Law Assignment on Legal Strategies to Overcome Agency Problem
Task: Identify and then critically evaluate the various legal strategies available to attempt to overcome the agency problem commonly experienced in the corporate form between shareholders and creditors.
The key objective of this law assignment is to analyze the legal strategies that are used to overcome the agency problem in the corporation, between the shareholder and the creditor in the corporate form. The report further analyses the various legal strategies to overcome the agency problem and to identify and critically analyses legal strategies available to attempt to overcome those problems.
In order to analyze the legal strategy of the agency problem, it is important to understand what the agency problem is and how it creates conflicts between the principals and the shareholders. The agency problem generally refers to the conflicts between the management of the company or the principles and stockholders of the company or the creditors. The problem usually arises when one party expects another party to act in accordance interest of another, and hence it is very common in corporate forms1 . In any firm, the manager acts as an agent for the principals and the creditors and is expected to act in order to maximize the wealth of the firm, though the manager on the other hand is interested to maximize their personal wealth also, and may act accordingly. In order to form an excellent capital structure, if the debt capital is used by the company, then the conflicts between the principle and creditor are very comm to arise. When one group acts as an agent of the principal, then an agency relationship is formed, and hence management can be seen acting as an agent of the principal. When manager works for the firm, it is common to for them to be tempted by their personal interest rather than the interest of the firm, and at the same time, the interest of the creditor is to provide the credit to the firm and to get the principal investment and the interests on time. In concern to their credit return, the creditors always monitor the monetary performance of the company, to check whether the business should be done properly, to ensure their interest. In such case, if the firm or the manager acts only as per their interest and fail to fulfill the interest of the creditor, then it will generally give rise to conflicts between the principles and the shareholders, who has invested in the firms’ project with the sole purpose to get interested from it2 .
Also, the interest and the investment of the creditor is based on a fixed rate of interest as per the contractual agreement within the given time, on the other hand, the investment and the interest of the shareholder are not only to increase the interest but also to increase the market price of their investment and shares. Hence, the creditors are concerned only with the return of their interest as per the contractual agreement, they do not prefer to ensure an extra return by additional risks. But, if the risk is taken by the firm, then they have to bear all the penalties created by the additional risk of the company, and they often deny such risks. For instance, if the company takes the risk and turned to be successful, then the profits will be enjoyed by the shareholder only, because the creditors will get only the fixed interest only in return, as per the contractual agreement. At the same time, if the additional risk will turn to be unsuccessful, then the creditors have to bear all the loss, thus the conflicts between them arise.
Legal Strategies to overcome the agency problem
The legal strategy is a universal method of using proper law or rules and regulations, in order to alleviate the susceptibility of the principals to the advantage of the agent. The legal strategy is implemented to develop the level of acknowledgment within the company and helps to reduce the agency problem, by taking legal actions against the counterfeit acts of the agents. The legal strategy, used to control agency problems, can be classified into two categories, respectively called regulatory strategy and governance strategy. The perspective of the regulatory strategy is to precept proper terms that regulate the suffice the relationship between the principle and the agent, tending to necessitate the behaviors of the agent directly. On the other hand, the perspective of the governance strategy is to expedite the control over the behavior of the agent. The adequacy of the governance strategy is significantly based on the principle’s ability to operate the control rights in accordance with them. As per the perspective of this strategy, the principles are allowed to monitor the activities of the agents, by giving incentives to the agents of the firm, including remuneration and bonus, to encourage and motivate the excellent behavior of the agent. On the other hand, the regulatory strategy aims to enforce rules to the agents to regulate the behavior of the agent.
Regulatory Strategy As already mentioned, the terms of the regulatory strategy are based totally on the regulation of the principal-agent relationship, minimizing the opportunities of the agent to misconduct their position. The regulatory strategy can be subcategorized and analyzed as following-
- Rules and Standards- This is one of the most applicable parts of the regulatory strategy, as it stifles agents by enforcing them not to take decisions, or make transactions, which will harm the principle's interest. Aa per the study, to prohibit certain specific behaviors, which leave the explicit conviction of the conformity to the arbitrator after the fact. According to Louis Kaplow, both rules and standards aimed to operate the substance of direct agency relationship, and the rules which specify particular behaviors of ex-ante are generally used to secure the corporations of creditors and public investors, incorporate context3 . Thus, the corporation edict generally comprises certain rules, such as remittance restrictions, margin requirements of capitalization, or following the severe loss of capital, rules requiring activities to be taken. Rules can also take certain enforcement, such as they can form standards, following which the agent has to comply exactly., but the conviction of the rupture is left to the arbitrator after the situation ensues. For instance, in the mitigation of agency relationships through rules, the financing market jurisdiction associates themselves, promote detailed operations to escort supple overture and surrogate voting 4 . Depending upon the drafts prepared by the lawyer and the power of the imposition within their environment, rules can become unchangeably imposed if violated, and on the other hand, standards always need to be present before the court or the decided arbitrator, in order to be justified and become legally imposed.
