The Fruits of Civilization (44-6) Agency Cost

Agency Cost

The flip side of shareholder short-termism is untoward agency cost: that management may not have maximizing the corporation’s worth as its objective.

An agency cost is the economic concept of a principal having an agent act on its behalf and paying a price for doing so. Because the principal and its agent may have different self-interests, and the agent has more relevant information, the principal cannot ensure that its agent is always acting in the principal’s best interests. In the case of a corporation, the principal comprises the shareholders who collectively own the company, and the agent is corporate management.

The interests of management, who might own little or no stock in the corporation, may be to maximize their own gain at company expense. In its most extreme form, management may brazenly loot the company, as happened with WorldCom, Enron, and Adelphia.

More subtly, managers can pad expenses, pay themselves lavishly, or invest company capital in ego-gratifying empire building at the considerable risk of profitability. The merger of Time Warner and AOL is a prime example.

Shareholders can theoretically limit agency cost by tossing out management; but to do so requires going through the corporate board, which may align itself with management rather than disgruntled shareholders. Corporate board members typically get on well with the CEO and other managers and are in the same social circle.