CORPORATE GOVERNANCE AND THE POLITICS OF AGENCY THEORY

1

CORPORATE GOVERNANCE

AND THE POLITICS OF AGENCY THEORY

by 1

Jordan Otten

[email protected]

&

Ben Wempe

[email protected]

RSM Erasmus University

Department of Business – Society Management

P.O. Box 1738

3000 DR Rotterdam

The Netherlands

Fax: +31 10 4089012

1 Both authors have contributed equally to the manuscript. The names are in alphabetical order.

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CORPORATE GOVERNANCE

AND THE POLITICS OF AGENCY THEORY

ABSTRACT. This paper applies Wolin’s sublimation thesis to the field of corporate

governance. Applying this thesis helps to explain how the dominant use of agency theory

and its predisposition with shareholder interests has gained both descriptive and

prescriptive powers in pointing out corporate governance problems and proposed

solutions to these problems. Although the focus of such a single approach has greatly

contributed to our understanding, it carries however some clear normative implications,

which are not always fully appreciated by present-day scholars of corporate governance.

We argue that the dominant use of this single theory has the downside effect of

hampering new theory developments and has considerable normative implications for our

contemporary understandings of corporate governance in both theory and practice.

KEYWORDS: agency theory, corporate governance, executive pay, neo-classical

economics, philosophy of science, shareholders, sublimation of politics, stakeholders

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Introduction

The American political theorist Sheldon Wolin is chiefly known for his monumental

study Politics and Vision (Wolin, 1960). Wolin taught at the University of California,

Berkeley, from 1954-1970 and at Princeton University from 1973-1987. Entire

generations of students around the world used this authoritative textbook, which

chronicles the history of political theory from the ancient Greeks via the church fathers,

Luther, Calvin, Machiavelli, Hobbes and Locke to the rise of Liberalism in the Modern

Age. In 2004 Wolin issued a second, expanded edition of his opus magnum, which added

seven substantive chapters dealing with his interpretation of nineteenth and twentieth

century thinkers such as Dewey, Marx, Nietzsche, Popper and Rawls.

From the point of view of organization studies arguably the most important part of

Wolin’s work is the concluding chapter in the first edition (chapter ten) dealing with ‘The

Age of Organization and the Sublimation of Politics’. In broad outline, Wolin argues here

that up until the modern age, the notion of politics was self-evidently related to the

concern for the common good of a community. For that reason political theory took on a

natural priority over all other issues and concerns. With the rise of organizations and the

conceptualization of ‘society’ as a separate sphere alongside the more traditional notion

of political community, concern for the common good lost the natural claim to primacy

that was attached to it by classical theories of politics.

This forms the immediate context of Wolin’s sublimation thesis, which claims that in

the modern age the state is no longer the unique and natural referent of political

argumentation. This function is increasingly taken over by institutions and smaller

community relations obscuring the idea of a comprehensive and self-evident common

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good. Therefore, the characteristic feature of modern public affairs is the ‘diffusion of the

political’, ‘the absorption of the political into non-political institutions and activities’:

‘One of the oddities of the times is that while there has been a noticeable decline in

political interest in non-totalitarian societies, social scientists have been busy

discovering political elements outside the traditional political structures. No longer

do legislatures, prime ministers, courts and political parties occupy the spotlight of

attention in the way they did fifty years ago. Now it is the “politics” of corporations,

trade unions, and even universities that is being scrutinized. This preoccupation

suggests that the political has been transferred to another plane, to one that formerly

was designated “private” but which now is believed to have overshadowed the old

political system’ (Wolin, 1960, p. 353).

A chief characteristic of the modern age was ‘the appearance of the masses on the

political stage’ rendering necessary new forms of organization of public life. Wolin

therefore analyzed modern political thought over the past 200 years as an attempt to

reconcile the requirements of organization and community. Given this need for

organization, the crucial problem for the modern age becomes how to create sufficient

space for community.

Accompanying the invention of ‘society’ and the more restricted forms of human

collaboration known as ‘organizations’ was the rise of a specialized branch of ‘social

sciences’ alongside the natural sciences. The great German sociologist Max Weber was

the first to perceive that the methodology of these new social sciences took on the

function that was traditionally reserved for political theory. To Weber, methodology was

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‘a type of political theory transferred to the only plane of action available to the

theorist at a time when science, bureaucracy, and capitalism had clamped the world

with the tightening grid of rationality’ (Wolin, 1981, p. 406).

Wolin thus credits Weber with the idea of a ‘politics of theory’. Although this idea

appeared implicitly throughout his work, it is explicitly addressed only in his essay on the

methodology of the social sciences (Wolin, 1981). Wolin draws a parallel between

‘founding in politics’ and ‘founding in science’. In the same ways as the foundations of

any existing political community is laid down by some legislator or leader, new theories

and new sciences build on the foundational work of some scientific hero. Weber clearly

acted as such a scientific founder, when he bequeathed us the hermeneutic tradition in

sociology. In his 1981 article Wolin reconstructs in some detail how this new science

acquired its legitimacy. He sets out that, once the initial, legitimacy-bestowing phase is

over, disciples continue the example set by the founder on the basis of a set of

methodological prescriptions specifying the authorized procedure to conduct scientific

inquiry.

The idea of a ‘politics of theory’ will serve in this paper to make clear that the

seemingly neutral introduction of new theories always commits us to more than theorists

want us to believe. For, as a rule, new theories cannot be laid down in the manner in

which one plants a flag on an inhabited island. In order to found a new science or theory

the newcomers need to expel (at least some) of the native inhabitants to render the theory

or science legitimate. Successful authors often succeed in presenting this colonial

conquest as something trivial. Only once a new theory has acquired sufficient legitimacy,

it can turn to the order of the day. From that moment on the emphasis lies on following

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the rules and conventions of the new paradigm by means of some methodological

prescription to order scientific activity.

