Agency theory – General discussion of theory

Agency theory is based on the separation of the roles of owner and manager, or of possession and control (Kiel & Nicholson, 2003). This theory is based on the principa l- agent framework. The inference here is that experts are hired as managers to manage the corporation, and are expected to look after the interests of the owners (Kiel & Nicholson, 2003). With the separation of ownership and control, the expectation is that organisat io ns will be managed expertly, with the managers taking the place of the owners, and keeping the owners’ interest as their mission (Hawley & Williams, 1997). When individuals invest in organisations, their goal is to maximise their returns, and managers, as their agents, are expected to ensure that their returns are maximised (Hawley & Williams, 1997). But this is not assumed to follow naturally, since the assumption is made that agents, as individua ls, seek their own self-interest at the expense of owners’ interests (Jensen & Meckling, 1976; Abdullah & Valentine, 2009).

It is on this basis that the assumption is made that agents cannot be trusted to seek the maximisation of owners’ returns without having mechanisms in place to monitor the operations of the agents (Abdullah & Valentine, 2009). This concern is understandable, as

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owners, or shareholders, entrust agents to invest large amounts of capital on their behalf. Having good corporate governance is considered an important aspect of the shareholders - manager or owners-agent relationship, in order to ensure that the interests of shareholders or owners are given the expected attention (Adams, 2005).

Agency theory is therefore concerned with investigating the relationship between owners and their agents. This theory examines ways to ensure that agents are responsible for their actions in looking after the interests of owners (Abdullah & Valentine, 2009). It further prescribes certain governance structures to minimise the conflicts in the relationships, reduce risks and maximise the wealth of the owners (Adams, 2005; Abdullah & Valentine, 2009).

Corporate governance can therefore be seen as a means to address agency problems. The problems that arise from the principal-agent relationship pose systemic risks (Garmaise & Liu, 2005). However, there is debate concerning whether corporate governance should focus on shareholder rather than stakeholder interests. On the one hand, some believe that the principal-agent relationship should focus on the shareholder, while others believe that agency theory must be applicable to the relationship between management and all stakeholders in an organisation (Letza, Sun, & Kirkbride, 2004).

3.2.1.1Application of agency theory to CG and risk-taking

First, stakeholders that have a strong influence on the resources of the organisation would necessarily be shown to be more positively affected when there is good corporate governance in the organisation (Lai & Chen, 2014; Gamble & Kelly, 2001). Studies done using agency theory to measure the performance of organisations provide different results. While some studies of corporate governance using the agency lens show that well- governed organisations have a positive impact on the performance of organisations, others refute this, while others are neutral in their findings (Lai & Chen, 2014). But Lai and Chen point out that the likely reason for this discrepancy in finding could be because distinct io n

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is not being made with respect to the stakeholders that are being considered. Lai and Chen (2014) point out that there is a necessity to make distinction because of the differe nt influences that stakeholders have on the firm.

Second, as Lai and Chen (2014) point out, major stakeholders or shareholders have been seen as more likely to desire little risk and more growth and that stakeholder gains in the organisation tended to favour the major shareholders more with better returns than other stakeholders. As Gamble and Kelly (2001) point out, shareholders are seen as privile ged, since the company focuses on protecting the interests of shareholders. Having alliance partners as one of the stakeholders in an organisation leads to tough competition in the global environment. This competitiveness is seen as making the organisation more efficient, very different from firms that face competition as they develop their own know- how (Lai & Chen, 2014).

Third, in the context of corporate governance, with strong board independence, it can be argued that agency theory sees directors as looking after the interests of the main shareholders, and therefore taking fewer risks with the investments of primary stakeholders or shareholders (Sternberg, 1997). On the other hand, secondary stakeholders do not have the same assurances, and it is likely that they would face greater risks than alliance partners or major partners (Lai & Chen, 2014). The rationale for major shareholders having greater wealth and less risk stems from the fact that boards of directors are thought to have greater fiduciary obligations to major shareholders than to any other stakeholders (Lai & Chen, 2012).

Fourth, Garmaise and Liu point to the fact that managers of organisations, under agency theory, are prone to investment, even when there is an indication that conditions may not be ideal. Dishonest managers would expose the organisation to systemic risks by taking chances and investing when there are indications that it may not be the best decision. In

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these instances, dishonest or corrupt managers are generally looking out for their own self- interest.

