CORPORATE GOVERNANCE

AND THE POLITICS OF AGENCY THEORY

by 1

Jordan Otten
jotten@rsm.nl
&
Ben Wempe
bwempe@rsm.nl
RSM Erasmus University
Department of Business Society Management
P.O. Box 1738
3000 DR Rotterdam
The Netherlands
Fax: +31 10 4089012

Both authors have contributed equally to the manuscript. The names are in alphabetical order.

CORPORATE GOVERNANCE
AND THE POLITICS OF AGENCY THEORY
ABSTRACT. This paper applies Wolins sublimation thesis to the field of corporate
governance. Applying this thesis helps to explain how the dominant use of agency theory
and its predisposition with shareholder interests has gained both descriptive and
prescriptive powers in pointing out corporate governance problems and proposed
solutions to these problems. Although the focus of such a single approach has greatly
contributed to our understanding, it carries however some clear normative implications,
which are not always fully appreciated by present-day scholars of corporate governance.
We argue that the dominant use of this single theory has the downside effect of
hampering new theory developments and has considerable normative implications for our
contemporary understandings of corporate governance in both theory and practice.

KEYWORDS: agency theory, corporate governance, executive pay, neo-classical

economics, philosophy of science, shareholders, sublimation of politics, stakeholders

Introduction
The American political theorist Sheldon Wolin is chiefly known for his monumental
study Politics and Vision (Wolin, 1960). Wolin taught at the University of California,
Berkeley, from 1954-1970 and at Princeton University from 1973-1987. Entire
generations of students around the world used this authoritative textbook, which
chronicles the history of political theory from the ancient Greeks via the church fathers,
Luther, Calvin, Machiavelli, Hobbes and Locke to the rise of Liberalism in the Modern
Age. In 2004 Wolin issued a second, expanded edition of his opus magnum, which added
seven substantive chapters dealing with his interpretation of nineteenth and twentieth
century thinkers such as Dewey, Marx, Nietzsche, Popper and Rawls.
From the point of view of organization studies arguably the most important part of
Wolins work is the concluding chapter in the first edition (chapter ten) dealing with The
Age of Organization and the Sublimation of Politics. In broad outline, Wolin argues here
that up until the modern age, the notion of politics was self-evidently related to the
concern for the common good of a community. For that reason political theory took on a
natural priority over all other issues and concerns. With the rise of organizations and the
conceptualization of society as a separate sphere alongside the more traditional notion
of political community, concern for the common good lost the natural claim to primacy
that was attached to it by classical theories of politics.
This forms the immediate context of Wolins sublimation thesis, which claims that in
the modern age the state is no longer the unique and natural referent of political
argumentation. This function is increasingly taken over by institutions and smaller
community relations obscuring the idea of a comprehensive and self-evident common

good. Therefore, the characteristic feature of modern public affairs is the diffusion of the
political, the absorption of the political into non-political institutions and activities:
One of the oddities of the times is that while there has been a noticeable decline in
political interest in non-totalitarian societies, social scientists have been busy
discovering political elements outside the traditional political structures. No longer
do legislatures, prime ministers, courts and political parties occupy the spotlight of
attention in the way they did fifty years ago. Now it is the politics of corporations,
trade unions, and even universities that is being scrutinized. This preoccupation
suggests that the political has been transferred to another plane, to one that formerly
was designated private but which now is believed to have overshadowed the old
political system (Wolin, 1960, p. 353).
A chief characteristic of the modern age was the appearance of the masses on the
political stage rendering necessary new forms of organization of public life. Wolin
therefore analyzed modern political thought over the past 200 years as an attempt to
reconcile the requirements of organization and community. Given this need for
organization, the crucial problem for the modern age becomes how to create sufficient
space for community.
Accompanying the invention of society and the more restricted forms of human
collaboration known as organizations was the rise of a specialized branch of social
sciences alongside the natural sciences. The great German sociologist Max Weber was
the first to perceive that the methodology of these new social sciences took on the
function that was traditionally reserved for political theory. To Weber, methodology was

a type of political theory transferred to the only plane of action available to the
theorist at a time when science, bureaucracy, and capitalism had clamped the world
with the tightening grid of rationality (Wolin, 1981, p. 406).
Wolin thus credits Weber with the idea of a politics of theory. Although this idea
appeared implicitly throughout his work, it is explicitly addressed only in his essay on the
methodology of the social sciences (Wolin, 1981). Wolin draws a parallel between
founding in politics and founding in science. In the same ways as the foundations of
any existing political community is laid down by some legislator or leader, new theories
and new sciences build on the foundational work of some scientific hero. Weber clearly
acted as such a scientific founder, when he bequeathed us the hermeneutic tradition in
sociology. In his 1981 article Wolin reconstructs in some detail how this new science
acquired its legitimacy. He sets out that, once the initial, legitimacy-bestowing phase is
over, disciples continue the example set by the founder on the basis of a set of
methodological prescriptions specifying the authorized procedure to conduct scientific
inquiry.
The idea of a politics of theory will serve in this paper to make clear that the
seemingly neutral introduction of new theories always commits us to more than theorists
want us to believe. For, as a rule, new theories cannot be laid down in the manner in
which one plants a flag on an inhabited island. In order to found a new science or theory
the newcomers need to expel (at least some) of the native inhabitants to render the theory
or science legitimate. Successful authors often succeed in presenting this colonial
conquest as something trivial. Only once a new theory has acquired sufficient legitimacy,
it can turn to the order of the day. From that moment on the emphasis lies on following

