Managerial Agency Costs Research Articles

Addressing Agency Costs Through Private Litigation in the U.S: Tensions, Disappointments, and Substitutes

Corporate legal scholarship largely focuses on addressing managerial agency costs. As part of this paradigm, legal scholars examine how effectively representative litigation, whether class actions or derivative suits, control managerial agency costs. While most corporate law academics believe that there are benefits created by these suits, they are qualified by the litigation agency costs that surround them. In recent years, concerns about litigation agency costs has resulted in many legislative and judicial actions that restrict shareholder litigation.In this article, we claim that recent corporate governance developments are a natural consequence of both the ineffectiveness and inefficiency of shareholder suits to address certain genres of managerial agency costs. As representative shareholder litigation has been constrained by numerous legal developments, our corporate governance system has developed new mechanisms as alternative means to address managerial agency costs. We further argue that these new governance responses are themselves becoming stronger because, in part, of the rising concentration of share ownership of public companies.Activist hedge funds are among the most obvious manifestation of developments that have changed ownership of American public companies and reduced managerial agency costs. Private equity firms assist them in their efforts and act as strong managerial monitors as well by introducing strong risk management systems among other things.But other forces are at work as well. For example, the passage of the Dodd-Frank Act further armed investors, both large and small, by mandating a non-binding Say on Pay vote. This new vote on executives' pay fills a corporate governance hole created by the failure of derivative suits to regulate compensation as say-on-pay resolutions enable shareholders, especially small institutional shareholders, to engage in direct monitoring of executive compensation.We next consider the rising role of the remedy that is moving to fill a monitoring gap created by the decline in the efficacy of shareholder litigation focused on acquisitions. As we will show, the proceeding, an old and previously largely defunct form of litigation, has been resuscitated by a few hedge fund investment groups, who have begun filing these actions in an effort to engage in what some have called appraisal arbitrage. They target underpriced acquisition transactions to recover substantial value which pressures bidders to improve prices.Finally, we conclude by examining how managerial oversight failures may be addressed using securities fraud class actions after the Supreme Court's most recent antifraud decision in Omnicare Inc. v. Laborer’s Dist. Council Const. Indus. Pension Fund. This monitoring gap is also targeted by private equity firms and their superior risk management techniques and superior board structures for portfolio companies.

Virtual Privatization: Governance Reforms for Government-Owned Firms

This article explores three different kinds of reforms that could be used to help governmental corporations achieve some of the benefits of privatized, market-based governance without giving up governmental control. The first, and simplest, proposal is to use an annual contract between GOC managers and their ministerial shareholders to reduce managerial agency costs. In addition to providing a benchmark for managerial performance, the contract also could be used to segment the GOC's different goals in order to minimize the downside effects of having multiple principals (with multiple objectives) monitoring the manager-agents. Second, I suggest that requiring at least some GOC's to issue subordinated debt would create a class of private investors who could provide additional monitoring as well as market signals about the prospects of the firm. Finally, I focus on various boundary problems with GOC's, as compared to private firms. I argue that GOC's should be required to set up separate subsidiaries when they expand into new product areas. Requiring the GOC to set up a separate subsidiary would make it much easier to police inappropriate cross subsidization.

Principal Costs and Governance Structures in the Theory of the Firm

The dominant paradigm in corporate law is agency-cost theory, which asserts that the law’s proper role is to reduce managerial agency costs by forcing firms to allocate more control to shareholders. That theory cannot explain why shareholders voluntarily invest in firms that circumscribe their powers to hold managers accountable. This Article introduces principal-cost theory, which states that each firm’s optimal governance structure minimizes the sum of principal costs, produced when investors exercise control, and agent costs, produced when managers exercise control. Because the optimal division of control is firm-specific, firms rationally select from a range of governance structures that empower shareholders to varying degrees. Principal-cost theory generates more accurate empirical predictions than agency-cost theory. It also suggests different policy prescriptions: rather than banning some governance features and mandating others, lawmakers should permit each firm to tailor its structure based on its firm-specific substitution rate between principal costs and agent costs.