In this paper we apply Wolin’s sublimation thesis and his ideas about the politics of

theory to point out the descriptive and prescriptive powers of agency theory (Jensen and

Meckling, 1976) and the manner in which this has shaped contemporary thinking about

corporate governance problems and problem resolutions. We apply Wolin’s ideas to

corporate governance because this field of study is clearly dominated by the use of this

single theoretical approach. The ‘agency logic’ (Zajac and Westphal, 2004) or ‘agency

paradigm’ (Bebchuk and Fried, 2004) most often serves as a foundation for new or

extending theory developments in the field and is commonly used as a blue print for

empirical studies.

The paper is structured as follows. First, we set out a brief description of agency

theory as it is typically used in current corporate governance research. Second, we set out

some of the current debates about its interpretation and applications and we apply

Wolin’s idea of a politics of theory to these discussions. Third and finally, we conclude

the paper arguing that the descriptive and prescriptive powers of this single dominant

theory have some clear normative implications, intended as well as unintended. It can for

instance hamper new theory developments; it can stretch the fundamental theoretical

assumptions beyond a reasonable depiction of the subject of study; and it can severely

constrain policy makers in developing new courses of action.

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Agency theory and the study of corporate governance

As Eisenhardt (1989) has reminded us, even the most basic question ‘what is agency

theory?’ is subject of controversy. Authors such as Kiser (1999) and Shapiro (2005) have

inventoried varieties of theories of agency in the fields of economics, management, law,

political science and sociology. Shapiro (2005) even concludes that the differences

between these approaches are so significant that she opposes the very idea of coupling

‘agency’ and ‘theory’. Be this as it may, we shall nevertheless seek to point out that there

is a common core to different disciplinary varieties of the theory of agency. For all these

theories start from the condition that one party ‘acts on behalf of another’ (Shapiro,

2005). As most of the disciplinary approaches regard this situation as problematic, there

is a recurrent theme of finding solutions or alleviations to ‘the agency problem’ in the

corporate governance literature. In the field of sociology, however, this situation is not

necessarily regarded as a problem, but it may as well serve as a likely solution to social

interactions and relationships (Kisser, 1999; Shapiro, 2005); in this framing, ‘agency is in

fact …. a neat kind of social plumbing’ (White, 1985, p. 188).

On the other hand, the economic variety of agency theory, which is dominant in the

corporate governance literature, typically regards delegation of activities as a problem. It

is centered on the agency problem between corporate shareholders and corporate

management.

This view proceeds from the lens of neoclassical economics, a perspective which can

be described as ‘an approach which (1) assumes rational, maximizing behavior by agents

with given and stable preference functions, (2) focuses on attained, or movements

toward, equilibrium states, and (3) excludes chronic information problems’ (Hodgson,

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1998, p. 169). This lens has led researchers to focus on transactions and contracts, which

are embedded in price and market mechanisms (cf. Augier, Kreiner and March, 2000;

Coase, 1988; Kay, 2000; Simon, 1991). The thrust and characteristic use of economic

agency theory is to analyze certain aspects of the relationship between collaborative

individuals. Human collaboration (as in the production of goods and services, for

example) potentially generates a cooperative surplus. If two or more people work

together, they can produce more than any individual on her own. This cooperative surplus

has three conditions for human cooperation to add value: 1) each individual must focus

on a specialized task; 2) various specializations need to be coordinated; and 3) parties

must agree on a standard for a fair distribution of the cooperative surplus. To fulfill the

conditions of coordination and distribution individuals can contract with one another.

Agency theory deals with a special case of such contracts, i.e. the situation in which one

of the parties delegates responsibilities to another, while the former lacks full information

about the efforts of the latter party, and the former’s wealth is dependent on the

performance of the latter’s efforts.

In its economic variety, agency theory makes assumptions about people (e.g., self-

interest, risk preferences), about organizations (e.g., goal conflict among members,

information asymmetry; corporate objective function), and about information (e.g.,

information is a commodity which can be purchased). Given those assumptions, it then

asks which type of contract is most efficient, a behavior-oriented contract (e.g., salaries,

hierarchical governance) or an outcome-oriented contract (e.g., commissions, stock

options, transfer of property rights, market governance). In its economic variety, agency

theory assumes that actors are fully rational, behave according to stable risk preferences,

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and maximize their self-interests (Jensen, 2001; Jensen and Meckling, 1976). The agency

problem arises here because of the ‘separation between ownership and control’ (Berle

and Means, 1932/2004). The fundamental problem is the differential interests and risk

preferences of firm owners and management. Firm owners can spread their wealth across

many different firms, and optimal portfolio theory suggests that it is in fact wise for them

to do so (Fama, 1980). Managerial wealth, on the other hand, is tightly linked to the firm

by which management is employed. These differential positions make that owners and

managers have different risk preferences, and therefore tend to have different interests

and subsequently behave differently in similar circumstances.

To solve these conflicts of interests, it is typically assumed that it is the goal of the

firm is to ‘maximize’ (Jensen, 2001) by furthering shareholders’ interests or to

‘economize’ (Williamson, 1991) by lowering transaction costs. Matters of organizational

and contractual design thus must be tackled with these objectives in mind. Given that

managers enjoy the delegated control over the firm, it is their influence that must be

tempered. In order to avoid them making self-interested decisions with subversive effects

on shareholders, a contract is typically drawn up between the firm owners (i.e. principals)

and firm managers (i.e. agents), which specifies desired managerial behaviors under all

circumstances. The purpose of this contract is to minimize residual losses for

shareholders.

Given that managers are expected to maximize their self-interests, they cannot be

expected to abide by the contract after signing it. To ensure managerial compliance with

the contract, owners have two basic instruments at their disposal. They can either monitor

managerial behavior to prevent management from making the ‘wrong’ decisions, or when

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perfect monitoring is not possible, provide management with incentives (bonding) to act

on their behalf. Since sub-optimal behavior by management cannot wholly be avoided,

the efficient contract is one that minimizes residual losses for shareholders. In practice,

this comes down to finding an optimal (i.e. efficient) balance between the costs

associated with monitoring and with bonding.