the rules and conventions of the new paradigm by means of some methodological
prescription to order scientific activity.
In this paper we apply Wolins sublimation thesis and his ideas about the politics of
theory to point out the descriptive and prescriptive powers of agency theory (Jensen and
Meckling, 1976) and the manner in which this has shaped contemporary thinking about
corporate governance problems and problem resolutions. We apply Wolins ideas to
corporate governance because this field of study is clearly dominated by the use of this
single theoretical approach. The agency logic (Zajac and Westphal, 2004) or agency
paradigm (Bebchuk and Fried, 2004) most often serves as a foundation for new or
extending theory developments in the field and is commonly used as a blue print for
empirical studies.
The paper is structured as follows. First, we set out a brief description of agency
theory as it is typically used in current corporate governance research. Second, we set out
some of the current debates about its interpretation and applications and we apply
Wolins idea of a politics of theory to these discussions. Third and finally, we conclude
the paper arguing that the descriptive and prescriptive powers of this single dominant
theory have some clear normative implications, intended as well as unintended. It can for
instance hamper new theory developments; it can stretch the fundamental theoretical
assumptions beyond a reasonable depiction of the subject of study; and it can severely
constrain policy makers in developing new courses of action.

Agency theory and the study of corporate governance

As Eisenhardt (1989) has reminded us, even the most basic question what is agency
theory? is subject of controversy. Authors such as Kiser (1999) and Shapiro (2005) have
inventoried varieties of theories of agency in the fields of economics, management, law,
political science and sociology. Shapiro (2005) even concludes that the differences
between these approaches are so significant that she opposes the very idea of coupling
agency and theory. Be this as it may, we shall nevertheless seek to point out that there
is a common core to different disciplinary varieties of the theory of agency. For all these
theories start from the condition that one party acts on behalf of another (Shapiro,
2005). As most of the disciplinary approaches regard this situation as problematic, there
is a recurrent theme of finding solutions or alleviations to the agency problem in the
corporate governance literature. In the field of sociology, however, this situation is not
necessarily regarded as a problem, but it may as well serve as a likely solution to social
interactions and relationships (Kisser, 1999; Shapiro, 2005); in this framing, agency is in
fact . a neat kind of social plumbing (White, 1985, p. 188).
On the other hand, the economic variety of agency theory, which is dominant in the
corporate governance literature, typically regards delegation of activities as a problem. It
is centered on the agency problem between corporate shareholders and corporate
management.
This view proceeds from the lens of neoclassical economics, a perspective which can
be described as an approach which (1) assumes rational, maximizing behavior by agents
with given and stable preference functions, (2) focuses on attained, or movements
toward, equilibrium states, and (3) excludes chronic information problems (Hodgson,

1998, p. 169). This lens has led researchers to focus on transactions and contracts, which
are embedded in price and market mechanisms (cf. Augier, Kreiner and March, 2000;
Coase, 1988; Kay, 2000; Simon, 1991). The thrust and characteristic use of economic
agency theory is to analyze certain aspects of the relationship between collaborative
individuals. Human collaboration (as in the production of goods and services, for
example) potentially generates a cooperative surplus. If two or more people work
together, they can produce more than any individual on her own. This cooperative surplus
has three conditions for human cooperation to add value: 1) each individual must focus
on a specialized task; 2) various specializations need to be coordinated; and 3) parties
must agree on a standard for a fair distribution of the cooperative surplus. To fulfill the
conditions of coordination and distribution individuals can contract with one another.
Agency theory deals with a special case of such contracts, i.e. the situation in which one
of the parties delegates responsibilities to another, while the former lacks full information
about the efforts of the latter party, and the formers wealth is dependent on the
performance of the latters efforts.
In its economic variety, agency theory makes assumptions about people (e.g., selfinterest, risk preferences), about organizations (e.g., goal conflict among members,
information asymmetry; corporate objective function), and about information (e.g.,
information is a commodity which can be purchased). Given those assumptions, it then
asks which type of contract is most efficient, a behavior-oriented contract (e.g., salaries,
hierarchical governance) or an outcome-oriented contract (e.g., commissions, stock
options, transfer of property rights, market governance). In its economic variety, agency
theory assumes that actors are fully rational, behave according to stable risk preferences,

