April 02, 2006
Static vs. Dynamic Agency Cost Theories of the Firm
Posted by Bobby Bartlett

I just finished reading Henry Hu and Bernie Black’s fascinating paper, Empty Voting and Hidden Ownership: Taxonomy, Implications, and Reforms. The paper examines how derivatives transactions can permit the decoupling of stock voting rights from the stock’s economic ownership. It was these techniques that lay behind the well-documented “vote-buying” brouhaha last year at Mylan Laboratories. Basically, through the use of fancy derivatives transactions, a hedge fund (Perry Capital) managed to acquire a 9% voting stake in Mylan without any concomitant economic stake. Why did Perry do this? It wanted to ensure that Mylan’s stockholders approved a pending and arguably over-priced acquisition of King Pharmaceutical—a company in which Perry held a significant long position. Hu and Black demonstrate that the Mylan episode may represent a larger trend towards “empty voting” by hedge funds and company insiders. This is problematic, Hu and Black suggest, because it allows a financial investor (or insider) to vote company shares in a manner that advances its own interests at the expense of other company stockholders.

I found the article interesting for a variety of reasons, but especially for a point not explicitly raised by Hu and Black. In particular, empty voting emphasizes the challenge posed by the dynamic nature of agency problems within a firm—a fact that gets little attention in corporate scholarship. In general, mainstream corporate literature continues to adhere to a Berle & Means vision of the corporation: given the separation of ownership and control, modern corporations are plagued by a significant divergence of interest between managers and shareholders. The primary function of corporate law should therefore be to minimize this divergence of interest and the agency problems it creates for shareholders. Fundamentally, the model is a static one in that it views these agency problems (and potential solutions to them) as frozen in time and isolated from other conflicts that might exist within a corporation.

Yet the agency problems that affect firms are frequently dynamic and inter-related. Take the use of empty voting by a stockholder (such as Perry in Mylan) with economic interests that are not shared by other company stockholders. Empty voting already allows the stockholder to influence stockholder voting in the context of change-in-control transactions. If we increase shareholder voting rights more generally to address “vertical” agency problems with managers (as, for example, is advocated by Lucian Bebchuk), what stops these shareholders from using empty voting in other contexts to advance their particular interests? A goal of Hu and Black’s paper is to propose a regulatory response to address empty-voting, but they concede that some form of empty voting will likely remain. In any event, one need not limit the challenge of shareholder opportunism to empty-voting. It arises in a variety of other contexts as has been documented by Iman Anabtawi and Stephen Bainbridge (see here and here).

In my view, a central challenge for corporate governance reform in general—and shareholder empowerment theories in particular—is the dynamic character of agency problems. I haven’t worked through fully the normative implications of this observation, but I have set forth some preliminary thoughts in a recent article, Managing Risk on a $25 Million Bet: Venture Capital, Agency Costs, and the False Dichotomy of the Corporation. The paper will be published in the UCLA Law Review later this year but is currently available on SSRN (abstract & paper here). In general, the article develops a dynamic agency cost theory of the firm by analyzing the agency problems that affect venture-backed start-up companies. I decided to use venture capital finance to illustrate the theory because it provides such a clear example of the dynamic formation of agency problems. Concerned about “vertical” agency risk with company managers, VC investors demand a variety of contract rights to protect against this risk. In so doing, however, they create a new dimension of horizontal agency problems among investors themselves. Interestingly, investors appear completely aware of this “dual-dimension” of agency risk in start-up companies, but VC scholarship has focused almost exclusively on the potential for “vertical” conflict with company managers. Why? One potential reason is that the standard analytical framework for analyzing agency problems in firms lacks the capacity to account for multi-dimensional, inter-related agency problems. If true, I suspect a similar phenomenon may be at work in analyses of public corporations.

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