Managerial Agency Costs of Socialistic Internal Capital Markets: Empirical Evidence from China

AbstractThis study provides empirical evidence of managerial agency costs in socialistic internal capital markets. Listed Chinese companies are required to disclose the amount of resources that are reallocated to other firms of the parent company, which provides us with a direct measure of the socialistic subsidization of weak member firms by strong member firms within a business group. We hypothesize that in strong member firms, managerial compensation is less sensitive to firm performance because cross‐subsidization makes it difficult for group CEOs to hold the managers in strong firms accountable for their own firms' performance, and also increases the noise in performance measures. We also hypothesize that socialistic cross‐subsidization results in an increase in managerial agency costs of strong member firms due to the low pay‐performance sensitivity and low incentive to work hard. We document empirical results that are consistent with these two predictions.

Management Insights

Management Insights

Corporate Politics, Governance, and Value Before and After Citizens United

This paper explores corporate politics, governance and value in the S&P 500 before and after Citizens United. In regulated and government-dependent industries (e.g., banking, telecommunications), political activity is nearly universal, and uncorrelated with measures of shareholder power, managerial agency costs, or value. But 11% of CEOs in 2000 who retired by 2011 obtained political positions after retiring, and in a majority of industries (e.g., apparel, retail), political activity is common but varied, and correlates negatively with measures of shareholder power (concentration, rights), positively with signs of managerial agency costs (corporate jet use by CEOs), and negatively with shareholder value (industry-relative Tobin’s q). The negative politics-value relationship is stronger in firms making large capital expenditures, suggesting that politics may lead firms to pursue value-destroying projects, and the relationship is also stronger in regressions with firm and time fixed effects, which rule out many potential omitted variables. After the exogenous shock of Citizens United, corporate lobbying and PAC activity jumped, in both frequency and amount, and firms that were politically active in 2008 had lower value in 2010 than other firms, consistent with politics at least partly causing and not merely correlating with lower value. Overall, the results are inconsistent with politics generally serving shareholder interests, and support proposals to require disclosure of political activity to shareholders.

Capital Structure Theory and Retention Policy

To explain the low-leverage puzzle, we propose a flexibility-adjusted trade-off model by integrating the motive of keeping financial slack into traditional tax/distress model when capital structure and dividend-retention decision are jointly determined. Our model shows that firms that efficiently utilize retention for reinvestments tend to have lower leverage and pay fewer dividends so as to conserve more cash flow as internal funds, whereas inefficient firms tend to have high dividends and high leverage. Besides, this model also suggests that an appropriate retention policy can help reduce bankruptcy probability and costs. Conforming to financial flexibility hypotheses, the bankruptcy costs of efficient firms negatively relate to retained internal capital; consistent with free cash flow hypothesis, bankruptcy costs of inefficient firms positively relate to retention. Finally, we show that more profitable firms manage to reduce managerial agency costs through issuing debt, whereas firms with higher liquidation costs do that through paying more dividends.

Clustering, Agency Costs and Operating Efficiency: Evidence from Nursing Home Chains

Models of horizontal integration typically describe a tradeoff between multi-unit efficiencies and managerial agency costs. In extreme cases where managers cannot be incented contractually private ownership is thought to be the primary organizational substitute. In this paper we explore geographic clustering as an alternative strategy for controlling managerial agency costs within the chain form of organization. Clustering may facilitate scale efficiencies in both monitoring and supervision, resulting in reduced agency costs and improved application of the chain’s business model. We test this hypothesis in the nursing home industry, which is characterized by managerial contract costs resulting from multi-task models of production. We find that clustered nursing homes achieve higher quality, conditional on labor inputs and patient characteristics. The clustering effect is concentrated on reductions in minor/potential harm violations, which are difficult to observe without close monitoring. Several proxies for local organizational experience (“local learning”) cannot account for our findings, which are robust to a variety of alternative clustering definitions and competing explanations based on gaming behavior. Further tests indicate that chains endogenously pursue clustering, presumably to realize the benefits of improved quality outcomes.