Fifth, another risk to the agency theory comes from the stakeholder perspective, which sees risk as associated with the failure of corporate governance to take into consideration the interests of all stakeholders (Letza et al., 2004). The risks for other stakeholders would be greater if corporate governance did not insist on all stakeholders and not just shareholders.

Therefore, if corporate governance is well established, it is expected that there would be little risk-taking with agency theory, as boards and directors would be working to protect the interests of the shareholders, as they represent the principal with the managers as their agents.

3.2.1.2Application of agency theory to CG and credit ratings

First, it is expected that when agency theory is applied to corporate governance and credit rating, credit rating would be positive in the presence of strong governance. Would-be lenders are impressed with good corporate governance systems, as agency problems which arise between ownership and control, from conflicts of interest between controlli ng and non-controlling shareholders, and from self-interested managers, would be greatly reduced or eliminated.

Second, investors are also concerned with maximising their investments, and they choose companies with a good credit rating. A good credit rating is based to a great degree on the absence of risk, and, as noted above, where there is much conflict in the principal-a ge nt relationship, there is much systemic risk (Garmaise & Liu, 2005). It would follow that a company with a good corporate governance structure and with appropriate mechanisms for reducing this conflict, would also be a company that would have good credit rating. Governments, investors, banks, and brokers all use credit ratings to determine creditworthiness. The corporate governance structure of an organisation can therefore

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indicate to an investor whether a company would make a good investment choice (Ahmad, Rashmi, Bakshi, & Saha, 2009).

Third, it was noted that where there is good corporate governance and a separation of the roles of CEO and chair of the board, organisations are more likely to be viewed more positively, as the detrimental effect of this duality is removed. In many organisations, the removal of this duality brings about better corporate governance. It is expected that credit ratings are more positive than where there is better corporate governance (Elbannan, 2009; Jiraporn, Kim, Kim, Kitsabunnarat, 2012).

Fourth, credit ratings are said to affect the ability of an organisation to borrow and so organisations that have poor governance and that are highly leveraged would very likely have low credit rating. As Elbannan (2009) points out, organisations that have poor governance are more likely to have poor credit ratings. According to agency theory, if there is good corporate governance, then there is likely to be good credit ratings for the firm.

3.2.1.3Application of agency theory to CG and cost of capital

First, according to Jensen & Meckling (1976), agency costs that are associated with the separation of ownership and management involve the expenditures that the principal would incur to monitor the operation, the bonding expenditures that the agent would incur, and the residual loss that the principal would incur as a result of the agent not looking after the interests of the principal. In the context of an organisation with corporate governance mechanisms, including a strong board, the board is seen as the monitoring mechanism that helps to minimise the problems associated with the principal agency relationship between shareholders and managers (Letting et al., 2012). This is why the OECD Principles of Corporate Governance call for outside independent boards and propose the separation of the roles of board chair and CEO (OECD 2004).

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Second, in applying agency theory, Garmaise and Liu (2005) point out that agents or managers are more likely to engage in investments. When corporate governance is in the hands of managers, managers representing shareholders are more likely to invest heavily, sometimes even more heavily than the shareholders would have wanted. If managers are dishonest, they can use their knowledge of the situation to hide a weak signal, and in the process reduce shareholder wealth (Garmaise & Liu, 2005). Dishonest managers could demonstrate ineffective corporate governance and, through corrupt means, increase the firm’s exposure to systemic risk and reduced organisational capital.

Third, another way in which corporate governance in order to overcome agency problems could affect firm value is that it could lead to reduce expectation of return on equity, and this could lead to lower cost associated with monitoring of shareholders’ equity (Ammann et al., 2011). The lower costs could lead to high valuation of the firm, but the costs that are associated with implementing the stronger governance mechanisms could be greater than the benefits that accrue because of the benefits derived from the lower costs of capital (Ammann et al., 2011). In short, it is held that stronger corporate governance mechanis ms are associated with higher valuation of the firm and lower costs of capital, and so corporate governance should be seen as “an opportunity rather than an obligation and pure cost factor” (Ammann et al., 2011, p. 54).

Fourth, better governance is seen as associated with less agency conflict (Jiraporn, Kim, Kim, Kitsabunnarat, 2012), better performance, and better valuation, which is further associated with greater creditworthiness and so cost of capital is less (Elbannan, 2009).