Agency Theory Essay 3

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

DAN R. DALTON
Kelley School of Business, Indiana University

MICHAELA. HITT
Mays College of Business, Texas A&M University

S. TREVIS CERTO
Mays College of Business, Texas A&M University

CATHERINE M. DALTON
Kelley School of Business, Indiana University

Abstract

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 secure, other elements derived directly from agency theory are far less settled. Indeed, even after some 75 years of conceptualization and empirical research, the three principal approaches that have long been proposed to mitigate the fundamental agency problem remain contentious. Accordingly, we provide a review of the fundamental agency problem and its mitigation through independence, equity, and the market for corporate control. 1

2 • The Academy of Management Annals Introduction Agency theory is secure among the pantheon of conceptual/theoretical foundations that inform research in corporate governance. Indeed, agency theory not only predates other influential theories, including resource dependence (e.g., Pfeffer & Salancik, 1978; Selznick, 1949; Thompson & McEwen, 1958; Zald, 1969), the resource-based view (e.g., Barney, 1991; Barney, Wright, & Ketchen, 2001; Wernerfelt, 1984), and institutional theory (e.g., DiMaggio & Powell, 1983; Meyer & Rowan, 1977; Oliver, 1991; Rogers, 2003; Scott, 1995), but remains the dominant perspective on which governance research relies.' A variety of comments may underscore that view. Bratton (2001; see also Bratton, 1989) described Berle and Means' impact on legal scholarship "as a paradigm that dominated the field" and their book. The Modern Corporation and Private Property, as "a singular event in the last century of academic corporate law" (p. 739). Shapiro suggested that agency theory represents a "new Zeitgeist" and "the dominant institutional logic of corporate governance" (Shapiro, 2005, p. 279). Gilson (1996) observed that "the intellectual mission of American corporate governance took the form of a search for the organizational Holy Grail, a technique that bridged the separation of ownership and control by aligning the interests of shareholders and managers" (p. 331). Roe (2005; see also Mizruchi, 2004; Roe, 1994), too, shared a similar perspective that "the core fissure in American corporate governance is the separation of ownership from control" and that "separation is the foundational instability of American corporate governance" (p. 9). Perhaps it is Davis (2005) who provided the most succinct summary of the role of agency theory: "This solution to managerialism became perhaps the dominant theory of the public corporation" (p. 145). The pivotal notion that focuses this manuscript is the central tenet of agency theory: that there is potential for mischief when the interests of owners and those of managers diverge. In those circumstances, and for a variety of reasons, managers may be able to exact higher rents than would otherwise be accorded them by owners of the firm. While we are confident that this foundation of agency theory is unavoidable and intractable, other elements derived directly from agency theory are far less settled. Indeed, even after some 75 years of conceptualization and empirical research, the three fundamental means of mitigating the agency problem (e.g., independence, equity, and the market for corporate control) remain contentious. The voluminous research on agency theory was propelled largely by the major challenge of how to solve the fundamental agency problem. How can an organization, through its owners and its...
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