Agency Theory and Shareholder Value

At the complete opposite end of the spectrum from the warm and fuzzy Stakeholder
Theory and Corporate Social Responsibility are the cold hard Agency Theory
and ‘Shareholder
Value’ approaches

Agency Theory

Agency theory first arose in the 1970s and was apparently developed by Ross (1973), Mitnick
(1973) [10] and
Jensen & Meckling (1976,
as cited in Eisenhardt
) [11].
Eisenhardt describes it:

"Specifically, agency theory is directed at the ubiquitous relationship,
in which one party (the principal) delegates work to another (the agent), who
performs that work. Agency theory attempts to describe this relationship using
the metaphor of a contract." (Eisenhardt, 1989:58).

Agency theory talks about two agency problems. 1) There is likely to
be a conflict between the interests and goals of managers and principals and
2) managers and principals will have different levels of risk aversion. The
costs of agency are said to be the cost to principals of 1) obtaining information
about what managers are actually doing and 2) enticing managers to act in the
interests of the principal.

Agency theory is both based on self interest (the agent will act in their
own interests and against those of the principal) and relies on self interest
in part to resolve this problem (different levels of incentive based on the
self interest of the agent are required to motivate the agent to act according
to the principal’s wishes).

This emphasis on self-interest causes concern for many of the theory’s detractors.
According to Eisenhardt (1989), "Perrow (1986) also criticized the theory
for being unrealistically one-sided because of its neglect of potential exploitation
of workers." and Mintzberg et al argue that the promulgation of this theory
through business schools as contributing to a wider social phenomenon of selfishness: 

The fabrication of economic man drives a wedge of distrust into society
between our individual wants and our social needs. (Mintzberg et al, 2002). [12]

Shareholder Value

If you’ve read anything in the business press over the last 20 years, you
would know that every board and senior executive has but one goal and responsibility
– to increase ‘Shareholder Value.’ Regarding this concept, Sally Eastoe

The term ‘shareholder value’ was first introduced in
the 1980s by US consultants who were selling value-based management to companies
already under stock-market pressure to increase returns. (Eastoe, 2005: 33) [13]

If you really want to undestand where this idea came from, you need to look
at Lazonick
and O’Sullivan
(I’ll mostly refer to them as L&O from now on)
trace the phenomenon back to the 1980s when “a relatively small number
of giant corporations … dominated
the economy of the United States”
(Lazonick & O’Sullivan,
2000: 14
). Accumulating huge revenues these
corporations allocated them according to a principle L&O call “retain
and reinvest”. The corporations tended to “retain both the money
that they earned and the people whom they employed.” (Ibid.) According
to L&O this enabled them to build a strong foundation for growth. However,
they argue, this principle began to run into problems because of the sheer
size of the organisations they had built and competition — mainly from
Japan at that time. Noting the rise of agency theory at this time and the

relatively poor performance of companies in the 1970s, agency theorists
argued that there was a need for a takeover market…. The rate of return
on corporate stock was their measure of superior performance, and the maximization
of shareholder value became their creed. (Ibid: 16)

In parallel with the agency theorists during the 1970s “the institutional
investor” (look up Jonk
) also became prominent at this time, resulting in the “transfer
of stockholding from individual households to institutions such as mutual funds,
pension funds and life insurance companies. (Ibid.) [14] L&O
trace how these developments, including the development of the junk bond market
which facilitated launching hostile takeovers, led to a new paradigm — “downsize
and distribute”

Finally, L&O argue that while it appears that a focus on shareholder value
has paid off (at least for US shareholders)

We must consider the possibility that the US stock-market boom is
encouraging US households to live off the past while corporations have less
incentive to invest for the future. (Ibid. 32)


Yet the stock-market boom has not made capital available to industry.
The persistent and massive flow of funds into stock-based mutual funds in the
1990s has bid up stock prices, increasing the market capitalizations of corporations.
But, as we have seen, net corporate equity issues have been negative over the
course of the 1990s because of corporate stock repurchases, while the main
impact of the stock-market boom on capital markets has been to raise consumption.

