Rethinking Agency Theory As a Foundational MODEL for Designing Executive Compensation Mechanisms in Public Corporations

This paper asserts that agency theory has failed as a foundational model for designing executive compensation mechanisms in public corporations.  This assertion is supported by the inconclusive nature of empirical evidence gathered over the past 35 years, which has failed to establish a significant connection between executive pay and stock price performance (see Frydman & Jenter, 2010). It is also widely-held view that agency theory has performed badly as an instrumental framework, especially during the 2008-2010 financial crisis (e.g., Roberts, 2010).

The article examines three different types of theorizing (after Donaldson & Preston, 1995) and locates the present paper in this taxonomy as instrumental theory. It describes the current standard agency model and a critique advanced by scholars (e.g., Blair & Stout, 1999; Bainbridge, 2003) writing in the economics and law tradition.  As an alternative to “shareholder primacy” (Friedman, 1970), Bainbridge (2003) proposes “director primacy” which treats the corporation is a vehicle for the board of directors to hire various factors of production.  In this model the board is: “a sui generis body – a sort of Platonic guardian serving as a nexus for the various contracts comprising the corporation” (Bainbridge, 2003, p.550-51).  Director primacy largely aligns with Blair and Stout’s analysis that the duties of directors of public corporations more closely resemble of trustees rather than agents.  It is also consistent with an alternative construction of the over-riding responsibility of directors, proposed in a later paper by Michael Jensen, of what he calls “enlightened stakeholder theory” or “total firm value maximization” (Jensen, 2001). This specifies the long-term value maximization of the whole firm (i.e., as distinct from its shareholders) as that the primary objective of company managers.

The paper finds support for this alternative construction of the nature of public corporations in its analysis of empirical data regarding shareholders and governance arrangements in public companies in the UK.  The paper concludes by proposing a revised model of agency in public corporations, predicated upon the principle of total firm (i.e., rather than shareholder) value maximization, distinguishing between two forces, a “strong principal-agent force” and a “weak fiduciary-beneficiary force”.  The revised model also incorporates a framework for allocating surpluses between different stakeholders.