Agency Theory of Corporate Governance

Corporate governance has become a crucial aspect of corporate functioning globally, including in India. With the increasing complexity and scale of modern businesses, the need for robust corporate governance mechanisms that safeguard the interests of shareholders and other stakeholders is more critical than ever. Among the several theories that explain the functioning of corporate governance, Agency Theory holds a central position. Agency theory focuses on the relationships between principals (owners or shareholders) and agents (managers) within a corporation and the potential conflicts that arise when their interests diverge.

What is Agency Theory of Corporate Governance?

Agency theory seeks to address the relationship between two key entities in a corporate setting: the principal, who delegates tasks, and the agent, who is hired to perform these tasks. In a corporate governance context, the principals are typically the shareholders who own the company, and the agents are the executive managers or directors who run the day-to-day operations of the company on behalf of the shareholders.

Jensen and Meckling, in their landmark 1976 paper titled “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure,” formalised the agency theory in corporate governance. They highlighted the principal-agent problem, which occurs when managers, acting as agents, prioritise their own interests over those of shareholders, who are the principals. This misalignment of interests can lead to inefficiencies, higher agency costs, and suboptimal performance.

In the Indian context, the application of agency theory has become increasingly important with the rise of public and listed companies where ownership and management are often separate, and minority shareholders must rely on corporate governance mechanisms to ensure that their interests are protected.

Principal-Agent Relationship in Indian Corporate Governance

The Role of the Principal in India

In India, the principal is represented by shareholders, who may include a mix of promoters, institutional investors, and public shareholders. Indian companies often have a promoter-driven structure, where the promoters are not just shareholders but also play an active role in the management of the company. However, with the globalisation of markets and the increase in institutional and foreign investment in Indian companies, the separation of ownership and management has become more pronounced, necessitating a focus on corporate governance principles.

Shareholders in Indian companies expect the management to run the business in a way that maximises shareholder value, while also adhering to the legal and ethical standards set by Indian corporate law, particularly the Companies Act, 2013 and SEBI’s (Securities and Exchange Board of India) guidelines.

The Role of the Agent in India

The agent in Indian corporate governance includes the company’s directors and executive management, who are tasked with making decisions that align with the interests of shareholders. However, managers may have their own personal objectives, such as increasing their remuneration or securing their position, which might not always coincide with the long-term goals of shareholders. This misalignment can create agency problems that need to be addressed through legal and governance frameworks.

Agency Costs in India

In the Indian corporate context, agency costs are the expenses incurred to ensure that managers (agents) act in the best interest of shareholders (principals). These include:

• Monitoring Costs: These are incurred to monitor the actions of management, such as conducting internal and external audits, compliance checks, and adherence to SEBI’s corporate governance norms.
• Bonding Costs: These costs arise when agents commit to performance-based contracts or other mechanisms that assure shareholders of their dedication to acting in the company’s best interests.
• Residual Loss: This represents the loss shareholders may suffer when the actions of managers deviate from the optimal path, even after monitoring and bonding efforts.

Agency Problems in Indian Corporate Governance

Moral Hazard

In India, moral hazard is particularly evident in family-owned or promoter-driven businesses. Promoters who hold managerial positions may engage in self-serving activities, such as diverting resources to related-party transactions, which benefit the promoters but not the shareholders. Such practices can lead to conflicts between minority shareholders and promoters, exacerbating agency problems.

Risk Aversion

Indian managers, especially in publicly listed companies, may exhibit risk aversion, preferring conservative business strategies to safeguard their jobs and future earnings. In contrast, shareholders might prefer more aggressive strategies that maximise returns, leading to potential conflicts. This risk aversion is heightened in companies where executive pay is not aligned with performance.

Earnings Retention

In India, companies often face the issue of earnings retention, where managers prefer to reinvest profits into the company rather than distribute dividends to shareholders. This may be done to increase the size and influence of the company, which in turn can enhance managerial remuneration. However, shareholders, especially minority shareholders, might prefer dividends, creating friction between the two groups.

Laws Governing for Corporate Governance in India

The Companies Act, 2013

The Companies Act, 2013 is the primary legislation governing corporate governance in India. The Act introduces several provisions aimed at reducing agency problems and enhancing corporate governance. Key provisions include:

• Section 149: This mandates the appointment of at least one woman director and a certain number of independent directors on the board, ensuring that the board is not entirely dominated by the management.
• Section 177: Establishes the requirement for companies to have an audit committee consisting of independent directors to oversee financial reporting and disclosures.
• Section 188: Regulates related-party transactions, which are often a source of agency conflicts in promoter-driven companies. It requires shareholders’ approval for significant related-party transactions, reducing the risk of promoters using company resources for personal gain.

