Agency Theory and the Question of Shareholder Primacy - Essay Example

Topic: Agency theory and the question of shareholder primacy Introduction The growth and expansion of any corporate firm isa process rather than an event. As part of the process, there are several disintegrated components that are brought together to form a single unit of organization that is made up of stakeholders who put their resources and ideas together to ensure growth and expansion. It is based on this fundamental principle that ownership and control are created within the same corporate firm. Unfortunately, Stout saw a situation where the distinctive relationship between ownership and control under the modern corporate firm structure leads to a conflict of interests among rival stakeholders (1190). As a way of dealing with such unhealthy tango that normally exists among owners and controllers such as shareholders, the corporate governance is usually used to structure and clarify the distribution and use of power among all stakeholders within the modern firm (Waitzer and Jaswal 480). In this paper, the role of corporate governance and law in general in ensuring effective power relationships among competing groups within the organization is reviewed from two perspectives. These perspectives are agency theory and shareholder primacy. As part of the review of the two perspectives, key debates in literature on perceived problems and benefits associated with agency theory and shareholder primacy will be discussed. Based on the review, a conclusion was taken that shareholder primacy fails to be a credible source of solution to most forms of conflicts and unrest that exists among various stakeholders within the organization and outside of it. This is conclusion is taken based on the fact that shareholder primacy seeks to prioritize the interest of shareholders only and thus create uneasiness with other stakeholders. Sources of power struggle within corporate organization In common-law based countries such as the US and the UK, power struggle has been identified to be very common because of the separation between ownership and control. As a result of the separation, anxieties of corporate control have often been created between owners and shareholders, bringing about corporate tensions that affect the running of organizations negatively (Jensen and Meckling 309). Unlike civil-law framework countries, the UK and US promote more diversified shareholder basis through delivering good security of minority shareholders (Mallin 11). In most corporate organizations, owners and shareholders have often looked over their shoulders, suspecting that the other person may be having some advantages that help serve their personal interests rather than the other. The need to create opportunistic and self-interest gains have therefore become a major source of power struggle within organizations where owners and shareholders have all wished to have the upper hand in having their interests met (Myers and Majluf 201). A typical example of scenarios of opportunistic and self-interest behaviors among shareholders and managers is with the issue of information asymmetry, where shareholders see themselves as being at a disadvantage to information regarding the enterprise’s operations (Mallin 10). Similarly, managers have also felt that voting rights given to shareholders on major enterprise based decisions favor the interest of shareholders and thus put the managers at a disadvantage. In effect, an era of lack distrust between managers or owners and shareholders is a major source of power struggle within corporate organizations across the globe, particularly those in the US and UK. Overview of agency theory and shareholder primacy There are a number of ways that law has been employed to handling issues of power struggle within the modern organization. The use of agency theory is one typical approach to the issue. The agency theory sees corporate organizations as a connection of contracts shared between resource holders (Fama and Jensen 332). In effect, the agency theory argues that real ownership is determined as a shared and collective responsibility which is fostered among all resource holders including managers and shareholders. In other academic arguments, agency theory is defined from a perspective where resource holders are not seen as equally yoked. Rather, there are identified principals who delegate their work to other parties known as agents and thus create an agency relationship between the two. In such instance, the owner will be seen as the principal while the director is seen as the agent (Mallin 10). In either way that agency theory is viewed, there is an underlining principle that seeks to address the issue of power structure. This principle has to do with the fact that corporate success cannot be achieved as a singular effort and so the claim of benefits from such successes must not be enjoyed by a few groups of persons. There are many who have argued that agency theory has not adequately addressed the issue of conflict between stakeholders because of agency cost which arises from the utilization of agency (Hayne 34). The issue of agency cost will be elaborated in subsequent sections of the paper. Apart from agency theory, shareholder primacy is another principle that has been employed with the aim of addressing manager and shareholder conflicts. In principle, what the shareholder primacy theory seeks to do is to clearly define where power should go and who should have the greatest portion of power. This is because shareholder primacy explains that shareholder interests should be given primary priority ahead of all other corporate stakeholders (Olson 780). On the surface, many see the shareholder primacy as a theory that even worsens the issue of manager and shareholder conflict. This is because it clearly puts the