Clustering, Agency Costs and Operating Efficiency: Evidence from Nursing Home Chains

Models of horizontal integration typically describe a trade-off between multiunit efficiencies and managerial agency costs. In extreme cases where managers cannot be incented contractually, private ownership is thought to be the primary organizational substitute. In this paper we explore geographic clustering as an alternative strategy for controlling managerial agency costs within the chain form of organization. Clustering may facilitate scale efficiencies in both monitoring and supervision, resulting in reduced agency costs and improved application of the chain's business model. We test this hypothesis in the nursing home industry, which is characterized by managerial contract costs resulting from multitask models of production. We find that clustered nursing homes achieve higher quality, conditional on labor inputs and patient characteristics. The clustering effect is concentrated on reductions in minor/potential harm violations, which are difficult to observe without close monitoring. Several proxies for local organizational experience (“local learning”) cannot account for our findings, which are robust to a variety of alternative clustering definitions and competing explanations based on gaming behavior. Further tests indicate that chains endogenously pursue clustering, presumably to realize the benefits of improved quality outcomes. This paper was accepted by Bruno Cassiman, business strategy.

Shareholder Committees in the United States and Switzerland: Blind Alley or Vital Branch in the Evolution of Corporate Governance?

Three Swiss corporate governance scholars have suggested recently that public corporations establish shareholder committees, which would have certain oversight functions and act as a communication link between shareholders and management. To assess the merits of this proposal, I review the history of shareholder committees in the United States, outline the spectrum of possibilities in designing shareholder committees, and evaluate their benefits and costs. Shareholder committees are not going to mitigate the collective action problem of shareholders, and they are unlikely to reduce managerial agency costs to a notable extent. Moreover, their potential for savings in information and communication costs is small. The costs of shareholder committees - transaction costs and additional agency costs - are unlikely to be substantial, but they might offset the limited benefits that a shareholder committee offers. Overall, I doubt whether it is in the best interest of public companies to have a shareholder committee. Nevertheless, given that shareholders will both bear the costs and reap the benefits of a shareholder committee, it should be up to them to decide whether to adopt one or not. Accordingly, the Swiss legislature should lift the restrictions that corporate law currently places on the establishment of shareholder committees. The paper is available in full text on [http://ssrn.com/abstract=1850566 SSRN]

A Resource Based Interpretation of Performance Enhancing Capital Structure Changes: The O.M. Scott LBO Revisited

The O.M. Scott case study published in 1989 in the Journal of Financial Economics has come to be a classic in illustrating the plausibility of some fundamental concepts that underpin mainstream models of the efficiency attributes of capital structure in modern corporate finance. In these models, high leverage traditionally appears as a strong incentive to refrain from sub-optimal investment behavior by self-interested managers. Thus reducing managerial agency cost has been considered as an essential driver of enhanced value in much of financial modeling. In the present paper, we attempt a somewhat different, albeit complementary, mainly resource based interpretation of the very rich empirical material contained in Baker and Wruck (1989). In fact, a close reading of the case suggests that the observed significant increase in operating performance post-LBO was to a great extent the consequence of the yet unexplored cognitive changes implied by switching dominant shareholders. Namely, we find that value at O.M. Scott was essentially increased by (1) a significant reduction in what may be termed cognitive agency costs while (2) the new dominant shareholder contributed substantial cognitive value by stimulating and advising a dynamic learning process leading to enforced managerial capabilities, especially with respect to more effective routines of cash management.

On the Optimal Allocation of Power between Shareholders and Managers

This paper formally investigates the optimal allocation of power for shareholders recognizing that they may be heterogeneous, and that agency problems exist with managers. In the model I treat shareholders as economic actors who choose decision rules (or the degree of shareholder power) under a veil of ignorance with the goal of maximizing their utility. Managers choose their consumption of private benefits based on the power allocation chosen by shareholders. I demonstrate that heterogeneous shareholders face a trade-off in deciding on the allocation of shareholder power. In the event they are in favor of an investment, shareholders would like to minimize their ability to veto a project. In the event they are against an investment, shareholders would like to maximize their veto power. The optimal voting rule balances these two considerations. Unhappy shareholders who can easily sell their shares do not face this trade-off, in which case they will grant more power to managers. I also demonstrate that in all circumstances shareholders will allocate more power to themselves as a way of controlling managerial agency costs.