This suggests that the focus on shareholder value has not achieved the results
suggested by its proponents at the macro level. In a future post, I am going
to discuss Sally Eastoe’s
Swinburne DBA thesis. Sally makes a strong argument that it does not
produce results at the individual corporation level either.

I argue that something else is needed, and has always been needed, to develop
commercial enterprise that is truly wealth creating over the long term. I suggest
that what we need is an enduring purpose.

Origins of CSR and Stakeholder Theory

Origins and development of Corporate Social Responsibility and Stakeholder

I’ve wondered for a long time how the belief in Shareholder Value
came to dominate corporate thinking. I started reading around this topic to
try to understand how this came to be. Clearly it is related to what each of
us see as the purpose of corporations.

In a previous post, I wrote about Art Kleiner’s ‘Age of corporate
dominance’. We’ve been arguing about the purpose of corporations
ever since.. Do they exist solely to make a profit and serve their shareholder
owners or do they have a social responsibility to other stakeholders as well?

In 1979, A.B.Carroll wrote:

The modern era of social responsibility, however, may be marked by
Howard R. Bowen’s 1953 publication of Social Responsibility of the
, considered by many to be the first definitive book on the subject
É By the mid-1950s, discussions of the social responsibilities of businesses
had become so widespread that Peter Drucker chided businessmen: “You might
wonder, if you were a consciencious newspaper reader, when the managers of American
business had any time for business” (p 497)

Stakeholder Theory came into being a decade later. Freeman
& Reed
suggest the term ‘stakeholder’ was “coined
in an internal memorandum at the Stanford Research Institute in 1963”
while they trace discussions of the social responsibilities of the modern corporation
back to Berle
and Means
in 1932 who “were worried about the ‘degree of prominence
entitling (the corporation) to be dealt with as a major social institution.’”

Chester Barnard [who] argued that the purpose of the corporation was
to serve society, and that the function of the executive was to instil this
sense of moral purpose in the corporation’s employees. (Ibid.)

They note that Igor
included a discussion of the new [stakeholder theory] concept in
his 1965 book, commented that systems theorists “led by Russell Ackoff
‘rediscovered’ stakeholder analysis” in the mid-1970s and
in 1975 Dill
“sought to move the stakeholder concept form the periphery of corporate
planning to a central place.” (Freeman & Reed, again)

By the mid 1970s the term “corporate social responsibility” had
come into common use (eg Sethi
in 1975) and was used to cover the same ground as stakeholder theory. Also by
this time, issues of definition and the terms meaning different things to different
people had come into play:

The phrase corporate social responsibility has been used in so many
different contexts that it has lost all meaning. Devoid of an internal structure
and content, it has come to mean all things to all people. Business executives,
academic scholars, government regulators, and social activists view the corporation’s
social role within their respective frames of reference, thereby allowing the
evaluator maximum discretion as to the amount of funds expended, the nature
of the activities engaged in, and the types of groups whose needs are responded
to. (Sethi)

Indeed Sethi represents an early attempt to resolve this divergence of views
by introducing the concept Corporate Social Performance. Carroll
takes this further by developing a three-dimensional model in which Corporate
Social Performance (CSP) is based on both Corporate Social Responsibility (CSR1)
and Corporate Social Responsiveness (CSR2)

Throughout this phase, an important distinction began to develop. As Mitchell
et al

In 1978 William C. Frederick observed that business and society scholarship
was in transition from a moral focus on social responsibility (CSR1)
to an amoral focus on social responsiveness (CSR2). When stakeholder
theory focuses only on issues of legitimacy, it acquires the fuzzy moral flavor
of CSR1. Focusing only on stakeholder power, however, as several
major organizational theories would lead us to do, yields the amorality and
self-interested action focus of CSR2. Instead we propose a merger.

That is, some scholars and practitioners began promoting the view that business
had to take stakeholders into account, not for any moral responsibility they
had to these stakeholders, but rather because they had to manage the risk to
the firm due to the influence activist group now had the power to exercise.
Social performance was seen as a way of demonstrating the company’s responsiveness
to social trends.

