Abstract

Agency relationship is a contract, under which one party (the principal) delegates some decisionmaking authority to another party (the agent). Agency conflict arises because of the separation of
ownership and control. The self opportunistic behavior of agent (management) is also
responsible for agency conflicts. As there is misalignment of interest between principal (owner)
and agent (management), the principal (owner) needs to induce the agent (management) to act in
the best interests of the principal. Thus the principal has to bear the cost of monitoring and
bonding the activities of the management. Some effective control mechanisms can be used to
align managers and shareholders interests. The interest of owners and management can be
aligned with the help some effective corporate governance mechanisms like powerful Board of
Directors, independent non-executive directors, corporate debt capital, managerial incentive
schemes linking the incentive to the performance of the company, managerial ownership and
presence of institutional shareholders. Independent non-executive directors can perform the
function of check and balance which can discipline the opportunistic behavior of management.
Managerial ownership can develop the sense of belonging among the management. This can
induce the management to become long term oriented and make value increasing decisions. Debt
financing can solve the problem of free cash flow problem and limit the managerial discretion at
spending the free cash flow. Institutional shareholders can raise voice against the opportunistic
behavior of management. Other mechanisms may include voluntary disclosure and market for
managerial talent. Agency costs can mitigated to a great extent by utilizing these corporate
governance mechanisms appropriately.

Introduction
Because of agency conflict, it is essential to find ways so that the interest of the shareholders and
management can be aligned. In the absence of proper control mechanisms, management can
pursue their own interest with the expense of the shareholders interest. Corporate governance
mechanisms include the rules to restrain the behavior of shareholders, board of directors and
managers within the firm, the market mechanism outside companies and external governance
mechanism such as laws and governments regulations. In this paper, we have mainly considered
the internal governance mechanisms. We have examined the effectiveness of the alternative
corporate governance mechanisms and devices in mitigating managerial agency problems. Value
of the firm can be maximized by tying the managers compensation directly to firm performance
or firm value.

Corporate Governance Mechanisms to Mitigate Agency

Costs
Agency costs have been a focus of corporate governance issues. In order to control and reduce
the costs of the agency relationship, control mechanisms must be considered to ensure that
managers act in the interests of the owners (Jensen & Meckling, 1976). Several governance
mechanisms can be used to align the interests of managers and shareholders. Utilizing
appropriate internal and external monitoring mechanisms can mitigate agency conflict. A good
corporate governance system is a key element to lead and control the performance of a business
in the best interest of shareholders. We have analyzed the effectiveness of some corporate
governance mechanisms and implications of these mechanisms in mitigating the agency cost.

Board characteristics
Board of directors can play a significant role in controlling the opportunistic
behavior of the managers. In the absence of proper monitoring devices, management can
pursue personal goals through increasing executive compensation, investing in power-enhancing
unprofitable projects in order to maximize their own interests. Therefore, the shareholders
delegate control to a board of directors and assign them to oversee the actions of management.
But the effectiveness of this mechanism depends on two factors:
i.

Size of Boards: Small boards cant play exert significant influence

over the management. Large boards are usually more powerful than
small boards. This can help them to take any corrective measures
such as firing and monitoring management, taking any actions
against the opportunistic behavior, changing the remuneration
schemes of management. A large powerful board helps to strengthen the
relation between company and external environment and provide more advice for
strategic choice, and plays an important role in contributing to coordinate different

ii.

stakeholders corporate objectives.

Composition of Board: Board composition is also very important. The proportion of
independent directors on the board can affect corporate governance. Dependent

directors may not take corrective actions because of their interest with the
management. Independent directors could restrain the application of management
discretion through exercise of their supervisory power to protect their effective and
reputation as independent decision-makers. Independent directors can ensure
transparency of the boards. Greater board independence is linked to more
transparency and better monitoring.
Nevertheless, the members of the board themselves may also have interests that diverge from
those of the shareholders and little incentive to monitor unless they are significant shareholders
themselves. When management dominates the board selection processes and the board is
compliant to management, management control is enhanced.