One important way of understanding agency theory is to assess the model of human

decision making that agency theorists normally subscribe to. Seen from an agency

perspective, decisions are taken on the basis of what Cyert and March (1963/1992) call

‘the logic of consequence’. This decision making logic is grounded in a rational choice

model of human behavior, in which actors are expected to ‘evaluate alternatives in terms

of the values of their consequences’ (Cyert and March, 1963/1992, p. 230). According to

this decision making logic, the decisions of principals and agents alike are rooted in

rational, calculative, anticipatory, and consequential actions (Cyert and March,

1963/1992). Agency-theoretical models produce accounts involving multiple strategically

interacting actors, ‘each pursuing self-interested objectives and constrained or facilitated

by the similar rational pursuit of self- interested objectives by others’ (Cyert and March,

1963/1992, p. 230). One of the pillars of agency theory is the assumption that efficient

market and pricing mechanisms determine actors’ decision making choices as these

choices are evaluated on the basis of the market values of their consequences. This logic

of consequence, facilitated by assumed efficient market forces, will rapidly lead to a

‘unique optimal that is guaranteed to be achieved’ (March and Olson, 1984, p. 737).

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The politics of agency theory

All theories simplify. The idea of a politics of theory draws attention to the manner in

which theories simplify and, more specifically, it focuses on the manner in which theories

predispose certain results by proceeding from certain conceptual frameworks and

problem settings. As a result the dominant paradigm can set the normative standards for

new theory development or theoretical extensions. Thereby empirical studies and

possible extracted policy implications for practice are based on the paradigm’s rules and

conventions.

The seminal contribution of Jensen and Meckling’s (1976) agency model dominates

the corporate governance literature. The corporate governance literature therefore serves

as a very good example of 1) the manner in which the dominant paradigm of agency

theory simplifies, 2) how it is predisposed with dominant (normative) foundations, and 3)

how it shapes the contemporary way of thinking on corporate governance. Although

agency theory has frequently been criticized before (see e.g. Eisenhardt, 1989; Perrow,

1986; Zingales, 1998) the present criticism is new in that it is systematically informed by

Wolin’s notion of a politics of theory. It is not intended as an overview of all possible

criticisms that have appeared in the literature. We do not claim that no other eminent

criticism is possible. Important to note, however, despite the critical comments, is that the

corporate governance literature also flourishes by the use of this dominant paradigm.

Given that the field of study is a relative new field of inquiry, the enormous number of

studies that have appeared in the literature since the 1970’s shows what significant role

corporate governance research has played in academic research to date (cf. Zingales,

1998).

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The predisposition with shareholder interests

There are several ways to illustrate how economic agency theory simplifies and how this

can be problematic in an analysis of corporate governance. An obvious bias in much of

the current corporate governance literature concerns the bestowal of the name ‘corporate

governance’ itself in combination with the standard perspective in which these studies are

most often conducted. The very label of ‘corporate governance’ suggests a series of

observations, analyses, or comments on the manner in which modern corporations are

being governed. Two very fundamental questions concerning this governance are: what is

the ‘corporate objective’ and what constitutes the basis of legitimacy for the corporation?

The connotation of the general label of governance in combination with the fact that

actual studies and current understandings of corporate governance in general are typically

reduced to the question how owners (i.e. shareholders, or principals in agency terms) can

control managers (which are supposed to work as their agents) (Shleifer and Vishny,

1997) suggests that this is the only or the main important issue to be raised in this field of

inquiry. As a result, when starting from the conventional agency corporate governance

perspective, any interests of other stakeholders are already placed in a subordinate

position in the debate. The agency framework in corporate governance suggests that the

furthering of shareholder interests is a privileged goal, maybe even the only legitimate

goal for a corporation to pursue. Within the framework of transaction costs economics, an

adjacent economic theory of organization, this claim is also supported by the argument

that shareholders are unique bearers of residual risk in any entrepreneurial project. In

other words: all other interest parties which form part of the enterprise have other means

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at their disposal c.q. have stakes which are secured before those of the bearers of residual

risks (Williamson, 1988, 1996).

This argument has been convincingly challenged by Blair (1995). This author has

pointed out that the restricted financial rendering of agency theory does not account for

this substantive restriction of the description of the goal of any corporation. It just picks

out the one relationship between corporate owners and management and treats this a-

priori as a privileged relationship. This predisposition with shareholder interests carries

normative implications of the application of the theory. As Perrow (1986) argues, these

predispositions and the inability to at the same time focus on the interests of the agent in

finding solutions, makes the paradigm a dangerous one, specifically because of its

ideological connotations. This can be illustrated by focusing on two of the fundamental

assumptions made in agency theory; 1) the assumption of maximizing social wealth by

maximizing shareholder wealth, and 2) the assumption of self-interests.

Wealth creation for all

A core argument made on behalf of the economic interpretation of agency theory is that

in governing the corporation, it makes sense to seek to produce maximum value first,

only after you have done this you can consider questions of distributive justice. The idea

is to make sure you produce the highest value for corporate owners first in order to create

the highest possible social welfare, only then you can and should start thinking about how

to distributive this welfare fairly.

