Corporate Governance is an important subset of Company/ Corporate Law. Within this, one of the main areas that corporate governance aims to regulate is ‘conflict of interest’ arising between insiders and outsiders of a company. These conflicts are what is known as an ‘Agency Problem’. This article aims to give a brief overview of the Agency Problem as it exists in the Indian scenario. We will be analysing the three different types of agency problems and also discuss the best legal strategies to resolve them.
Broadly speaking, an agency problem involves the functioning of a typical Principal- Agent relationship as seen in contractual agreements however, the problem here is ensuring that the agent acts in the principal’s interest, rather than his own. The agency problem occurs due to the fact that the agent has better knowledge of the facts of a given transaction as opposed to the principal and thus the principal has no assurance that the agent’s actions were indeed in his best interest. There is room created for the agent to act opportunistically in such scenarios. Consequently, there is a conflict of balance of powers.
TYPES OF AGENCY PROBLEMS
As described by John Armour, Henry Hansmann and Reinier Kraakman in their paper titled “Agency Problems, Legal Strategies And Enforcement”, there are 3 basic types of agency problems. The first problem is a conflict between the owners of a firm and the hired managers. The owners are the principals here and the mangers who have been hired to run the company are the agents. The problem comes to existence because of the owner’s insecurities wherein they wish to ensure that the managers are responsive to them and do not merely pursue their own interests. The second type of problem is the conflict between the controlling owners of a firm who hold majority and the non- controlling, minority shareholders. There is a problem of overwhelming degree of control here between the controlling owners who are the agents and minority shareholders who are the principals. In these companies, the owners have all the controlling power in the company’s affairs and hence their interests supersede that of the remaining shareholders. The third type of agency problem is the conflict between owners of the firm and third transacting parties such as creditors, customers and other employees. The problem here lies in ensuring that the firm or the agent, does not behave opportunistically towards these other principals.
These agency problems arise in the legal corporate scenario due to multiple reasons. The first reason is “perception of risk” where it is assumed that the agent is usually someone who averts risks whereas the principal is a risk seeker. This motivates the agent to act for his own benefit and skimp on the quality of the company’s performance since the extent of involvement of the agent with the transactions of the company is far greater than that of the principal. Second reason is that of “separation of ownership and control”. The principal, as the owner, does not get to directly take part in the day to day decision making process of the company because that work is delegated to the management. Another important reason is the “information asymmetry” which occurs when there is a gap in information and knowledge between the agent and the principal because one person (usually the agent) has better knowledge of the state of affairs and performance of the company. Lastly, one of the main reasons is the problem of “agency or coordination costs”. These costs further worsen the agency problem because there are multiple principals involved here. When there are multiple interests involved, it becomes difficult for them to coordinate with each other. This leads to excessive delegation of duties to agents hence making it even more tough to ensure that the agent doesn’t act in his own interests and does the right thing. These costs create a vicious cycle of persistent agency problems and are the most important to tackle.
LEGAL STRATEGIES TO SOLVE THE AGENCY PROBLEM
Law plays an important enabling role in the elimination of agency costs and problems. Legal Strategy in this context means “a generic method of deploying substantive law to mitigate the vulnerability of principals to the opportunism of their agents.” Procedural rules help enhance the levels of disclosure inside companies and also help by taking action against agents for their fraudulent or dishonest acts. Disclosure of information in the forms of periodic disclosure or the annual reports shared with shareholders is a very important form of communication which can greatly reduce agency problems. In India, the Companies Act, 2013 contains provisions for mandatory disclosure of this information through various sections such as S. 92 (annual returns), S. 177 (vigil mechanism), Rule 18 (notice of meetings), Rule 23 (special notice on website) etc.
A) Regulatory Strategy
There are two primary legal strategies for controlling the agency costs. First is the “regulatory strategy”. These are prescriptive strategies that dictate the legal terms for governing the principal – agent relationship. They aim to regulate the agent’s behaviour by enforcing rules on them. In India, there are many instances of this strategy being used. Apart from the regulations enclosed in the Companies Act, 2013 which are enforced by the Ministry of Corporate Affairs (MCA), many external bodies have also been established in India to look after the activities of companies. These include the Securities and Exchange Board of India (SEBI). There are also two national stock exchanges in India- the Bombay Stock Exchange and the National Stock Exchange. Companies that wish to enlist themselves on these are expected to be registered with SEBI. The SEBI Act of 1992 grants SEBI the authority to regulate the stock exchanges, including the power to conduct inspection which aids in controlling agency costs. Additionally, the National Company Law Tribunal (NCLT) is another regulatory body which helps to resolve disputes within companies and drastically reduce the agency problem by ensuring that fraudulent agents are held accountable.
B) Governance Strategy
Second legal strategy is “governance strategy” which aims to make it easier for the principal to exert control over the agent’s behaviour. These strategies ensure that within the company itself, the principals are able to monitor the acts of the agents. For instance, a good governance strategy might be to incentivise the agents of a company by introducing rewards or bonuses to encourage good behaviour. Other examples of governance strategies in the Indian scenario include the provisions for selection/ appointment and removal of directors in the Companies Act, 2013 which is specified under S. 149 and S. 169 respectively. It was established in the case of Ferguson v. Wilson that director is an agent of the company and his actions should be in the best interest of the company. The appointment of independent directors under S. 149 (6) is also an important strategy to for controlling agency costs as they are expected to be “not related to promoters or directors in the company, its holding, subsidiary or associate company and someone who has or had no pecuniary relationship with the company, its holding, subsidiary or associate company, or their promoters, or directors”. They comprise of 1/3 of the Board of Directors and play an important impartial role in the decision making process which can help balance out the conflict of interests. Other effective examples of governance strategies in India include provisions for external auditors. Under S. 143, “if an auditor of a company in the course of performance of his duties has reason to believe that an act of fraud is being committed against the company by the employees of the company, he shall immediately report the matter to the central government”. The formation of an audit committee is a statutory requirement and an imperative governance mechanism which acts as bulwark against the mounting agency conflicts.
In our opinion, in the Indian scenario, regulatory strategies are more effective than governance strategies because their effectiveness depends solely on the efficiency of external regulatory bodies for ensuring accountability. As opposed to governance strategies where the principal needs to internally ensure adherence of the agent to the accountability measures, regulatory strategies depend on the smooth functioning of bodies such as the NCLT which have been a stronger compliance rate in India and greater standards of expertise. Another reason why governance strategies are not as effective is because sometimes companies can engage in “symbolic governance”. As seen in many Indian cases such as the ICICI Bank and Videocon Loan case, companies have independent directors, constitute various committees as required by the law, fulfil their annual report requirements etc but this is all merely just a box ticking exercise to avoid inspection. Thus regulatory measures ensure real accountability and can be better.
Agency problem is the type of conflict which can create many difficulties in the operations of a company. It can cause distrust between owners and the employers, lead to lack of transparency and the thus inhibit the smooth functioning of the company. However, there are ways to resolve this. The problem can be mitigated by closely arranging the incentives of the agents with those of the principal and as discussed in this article, it can be regulated via means of external regulatory bodies in India. While complete elimination of all agency problems might be impossible, addressing and fixing the main ones is important for proper functioning and survival of a company.
Statutes and Legal Papers