Agency Theory

Agency Theory



Agency Theory

“However, according to agency theory (Jensen & Meckling, 1976), there is an operating assumption, deemed true, that there are always conflicting interests between the agents and the principals.”

The above statement explains how the agency theory assumes that agents and principles in the corporate world are always encountering conflicting interests. The agency hypothesis was put forward by Michael Jasen and William Meckling in 1976 (Jensen & Meckling, 1976). The two philosophers were trying to explain the conflicting interests between shareholders and managers by arguing that agents will tend to allocate more priority to their private interests and add value of the company rather than that of the principals (Jensen & Meckling, 1976). To this extent, the statement quoted above addresses the issues raised by Jasen and Meckling. However, it fails to state that the agency theory is also strongly rooted in the law.

In a sole proprietorship, the existence of a business entity can be tied to one individual because all matters and decisions pertaining to its operations are made by the owner. However, it is a decidedly different case in public listed companies. This is because the shareholders or agents, who are normally the owners of the company, have to hire skilled officers, tasked with managerial functions and conducting the business daily operations. However, the agency problem arises when managers give more priority to adding value to the firm, rather than shareholders’ wealth maximization. Nonetheless, the law has provided substantial guidance on how a framework of contractual relations can be used to bring equilibrium between conflicting objectives among individuals (Petrie, 2002).

The law has made agency theory a cornerstone of corporate governance by influencing business practices and policies. Firstly, the law brings corporate firms into existence. It makes them legal fictions with no substantial reality, and only exists in the law. By doing so, the law defines various aspects of the company such as dividend policies, qualifications, functions, election, terms in office and composition of board directors. Some legal provisions would allow shareholders to recall the managers and replace them with new agents. In addition, it also dictates the minimum revenue allocation that has to be distributed to shareholders as dividends. Furthermore, based on the agency theory, the law provides a clear outline of the board composition. This ensures that the shareholders are well represented by their delegates during delegates.

Secondly, laws governing codes of good conduct, business ethics, auditing and training of senior employees have also been influenced by agency theory doctrines. Once corporations have come into existence, the law still plays a vital role in defining its operations and the conducts of all employees. For instances, firms would aim at ensuring that all their financial filings and records accurate and that all employees are using the company’s assets responsibly. The codes of conduct would also monitor gifts, entertainments, remunerations awarding of tenders, personal finances, employment and termination of corporate agents.

In addition, the law also demands the presence of auditors or their representatives during shareholders or stakeholders’ annual general meetings (U.S. Securities and Exchange Commission, n.d.). During these meetings, the law allows the auditors or representatives to address the principals and answer all queries that might result to conflicting interests. Finally, the law might also be used to set the academic standards of all senior managers. This included recruiting qualified agents, and organizing training sessions to improve their skills. This will equip them with the necessary skills required in balancing conflicting objectives within their companies.


Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3 (4), 305-360. Retrieved from

Petrie, M. (2002). A Framework for Public Sector Performance Contracting. OECD Journal on Budgeting, 1 (3), 117-153. Retrieved from

U.S. Securities and Exchange Commission. (n.d.). Audit Committees and Auditor Independence. Washington, DC: U.S. Securities and Exchange Commission, Office of the Accountant.

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