Agency Theory Essay 3

29591 Words119 Pages
The Fundamental Agency Problem and Its Mitigation:
Independence, Equity, and the Market for Corporate Control

Kelley School of Business, Indiana University

Mays College of Business, Texas A&M University

Mays College of Business, Texas A&M University

Kelley School of Business, Indiana University


A central tenet of agency theory is that there is potential for mischief when the interests of owners and managers diverge. In those circumstances, and for a variety of reasons, managers may be able to exact higher rents than are reasonable or than the owners of the firm would otherwise accord them. While that foundational element of agency theory is
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The Fundamental Agency Problem and Its Mitigation • 3 Early on, three principal approaches were developed to minimize the agency problem. One, the "independence" approach, suggested that boards of directors, comprised to be independent of management, can monitor managers and assure that their interests do not diverge substantially from those of owners (Fama, 1980; Fama & Jensen, 1983a, 1983b; Jensen & Meckling, 1976; Mizruchi, 1983; see also Chandler, 1977). Another method, the "equity" approach, proposed that managers with equity in the firm were more likely to embrace the interests of other equity holders and, accordingly, to direct the firm in their joint interests (Fama & Jensen, 1983b; Jensen & Meckling, 1976). Lastly, there was the notion of the "market for corporate control," which set forth the principle that corporate markets may operate to discipline managers who inappropriately leverage their agency advantage. In such cases, self-serving executives may subject the firm to acquisition by other firms (Fama & Jensen, 1983a; Jensen & Ruback, 1983; Manne, 1965). While these three corporate governance approaches are rational in principle, the efficacy of these approaches in practice remains subject to debate. Accordingly, in subsequent sections of this manuscript, we provide a multidisciplinary overview of agency theory with an emphasis on the three mechanisms through which the fundamental agency
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