Independent Non-executive Directors

While executive directors have the knowledge and expertise on the firm activities, nonexecutive directors must not only provide advice in strategic decisions but also monitor the
executive directors. Non-executive directors (NEDs) are professionals with the required
knowledge, expertise and abilities, free from any type of personal or business relationship that
could interfere due to a conflict of interests, in the exercise of an independent judgment. They
can limit the exercise of managerial discretion by limiting their monitoring
ability and protecting their reputations as effective and independent decision
makers. (Rosenstein & Wyatt, 1990) proposed the proportion of independent directors
has a positive correlation with company performance.
Dhiman Chowdhury in his book Incentive, Control and Development:
Governance in Private and Public Sector with Special Refernce to Bangaldesh
classified the Non-executive directors into two categories: dependent NEDs
and independent NEDs (Chowdhury, 2012). He defined the dependent
directors are those who were either the employees in that firm or worked as
NEDs in the same firm for 10 or more years. According to him, the
independent NEDs should possess two essential qualities: expertise and
independence. Here, independence means that the NEDs are not involved in

any financial transactions with the organization and the NEDs are free from
the influence from the inside management. He stated that the dependent
NEDs dont play significant influence in mitigating the agency costs. Instead,
they support the management in taking higher compensation. So, there is
positive

association

between

dependent

NEDs

and

higher

executive

compensation. On the other hand, independent NEDs can mitigate the

opportunistic behavior of managers. They can perform check and balance of
the opportunistic behavior of management.
Independence becomes a crucial requirement to control the costs of the different agency
relationships within the firm. Thus the presence of a significant proportion of independent nonexecutive directors tends to ensure an objective control over opportunistic behavior of managers.
It has been stated by (Weisbach, 1988) that a poorly performing CEO is more likely to be
replaced if the firm has a majority of outside directors. However, the outside directors may be
unwilling to discipline and take actions against the management who have selected them.

Corporate Debt Capital

Agency problems within a firm are usually related to free cash-flow and asymmetric information
Problems (Jensen, 1986). Debt obligations help to the reduction of agency problems caused by
these factors. By issuing debt in exchange for stock, managers are bonding their promise to pay
out future cash flows in a way that cannot be accomplished by simple dividend increases. In
doing so, they give shareholder recipients of the debt the right to take the firm into bankruptcy
court if they do not maintain their promise to make the interest and principal payments. Thus
debt reduces the agency costs of free cash flow by reducing the cash flow available for spending
at the discretion of managers. These control effects of debt are a potential determinant of capital
structure. The threat caused by failure to make debt service payments serves as an effective
motivating force to make such organizations more efficient. The control function of debt is more
important in organizations that generate large cash flows but have low growth prospects, and
even more important in organizations that must shrink. (Grossman & Hart, 1982) similarly argue
that the existence of debt forces managers to consume fewer perquisites and become more

efficient as this lessens the probability of bankruptcy and the loss of control and reputation. Thus,
the agency cost can be mitigated by increasing the debt capital of the firm.
But increased debt can create costs to the company. Debt covenants can restrict the firms
production and investment policy (Chowdhury, 2012). Thus, it can impose
restrictions on the management decisions. Increased leverage also has costs. As
leverage increases, the usual agency costs of debt rise, including bankruptcy costs. Thus, the
optimal capital structure should be maintained. .The optimal debt-equity ratio is the point at
which firm value is maximized, the point where the marginal costs of debt just offset the
marginal benefits.

Managerial Compensation
Corporate governance mechanisms can reduce agency cost by aligning the interest of managers and
shareholders. This objective can be achieved by tying the managers compensation directly to firm
performance or firm value. Managerial remuneration is an important part of corporate governance

mechanisms. Since asymmetric information between managers and shareholders, it is essential to

implement incentive compensation. (Core, Guay, & Larcker, 2001) suggested that incentive
managerial remuneration was an effective way to motivate manager to take actions which helped
to maximize shareholder wealth. An increase in managerial compensation may
reduce managerial agency costs in the sense that satisfied managers will be
less likely to utilize insufficient effort, perform expropriation behaviour and,
hence, risk the loss of their job. Jensen and Murthy (1990) have found a
statistically

significant

relationship

between

the

level

of

pay

and

performance. Compensation motivates managers to increase firm value.

Employee profit sharing schemes can be a good tool to align the interest of
owners and management. This will motivate the managers to maximize the
value of the firm. The management can get residual claim because of this
schemes. Here the compensation is directly tied to the performance of the

firms. However, this has some negative impacts. The management may be
interested to manipulate profits in order to maximize their compensations. In
addition, the managers and executives may become short term oriented. For
example, a manager may be reluctant to invest in capital expenditures as
they may not provide positive results within a short period. They may not be
interested in value maximizing investment with long term focus. Thus, this
may increase short-termism among the management (Chowdhury, 2012).