and maximize their self-interests (Jensen, 2001; Jensen and Meckling, 1976). The agency
problem arises here because of the separation between ownership and control (Berle
and Means, 1932/2004). The fundamental problem is the differential interests and risk
preferences of firm owners and management. Firm owners can spread their wealth across
many different firms, and optimal portfolio theory suggests that it is in fact wise for them
to do so (Fama, 1980). Managerial wealth, on the other hand, is tightly linked to the firm
by which management is employed. These differential positions make that owners and
managers have different risk preferences, and therefore tend to have different interests
and subsequently behave differently in similar circumstances.
To solve these conflicts of interests, it is typically assumed that it is the goal of the
firm is to maximize (Jensen, 2001) by furthering shareholders interests or to
economize (Williamson, 1991) by lowering transaction costs. Matters of organizational
and contractual design thus must be tackled with these objectives in mind. Given that
managers enjoy the delegated control over the firm, it is their influence that must be
tempered. In order to avoid them making self-interested decisions with subversive effects
on shareholders, a contract is typically drawn up between the firm owners (i.e. principals)
and firm managers (i.e. agents), which specifies desired managerial behaviors under all
circumstances. The purpose of this contract is to minimize residual losses for
shareholders.
Given that managers are expected to maximize their self-interests, they cannot be
expected to abide by the contract after signing it. To ensure managerial compliance with
the contract, owners have two basic instruments at their disposal. They can either monitor
managerial behavior to prevent management from making the wrong decisions, or when

perfect monitoring is not possible, provide management with incentives (bonding) to act
on their behalf. Since sub-optimal behavior by management cannot wholly be avoided,
the efficient contract is one that minimizes residual losses for shareholders. In practice,
this comes down to finding an optimal (i.e. efficient) balance between the costs
associated with monitoring and with bonding.
One important way of understanding agency theory is to assess the model of human
decision making that agency theorists normally subscribe to. Seen from an agency
perspective, decisions are taken on the basis of what Cyert and March (1963/1992) call
the logic of consequence. This decision making logic is grounded in a rational choice
model of human behavior, in which actors are expected to evaluate alternatives in terms
of the values of their consequences (Cyert and March, 1963/1992, p. 230). According to
this decision making logic, the decisions of principals and agents alike are rooted in
rational, calculative, anticipatory, and consequential actions (Cyert and March,
1963/1992). Agency-theoretical models produce accounts involving multiple strategically
interacting actors, each pursuing self-interested objectives and constrained or facilitated
by the similar rational pursuit of self- interested objectives by others (Cyert and March,
1963/1992, p. 230). One of the pillars of agency theory is the assumption that efficient
market and pricing mechanisms determine actors decision making choices as these
choices are evaluated on the basis of the market values of their consequences. This logic
of consequence, facilitated by assumed efficient market forces, will rapidly lead to a
unique optimal that is guaranteed to be achieved (March and Olson, 1984, p. 737).

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The politics of agency theory

All theories simplify. The idea of a politics of theory draws attention to the manner in
which theories simplify and, more specifically, it focuses on the manner in which theories
predispose certain results by proceeding from certain conceptual frameworks and
problem settings. As a result the dominant paradigm can set the normative standards for
new theory development or theoretical extensions. Thereby empirical studies and
possible extracted policy implications for practice are based on the paradigms rules and
conventions.
The seminal contribution of Jensen and Mecklings (1976) agency model dominates
the corporate governance literature. The corporate governance literature therefore serves
as a very good example of 1) the manner in which the dominant paradigm of agency
theory simplifies, 2) how it is predisposed with dominant (normative) foundations, and 3)
how it shapes the contemporary way of thinking on corporate governance. Although
agency theory has frequently been criticized before (see e.g. Eisenhardt, 1989; Perrow,
1986; Zingales, 1998) the present criticism is new in that it is systematically informed by
Wolins notion of a politics of theory. It is not intended as an overview of all possible
criticisms that have appeared in the literature. We do not claim that no other eminent
criticism is possible. Important to note, however, despite the critical comments, is that the
corporate governance literature also flourishes by the use of this dominant paradigm.
Given that the field of study is a relative new field of inquiry, the enormous number of
studies that have appeared in the literature since the 1970s shows what significant role
corporate governance research has played in academic research to date (cf. Zingales,
1998).

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The predisposition with shareholder interests

There are several ways to illustrate how economic agency theory simplifies and how this
can be problematic in an analysis of corporate governance. An obvious bias in much of
the current corporate governance literature concerns the bestowal of the name corporate
governance itself in combination with the standard perspective in which these studies are
most often conducted. The very label of corporate governance suggests a series of
observations, analyses, or comments on the manner in which modern corporations are
being governed. Two very fundamental questions concerning this governance are: what is
the corporate objective and what constitutes the basis of legitimacy for the corporation?
The connotation of the general label of governance in combination with the fact that
actual studies and current understandings of corporate governance in general are typically
reduced to the question how owners (i.e. shareholders, or principals in agency terms) can
control managers (which are supposed to work as their agents) (Shleifer and Vishny,
1997) suggests that this is the only or the main important issue to be raised in this field of
inquiry. As a result, when starting from the conventional agency corporate governance
perspective, any interests of other stakeholders are already placed in a subordinate
position in the debate. The agency framework in corporate governance suggests that the
furthering of shareholder interests is a privileged goal, maybe even the only legitimate
goal for a corporation to pursue. Within the framework of transaction costs economics, an
adjacent economic theory of organization, this claim is also supported by the argument
that shareholders are unique bearers of residual risk in any entrepreneurial project. In
other words: all other interest parties which form part of the enterprise have other means