manager or owner at a disadvantage when it comes to the serving of personal interests (Kee 45). This position has however been refuted by Smith who explained that the rationale behind the shareholder primacy theory is to ensure that the real spenders within the organization have value for money because in the absence of their stakes which come through capital investment, the corporate firm would not be running (40). In effect, shareholder primacy endorses the practice where the higher a person invests in an organization, the more represented the person should be (Kee 54). The practices and benefits of shareholders as protected by the shareholder primacy are therefore enshrined in the five major principles of corporate governance.1 Relating the two concepts, it would be noted that shareholder primary is inherent in agency theory whiles the two become a fulcrum around which the principles of corporate governance revolves (Smith, 2011). This is because it is through the theoretical support of the agency theory whereby roles are delegated by managers that shareholders come in as stakeholders of the corporation. But as the shareholders come in, they are given further and better coverage under five principles of corporate governance, particularly the first three principles. Perceived problems and benefits with the shareholder primacy model Several studies have identified problems with the shareholder primacy model, challenging the ability of the model in solving issues of power struggle at the workplace. In one line of the arguments identifying problems with the shareholder primary model, it has been criticized for the promotion of minority shareholder oppression (Mallin 18). Minority shareholder oppression is a situation where majority shareholders of a corporate firm take actions that are considered by minority shareholders as prejudicing and vulnerable to the sustainable growth of the position of minority shareholders in the organization (Smith 43). Minority shareholder oppression has been associated with shareholder primacy because of the fundamental recognition of shareholder interest based on the quantum of stake or shares a person has in a corporate firm. By implication, shareholder primacy has a problem of staging or starting power struggle and conflicts right at the shareholder level even before transferring this to the management level. Relating this situation to the five main structural characteristics of public corporations2, there are many who have argued about the failure shareholder primacy to clearly differentiate the exclusive and unique rights of other stakeholders within the organization (Olson 781). This is said as shareholders may be very important in the organization but do not play all the roles that bring about success, growth and expansion for the organization. Another problem that is associated with shareholder primacy is its lack of unambiguous cohesion with agency theory in ensuring that the issue of agency cost is adequately taken care of. As observed by Jensen and Meckling, agency gives rise to agency costs and so it is expected that the distribution of the agency cost as suffered by agents will be fairly transferred to them by giving them higher and better representation of stake and interest (350). Meanwhile, such privileges given to agents who are mainly directors is grossly overlooked under the shareholder primacy model, creating more chances and possibilities with agency agitations and dissatisfaction (Myers and Majluf 200). writing on agency cost, Hayne explained that whiles agents such as directors try to sustain an effective agency relationship, there are costs that they incur such as bonuses given to managers to act in the interest of shareholders (40). Meanwhile, referring to the Canadian legal system of Canada Business Corporate Act (CBCA), which defines the duty of care of directors3, it will be seen that there are no provisions made for the directors or agents to make up for the agency cost that are created for the good of shareholders. Indeed, as long as this situation remains unresolved under the shareholder primacy, one can expect that issues of conflicts between principals and agents, and agents and shareholders will continue, rendering the shareholder primacy incapable of addressing conflicts at the organizational level. The identified problems notwithstanding, there are three major arguments that are commonly made in literature for shareholder primacy. The first of this has to do with shareholder ownership, where it is argued that shareholder primacy helps in the promotion of the separation ownership and control (Stout 1198). In Canadian law, the CBCA takes a position that separation ownership and control is important in fostering checks and balance in the utilization of the resources of the firm, which has been collectively worked for by stakeholders (Fama and Jensen 385). Through shareholder ownership therefore, what would have been a denial of the control of rights to shareholders is taken care of. Another argument made for shareholder primacy is the residual claimants. As residual claimants of the corporation, shareholders are seen as people who endure the worse forms of burdens of the corporate firm, given that their interests are affected directly by the profits and losses that the corporation makes (Paddy 50). Because of the loss of investment that shareholders will suffer when the corporation is run in such a way that brings about losses, it only makes sense that through shareholder primacy, shareholders will be given a better say and incentives to gain control power over corporate management issues. Finally, there is the argument of economic efficiency made for shareholder primacy, where it is explained that since shareholders stand to loss when the company runs a deficit, their mandate as owners will only be used in a way that