This article explores “normative” agency cost theory. It does so by examining its most discussed prescriptions for making healthy corporations (empowered shareholders, monitoring boards, pay-for-performance, and the market for corporate control). Presenting very impressive evidence, the article concludes that the remedies prescribed don’t work either to minimize managerial self-dealing or increase returns to shareholders. Yet despite the evidence, these remedies are still being prescribed. Professor Tingle’s confrontation with that fact is a singular contribution. Until I read this article, I believed the response “agency cost theory is good, it just has been poorly implemented; the dosages just need adjusting.” Professor Tingle offers a different response, the incontestability of agency theory’s “seductive simplicity” (P. 60).
Tingle reveals that normative agency theory’s continuing power derives from it telling a tale of temptation and seduction that “seems uncontroversial” (P. 15). It provides an account of how self-interested and unrestrained agents would act if given the opportunity to cheat. Without evidence, it assumes that “managers are systematically disloyal” (P. 59). And this assumption is not testable. If corporations were run by monks, the successes of their corporations would confirm the theory, and if their corporations were unsuccessful, the monks would be revealed to be disloyal by how they were selected or by their ignorance (Pp. 10-11).
Tales of temptation and seduction are universal. But they do not need to become normative. Chastity belts and chaperones can sometimes reduce disloyalty. When couples’ interests are aligned, that too can sometimes reduce disloyalty. But these need not become best practices. In fact, there are other sources for loyalty and attention to them will better determine long-term success. And, presuming disloyalty may itself induce it. It is a question of fact for each relationship how to promote loyalty (in the face of many possibilities for disloyalty). That is why there are so many different tales of temptation and seduction in literature. In this sense, agency theory has a genre. However, the empirical evidence reveals that the drama of corporate life is much more particularized.
Saying that a theory has legs is to refer idiomatically to its strength. Agency theory has long legs in part because of its many carriers. Agency theory legitimated monitoring and bonding costs. Furnishing them became the task for corporate governance, employing many. There is a “governance industry” of fund managers, fund advisors, proxy advisors, corporate consultants, regulators and legislators (P. 16). This is not to suggest venality. After all, even “corporate managers themselves” diagnose governance deficiencies and have their corporations take the prescribed remedies (P. 58). Furthermore, in some cases, “the market believes the agency cost theory story, but the market is wrong,” as with the undervaluation of dual-class stock companies (P. 27) and the mispricing of acquisitions (P. 45).
The governance industry thrives because agency theory is simplistic in another sense. The “best practices” so prized in corporate governance are easily implemented, no idiosyncratic, insider knowledge is required (P. 7). Governance inputs neither calibrate markets, prescribe competitive strategy, nor otherwise contribute to the business plan.
In part because of the governance industry, good governance has become an end in itself. No one demands proof of its effectiveness. “Outside of some rhetorical flourishes” (P. 61), governance industries do not stake their rewards on demonstrating the competitive advantage of their remedies. Hence, they are not undone when remedies, such as “shareholder activism,” turn out to have no empirical correlation with “business improvement” (P. 23). Despite agency theory’s justifications for its prescribed remedies having been “contradicted by all available evidence” (P. 36), there has been “no impact on the behavior of institutional shareholders, regulators, proxy advisors, or governance experts” (P. 32). Not agency theory but its prescriptions are normative. We apply its remedies even though they neither reduce agency costs (by firing shirking CEO’s) nor increase shareholder returns. We desire pay-for-performance plans without any demonstration that they improve shareholder returns. We approve of increases in shareholder power not because we actually subscribe to the precepts of agency theory but because agency theory has flourished in a context in which shareholders are understood to be “owners.” The sociology of these normative beliefs includes agency theory but is not determined by it. As Tingle notes, “Increasing shareholder power” may be justified because it “will lead to better corporate outcomes” (P. 15, emphasis deleted). However, the normative thrust of agency theory is only to sanction “increasing power relative to managers” (P. 13), not to give shareholders leadership, let alone control. What is being worked out by the governance industry are norms that are not of proper control but of ownership.
One reason that agency theory survives is that it takes a theory to beat a theory. Agency cost theory displaced managerial theories about the benefits of agents, theories whose simplistic optimism no one misses. Agency theory’s simplifying foundational assumption of “unfaithful agents” (P. 55), on the other hand, commands attention. Agency theory is part of a general attack on bureaucracies, as Oliver Williamson demonstrated. Michael Jensen wrote that without pay-for-performance, corporate leaders are “like bureaucrats” (P. 40). When “bureaucrat” is a term of opprobrium, agency cost theories reign. For a counterweight to agency theory, most observers look to stakeholder theory, which does add the common weal to the criteria of being a faithful agent. But it makes no attempt to beat agency theory’s account of agent motivation. Professionalism once was an alternative theory, but is no longer on the active list. How can it be revived when expertise is understood as undemocratic and largely a means for opportunism?
Despite its simplicity, agency theory is praised for going beyond corporate law’s “black box” understanding of the firm (Pp. 5, 55). But it does not go very far. It does not add to the classic actors of corporate law: shareholders, boards, and a poorly defined group of officers and managers. It opens the black box only to make assumptions about the actors’ motivations, tracing complications arising therefrom.
Agency theory, to the extent that it is “the most important theory in corporate law,” also distorts our responses to the evidence., including the evidence about its failed predictions. Consider its recommendations for independent directors. First, the evidence demonstrates that the rise of independent directors has increased agency costs, at least as judged by executive compensation. Second, the evidence demonstrates inside directors can be cost-beneficial: While they impose costs when monitoring themselves as board members, they often bring benefits, especially in complex or innovating environments. It follows that the prescribed best practice doesn’t work. Yet this result is not taken to contradict the theory. It only adds a caveat that requires better dosing. The theory, as Tingle emphasizes, renders these facts as “idiosyncrasies.” They do not perturb agency theory’s remedy of getting the proper mix of independent and inside directors.
Actually, the research Tingle reviews demonstrates that agency theory asks the wrong question and that “knowledge” is the important mediating variable. “Independent” and “inside” are weak surrogates for knowledge. If we were not limited by agency theory, we might look beyond board composition to better respond to the knowledge problem. For example, we might increase reporting lines to the board, such as the Chief Compliance Officer enjoys. Or we might engage workers, even creating a new monitoring board. Or, we could establish a powerful “Secretary to the Board” to loosen executives’ controls on what the board knows. Agency cost theory limits inquiry into the improvement of board governance. But it is strengthened by confining itself to the box already known to corporate law.
As Tingle puts it, agency cost theory creates “the invisibility of countervailing considerations” (P. 9). It misdirects by creating a search for a “Holy Grail,” “a technique” that perfectly aligns the interests of managers and shareholders (P. 10). And, it seduces us with a tale of undisciplined temptation. Fortunately, as Tingle concludes, “corporate actors’ attention and anxiety” are not on the temptations ascribed to them by agency theory, but “are focused on the firm’s competitive activities” (P. 61). They are not seduced by agency cost theory, despite their positive responses to the governance industry. Why should we be?