12

at their disposal c.q. have stakes which are secured before those of the bearers of residual
risks (Williamson, 1988, 1996).
This argument has been convincingly challenged by Blair (1995). This author has
pointed out that the restricted financial rendering of agency theory does not account for
this substantive restriction of the description of the goal of any corporation. It just picks
out the one relationship between corporate owners and management and treats this apriori as a privileged relationship. This predisposition with shareholder interests carries
normative implications of the application of the theory. As Perrow (1986) argues, these
predispositions and the inability to at the same time focus on the interests of the agent in
finding solutions, makes the paradigm a dangerous one, specifically because of its
ideological connotations. This can be illustrated by focusing on two of the fundamental
assumptions made in agency theory; 1) the assumption of maximizing social wealth by
maximizing shareholder wealth, and 2) the assumption of self-interests.

Wealth creation for all

A core argument made on behalf of the economic interpretation of agency theory is that
in governing the corporation, it makes sense to seek to produce maximum value first,
only after you have done this you can consider questions of distributive justice. The idea
is to make sure you produce the highest value for corporate owners first in order to create
the highest possible social welfare, only then you can and should start thinking about how
to distributive this welfare fairly.
Of fundamental concern in this respect is the complete contracting assumption of
agency theory. Following Zingales (1998), in a world of complete contracts no
meaningful definition of corporate governance is however possible. The argument here is

13

that investments in the corporation can be sunk and firm-specific in a way that they create
additional surplus to only the supplier of the good and the consumer of that good. These
transactions create so-called quasi-rents (Zingales, 1998). In those cases, products cannot
be sold immediately on the market at current market prices, as market prices do not
reflect the specific value the contracting parties contribute to it or cannot immediately be
sold without interfering the production process. To effectively structure the bargaining
processes over these rents is the reason for corporate governance in the first place
(Zingales, 1998). In a world of complete contracts however, the designer of the contract
would have anticipated all possible disputes about the distribution and bargaining over
quasi-rents in the ex-ante contract. Ex-post agency problems can therefore not occur
because they are already resolved in the initial ex-ante contract. In other words, by
solving all possible problems ex-ante the issue of clearly existing problems of ex-post
bargaining cannot even be raised (Zingales 1998).
The different contracts which make up the firm in this nexus of contracts approach
would thereby somehow have to systematically be related to each other. Ex-ante the
designer of this system would have to have insights in all possible (future) problems to be
able to give priority to a given contract, or at least give priority to parts of a contract to
other parts of the (other) contracts. .[D]elegation is always weakly dominated by a
fully centralised mechanism, where decisions are made ex-ante by the designer
(Zingales 1998, p. 6). In the original statement of the theory, Jensen and Meckling (1976)
consider this type of mechanisms to be constant. Although these authors acknowledge the
role of for instance the legal enforcements of contracts and the role of political
interference, they do not incorporate these influences in their theory. They are considered

14

to be constant factors and therefore exogenous to the model. The central mechanism in
agency theory is the market. Other mechanism such as legal institutions to alleviate expost bargaining problems and the distribution of qausi-rents, which value per definition
cannot be determined ex-ante, are not considered. Such mechanisms would however have
to exist in a contract approach but it is not addressed in the theory how such a mechanism
would operate or can or is constructed.
In a world of complete contracts no problems of ex-post bargaining can occur. The
ex-ante approach of complete contracting of agency theory makes bargaining over these
ex-post rents impossible and thus rules out their existence. The agency approach thereby
ultimately rules out the consideration of problem resolutions within the firm and
disregards the hierarchical structures within firms to alleviate agency problems and
thereby in the limit rules out any meaningful discussion on corporate governance
(Williamson, 1988; Zingales 1998).
The theoretical point is that the assumed efficient market forces cannot completely
influence efficient decision making, as markets provide only signals to inform the
decision making process (Cyert and March, 1963/1992; Kay, 2000). When bilateral
dependencies come together because of clear incomplete contracting and asset
specificity, such as sunk- investments, or bargaining over (quasi) rents, markets are
simply not able to (immediately) sanction these decisions (cf. Roe, 2003; Shleifer and
Vishny, 1997; Williamson, 1988; Zingales, 1998). Thus, the problems of a wide range of
different bilateral dependencies indicate that actors discretion and other mechanisms are
clearly at play in corporate governance (cf. Williamson, 1988).