The Use and Abuse of Investor Suits – An Inquiry into the Dark Side of Shareholder Activism –

This paper builds on the wide-ranging policy discussion on shareholder activism in Europe. It seeks to define which shareholder actions are useful in reducing managerial agency costs and which could be interpreted as frivolous or abusive. We develop a typology, comprising of a number of Abuse Indicators which may assist courts, investors and management in identifying suits that create unjustified and opportunistic shareholder litigation costs. Investors' actions could be considered as abusive more often than not, if the actions are 1) filed by low-tier law firms that 2) represent professional and recurrent plaintiffs; 3) which hold a small rather than significant stake in the company's stock; 4) the complaints on which the suits rely are of a boiler-plate / carbon copy / formalistic nature; 5) the key motivation of the suits are expected side benefits rather than the desire to enhance the value of the issue in which the plaintiff invested; and 6) the suits are lacking institutional backing by shareholder associations or government agencies. Drawing on two unique datasets, which involve cases respectively in the Dutch Inquiry Proceeding (‘Enquêterecht’) and the Rescission Suit in Germany (‘Anfechtungs- und Nichtigkeitsklage’), we hold that Dutch Inquiry Proceedings initiated in the years 2002 through 2008, which often results in a court-induced settlement, involved mostly ‘useful’ shareholder interventions to reduce managerial agency costs whereas the bulk of the German Rescission Suits filed between October 2005 and January 2009 – prior to the reform of the law on rescission suits that has come into force in Fall 2009 – were abusive.

Entrepreneurial Financing and Costly Due Diligence

AbstractIn the traditional solution to the adverse selection problem, entrepreneurs indirectly signal quality via security choice, typically debt. This paper models an alternative solution. The costly due diligence of venture capitalists directly reveals the quality of projects, thereby reducing information asymmetry. It is shown that this mechanism necessitates profit‐sharing, a contractual feature usually associated in the literature with managerial agency costs rather than adverse selection.

Legal Institutions, Board Diligence, and Top Executive Pay

ABSTRACTManuscript Type: EmpiricalResearch Question/Issue: We examine whether anti‐director laws and legal director liability rules affect the diligence of directors in setting the compensation of CEOs. The study uses a world‐wide data set covering 27 countries for the period 1995 to 2005.Research Findings/Results: Controlling for a number of legal and economic determinants, we find that independent of managerial risk‐aversion, CEO pay is always less generous under stricter anti‐director rules and a stronger rule of law. Director liability rules are associated with more generous pay schemes. The results persist once we control for the presence of institutional investors and cross‐listing in the US.Theoretical Implications: Our results suggest that there exists an agency conflict between shareholders and outside directors reflected in the degree to which directors act diligently when negotiating the pay contract with the CEO. However, this conflict may be alleviated by specific legal rules making boards more accountable to shareholders. Private measures of shareholder protection do not seem entirely capable of substituting for legal institutions.Practical Implications: Reducing managerial agency cost is commonly viewed as a desirable policy goal. We advocate the view that specific legal institutions that strengthen procedural rights of shareholders' voting on directors and the overall quality of the legal system help to achieve this goal. Director liability rules, however, appear to be ineffective for this purpose.

Investor protection and convertible debt design

An important issue that firms consider when designing convertible debt is to specify security features such as conversion ratio, maturity date and call period. Following Lewis et al. [Lewis, M., Rogalski, R., Seward, J., 2003. Industry conditions, growth opportunities and market reactions to convertible debt financing decisions. Journal of Banking and Finance 27, 153–181], we employ a single measure that simultaneously considers all of these features: the expected probability (measured at issue date) that the convertible will be converted to equity at maturity. We find that firms in countries with stronger shareholder rights issue convertible debt with a higher expected probability of converting to equity. The positive association between the expected probability of conversion and shareholder rights is less pronounced in firms for which ownership structures create potentially high managerial agency costs. Specifically, in countries with stronger shareholder rights, firms with higher separation of control rights and cash flow rights tend to issue convertibles with lower probability of conversion. Furthermore, we find that large non-management block ownership strengthens the likelihood of issuing convertible debt with higher probability of conversion in countries with stronger shareholder rights. In contrast, firms in countries with stronger creditor rights issue convertibles with lower probability of conversion. We also document that the negative association between creditor rights and probability of conversion is more pronounced in firms with higher separation of control rights and cash flow rights.