Of fundamental concern in this respect is the complete contracting assumption of

agency theory. Following Zingales (1998), in a world of complete contracts no

meaningful definition of corporate governance is however possible. The argument here is

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that investments in the corporation can be sunk and firm-specific in a way that they create

additional surplus to only the supplier of the good and the consumer of that good. These

transactions create so-called quasi-rents (Zingales, 1998). In those cases, products cannot

be sold immediately on the market at current market prices, as market prices do not

reflect the specific value the contracting parties contribute to it or cannot immediately be

sold without interfering the production process. To effectively structure the bargaining

processes over these rents is the reason for corporate governance in the first place

(Zingales, 1998). In a world of complete contracts however, the designer of the contract

would have anticipated all possible disputes about the distribution and bargaining over

quasi-rents in the ex-ante contract. Ex-post agency problems can therefore not occur

because they are already resolved in the initial ex-ante contract. In other words, by

solving all possible problems ex-ante the issue of clearly existing problems of ex-post

bargaining cannot even be raised (Zingales 1998).

The different contracts which make up the firm in this nexus of contracts approach

would thereby somehow have to systematically be related to each other. Ex-ante the

designer of this system would have to have insights in all possible (future) problems to be

able to give priority to a given contract, or at least give priority to parts of a contract to

other parts of the (other) contracts. ‘….[D]elegation is always weakly dominated by a

fully centralised mechanism, where decisions are made ex-ante by the designer’

(Zingales 1998, p. 6). In the original statement of the theory, Jensen and Meckling (1976)

consider this type of mechanisms to be constant. Although these authors acknowledge the

role of for instance the legal enforcements of contracts and the role of political

interference, they do not incorporate these influences in their theory. They are considered

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to be constant factors and therefore exogenous to the model. The central mechanism in

agency theory is the market. Other mechanism such as legal institutions to alleviate ex-

post bargaining problems and the distribution of qausi-rents, which value per definition

cannot be determined ex-ante, are not considered. Such mechanisms would however have

to exist in a contract approach but it is not addressed in the theory how such a mechanism

would operate or can or is constructed.

In a world of complete contracts no problems of ex-post bargaining can occur. The

ex-ante approach of complete contracting of agency theory makes bargaining over these

ex-post rents impossible and thus rules out their existence. The agency approach thereby

ultimately rules out the consideration of problem resolutions within the firm and

disregards the hierarchical structures within firms to alleviate agency problems and

thereby in the limit rules out any meaningful discussion on corporate governance

(Williamson, 1988; Zingales 1998).

The theoretical point is that the assumed efficient market forces cannot completely

influence efficient decision making, as markets provide only signals to inform the

decision making process (Cyert and March, 1963/1992; Kay, 2000). When bilateral

dependencies come together because of clear incomplete contracting and asset

specificity, such as sunk- investments, or bargaining over (quasi) rents, markets are

simply not able to (immediately) sanction these decisions (cf. Roe, 2003; Shleifer and

Vishny, 1997; Williamson, 1988; Zingales, 1998). Thus, the problems of a wide range of

different bilateral dependencies indicate that actors’ discretion and other mechanisms are

clearly at play in corporate governance (cf. Williamson, 1988).

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Apparently, what is at stake in economic agency theory is first and foremost ‘wealth

creation for all’. The thrust of the agency theory model is that it aims to increase the total

sum of possible wealth creation. This is ‘the larger and more important point of the

principal-agent contract’ and more generally of all economic theories of organization:

first enlarge or optimize the total output, only then look at its distribution. Now, the

practical point is of course that economic theories never get round to matters of

distributive justice, they are just restricted to optimalising wealth. Under the strict

assumption of efficient market forces, ultimately everybody will receive his or her

‘optimal’ or ‘efficient’ share.

Adherence to the agency paradigm effectively rules out any query of the normative

foundations and structures of corporate governance, as assumptions of pure self-

interestedness do not cohere with normative analyses. In a world where actors strictly

serve their own interests, actors ‘are committed to a language in which ‘good’ can only

mean ‘good for me’ or more particularly, ‘in my interests’ (…) In that world there is

simply no meaningful possibility of distinctively moral or justificatory argument’

(Brennan and Hamlin 2000, p. 26). The theoretical point is that the idea of optimalising

an industrial process (like the production of goods and services) cannot be done in a

politically neutral way. Before you can establish a unique optimum in any meaningful

sense, you need to specify certain parameters concerning the parties collaborating in the

production as well as those affected by such a production. The underlying argument is

that some form of ‘stable condition of human interaction’ (North, 1990) or ‘social peace’

(Roe, 2003) is needed to make production possible. In the stylized world propagated by

agency theorists, there is thus not much room for variety with respect to different systems

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of corporate governance that give guidance to achieve these conditions of relative social

peace.

Coping with the narrow focus of the economic agency

perspective

All this is leading to the increased critique that agency theory neglects the institutional

conditions and social relationships in which any contract is made up. Given that this

approach is rooted in neo-classical economic theory, the embedded conditions and the

social relationships in which the actors are involved are not considered in the typical

agency inspired corporate governance article. Given the incompatibility of the

assumption of complete contracts and the ambition to address the social system in which

the contract is made up (cf. Zingales, 1998), principals and agents are in these studies

typically reduced to a set of ‘ontological actors, frozen in space and time and isolated

from social and cultural context’ (Aguilera and Jackson, 2003: 449).

There is a growing body of literature, however, that addresses specifically the issue

whether there will be a single most efficient way to structure corporate governance across

different societies. Some have argued that market forces will ultimately lead to a single

most efficient corporate governance system based on the agency theoretical set up (cf.

Hansmann and Kraakman, 2004; Gilson, 2001). Others argue that even though there are

compelling arguments of economic efficiency, complete convergence to a single model

will not occur because of local institutional constrains (e.g. Bebchuk and Roe, 1999;

Coffee, 1999; Heugens and Otten, 2007; Khanna et al., 2006).

Several discussions in the corporate governance literature can serve as examples how

the problem of the narrow focus of the theory and neglect of institutional embeddedness

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are discussed. Some studies have for instance looked at the world wide spread of reform

attempts by governments to improve their national corporate governance arrangements.