15

Apparently, what is at stake in economic agency theory is first and foremost wealth
creation for all. The thrust of the agency theory model is that it aims to increase the total
sum of possible wealth creation. This is the larger and more important point of the
principal-agent contract and more generally of all economic theories of organization:
first enlarge or optimize the total output, only then look at its distribution. Now, the
practical point is of course that economic theories never get round to matters of
distributive justice, they are just restricted to optimalising wealth. Under the strict
assumption of efficient market forces, ultimately everybody will receive his or her
optimal or efficient share.
Adherence to the agency paradigm effectively rules out any query of the normative
foundations and structures of corporate governance, as assumptions of pure selfinterestedness do not cohere with normative analyses. In a world where actors strictly
serve their own interests, actors are committed to a language in which good can only
mean good for me or more particularly, in my interests () In that world there is
simply no meaningful possibility of distinctively moral or justificatory argument
(Brennan and Hamlin 2000, p. 26). The theoretical point is that the idea of optimalising
an industrial process (like the production of goods and services) cannot be done in a
politically neutral way. Before you can establish a unique optimum in any meaningful
sense, you need to specify certain parameters concerning the parties collaborating in the
production as well as those affected by such a production. The underlying argument is
that some form of stable condition of human interaction (North, 1990) or social peace
(Roe, 2003) is needed to make production possible. In the stylized world propagated by
agency theorists, there is thus not much room for variety with respect to different systems

16

of corporate governance that give guidance to achieve these conditions of relative social
peace.

Coping with the narrow focus of the economic agency

perspective
All this is leading to the increased critique that agency theory neglects the institutional
conditions and social relationships in which any contract is made up. Given that this
approach is rooted in neo-classical economic theory, the embedded conditions and the
social relationships in which the actors are involved are not considered in the typical
agency inspired corporate governance article. Given the incompatibility of the
assumption of complete contracts and the ambition to address the social system in which
the contract is made up (cf. Zingales, 1998), principals and agents are in these studies
typically reduced to a set of ontological actors, frozen in space and time and isolated
from social and cultural context (Aguilera and Jackson, 2003: 449).
There is a growing body of literature, however, that addresses specifically the issue
whether there will be a single most efficient way to structure corporate governance across
different societies. Some have argued that market forces will ultimately lead to a single
most efficient corporate governance system based on the agency theoretical set up (cf.
Hansmann and Kraakman, 2004; Gilson, 2001). Others argue that even though there are
compelling arguments of economic efficiency, complete convergence to a single model
will not occur because of local institutional constrains (e.g. Bebchuk and Roe, 1999;
Coffee, 1999; Heugens and Otten, 2007; Khanna et al., 2006).
Several discussions in the corporate governance literature can serve as examples how
the problem of the narrow focus of the theory and neglect of institutional embeddedness
17

are discussed. Some studies have for instance looked at the world wide spread of reform
attempts by governments to improve their national corporate governance arrangements.
These studies show that countries differ in the timing of adapting reforms and differ in
the issues addressed that need reforms (Aguilera and Cuervo-Cazurra, 2004, Heugens and
Otten, 2007). For instance, although shareholder interests play a large role in corporate
governance codes of best practices, their interest are not the only ones considered. The
role of for instance employees is also addressed in many of these policy codes (Heugens
and Otten, 2007). Incompatible with the agency paradigm is the typical conclusion of
these studies that countries (still) differ in how they structure their corporate governance
arrangements and that other actors beside shareholders and managers and institutions
play a significant role in shaping corporate governance arrangements (cf. Bebchuck and
Roe, 1999; Coffee, 1999; Gordon and Roe, 2004; Khanna et al., 2006; Pagano and
Volpin ; 2005, Roe, 2003).
Other studies focus on what Marc Roe (2003) has labeled the legal thesis on
corporate governance. Based on the agency inspired set up, the make up and quality of
legal institutions are investigated and especially applied to the question to what degree
corporate ownership structures are dispersed. Using agency theory the typical argument is
that better protection of (minority) shareholders leads to more dispersed ownership
resulting in a sharp separation of dispersed ownership from managerial control and thus
to an efficient and modern state of affairs (Hansmann and Kraakman, 2000; Kerr,
Dunlop, Harbison, and Myers, 1960; La Porta et al, 1999; La Porta et al, 1997; 1998;
Shleifer and Vishny, 1997). An other stream of literature in which this legal thesis is
often applied is the literature on shareholder activism (Black, 1998; Gillan and Starks,

18

1998, Karpoff, 2001, Romano, 2001) The major concern in this stream of literature
focuses on how shareholders can intervene managerial decision making in a way that
ensures decisions are made on the basis of shareholder wealth maximization (De Jong et
al., 2007).