Managerial Ownership
The conflicts of interest between managers and shareholders arise mainly from the separation
between ownership and control. The goal of corporate governance is to reduce the magnitude of
these conflicts and their adverse effects on firm value. Jensen and Meckling (1976) suggest that
managerial ownership could align the interest between the two different groups of claimholders
and, therefore, reduce the agency costs within the firm. Managerial ownership increases the
belongingness among the managers as they have stake in the ownership. Managers who own
little equity in the companies they run have little incentive to serve their shareholders.
Managerial stock ownership helps in aligning managerial interests with those of the external
stockholders. Jensen and Meckling (1976) show that managers have a tendency to engage in
excessive perquisite consumption and other opportunistic behavior since they receive the full
benefit of such activity but bear less than their full share of the costs. They refer to this as the
agency cost of equity and show that it could be mitigated by increasing managerial ownership in
the firm, thus forcing managers to bear the wealth consequences of their actions.
Employee share ownership schemes and share options schemes are most significant examples of
managerial ownership. Under share ownership, the employees are given certain shares of the
company. The main objective of this scheme is to develop the sense of belonging among the
employees (Chowdhury, 2012). Here the shares are offered at the face value or at premium. On
the other hand, under share option schemes, the employees get a conditional right to buy the

equity of the company after certain time (normally three years) at a stipulated market price.
Share options are long term incentive plans and this can increase long-termism among the
employees (Chowdhury, 2012). Generally the managers are risk averse. This scheme can reduce
the risk aversion as the managers can be benefitted from risky but value adding investment
projects. (Ryan & R., 2002) reported a positive relationship between stock options holdings and
Research and Development investment and negative relationship between restricted stocks and Research
and Development investment. Thus, this scheme can reduce monitoring and bonding cost as the sense of
belonging among the employees can be developed. But this scheme may not function properly if the
management is short term oriented. When the managers want to switch to other firms within a short
period, this scheme may not work.

Institutional Shareholders (Ownership Concentration)

Shareholders can take themselves an active role in monitoring management. However, given that
the monitoring benefits for shareholders are proportionate to their equity stakes, a small or
average shareholder has little or no incentives to exert monitoring ?behavior. They can simply
exit (sell their shares) instead of raising voice. In contrast, shareholders with substantial stakes
have more incentives to supervise management and can do so more effectively. (Shleifer &
Vishny, 1986) argue that large shareholders, in view of their significant economic stakes, have an
incentive to monitor managers. They can raise voice against the opportunistic behavior of
management. Institutions are important monitoring agents and exercise an active role consistent
with protecting their significant stake in the firm. Large shareholders can be particularly
important in corporate governance since not all shareholders are able and willing to control
management, but presume that owners with large stakes will oversee the management.
Institutional owners such as mutual or pension funds may also play a significant role in
mitigating agency costs.
Agency costs can be reduced through the presence of large-block shareholders, also known as
blockholders. With a large stake in the firm and hence significant voting rights, blockholders can
directly and indirectly influence the decision making process of the firm. As blockholder

ownership increases, blockholders have a greater incentive to increase firm value through better
monitoring. Consequently agency costs would be reduced and firm value increased.
Although large shareholders may help in the reduction of agency problems associated with
managers, they may also harm the firm by causing conflicts between large and minority
shareholders. The problem usually arises when large shareholders gain nearly full control of a
corporation and engage themselves in self-dealing expropriation procedures at the expense of
minority shareholders.

Other Mechanisms
Other Corporate Governance mechanisms that can be used to mitigate the agency cost may
include the following:
Voluntary disclosure
The information asymmetry between the management and shareholders may create agency
conflicts. The traditional financial statements are not enough to convey the future prospects of a
firm for creating value. Additional financial and non-financial information can reduce the
information asymmetry. Business reporting is more than financial statements. It includes a
number of different elements such as operating data, performance measures, and analysis of data,
forward-looking information, and information about the company, its managers and shareholder.
Market for managerial talent
Apart from the internal mechanism, there are market-wide mechanisms that can constrain the
opportunistic behavior of management. According to market for managerial talent, managers are
hired on the basis of their talent and reputation. So, if they cant maximize the value of the firm,
their reputation will be damaged. This will exert negative influence on his career. So, the
managers will try to maximize the wealth of the shareholders in absence of any regulations.

Findings
Agency conflict arises due to the self opportunistic behavior of the management and the
separation of ownership and control. Misalignment of managers and shareholders interest is the
main reason for agency cost. So, the principal (Shareholders) have to incur costs in order to
monitor the activities of the agents (Management) and try to induce them to work for the interest
of the agent. For this, it is essential to align the interest of the managers and shareholders. A good
corporate governance system is a key element to lead and control the performance of a business
in the best interest of shareholders. So, there is need for governance control mechanisms to align
managers and shareholders interests. A good corporate governance system is a key element to
lead and control the performance of a business in the best interest of shareholders. We have
examined the effectiveness of the alternative corporate governance mechanisms and devices in
mitigating managerial agency problems in the market, such as board characteristics, managerial
remuneration, managerial ownership, ownership concentration and debt financing. These
mechanisms can be useful in mitigating the agency cost but there are certain limitations on the
importance of these mechanisms. The corporate governance mechanisms, their implications in
mitigating agency cost and limitations have been shown in the table below:
Corporate
Governance
Mechanisms

