separation of ownership and control. Self-interest on the part of managers acting as agents, and shareholders who are acting as principals exists within the corporate business organization. Agency theory allows us to understand the behaviors and conflicts that exist for corporation stakeholders and the managers of the company, and can allow for designing of effective incentive structures and other monitoring mechanisms to resolve the agency problem. Institutional ownership also plays a part in monitoring, and controlling agency costs within the corporate form of organization.

Nature of Agency

In an ideal situation, boards of directors would have complete information and therefore be able to detect and prevent the abuse of managerial power directly. Smaller board sizes are typically more organized, and considered more effective in attaining higher levels of monitoring, as they have fewer disagreements among the board members than larger boards. Structuring management compensation to align management and share a common interest can be another method utilized to link the compensation of managers to the performance of the corporation, further including in the rules and policies limits for managers decision-making authority in order to constrain the potential for agent opportunism in manipulating financial results (Michael & Pearce, 2004). Thus, control mechanisms also should play a key role for the board of directors in reducing existing agency issues.

Managerial Ownership May Resolve Agency

In the business world today, this type of investor group, that includes such investors as banks, insurance companies, and pension funds, owns the majority of stock and thus they are able to exert influence over managers, and often act as lobbyists for investors (Brigham & Houston, 2011). Institutional investors have fiduciary responsibilities that give them strong reasons for making corporate governance increasingly important in making investment decisions, and are often the motivation for their stockholder activism (Chung & Zhang, 2011).

Institutional owners as part of their involvement in a monitoring role can sponsor proposals to be voted on at stockholder meetings, without needing management support. Since the passage of the Dodd Frank Act, owners also have the right to nominate directors to the corporation board, and vote on approval of executive compensation structures (Brigham & Houston, 2011). Although the results are non-binding, these monitoring activities of investors send a clear message to management.

Best Form of Monitoring Including Academic Supporting