It was in this context that Freeman & Reed made an attempt to resolve these
dilemmas in part by focusing on the political nature of stakeholder power and
its implications for corporate governance:

We have hesitated to suggest particular strategies for directors that
find themselves in one of the conflict situations we have explored. Our goal
has been, rather, to counterbalance the great weight of attention expended on
changing the (perceived) status quo and mandating certain types of board structure
of behavior with attention placed on a realistic appraisal of the current situation
and a sensitive elaboration of the potential lines of action currently available.

In other words, there is no simple formula that managers or directors can apply
to determining what they need to do. Rather they have to exercise their judgment
in each situation and on each issue.

As noted above, Mitchell et al (1997) made an important contribution
in this phase as well. In Corporate Social Responsibility (and its derivatives
— CSR2 and CSP) the question had been around whether to take
a wide or narrow view of a corporation’s responsibilities (ie did they
extend beyond economic and legal?) while in stakeholder theory there was a similar
dilemma regarding the definition of ‘stakeholder’. The business
rationalists defined stakeholder narrowly as ‘stockholder’ while
other views include

The Narrow Sense of Stakeholder: Any identifiable group or
individual on which the organization is dependent for its continued survival.
& Reed


The Wide Sense of Stakeholder Any identifiable group or individual
who can affect the achievement of an organization’s objectives or whi
is affected by the achievement of an organization’s objectives. (Freeman
& Reed

Mitchell et al’s contribution was twofold. First they attempted
to answer the questions “Who is a stakeholder and what is at stake?”
(Mitchell et al, 1997) by identifying stakeholders and their influence
along the dimensions of Power; Legitimacy, Urgency and Salience.  Secondly
they make the important call for

empirical research that answers these questions: Are present descriptions
of stakeholder attributes adequate? Do the inferences we make herein hold when
examining real stakeholder-manager relationships? Are there models off interrelationships
among the variables identified (and possible others) that reveal more subtle,
but perhaps more basic, systematics? (Ibid.)

Unfortunately, it appears their call for empirical research in this area has
largely gone unheeded.

claims to present results from a 10 year research program but rather presents
conclusions without data and, at best, sketchy details of his methodology.

(1995) cites studies by Alexander
and Buchman
(1978), Cochran
& Wood
(1984) and Sturdivant
& Ginter
(1977) but concludes “none has been based on a credible

In my next post in this series, I will look at the origins of Agency Theory
and Shareholder Value.

A brief history of the corporation

I’ve been thinking a lot lately about how corporations came to be and
how they came to be so powerful. There is nothing wrong in my mind with
powerful corporations. More important is how they exercise their power
and what moral, ethical and legal power we have to place constraints
on their exercise of power.

It put me in mind of something I read some time ago written by Art
Kleiner – The Age of Heretics

Kleiner, summarizing John P Davis’ book Corporations (Capricorn
Books1961), traces the history of the modern corporation back to “the
monasteries of the early Christian Church’. Commercialisation
came when the mercantile stock companies began organizing expeditions
to far parts of the globe across dangerous waters:

If a ship failed to return, the owner would qualify for debtor’s
prison; if an owner died before a ship returned, his creditors might
not be paid. Thus European kings and queens chartered corporations —
creatures of legal sovereignty, named after the Latin word for “body.”
The stock company had no human body, but it was corporeal in every other
sense. It could own property, outlive its human members, and borrow
or lend money. The monarchs had designed these new institutions to carry
out the policies that they found too risky to undertake themselves.

Kleiner goes on to recount a major turning point in corporate
history when, in 1811, the New York legislature

established a blanket corporate charter. Anyone who met the
legal criteria was automatically granted the powers of a company.

This led to a flurry of legislation as the states of America
at one and the same time competed to attract entrepreneurs but also limit
those same entrepreneurs’ abuse of privileges the legislatures had granted
them. Finally, Kleiner concludes:

By 1945, … the commercial corporation had come to dominate
the culture of the world.

I have posted this brief history because over the next few days I want
to discuss the purpose of corporations. Corporations were, and still
are, created by an act of the state. Individuals are given protection
and privileges under law to act as a company. In return the state can
expect those same companies to meet certain obligations and responsibilities.
There’s plenty of room to discuss what those obligations and responsibilities
might be, but that they exist and corporations have both a legal and
moral duty to meet them is beyond dispute.