Market Solutions to the Agency Problem in Periodic Financial Reporting
Edgar Carlos Duarte Aguilar
“The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be as dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.”
Enron’s bankruptcy in 2001 was a milestone in recent times as far as corporate governance regulations it is concerned. Besides the ...view middle of the document...
In contrast, we will also analyze the solutions that emerge spontaneously in the market to address the agency problem and how they are superior to governmental regulation in achieving this goal.
The essay consists of six parts: the first part is this introduction, in the second part we will explain what the agency problem is, in the third part we will explain the regulatory background for US public companies in which the Enron scandal took place, and the incentives these companies faced, in the fourth part we will discuss the new regulation of the SOA on public companies and external auditors and we will highlight how the incentives that this regulation creates make it highly inefficient for achieving its objective, in the fifth part we will explain how the market solves the agency problem and how this solutions are superior in terms of effectiveness and efficiency, and finally, we will add a conclusion for this essay.
The Agency Problem
Economics studies the incentives that motivate human action. Indeed, human beings act to achieve ends that they value and use means at their disposal to do so (Mises 1998 , pp. 12-13 and passim.). An agency contract occurs when a person, the principal, hires another, the agent, to perform a service (Krause 2000, p. 1). The principal contracts the agent to look after his interests, say, to administer his property. An agency problem happens when the agent acts in its own interests to the detriment of the interests of the principal that hired him. According to Fama & Jensen, this problem arises when there is a separation between the decision-making and the risk bearing (Fama & Jensen 1983, p. 302). Due to this, it is necessary to supervise the agent.
Adam Smith had already noticed this problem when he wrote:
“The trade of a joint-stock company is always managed by a court of directors. This court, indeed, is frequently subject, in many respects, to the control of a general court of proprietors. But the greater part of these proprietors seldom pretend to understand any thing (sic) of the business of the company; and when the spirit of faction happens not to prevail among them, give themselves no trouble about it, but receive contentedly such half-yearly or yearly dividend as the directors think proper to make to them… The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own… Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.” (Smith 1776, Book V, Chapter I, Part II, Art. I)
The agency problem became more serious as the corporation came to be the most common form of ownership, and thanks to the stock exchanges, the company ownership was now diluted among more people (Krause 2000, p. 2). In this case each...