- Entry and exit- As per the study, this form of regulatory strategy is focused on the requirements of entry and exit. Rather than setting the rules and standards, the perspective of the law is set as such a term that operates the activities of the agent after the relationship between the principal and agent is established 5 . The entry term refers to the requirement of the agent before associating with the company, on the other hand, the exit terms provide opportunities to the principal exit, in order to escape a purportedly expensive relationship with the agent. The role of entry strategy is to minimize the agent’s opportunistic behavior, mainly in public capital markets, as generally, the investors may not know much about the companies in such markets. As per the study, the public investors need some sort of standardized exposure to get a sufficient supply of the data, and hence legal rules authorizing such exposure to give an example of an entry strategy because unless the required data is outfitted, stocks cannot be sold. As per the academic literature, the exit strategy can be of two types, one gives the right to withdraw or disengage the investment, and the other gives the right to transfer.
The governance strategy is based on the hierarchical elements of the relationship between principal and agent and can be analyzed as follow:
- Selection and removal- The selection and removal strategy is one of the major characteristics of the governance strategy, as it can also minimize the costs of agency in a very adequate way. As per this strategy, the shareholder is not only permitted to select the management but also remove of the management, in case of dereliction6. It is one of the effective ways to protect the principal from agents, on various level, as it does not only refer to agency problem between the relationship of the management and shareholder, but also within some jurisdiction, it also refers to the agency problem in relation to the minority shareholder and authorizing shareholder, and the relationship between employees and shareholder as a class7. The main perspective of this strategy is that the corporate form has the authority to appoint and remove directors and managers on any basis of negligence.
- Initiation and Ratification- As per this strategy, the principal will be given the power to initiate or ratify the decisions of the management, which can be said one step forward over the power of management. The implementation of this strategy grants more power to the principles, and hence cannot be seen implemented often in corporate governance. It is more like a vehicle for the authorization of the manager's power over the board of directors which doesn't make much sense in corporate law.
- Trusteeship and Reward- This strategy is entirely base on the remuneration, either with the expectation that the work will be on the basis of the interest of the company, providing trustee status or by giving rewards for the success to ensure shareholder interest. The trusteeship strategy tends to reduce the conflicts of ex-ante interest to make sure that the bad conduct and behavior will not be given any rewards. As per the study, the main aim of this strategy is to minimize the opportunistic behaviors of the agent by proving high remuneration, so that the agent will act as per the interest of the principle, without causing any agency problem, and at the same time to attain the goal of the principal.
Ex- post and Ex- ante strategies
These strategies state the fact that half of the strategy may be effective before the act of the agent, while the other half react after the action of the agent. For instance, in regulatory strategy, the rules define what the agent can or cannot do ex-ante, on the other hand, standards define the general rules adjacent, which the action of the agent will be judged ex-post. Likewise in terms of entry and exit, an entry strategy defines the action of the principal to be done before the deal with the agent, and on the other hand, exit strategy allows the principal to react after the action of the agent is revealed8 . Similarly, the governance strategy also comes under this pairs of e4x-ante and ex-post. Such as appointment of the agent ax-ante and removal of its ex-post, after judging the loyalty. Trusteeship as an ex-ante strategy, as the adverse interest of the agent, is neutralized, by the principle, before the appointment and reward act as an ex-post as the return are unforeseen on uncertain future outcomes.
It is very common to notice the problem is any corporate firms in between the agency, shareholders, and the creditor, as all of them will have their own self-interest before adding to any contracts with the firms, which may lead to several conflicts between them. As per their interest, all of them want the result of the negotiated agreements on the basis of their personal benefits, and hence, because of their own motives, many obstacles may arise in the negotiated agreement, as they all with be working with their own purpose and motives, which is to benefit their personal need. Thus, the legal strategies that have been drawn in the above section deliver suggestions towards improving the affiliation amongst the shareholder and the creditors. The above strategies are mostly based on the agency problem wherein regulatory; government and ex-post and ante-strategies have been discussed accordingly.
1. Md Nahian Mahmud Shaikat, “Conflict between Shareholders and Creditors” (ORDNURJanuary 14, 2015)
2. Smriti, “Agency Problem between Shareholders and Creditors | Financial Management” (Management NotesSeptember 10, 2016)
3. Meri Boshkoska, “The Agency Problem: Measures for Its Overcoming” (2014) 10 International Journal of Business and Management
4. John Armour and others, “Agency Problems, Legal Strategies, and Enforcement”
5. Corporatefinanceinstitute.com, “Principal-Agent Problem - Overview, Examples and Solutions” (Corporate Finance Institute2018)
6. Aadhya Shrotriya, “Overview of Agency Problem: Its Types & Legal Strategies to Control It” (Siddhartha Goswami| ed, TaxGuru2020)
7. Quickbooks, “Conflict of Interest: Resolving the Agency Problem” (QuickBooks CanadaMarch 15, 2017)
8.Ratnam Vijayakumaran, “Ownership Reform, State Ownership, Corporate Governance, and Agency Costs: The Case of Chinese Listed Companies” (2019) 10 Research in World Economy 91. https://www.researchgate.net/publication/334034122_Ownership_Reform_ State_Ownership_Corporate_Governance_and_Agency_Costs_The_Case_of_Chinese_Listed_Companies
Smriti, “Agency Problem between Shareholders and Creditors | Financial Management” (Management NotesSeptember 10, 2016)