Chapter 19: Agency Problems & Corporate Governance

Agency Problems & Corporate Governance begins by defining the fundamental conflict between shareholders, who act as principals, and managers, who serve as agents. Since managers do not naturally possess a gene that aligns their personal interests with shareholder value maximization, they may succumb to various temptations that generate agency costs. The text details five primary manifestations of these agency problems: reduced effort or "shirking" where managers pursue a "quiet life" rather than difficult value-creating projects; the consumption of private benefits and lavish perquisites such as corporate jets; overinvestment or empire building to increase personal power and prestige; distorted risk preferences, ranging from excessive risk-aversion to preserve job security to "gambling for resurrection" when a firm is in distress; and short-termism, where long-term value is sacrificed to meet immediate earnings targets. To mitigate these issues, the chapter explores the critical role of the board of directors as the primary monitoring mechanism, discussing factors that influence board effectiveness such as independence, size, and the debate over staggered elections. It also examines the unique German model of codetermination, which involves a two-tiered board structure with employee representation. The narrative then shifts to the role of shareholders in stewardship, outlining how they exercise control through voting, engagement, and the threat of exit, often referred to as the Wall Street Walk. This section includes a discussion on proxy fights, the rise of activist investors and hedge funds, and the governance implications of dual-class equity structures that separate voting rights from cash-flow rights. Beyond internal stakeholders, the chapter highlights external monitors including auditors, lenders, and the market for corporate control via takeovers. A significant portion of the discussion is dedicated to executive compensation, analyzing why CEO pay in the United States is significantly higher than in other regions—potentially due to the scalability of talent—and how compensation packages are structured using salaries, bonuses, stock options, and restricted stock to align incentives. The text critiques the potential for these incentives to backfire, leading to manipulation or "pay for luck," and introduces Long-Term Incentive Plans (LTIPs) as a countermeasure. Finally, the chapter contrasts different governance regimes globally, comparing the market-based systems of the US and UK with the bank-based and concentrated ownership models found in Japan and Germany. It explains complex ownership structures like the Japanese keiretsu, cross-holdings, pyramids, and the risk of tunneling, where controlling shareholders expropriate value from minority investors. The chapter concludes by evaluating whether market-based systems better foster innovation in new industries while bank-based systems may offer stability for established sectors.