These studies show that countries differ in the timing of adapting reforms and differ in

the issues addressed that need reforms (Aguilera and Cuervo-Cazurra, 2004, Heugens and

Otten, 2007). For instance, although shareholder interests play a large role in corporate

governance codes of best practices, their interest are not the only ones considered. The

role of for instance employees is also addressed in many of these policy codes (Heugens

and Otten, 2007). Incompatible with the agency paradigm is the typical conclusion of

these studies that countries (still) differ in how they structure their corporate governance

arrangements and that other actors beside shareholders and managers and institutions

play a significant role in shaping corporate governance arrangements (cf. Bebchuck and

Roe, 1999; Coffee, 1999; Gordon and Roe, 2004; Khanna et al., 2006; Pagano and

Volpin ; 2005, Roe, 2003).

Other studies focus on what Marc Roe (2003) has labeled the ‘legal thesis’ on

corporate governance. Based on the agency inspired set up, the make up and quality of

legal institutions are investigated and especially applied to the question to what degree

corporate ownership structures are dispersed. Using agency theory the typical argument is

that better protection of (minority) shareholders leads to more dispersed ownership

resulting in a sharp separation of dispersed ownership from managerial control and thus

to an ‘efficient’ and ‘modern’ state of affairs (Hansmann and Kraakman, 2000; Kerr,

Dunlop, Harbison, and Myers, 1960; La Porta et al, 1999; La Porta et al, 1997; 1998;

Shleifer and Vishny, 1997). An other stream of literature in which this legal thesis is

often applied is the literature on shareholder activism (Black, 1998; Gillan and Starks,

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1998, Karpoff, 2001, Romano, 2001) The major concern in this stream of literature

focuses on how shareholders can intervene managerial decision making in a way that

ensures decisions are made on the basis of shareholder wealth maximization (De Jong et

al., 2007).

Theoretical implications

The manner in which theory development and theory extensions build on the agency

paradigm can for instance be illustrated by the discussion on executive compensation

between Bruce, Buck and Main (2005) and Gomez-Mejia, Wiseman and Dykes (2005).

The issue here is agency theory’s neglect of institutional embeddedness of pay practices.

Bruce et al. (2005) argue that the dominance of principal-agent theory has led to a narrow

focus in the literature that may give rise to problems in the context of research that

examines cross-country differences of executive pay. They suggest that agency theory is

under-socialized and therefore lacks generalizability to settings where other social

solutions would seem to alleviate the agency problem by other means than providing

management with incentives to serve shareholder interests. To address these

shortcomings, institutional theory is offered as a useful overarching framework within

which appropriate variants of these approaches can be deployed to better comprehend

current developments in executive pay. In reaction, Gomez-Mejia et al. (2005) argue,

while agreeing that agency theory does not explicitly recognize contextual factors, that

this abstraction from context gives agency theory greater generalizability and thus greater

explanatory power. The fact that an institutional perspective provides for a fuller

explanation of executive pay arrangements across different institutional contexts does not

necessarily mean that can all these arrangements can be conceived as solutions to the

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agency problem. In a counter response Bruce et al. argue that more fundamental issues

are at stake since the appropriate yardstick for the evaluation of pay packages may differ

between institutional environments and may be required to serve for social legitimacy as

well as the mitigation of agency problems. They emphasize that it is the drive for

legitimacy rather than any immediate concern with distributive justice that makes

institutional explanations of executive remuneration so fundamental (Bruce et al., 2005).

This exchange illustrates that the agency perspective is often complemented with

different types of frameworks. In her early survey of the state of the art, Eisenhardt

concluded that agency theories’ ‘ideas on risk, outcome uncertainty, incentives, and

information systems are novel contributions to organizational thinking, and the empirical

evidence is supportive of the theory, particularly when coupled with complementary

theoretical perspectives’ (1989, p. 58). But the appeal to a number of fixed companion

theories may well lead to theory stretching beyond the limits of the original theoretical

foundations of the agency paradigm. Especially the use of institutional approaches in

combination with agency theory have increased over time (e.g. Aguilera and Jackson,

2003; Davis and Thompson, 1994; Roe, 2003; Zajac and Westhal 2004) and may serve as

case in point how these frameworks stretches agency theory beyond its most fundamental

conventions and foundations.

The influence from institutional frameworks in the corporate governance debates

leads to an increased attention to the role of other actors than merely shareholders and

management. The role of other stakeholders such as employees is typically neglected in

the corporate governance literature (Bebchuk and Roe, 1999; Blair, 1995, Blair and Roe,

1999; Roe, 2003). It has been argued that agency theory may very well be compatible

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with a stakeholder perspective (e.g. Hill and Jones, 1992; Gomez Meija et al., 2005;

Jensen, 2001). A stakeholder perspective would simply enlarge the number of interest

parties which a firm or its management should factor in elaborating the corporate

governance equation.

‘Stakeholder theory simply reminds us that an agent must also attend to the interests

of non-principal stakeholders to the degree that each stakeholder is willing to

continue their participation, if the agent is to fulfill her responsibilities to the

principal’ (Gomez Mejia et al., 2005, p. 1511).

This may be resolved by replacing the dyadic model by a multi-principal, multi-agent

model. But Gomez Mejia et al. (2005) also make another point from which the one-

sidedness and the political overtones of the agency model clearly emerges:

‘…distributive justice is an inappropriate metric upon which to base the design of a

principal-agent contract since it misses the larger and more important point of the

principal-agent contract, which, in the case of commerce, is to motivate the agent to

create more wealth, which increases the amount available to all stakeholders’

(Gomez Mejia et al., 2005, p. 1511).

The problem is that the combination of other frameworks with that of the agency

theory as advanced in the corporate governance literature stretch the dominant paradigm

beyond its conceptual limits. The fundamental assumption in agency theory is that the

actors make decisions grounded in a rational choice model of human behavior, in which

actors are expected to ‘evaluate alternatives in terms of the values of their consequences’

(Cyert and March, 1963/1992, p. 230). It is assumed that the actors have no chronic

information problems (Hodgson, 1998) and ultimately are forced to make shareholder

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wealth-maximizing decisions by monitoring or bonding mechanisms that are facilitated

by market and pricing mechanisms. The outcomes of the decision making process are

evaluated on their ultimate value and thus the different alternative options when making a

decisions are typically considered simultaneously (Cyert and March, 1963/1992).