SEBI’s Listing Obligations and Disclosure Requirements (LODR)

SEBI, as the market regulator, has implemented the Listing Obligations and Disclosure Requirements (LODR) Regulations to ensure transparency and accountability in listed companies. These regulations emphasise the importance of disclosure and corporate governance to protect the interests of minority shareholders. Key provisions include:

• Independent Directors: SEBI mandates that one-third of the board of listed companies must consist of independent directors, ensuring that management actions are subject to independent scrutiny.
• Audit and Nomination Committees: SEBI requires companies to have committees that oversee critical aspects of governance, such as auditing and executive appointments, providing a check on managerial actions.

Fiduciary Duties of Directors

In India, directors have fiduciary duties under the Companies Act, which require them to act in the best interest of the company and its shareholders. These duties include:

• Duty of Care: Directors must make informed decisions, exercising due diligence and caution.
• Duty of Loyalty: Directors must prioritise the company’s interests over their personal interests.
• Duty of Good Faith: Directors are expected to act in good faith and for the benefit of the company as a whole, including minority shareholders.

Failure to comply with these duties can result in legal action against directors, providing a legal remedy for agency problems.

Mechanisms to Mitigate Agency Problems in India

Enhanced Transparency and Disclosure

India’s corporate governance framework places significant emphasis on transparency and disclosure. The LODR regulations require timely and accurate disclosure of financial performance, executive compensation, and related-party transactions, ensuring that shareholders have access to critical information. This transparency reduces the information asymmetry between shareholders and managers, mitigating agency problems.

Incentive Structures

Indian companies are increasingly adopting performance-based compensation schemes to align the interests of managers with shareholders. For instance, stock options and bonuses linked to company performance ensure that managers benefit when the company performs well, aligning their goals with those of the shareholders. However, care must be taken to ensure that such incentives do not lead to short-termism, where managers focus on short-term profits at the expense of long-term sustainability.

Independent Directors and Board Committees

The requirement for independent directors and board committees plays a crucial role in reducing agency problems in India. Independent directors are expected to provide unbiased oversight of managerial actions and ensure that decisions are made in the best interest of all shareholders. Committees such as the Audit Committee and the Nomination and Remuneration Committee serve as important mechanisms for overseeing executive performance and compensation, thereby reducing the potential for managerial opportunism.

Shareholder Activism

In recent years, shareholder activism has emerged as a powerful tool for mitigating agency problems in India. Institutional investors, such as mutual funds and pension funds, have become more vocal in holding companies accountable for their actions. Proxy voting and shareholder resolutions are increasingly being used to influence corporate decisions and ensure that management acts in the best interests of shareholders. SEBI’s introduction of e-voting has further empowered shareholders, particularly retail investors, to participate in governance matters.

Criticisms of Agency Theory in India

Despite its wide application, agency theory has faced several criticisms in the Indian context.

Overemphasis on Shareholder Interests

Agency theory primarily focuses on the principal-agent relationship between shareholders and managers, often at the expense of other stakeholders such as employees, creditors, and society at large. In India, where corporate social responsibility (CSR) is legally mandated, this narrow focus on shareholders may overlook the broader social and environmental responsibilities of businesses.

Family-Owned Businesses

In India, a large number of companies are family-owned or promoter-driven, where the distinction between ownership and management is often blurred. In such cases, agency theory’s relevance is limited, as promoters may already control both the management and the board. Instead of agency problems, such businesses may face entrenchment issues, where promoters use their control to prioritise their interests over those of minority shareholders.

Short-Termism

Another criticism is that agency theory’s focus on aligning executive compensation with shareholder value can lead to short-termism. Managers may prioritise short-term profits, which boost their compensation, rather than focusing on long-term growth and sustainability. This can be detrimental in an economy like India, where businesses often require long-term investments in infrastructure and innovation to compete globally.

Conclusion

Agency theory plays a crucial role in understanding the dynamics of corporate governance in India, particularly in companies where there is a separation between ownership and management. The legal framework in India, led by the Companies Act, 2013, SEBI regulations, and corporate governance codes, provides several mechanisms to reduce agency problems, including enhanced transparency, independent board oversight, and performance-based incentives.

However, the unique characteristics of the Indian corporate landscape, such as the prominence of family-owned businesses and the emphasis on CSR, suggest that agency theory alone may not provide a comprehensive solution to corporate governance challenges in India. While agency theory remains relevant, it must be complemented with broader governance frameworks that address the interests of all stakeholders and promote long-term sustainability.