Putting the Good Back in Good Corporate Governance: The Presence and Problems of Double‐Layered Agency Theory

• Published date: 01 September 2013
• Author: Krista Bondy,Jonathan D. Raelin
• DOI: http://doi.org/10.1111/corg.12038
• Date: 01 September 2013

Putting the Good Back in Good Corporate

Governance: The Presence and Problems of

Double-Layered Agency Theory

Jonathan D. Raelin* and Krista Bondy

ABSTRACT

Manuscript Type: Conceptual

Research Question/Issue: Given its position as a dominant logic in corporate governance, this paper evaluates the theo-

retical and practical implications of agency theory on good governance. Agency theory is presented as consisting of two

layers, one resting on the assumption of oppositional shareholder–manager interests and the other resting on the assump-

tion of supportive shareholder–society interests. Given the dominance of the simple economic depiction of agency theory,

its f‌irst layer is heavily researched and supported, while the second layer is largely unsubstantiated and often exploited to

obscure ineff‌iciencies in the f‌irst layer.

Research Findings/Insights: Agency theory is shown to f‌ill a highly institutionalized position in governance, despite often

violating the second layer’s assumption of aligned shareholder–society interests. We assert that the relationship between

societal benef‌its and value maximization must be reconceptualized from interdependent to correlated but independent.

Otherwise, when the second layer of agency theory is undercut, shareholders can eschew their role as societal guardians to

partner with managers and engage in mutual managerialism at the expense of society. We detail how ineff‌iciencies in f‌irst

layer mechanisms (market regulation, monitoring, and contracts) impact agency theory’s second layer and present the new

mechanisms of oversight boards and expanded founding f‌irm documents to reintegrate a societal orientation.

Theoretical/Academic Implications: Aligned shareholder–society interests are shown to be frequently undermined, arti-

f‌icially substantiating the second layer assumption that societal betterment can be suff‌iciently promoted via f‌inancial

rewards and sanctions. We discuss agency theory’s underlyinglogic and present the possibility that a violated second layer

can be exploited to obscure f‌irst layer ineff‌iciencies. Ineffectiveness in the f‌irst layer’s key mechanisms is shown to

potentially undercut agency theory’s promotion of good corporate governance on an organizational and societal level.

Practitioner/Policy Implications: Oversight boards and expanded founding f‌irm documents are presented to make agency

theory’s second layer explicit, ensuring the assumed supportive nature of the shareholder–society relationship is substan-

tiated. Specif‌ically, oversight boards formalize how members of boards of directors are vetted, oversee societal claims to

ensure that appropriate ones are suff‌iciently presented and addressed, supervise reporting, and sanction f‌irms who fail to

enact these duties. Revised founding documents ensure that both economic and social goals are enshrined in the mission of

incorporated f‌irms. Together the two help establish the foundation of a measurable approach to socially responsible actions.

Keywords: Corporate Governance, Agency Theory, Managerialism, Institutional Theory, Responsible Governance

INTRODUCTION

Recent events, such as the fall of Enron (Clarke, 2005), the

widespread corporate bailouts (Hill, 2010), and the

ethical questioning of Halliburton (Rothe, 2006), highlight

on-going problems with long taken-for-granted models of

“good” corporate governance. Despite extensive theoretical

development and empirical exploration in this domain

(Arora & Dharwadkar, 2011), popular depictions of good

corporate governance remain predominantly rooted in

the economic notion that “good” means actions maximizing

f‌irm value (Daily, Dalton, & Cannella Jr, 2003). With

“good” def‌ined economically, other crucial approaches are

marginalized, such as those focused on ensuring that f‌irms

*Address for correspondence: Departmentof Management, School of Business, George

Washington University, 2201 G Street NW, Funger Hall Suite 315, Washington, DC

20052, USA. Tel: 2029947375; Fax:2029947422; E-mail: jonraelin@yahoo.com

420

Corporate Governance: An International Review, 2013, 21(5): 420–435

© 2013 John Wiley & Sons Ltd

doi:10.1111/corg.12038

uphold social contracts between themselves and societies in

which they operate (Donaldson & Dunfee, 1994).

The dominant theory in corporate governance, and an

example of this economic focus, is agency theory. Despite

recent research indicating possiblywaning interest in agency

theory given a lack of predictive validity (Judge, 2009), it

remains highly inf‌luential in management’s depiction of

good corporate governance(Clegg, 2010; Cuevas-Rodríguez,

Gomez-Mejia, & Wiseman, 2012). In fact, it remains the

seminal theory of good corporate governance in related

domains including accounting (Seal, 2006), economics

(Ward & Filatotchev, 2010), f‌inance (Jensen, 2005), law (Lan

& Heracleous, 2010), and strategy (Thomsen & Pedersen,

2000). Despite its potential decline, it is still, “the dominant

theoretical framework from whence much corporate gover-

nance emanates”(Judge, 2009:iii). Thus, ref‌ining and extend-

ing agency theory to more appropriately ref‌lect changes in

the dominant perceptions of legitimatebusiness, and of their

governance, remains critical in management scholarship.