Combining institutional frameworks with agency theory prevents however its

successful application to a broader stakeholder domain. It ultimately rules out a

successful broader framing of corporate governance problems and problem resolutions

beyond the agency problem between shareholders and managers.

Decision-making is a decidedly social process. It is so precisely because individuals

do not only draw on rational factors when making decisions, but also on factors like

norms, trust, culture, advice, rules, history, and authority (e.g. Cyert and March,

1963/1992; March and Olson, 1984). In an institutional approach not all human behavior

is rooted in ‘deliberation’ or ‘computation’ (Hodgson 1988; Kahneman and Tversky,

1979, North, 2005). Individuals also draw on rules of thumb and other heuristics, which

make at least part of their behavior ‘habitual’ or ‘reflexive’ (Cyert and March,

1963/1992; Hodgson, 1988; Scott, 2001). All individuals are constrained in their capacity

to make fully rational decisions, due to the cost and unavailability of appropriate

information and because of their own cognitive limitations (Cyert and March, 1963/1992;

DiMaggio and Powell, 1983; Elster, 1989; Jepperson, 1991; March and Olson, 1984;

Meyer and Rowan, 1977; North, 2005). Rather than searching for ‘optimal’ or

‘maximizing’ decisions, individuals quite often tend to select the decision alternative that

simply seems ‘appropriate’ or ‘legitimate’ against the background of perceived

institutional norms, values, and beliefs (Jepperson, 1991; Meyer and Rowan, 1977;

23

Suchman, 1995). Decision alternatives are typically understood to be made sequentially,

also dependent on the evolved or not yet materialized results of previous decisions (Cyert

and March, 1963/1992). Approaches that acknowledge the influences of such factors on

human behavior are typically labeled as ‘institutional’ approaches (e.g., see Elster, 1989;

Greif, 2006; North, 1990; 2005). The alternative of an institutional approach trumps the

agency perspective, because it relies on a different, less stringent assumption of human

behavior. It assumes that social actors are ‘satisficers’ rather than ‘maximizers’ (Cyert

and March, 1963/1992).

Following Elster’s broad definition of an institution as ‘a rule enforcing mechanism’

(Elster 1989, p. 147), we may say that ‘all institutions simultaneously empower and

control’ (Jepperson, 1991, p. 146). This means that institutions not only influence social

stability, but also influence instability. Institutions thus not only play a background role,

but institutional forces simultaneously empower and control those decision making actors

that employ, develop, and contest them. In contrast to the agency paradigm, an

institutional approach considers the embeddedness of the issue under investigation. This

implies that decisions are not only based in the idea of the role of background institutions,

but also on the idea that current or past decisions shape and influence the institutional

context in which future decisions are made. This problem is considerably expanded if we

broaden the objective function of the corporation.

Even one of the founding fathers of agency theory, Jensen (2001) has recently argued

that the interests of all stakeholders need to be considered so as to make tradeoffs to

maximize firm value. In his ‘enlightened stakeholder theory’, Jensen (2001) clearly

separates shareholders’ interests from the interest of the organization as a whole. He

24

argues that the firm’s governance objective function should incorporate the interests of all

stakeholders and that trade offs between the interests of stakeholders should be based

whether they maximize long term firm value and not whether (short term) shareholder

value is maximized.

If, following Jensen (2001), we view the modern corporation as a diffuse, multi-

stakeholder entity with a correspondingly broad objective function, it will always be

surrounded by an imperfect or ambiguous information regime. Even when serving a

particular interest corporate governance problems exist. Corporate governance problems

not only pertain to problems of conflicting interests but also pertain to conflicts of

opinions, expectations, notions, and perceptions of appropriate actions. Subsequently the

wide spectrum of possible (normative) corporate governance problems can only be

alleviated for a relative short period of time. Corporate governance mechanisms are

employed to mediate problem resolutions and are most likely driven by reasons of

aptness in order to overcome the wide spectrum of possible conflicts (Otten, 2007). Most

striking is that Jensen, together with Murphy, also argue that corporate governance

problems can only be temporarily ‘mitigated’, rather than resolved indefinitely, but that

their argument still adheres to assumptions of rational actors that maximize their self-

interests, implying that there is something like a perfect solution to the governance

problem of conflict of interests, which they put forward as being the only problem

(Jensen and Murphy, 2004). The combination between the agency set up and institutional

approaches thus stretches the agency paradigm beyond its fundamental foundations.1

25

Implications for empirical studies and practice

Important in the analysis of the politics of theory is the concerns of a distinct confusion of

descriptive/explanatory validity of the theory to the neglect of normative impact of the

model in terms of its unequal consideration of various interests. Much effort has been put

into the question as to the descriptive/explanatory validity of the agency perspective, the

argument being that agency theory has a greater predictive value. It is argued that it is

better capable of predicting and explaining managerial conduct than rival theoretical

frameworks and should therefore serve as a blue print for practice (cf. Hansmann and

Kraakman, 2000).

A good example in this respect is the ‘academic tournament’ (Bratton, 2005) about

explanations of executive compensation in the corporate governance literature. The

discussions about executive pay in both theory and practice show how the politics of

theory has a great impact on the contemporary way the phenomenon is understood in

theory and practice. First, it shows that the strength of the agency paradigm is very strong

in the corporate governance literature. This can for instance be indicated by Bebchuck

and Fried’s (2003, 2004) label of this theory as the ‘official story’ on executive pay.