Theoretical implications
The manner in which theory development and theory extensions build on the agency
paradigm can for instance be illustrated by the discussion on executive compensation
between Bruce, Buck and Main (2005) and Gomez-Mejia, Wiseman and Dykes (2005).
The issue here is agency theorys neglect of institutional embeddedness of pay practices.
Bruce et al. (2005) argue that the dominance of principal-agent theory has led to a narrow
focus in the literature that may give rise to problems in the context of research that
examines cross-country differences of executive pay. They suggest that agency theory is
under-socialized and therefore lacks generalizability to settings where other social
solutions would seem to alleviate the agency problem by other means than providing
management with incentives to serve shareholder interests. To address these
shortcomings, institutional theory is offered as a useful overarching framework within
which appropriate variants of these approaches can be deployed to better comprehend
current developments in executive pay. In reaction, Gomez-Mejia et al. (2005) argue,
while agreeing that agency theory does not explicitly recognize contextual factors, that
this abstraction from context gives agency theory greater generalizability and thus greater
explanatory power. The fact that an institutional perspective provides for a fuller
explanation of executive pay arrangements across different institutional contexts does not
necessarily mean that can all these arrangements can be conceived as solutions to the

19

agency problem. In a counter response Bruce et al. argue that more fundamental issues
are at stake since the appropriate yardstick for the evaluation of pay packages may differ
between institutional environments and may be required to serve for social legitimacy as
well as the mitigation of agency problems. They emphasize that it is the drive for
legitimacy rather than any immediate concern with distributive justice that makes
institutional explanations of executive remuneration so fundamental (Bruce et al., 2005).
This exchange illustrates that the agency perspective is often complemented with
different types of frameworks. In her early survey of the state of the art, Eisenhardt
concluded that agency theories ideas on risk, outcome uncertainty, incentives, and
information systems are novel contributions to organizational thinking, and the empirical
evidence is supportive of the theory, particularly when coupled with complementary
theoretical perspectives (1989, p. 58). But the appeal to a number of fixed companion
theories may well lead to theory stretching beyond the limits of the original theoretical
foundations of the agency paradigm. Especially the use of institutional approaches in
combination with agency theory have increased over time (e.g. Aguilera and Jackson,
2003; Davis and Thompson, 1994; Roe, 2003; Zajac and Westhal 2004) and may serve as
case in point how these frameworks stretches agency theory beyond its most fundamental
conventions and foundations.
The influence from institutional frameworks in the corporate governance debates
leads to an increased attention to the role of other actors than merely shareholders and
management. The role of other stakeholders such as employees is typically neglected in
the corporate governance literature (Bebchuk and Roe, 1999; Blair, 1995, Blair and Roe,
1999; Roe, 2003). It has been argued that agency theory may very well be compatible

20

with a stakeholder perspective (e.g. Hill and Jones, 1992; Gomez Meija et al., 2005;
Jensen, 2001). A stakeholder perspective would simply enlarge the number of interest
parties which a firm or its management should factor in elaborating the corporate
governance equation.
Stakeholder theory simply reminds us that an agent must also attend to the interests
of non-principal stakeholders to the degree that each stakeholder is willing to
continue their participation, if the agent is to fulfill her responsibilities to the
principal (Gomez Mejia et al., 2005, p. 1511).
This may be resolved by replacing the dyadic model by a multi-principal, multi-agent
model. But Gomez Mejia et al. (2005) also make another point from which the onesidedness and the political overtones of the agency model clearly emerges:
distributive justice is an inappropriate metric upon which to base the design of a
principal-agent contract since it misses the larger and more important point of the
principal-agent contract, which, in the case of commerce, is to motivate the agent to
create more wealth, which increases the amount available to all stakeholders
(Gomez Mejia et al., 2005, p. 1511).
The problem is that the combination of other frameworks with that of the agency
theory as advanced in the corporate governance literature stretch the dominant paradigm
beyond its conceptual limits. The fundamental assumption in agency theory is that the
actors make decisions grounded in a rational choice model of human behavior, in which
actors are expected to evaluate alternatives in terms of the values of their consequences
(Cyert and March, 1963/1992, p. 230). It is assumed that the actors have no chronic
information problems (Hodgson, 1998) and ultimately are forced to make shareholder

21

wealth-maximizing decisions by monitoring or bonding mechanisms that are facilitated

by market and pricing mechanisms. The outcomes of the decision making process are
evaluated on their ultimate value and thus the different alternative options when making a
decisions are typically considered simultaneously (Cyert and March, 1963/1992).
Combining institutional frameworks with agency theory prevents however its
successful application to a broader stakeholder domain. It ultimately rules out a
successful broader framing of corporate governance problems and problem resolutions
beyond the agency problem between shareholders and managers.
Decision-making is a decidedly social process. It is so precisely because individuals
do not only draw on rational factors when making decisions, but also on factors like
norms, trust, culture, advice, rules, history, and authority (e.g. Cyert and March,
1963/1992; March and Olson, 1984). In an institutional approach not all human behavior
is rooted in deliberation or computation (Hodgson 1988; Kahneman and Tversky,
1979, North, 2005). Individuals also draw on rules of thumb and other heuristics, which
make at least part of their behavior habitual or reflexive (Cyert and March,
1963/1992; Hodgson, 1988; Scott, 2001). All individuals are constrained in their capacity
to make fully rational decisions, due to the cost and unavailability of appropriate
information and because of their own cognitive limitations (Cyert and March, 1963/1992;
DiMaggio and Powell, 1983; Elster, 1989; Jepperson, 1991; March and Olson, 1984;
Meyer and Rowan, 1977; North, 2005). Rather than searching for optimal or
maximizing decisions, individuals quite often tend to select the decision alternative that
simply seems appropriate or legitimate against the background of perceived
institutional norms, values, and beliefs (Jepperson, 1991; Meyer and Rowan, 1977;