Despite a recent symposium where Jensen (2012) adapted

agency theory to prioritize the impact of personal integrity,1

supported by keeping one’s word, not acting opportunisti-

cally when one’s acts can be easily obscured, and involving

major constituencies regardless of personal impact, agency

theory is widely interpreted and applied in the modern

political-economic environment as a simple economic

theory (Heath, 2009). For example, while Jensen (2012) in his

symposium and recent writings has been willing to relax the

underlying principles of agency theory to allow the possi-

bility that incorporating legal, moral, and social claims on

residual can be interpreted as value enhancing, this has been

slow to be integrated into practice. He states, “The critical

importance of...accountability, its assignment, and its

implications for performance...has long been unrecog-

nized and therefore ignored in most organizations” (Jensen

& Murphy, 2004:5). Similarly, while shareholder primacy is

debated, especially from a legalistic standpoint (i.e., Lan

& Heracleous, 2010; Stout, 2002), it is an institutionally

and socially embedded approach that dominates practice

(Deakin, 2005). Finally, while there is interest in relaxing the

economic assumptions to integrate trust into agency theory,

this research is nascent and yet to be integrated into the

broader f‌ield (Cuevas-Rodríguez et al., 2012). While such

alternative interpretations, theories, and mechanisms exist

(Jensen, 2002), we focus on the simple economic interpreta-

tion as, even though often overstated and abridged, it

remains the most widely used and applied theory of good

governance in management (Thomsen & Pedersen, 2000) as

well as associated disciplines (i.e. Jensen, 2005; Seal, 2006;

Ward & Filatotchev, 2010).

Given the confounding of “good” with f‌inancially viable

in agency theory (Fama, 1980), the dominant theory of cor-

porate governance, it is critical to uncover how its portrayal

shapes the f‌ield and how it can be adjusted to facilitate a

broader depiction of “good” while remaining true to its

theoretical foundation. We thus seek to make the normative

foundations of agency theory explicit through four linked

sections in this paper. We f‌irst discuss how “good” gover-

nance is impacted by focusing on the mitigation of agency

costs (heretofore referred to as agency theory’s f‌irst layer).

Second, we present the practical mechanisms and associated

limitations in the f‌irst layer’s attempt to promote good gov-

ernance. Third, we reveal a second layer of agency implied in

agency theory, showing how it can be exploited to address

ineff‌iciencies arising in the f‌irst layer. Fourth, we suggest

two mechanisms to help support the second layer of agency:

industry oversight boards and f‌irms’ dual purpose being

recognized in founding documents. We contribute to the

governance literature by explicitly placing society in the

central position implied by agency theory’s second layer

and by linking agency theory to the broader governance

debate around the role of business in society. By realigning

agency theory with a socially-oriented approach to good

governance, we embrace a more nuanced approach to

agency theory and bring “good” back into good governance.

In so doing, we also hope to make a step towards addressing

Jensen’s (2005) concern that: “[T]he problem here is that we

do not now know how to create...well-functioning gover-

nance systems” (p. 15).

AGENCY THEORY AND GOOD

CORPORATE GOVERNANCE

Given the dominance of agency theory within corporate

governance, good corporate governance is often interpreted

by the modern political-economic environment as solely ori-

ented to valuemaximization, frequently used synonymously

with prof‌it maximization (Daily et al., 2003). In other words,

“good” is equated with f‌inancial viability (Fama, 1980) and

“corporations exist to generate economic returns, not to

solve societal problems” (Devinney, 2009:49). Agency theo-

rists therefore reduce good corporate governance to a cost–

benef‌it calculation that merely describes what managers and

shareholders do to maximize value, without judging the

moral veracity of these actions. It therefore also remains

largely descriptive about who is a legitimate claimant (i.e.,

society, employees, customers) (Jensen & Meckling, 1976),

ignoring normative foundationsin preference of value maxi-

mization as its key organizing principle (Jones & Hunt III,

1991).

With a focus on value maximization comes an orientation

to agency theory’s f‌irst layer which is, in line with the above

discussion, oft-depicted as solely driven by prof‌it and

self-interest (Jensen, 2002). Specif‌ically, in the f‌irst layer

managers are portrayed as agents of f‌irms who engage

in managerialism, a form of opportunism related to the

principal–agent problem, where f‌irm wealth is sacrif‌iced for

enhanced salaries, reputations, bonuses, and other desired

outcomes (Fama & Jensen, 1983). With conf‌licts arising

between managers pursuing personal wealth and share-

holders pursuing maximized f‌irm value (Cyert, Kang, &

Kumar, 2002), agency theory strives to limit managerialism

and restore goal alignment to the manager–shareholderrela-

tionship. To do this, the f‌irst layer of agency theory was

developed, which positions shareholders and managers as

adversaries. With shareholders depicted as oriented to value

maximization and managers depicted as oriented to per-

sonal value, a competition arises around the distribution of

scarce resources. The adversarial relationship arises as both

parties direct scarce resources in potentially oppositional

PUTTING THE GOOD BACK IN GOOD CORPORATE GOVERNANCE 421

Volume 21 Number 5 September 2013© 2013 John Wiley & Sons Ltd