Second, it shows the possible bias of scholars to explain the phenomenon. As Bebchuck

and Fried’s (2004) indicate, agency scholars come up with clever explanations for pay

practices that appear to be inconsistent with the dominant paradigm (Bebchuk and Fried,

2004). ‘Practices for which no explanation has been found have been considered

“anomalies” or “puzzles” that will ultimately either be explained within the paradigm or

disappear’ (Bebchuk and Fried, 2004, p, 3). Third, it shows the rhetoric used to

26

legitimize and explain seemingly excessive pay in practice. And fourth it shows how

empirical studies are based on theoretical foundations of the dominant paradigm.

A very large part of the executive literature has been occupied to find a robust

relationship between executive compensation and firm performance (c.q. shareholder

wealth).2 After all, a positive relationship would show that shareholders can write an

efficient contract that ensures that management will make shareholder value maximizing

decisions. Nevertheless, there are literally thousands of empirical studies dealing with

this relationship and these studies typically show mixed results and overall only provide

weak support for this link at best.

These empirical results have triggered methodological debates about for instance

estimation techniques, definitions of the variables used and the mediating effects of other

determinants of executive compensation on this relationship (See for instance Agarwal,

1981; Ciscel and Carroll, 1980; Conyon and Murphy, 2000; Gomez-Mejia and Wiseman;

1997; Rosen, 1990). The agency paradigm gives however little guidance in which

determinants should play a theoretical role. Subsequently, empirical studies on the

determinants of executive pay mostly lack theoretical foundations and show a rather

weak fit with the data (Hambrick and Finkelstein, 1995; Mueller and Yun, 1997).

The failure to find a robust relationship between executive compensation and firm

performance leads to debates and disputes still remain on whether or not executive pay

provides enough incentives to trigger efficient management behavior and whether these

empirical results support the incentive alignment argument of agency theory (Gomez-

Mejia and Wiseman, 1997, Jensen and Murphy, 1990, Rosen, 1990).

27

Paradoxically however, the lack of finding a robust positive relationship between

corporate performance and executive compensation could be interpreted as evidence

favoring one of the theory’s fundamental theoretical assumptions: agents will pursue their

self-interests that deviate and conflict with the objectives of the principal, which actually

is a reflection of their discretion (Berrone and Otten, 2008). Because of the strict

assumptions of agency theory, actors’ discretion in the decision making process is

theoretically ruled out as real possible behavior (Grabke-Rundell and Gomez-Mejia,

2002) Discretion (the latitude of decision options actors have to influence the decision

outcomes and the context in which the decisions are made), is theoretically ruled out

because inefficient behavior (i.e., (boundedly) rational behavior that has sub-optimal

effects for shareholder value) is instantly sectioned by others in their own rational pursuit

of maximizing their self-interests facilitated by pricing and market mechanisms (Otten,

2007).

Because of scholars’ use and commitment to the dominant paradigm, their known

biases and ideological orientation often serve as the best predictors of the findings

presented (Bebchuk and Fried 2004; Gomez-Mejia, 1994; Gomez-Mejia and Wiseman,

1997). The apparent lack of success in finding a robust relationship between firm

performance and pay, in combination with the considerable number of studies seeking to

find proof of this link has led Gomez-Mejia (1994) to compare this quest with the search

for the ‘Holy Grail’. Subsequently, the dominant use of the agency paradigm to find this

relationship is leading us into a ‘blind alley’ (Barkerma and Gomez-Mejia, 1998) to find

conclusive explanations of pay practices.

28

This academic debate has not missed its effects in practice. Especially in cases where

pay rises and where firms show bad performance results or have to downsize, it seems to

be a matter of fairness to the general public that pay should be (more) related to

performance (Gomez-Mejia, 1994; Jensen and Murphy, 2004; and Murphy, 1997). The

lack of proof of this positive relationship fuels the public outcry over seemingly

executive pay arrangements (Bebchukc and Fried, 2004) and leads to problems in

practice to explain and legitimize executive pay arrangements to the public at large (cf.

Garvey and Milbourn, 2006; Wade et al., 1997; Zajac and Westphal, 1995).

Wolin’s politics of theory perspective helps us to distinguish between the

descriptive/explanatory validity of a theory and its prescriptive uses. On one hand, it

could be argued that the incentives are seemingly too low in practice. Following the

prescriptive power of the theory, executives should receive more pay that is contingent on

performance. This trend can be observed in current corporate governance codes of best

practices (cf. Heugens and Otten, 2007). It can also be seen from the increased use of

options and shares as forms of executive compensation (e.g. Abowd and Bognanno,

1995; Murphy, 1999) On the other hand, the theory could also simply furnish weak

explanations of the observable pay arrangements in practice. Its theoretical applicability

could somehow be limited in the sense that incentives lead to other outcomes (in theory

and/or practice). The effectiveness of incentives, bonding, or the monitoring mechanisms

for that matter, could be influenced by factors or theoretical foundations that are not

considered by the used agency model. Furthermore, actors may in practice simply choose

not to adhere to agency theory’s prescriptions or not be able to follow its logic of

consequence.

29

Discussion & conclusion

The agency paradigm as it is most often used in the corporate governance literature does

not cover all the connotations of the term corporate governance. As Bebchuk and Fried

(2003, 2004) have argued concerning the issue of executive compensation, executive pay

is not a solution to the agency problem between shareholders and management, but is in

fact a representation of the agency problem itself. Rather than an instrument, executive

pay is thus much more the outcome of socially constructed corporate governance

arrangements (Otten, 2007). Arguably, extending these ideas to other solutions to the

agency problem3 are all a reflection of the relative discretionary position agents have

relative to the principal they are expected to serve. Following Zingales (1998), we argue

that every contract presupposes a previous contract in order to ensure that the agent will

act in the interest of the principal. The discretionary position of the agent to contract in

the first place would always be based on an agency problem. The fundamental problem is

how to ensure that the agent will act on behalf of the principal in the first place.