22

Suchman, 1995). Decision alternatives are typically understood to be made sequentially,

also dependent on the evolved or not yet materialized results of previous decisions (Cyert
and March, 1963/1992). Approaches that acknowledge the influences of such factors on
human behavior are typically labeled as institutional approaches (e.g., see Elster, 1989;
Greif, 2006; North, 1990; 2005). The alternative of an institutional approach trumps the
agency perspective, because it relies on a different, less stringent assumption of human
behavior. It assumes that social actors are satisficers rather than maximizers (Cyert
and March, 1963/1992).
Following Elsters broad definition of an institution as a rule enforcing mechanism
(Elster 1989, p. 147), we may say that all institutions simultaneously empower and
control (Jepperson, 1991, p. 146). This means that institutions not only influence social
stability, but also influence instability. Institutions thus not only play a background role,
but institutional forces simultaneously empower and control those decision making actors
that employ, develop, and contest them. In contrast to the agency paradigm, an
institutional approach considers the embeddedness of the issue under investigation. This
implies that decisions are not only based in the idea of the role of background institutions,
but also on the idea that current or past decisions shape and influence the institutional
context in which future decisions are made. This problem is considerably expanded if we
broaden the objective function of the corporation.
Even one of the founding fathers of agency theory, Jensen (2001) has recently argued
that the interests of all stakeholders need to be considered so as to make tradeoffs to
maximize firm value. In his enlightened stakeholder theory, Jensen (2001) clearly
separates shareholders interests from the interest of the organization as a whole. He

23

argues that the firms governance objective function should incorporate the interests of all
stakeholders and that trade offs between the interests of stakeholders should be based
whether they maximize long term firm value and not whether (short term) shareholder
value is maximized.
If, following Jensen (2001), we view the modern corporation as a diffuse, multistakeholder entity with a correspondingly broad objective function, it will always be
surrounded by an imperfect or ambiguous information regime. Even when serving a
particular interest corporate governance problems exist. Corporate governance problems
not only pertain to problems of conflicting interests but also pertain to conflicts of
opinions, expectations, notions, and perceptions of appropriate actions. Subsequently the
wide spectrum of possible (normative) corporate governance problems can only be
alleviated for a relative short period of time. Corporate governance mechanisms are
employed to mediate problem resolutions and are most likely driven by reasons of
aptness in order to overcome the wide spectrum of possible conflicts (Otten, 2007). Most
striking is that Jensen, together with Murphy, also argue that corporate governance
problems can only be temporarily mitigated, rather than resolved indefinitely, but that
their argument still adheres to assumptions of rational actors that maximize their selfinterests, implying that there is something like a perfect solution to the governance
problem of conflict of interests, which they put forward as being the only problem
(Jensen and Murphy, 2004). The combination between the agency set up and institutional
approaches thus stretches the agency paradigm beyond its fundamental foundations.1

24

Implications for empirical studies and practice

Important in the analysis of the politics of theory is the concerns of a distinct confusion of
descriptive/explanatory validity of the theory to the neglect of normative impact of the
model in terms of its unequal consideration of various interests. Much effort has been put
into the question as to the descriptive/explanatory validity of the agency perspective, the
argument being that agency theory has a greater predictive value. It is argued that it is
better capable of predicting and explaining managerial conduct than rival theoretical
frameworks and should therefore serve as a blue print for practice (cf. Hansmann and
Kraakman, 2000).
A good example in this respect is the academic tournament (Bratton, 2005) about
explanations of executive compensation in the corporate governance literature. The
discussions about executive pay in both theory and practice show how the politics of
theory has a great impact on the contemporary way the phenomenon is understood in
theory and practice. First, it shows that the strength of the agency paradigm is very strong
in the corporate governance literature. This can for instance be indicated by Bebchuck
and Frieds (2003, 2004) label of this theory as the official story on executive pay.
Second, it shows the possible bias of scholars to explain the phenomenon. As Bebchuck
and Frieds (2004) indicate, agency scholars come up with clever explanations for pay
practices that appear to be inconsistent with the dominant paradigm (Bebchuk and Fried,
2004). Practices for which no explanation has been found have been considered
anomalies or puzzles that will ultimately either be explained within the paradigm or
disappear (Bebchuk and Fried, 2004, p, 3). Third, it shows the rhetoric used to

25

legitimize and explain seemingly excessive pay in practice. And fourth it shows how
empirical studies are based on theoretical foundations of the dominant paradigm.