Implication in mitigating agency cost

Limitations or Drawbacks

Large Board of

Directors

More powerful and thus can

discipline

and

opportunistic

monitor

behavior

the

the board selection processes

of

and thus board may be

management
Independent

compliant to management

perform check and balance

management in taking higher

functions
Because of being independent,
they can exert an objective

2012)
NEDs May hesitate to take

NEDs

control

over

opportunistic

behavior of managers
Having vast knowledge and

Capital

Solves free cash flow problems

Limits managerial discretion at

Managerial

spending the free cash flow

Work as a disciplining device
Management can get residual

compensation

Managerial

actions

Institutional

management

the

who

has

appointed them.
restrict the firms production
and investment policy

Management

may

management
Management may become

will

try

to

belonging

the

sense

among

of

in

be

management

conscious
Develops

against

involved

(Chowdhury,

claim on the profits. Thus, the

maximize the profits of the firm
Management can be cost

Ownership

Dependent NEDs support the

compensation

expertise
Corporate Debt

Management may dominate

earnings

short term oriented

If the managers want to

the

switch to other firms within a

management
Develops long-termism among

short period, this scheme

the management (Chowdhury,

functions

2012)
Shareholders with substantial

may not give its intended

They can engage themselves

shareholders

stakes can raise voice against

in self-dealing expropriation

(Concentrated

management
influence the decision making

procedures at the expense of

Ownership)

process of the firm

minority shareholders

From the above analysis, it is evident that the effectiveness of the mechanisms depends on
certain facts. They can produce its intended functions if they are utilized properly. Board of
Directors can monitor and discipline the opportunistic behavior of the management if they are
beyond the influence of the management. In addition, a large board can exert more power and
thus it can help in mitigating agency costs. Debt financing can reduce the available cash flow to
the management and limits the decisions of management. But it can prevent the management to
take certain investment and production decisions. Thus it can hamper the flexibility. So, an
optimal capital structure should be maintained. This can reduce the agency cost and improves
flexibility to the management decision making. Incentive schemes should be based on the
performance. When the compensation is tied with the performance, the management may
become more interested to reveal their expertise. But short term schemes like employee profit
sharing may lead the management to become short term oriented. Thus, they may engage in
earnings manipulation or they can crease short term benefits with the expense long term
profitability. Thus the management may be reluctant to take long term value increasing projects.
On the other hand, managerial ownership can develops the sense of belonging among the
employees as they can become owner of the company with these schemes. Thus, the
management becomes long term oriented. Optimally structured pay packages may provide
managers with suitable incentives to engage in value-maximizing investments, thereby reducing
agency costs. Finally, the ownership concentration or institutional shareholders can exert
significant control over the decision making of the company while the individual investors may
exit instead of raising voice. But they should work for the interest of the other shareholders.
Thus, in order to mitigate the agency conflict and align the interest of the management and
shareholders, the above mentioned mechanisms should be utilized carefully.

Conclusion
Agency relationship arises when one party (the principal) engages another party (the agent) to
perform some services on behalf of the principal. Agency costs refer to various expenses paid
for monitoring and bonding the activities of management. The goal of corporate governance is to
minimize these costs by aligning the interest of the shareholders and management. A good
corporate governance system can improve the performance of a business in the best interest of
shareholders. In order to control and reduce the costs of the agency relationship, control
mechanisms must be considered to ensure that managers act in the interests of the owners. We
have examined the effectiveness of some corporate governance mechanisms and devices in
mitigating managerial agency problems. They include large Board of Directors, independent
NEDs, corporate debt capital, managerial incentive, managerial ownership, institutional
shareholders, voluntary disclosures and market for managerial talent. All of these mechanisms
can mitigate the agency cost but there are certain limitations on the use of these mechanisms. For
example, independent non-executive directors can discipline the opportunistic behavior of
management but dependent non-executive directors may not help in mitigating agency costs.
Large and powerful Board of Directors can monitor the activities of management. If the
management exerts influence in selecting the Boards, then their effectiveness will be limited.
Debt financing can limit the managerial discretion in spending but it can restrict the management
to take productive investment decisions. Managerial ownership schemes can reduce the risk
aversion of the management but this scheme may not be fruitful if the managers prefer short term
incentives. So, these mechanisms should be utilized carefully so that the best possible result can
be obtained.

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