promotes social wealth (Shankman 240). Applicability of shareholder primacy and agency theory within the modern organization From the discussions that have fallen out of the review above, a position will be taken that shareholder primacy tend to overly favor the interest of shareholders, particularly majority shareholders against other stakeholders of the corporate firm. Meanwhile, the day-to-day running and management of the organization depends on shareholders as much as it depends on non-shareholder stakeholders such as directors, managers, owners, employees, customers, suppliers, and government agencies (Waitzer and Jaswal 493). It is therefore expected that the utilization of any theories or principles that seek to control conflicts at the corporate levels of the organization will also seek to promote fairness in the distribution of power. This is because whenever there is disparity in the distribution of power, there is the creation of a legal imbalance with control, which makes it possible for the side that is seen to be favored with power to take undue advantage to champion their interests to the detriment of others. There is a real life example with Shell, where Paddy reported of a case where the absence of balance of interest between shareholders and other stakeholders resulted in several years of conflict arising from lack of commitment by the shareholders for the company to pursue its social responsibilities (80. This was because shareholders were expecting to make profits and thus saw the overly spending in corporate social responsibility as a way of limiting such profitability. Based on the example given above, it can be said that in a wake of trying to promote corporate governance, there are serious social consequences that are suffered. But as far as agency is concerned, it would be noted that when the selection of agents is done in the right way where the delegation of roles is made to be well represented among all stakeholders, helps to solve the social consequences. A scenario that can be given to this effect is a situation where agency does not only focus on directors as agents but also on external stakeholders such as pressure groups, government agencies and customers. In a situation like this, because these external stakeholders are society oriented, chances that they will help in sustaining the social interests of the corporate firm are higher. In the application of the agency theory in modern organizations therefore, it is expected that there will be a very clear definition of what roles should be. As part of the agency theory, roles should not only be seen as the day-to-day internal management of the organization of expanding the organization’s management to include all aspects of social, economic, environmental, and governance sustainability (Shankman 265). Conclusion In conclusion, it will be said that the shareholder primacy model has its own merits and arguments for which it is suitable for corporate governance. However, the model has failed to be the source of solution to most forms of manager and shareholder conflicts. As seen in the essay, there is even a developing situation whereby the shareholder primacy model can be said to be accountable for minority shareholder oppression, which is also a source of conflict among shareholders. It is therefore important that the shareholder primacy model will be reviewed to know instances where it should be considered as a ceremonial principle of corporate governance and times when its doctrines should be seen to be really transferred into the management of the corporate firm. The agency theory on the other hand seem to be a very good model that could help address most forms of conflicts arising from power struggle. Its usage has however been limited to internal promotion of corporate management rather than extending its usage to foster social corporate sustainability. What is worse, the shareholder primacy model seems to have overshadowed the agency theory, making its application virtually a mirage. Works Cited Christine Mallin. “Theoretical Aspects of Corporate Governance” from Corporate Governance, 3rd edition. Oxford University Press. 2010, 9-17. Fama, Eugene, and Jensen, Michael. "Agency Problems and Residual Claims." Journal of Law and Economics 26 (1983), 327-349. Hansmann, Henry and Kraaman, Reinier. “The end of history for corporate law.” Harvard Law School, 2000, 5-37 Hayne, Leland E. "Agency Costs, Risk Management, and Capital Structure." Journal of Finance, 6.3 (1998), 34-56. Jensen, Michael C., and Meckling, William H. "Theory of the Firm, Managerial Behavior, Agency Costs, and Ownership Structure." Journal of Financial Economics 3 (1976), 305-360. Kee, James. “The Ethical Corporation?” The Free Market, 13.5 (1995), 45-59. Myers, Stewart, and Majluf, Nicholas. "Corporate Financing and Investment Decisions When Firms Have Information that Investors do not have." Journal of Financial Economics 13 (1984), 187-221. Olson, John F. "The Myth of the Shareholder Franchise" Virginia Law Review 93.3 (2007), 773–787. Paddy Ireland. “Shareholder Primacy and the Distribution of Wealth”. Wiley Blackwell Publishing Ltd., 2005, 49-81. Shankman, Neil A. "Reframing the Debate between Agency and Stakeholder Theories of the Firm." Journal of Business Ethics, 34.5 (1999), 232-344. Smith, Gordon D. “The Shareholder Primacy Norm” Journal of Corporation Law, 23.2 (2001), 23-55 Smith, R. Thomas. Agency theory and its consequences. 2011. Web. December 3, 2014. Stout, Lynn A. New Thinking On "Shareholder Primacy". Accounting, Economics, and Law 2.2 (2012): n. pag. Web. 28 Nov. 2014. Stout, Lynn A.. “Bad and Not-So-Bad Arguments for Shareholder Primacy”. Gould School of Law, 2002, 1189-1210. Waitzer, Ed and Jaswal, Johnny. Peoples, BCE and the Good Corporate Citizen. Osgood Hall Law Journal, 47.3 (2009), 439-496. Read More