What is Agency Theory?
Agency theory posits that corporations act as agents of its shareholders. That is, shareholders invest in corporate ownership and thereby entrust their resources to the management of the directors and officers of the corporation, who serve as agents of the shareholders.
Agency Theory and the Best Interest of Shareholders
Agency Theory posits that corporations, as agents of shareholders, must take actions and pursue activities that promote the best interest of shareholders. This is generally interpreted as corporations must prioritize making decisions and take actions that increase shareholder wealth.
How Do Individual Interests Affect Agency Theory?
In larger corporations, there is often a sharp divergence between the short and long-term interest of officers and shareholders. This is primarily brought on by short-term demand for profits and the asymmetry of information that officers and directors possess compared with that of shareholders.
The divergence of interest between officer, director, and shareholder is thought to influence the actions and decisions of officers and directors who may become detached from shareholder interests. This is inconsistent with the role of an agent.
How Does Agency Theory Affect Corporate Governance?
Corporate governance rules seek to establish a legal framework similar to that of the agent-principal relationship. These rules seek to:
- align the incentives of officers and directors with those of shareholders
- establish norms and customs that prevent the adverse results of divergent corporate interests;
- affect the duties that officers or director owe to the corporation.