Alleviations to agency problems in the agency-based corporate governance literature,

then, seem to be based on a theoretical rhetoric that surpasses the fundamental

assumptions and prescriptions of this paradigm. Its use of efficient market and perfect

contracting assumptions and predisposition with the wealth creation of a single social

actor effectively rules out other actors involved, other means besides markets to alleviate

the problems and considers solutions to only one considered problem that is

fundamentally a representation of the problem itself.

Applying Wolin’s (1960, 1981, 2004) ‘sublimation thesis’ and his idea of a ‘politics

of theory’ to the field of corporate governance illustrates that the dominant use of agency

30

theory and its predisposition with shareholder interests has both descriptive and

prescriptive powers in pointing out corporate governance problems and proposed

solutions to these problems. Although the theoretical strength of the paradigm is to show

that there are problems when activities are delegated to another party, its application to

the wide range of corporate governance issues is problematic. While the focus of such a

single approach has greatly contributed to our understanding, it carries clear normative

implications.

A certain extent of simplification is inherent in the very idea of theory-building. In

this paper, we have invoked Wolin’s ideas to show how the presently dominant agency

approach in corporate governance (over)simplifies its object of study and how the agency

lens is normatively biased by its conceptual framework and its problem-setting. The very

name of corporate governance suggests a series of observations, analyses, or comments

on the manner in which modern corporations are being governed. Two very fundamental

questions that arise are: what is the ‘corporate objective’ and what constitutes the basis of

legitimacy for the corporation? Given that agency theory is founded in neo-classical

economics with its assumptions of maximizing self-interests, complete contracts and

predisposition with shareholder interests, ultimately leads to the inability to raise

normative questions about distributive justice and legitimization arguments. Given the

assumptions of the theory and its application to governing corporations, economic agency

theory in its current usage ultimately rules out even a usable definition of corporate

governance (Zinagales, 1998).

The common applications of the theory a-priori set the principals’ interests on a

footstool without giving much regard to the interests of the agent or other stakeholders

31

that influence corporate governance. By making the assumption that maximal social

welfare is achieved by maximizing shareholder wealth, it subsequently has the normative

implications in finding solutions to only one agency problem considered. The typical

considered corporate governance mechanisms that should alleviate the agency problem

between shareholders and management (i.e. monitoring and bonding facilitated by market

and pricing mechanisms) are most often assumed to serve the principals’ interests only.

The assumption of efficient market forces neglects the embeddedness of the different

ways societies construct and develop (other) arrangements to achieve varieties of social

peace to make production possible in the first place. This clearly overlooks the fact that

the agency problem between shareholders and management (and other agency problems

between other stakeholders for that matter) can also be alleviated by other actors and

corporate governance arrangements that are a-priori ruled out by the theory. This can be

illustrated from the literature on comparative corporate governance (e.g. Aguilera and

Cuervo-Cazurra, 2004; Coffee, 1999; Hansmann and Kraakman, 2000; Heugens and

Otten, 2007; Khanna et al., 2006; Pagano and Volpin; 2005), studies that apply the ‘legal

thesis’ (Roe, 2003) on corporate governance (e.g. the literature on shareholder activism

(e.g. Black, 1998, Romano, 2001), and the numerous studies on executive pay (Bebchuk

and Fried, 2003, 2004; Bruce et al., 2005; Gomez-Mejia and Wiseman, 1997).

The dominant use of a single theory has the possible downside effect of hampering

new theory developments. The focus on the wide-spread application of the theory to

corporate governance may lead to a neglect to employ scholars’ scarce resources to

investigate potentially more fruitful ways to explore corporate governance as a scientific

field of inquiry. Thereby the commitment to the dominant paradigm could lead to theory

32

stretching. The combination of agency theory with a number of other theories may lead to

stretching the theory beyond the limits of the original theoretical foundations of the

agency paradigm as for instance evidenced by the combination of the theory with

institutional frameworks (e.g. Aquilera and Jackson, 2003; Davis and Thompson, 1994;

Roe, 2003; Zajac and Westhal, 2004). Furthermore, the implications of the dominant

agency approach also did not miss their inferences in practice. The lack of proof of a

positive relationship between pay and performance, a typical assumption derived from

the agency model, is a clear case in point. The theoretical predisposition to find this link

and the lack of convincing results fuels the public outcry over seemingly excessive and

leads to problems in practice to explain and legitimize executive pay arrangements to the

public at large. The dominant use of the theory thus has considerable normative

implications for our contemporary understandings of corporate governance in both theory

and practice.

All in all, an appropriate understanding of the politics of agency theory in corporate

governance goes to show that the seemingly neutral position of agency theory commits us

to many more intended and possibly unintended (normative) implications than is

commonly recognized by scholars using this perspective as a theoretical framework. Ever

since the agency paradigm in corporate governance acquired sufficient legitimacy in the

1970s, it has framed the way corporate governance issues are understood in theory and

practice. Its prescriptive and explanatory powers and the apparent confusion about this

distinction can be clearly observed in the corporate governance literature. Applying these

notions with the previous criticism of the theory in combination with some clear

examples of theory stretching, it seems that we may well be in the middle of a paradigm

33

shift. Possibly, after a number of years we can apply Wolin’s ideas again. We may then

be able to reconstruct in some detail how a new theory acquired its legitimacy and set out

how its disciples continued the example set by its founder(s) on the basis of a set of

methodological prescriptions specifying the authorized procedure to conduct scientific

inquiry in the field of corporate governance research.

Notes

1 See also North (2005) for the argument that neo-classical economic approaches (such as agency theory)

are not designed to explain the influence from institutions on economic change.

2 See Tosi et al. (2000) for an overview of empirical studies.

3 Typically this is sought in an explicit complete optimal contract that specifies the monitoring and bonding

mechanisms to ensure agents compliance with the optimal contract based on the principals interests,

embedded in and facilitated by efficient market conditions.

34

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