Managerial Behavior, Risk Attitude, and Shareholders' Welfare

This paper studies the effects of risk aversion attitudes on shareholders' welfare and agency costs with the stochastic optimal control model. The results show that there exists a complex non-linear relationship between agency costs and risk aversion attitudes under the context of management on-job consumption. And then we discuss some special case in which the managerial behavior and risk aversion how influence the welfare of shareholders. In the fist case we discuss the managerial behavior under exogenous stochastic shock, and we find that agency cost become observable and no verifiable. Under this condition, management on-job consumption level has a quasi-linear relationship with risk aversion attitude. The finding means that managers could manipulate information through unconventional information disclosure and exaggerate the probability of abrupt events, hence leading to investors' panic and herding behavior. The second case we discuss the risk attitude how influence the agency cost, we find an interesting phenomenon that there exists a non-linear relationship between agency costs and risk aversion attitudes, Agency costs rise as management on-job consumption increases, while shareholders' risk aversion attitudes can be hardly deduced through observation of agency costs. Put it another way, given management abuses shareholders' welfare for its on-job consumption, same agency costs may mean different risk aversion attitudes. Excluding the assets scale from consideration, the results demonstrate that different risk aversion attitudes may mean identical agency costs. At last, we discuss the managerial behavior and agency cost under different culture background and transitional economies.

Legal Institutions, Board Diligence, and Top Executive Pay

Reducing managerial agency cost is commonly viewed as a desirable policy goal. We advocate the view that specific legal institutions that strengthen procedural rights of shareholders' voting on directors and the overall quality of the legal system help to achieve this goal. Director liability rules, however, appear to be ineffective for this purpose.Our results suggest that there exists an agency conflict between shareholders and outside directors reflected in the degree to which directors act diligently when negotiating the pay contract with the CEO. However, this conflict may be alleviated by specific legal rules making boards more accountable to shareholders. Private measures of shareholder protection do not seem entirely capable of substituting for legal institutions. Controlling for a number of legal and economic determinants, we find that independent of managerial risk-aversion, CEO pay is always less generous under stricter anti-director rules and a stronger rule of law. Director liability rules are associated with more generous pay schemes. The results persist once we control for the presence of institutional investors and cross-listing in the US. We examine whether anti-director laws and legal director liability rules affect the diligence of directors in setting the compensation of CEOs. The study uses a world-wide data set covering 27 countries for the period 1995 to 2005.

Uncorporating the Large Firm

This article examines private equity firms as an example of partnership-type, or uncorporate, structures in the governance of large firms. Other examples include publicly traded partnerships, real estate investment trusts, hedge funds and venture capital funds. These firms can be seen as an alternative to the corporate form in dealing with the central problem of aligning managers' and owners' interests. In the standard corporate form, shareholders monitor powerful managers by voting on directors and corporate transactions, suing for breach of fiduciary duty and selling control. These mechanisms deal with managerial agency costs by relying on other agents, including auditors, class action lawyers, judges, independent directors and shareholder intermediaries such as mutual and pension funds. Uncorporations substitute other devices for corporate-type monitoring, including more closely tying managers' economic well-being to the firm's fortunes and greater assurance of distributions to owners. Continued concerns with managerial agency costs, the inadequacy of regulatory responses such as the Sarbanes-Oxley Act, changing costs and benefits of public ownership, leverage and capital lock-in all contribute to the rise of uncorporate structures in large firms. Political considerations may, however, constrain these developments.

Debt financing, soft budget constraints, and government ownership Evidence from China1

AbstractDebt financing is expected to improve the quality of corporate governance, but we find, using a large sample of public listed companies (PLCs) from China, that an increase in bank loans increases the size of managerial perks and free cash flows and decreases corporate efficiency. We find that bank lending facilitates managerial exploitation of corporate wealth in government‐controlled firms, but constrains managerial agency costs in firms controlled by private owners. We argue that the failure of corporate governance may derive from the shared government ownership of lenders and borrowers, which nurtures soft budget constraints.