A very large part of the executive literature has been occupied to find a robust
relationship between executive compensation and firm performance (c.q. shareholder
wealth).2 After all, a positive relationship would show that shareholders can write an
efficient contract that ensures that management will make shareholder value maximizing
decisions. Nevertheless, there are literally thousands of empirical studies dealing with
this relationship and these studies typically show mixed results and overall only provide
weak support for this link at best.
These empirical results have triggered methodological debates about for instance
estimation techniques, definitions of the variables used and the mediating effects of other
determinants of executive compensation on this relationship (See for instance Agarwal,
1981; Ciscel and Carroll, 1980; Conyon and Murphy, 2000; Gomez-Mejia and Wiseman;
1997; Rosen, 1990). The agency paradigm gives however little guidance in which
determinants should play a theoretical role. Subsequently, empirical studies on the
determinants of executive pay mostly lack theoretical foundations and show a rather
weak fit with the data (Hambrick and Finkelstein, 1995; Mueller and Yun, 1997).
The failure to find a robust relationship between executive compensation and firm
performance leads to debates and disputes still remain on whether or not executive pay
provides enough incentives to trigger efficient management behavior and whether these
empirical results support the incentive alignment argument of agency theory (GomezMejia and Wiseman, 1997, Jensen and Murphy, 1990, Rosen, 1990).

26

Paradoxically however, the lack of finding a robust positive relationship between

corporate performance and executive compensation could be interpreted as evidence
favoring one of the theorys fundamental theoretical assumptions: agents will pursue their
self-interests that deviate and conflict with the objectives of the principal, which actually
is a reflection of their discretion (Berrone and Otten, 2008). Because of the strict
assumptions of agency theory, actors discretion in the decision making process is
theoretically ruled out as real possible behavior (Grabke-Rundell and Gomez-Mejia,
2002) Discretion (the latitude of decision options actors have to influence the decision
outcomes and the context in which the decisions are made), is theoretically ruled out
because inefficient behavior (i.e., (boundedly) rational behavior that has sub-optimal
effects for shareholder value) is instantly sectioned by others in their own rational pursuit
of maximizing their self-interests facilitated by pricing and market mechanisms (Otten,
2007).
Because of scholars use and commitment to the dominant paradigm, their known
biases and ideological orientation often serve as the best predictors of the findings
presented (Bebchuk and Fried 2004; Gomez-Mejia, 1994; Gomez-Mejia and Wiseman,
1997). The apparent lack of success in finding a robust relationship between firm
performance and pay, in combination with the considerable number of studies seeking to
find proof of this link has led Gomez-Mejia (1994) to compare this quest with the search
for the Holy Grail. Subsequently, the dominant use of the agency paradigm to find this
relationship is leading us into a blind alley (Barkerma and Gomez-Mejia, 1998) to find
conclusive explanations of pay practices.

27

This academic debate has not missed its effects in practice. Especially in cases where
pay rises and where firms show bad performance results or have to downsize, it seems to
be a matter of fairness to the general public that pay should be (more) related to
performance (Gomez-Mejia, 1994; Jensen and Murphy, 2004; and Murphy, 1997). The
lack of proof of this positive relationship fuels the public outcry over seemingly
executive pay arrangements (Bebchukc and Fried, 2004) and leads to problems in
practice to explain and legitimize executive pay arrangements to the public at large (cf.
Garvey and Milbourn, 2006; Wade et al., 1997; Zajac and Westphal, 1995).
Wolins politics of theory perspective helps us to distinguish between the
descriptive/explanatory validity of a theory and its prescriptive uses. On one hand, it
could be argued that the incentives are seemingly too low in practice. Following the
prescriptive power of the theory, executives should receive more pay that is contingent on
performance. This trend can be observed in current corporate governance codes of best
practices (cf. Heugens and Otten, 2007). It can also be seen from the increased use of
options and shares as forms of executive compensation (e.g. Abowd and Bognanno,
1995; Murphy, 1999) On the other hand, the theory could also simply furnish weak
explanations of the observable pay arrangements in practice. Its theoretical applicability
could somehow be limited in the sense that incentives lead to other outcomes (in theory
and/or practice). The effectiveness of incentives, bonding, or the monitoring mechanisms
for that matter, could be influenced by factors or theoretical foundations that are not
considered by the used agency model. Furthermore, actors may in practice simply choose
not to adhere to agency theorys prescriptions or not be able to follow its logic of
consequence.

28

Discussion & conclusion

The agency paradigm as it is most often used in the corporate governance literature does
not cover all the connotations of the term corporate governance. As Bebchuk and Fried
(2003, 2004) have argued concerning the issue of executive compensation, executive pay
is not a solution to the agency problem between shareholders and management, but is in
fact a representation of the agency problem itself. Rather than an instrument, executive
pay is thus much more the outcome of socially constructed corporate governance
arrangements (Otten, 2007). Arguably, extending these ideas to other solutions to the
agency problem3 are all a reflection of the relative discretionary position agents have
relative to the principal they are expected to serve. Following Zingales (1998), we argue
that every contract presupposes a previous contract in order to ensure that the agent will
act in the interest of the principal. The discretionary position of the agent to contract in
the first place would always be based on an agency problem. The fundamental problem is
how to ensure that the agent will act on behalf of the principal in the first place.
Alleviations to agency problems in the agency-based corporate governance literature,
then, seem to be based on a theoretical rhetoric that surpasses the fundamental
assumptions and prescriptions of this paradigm. Its use of efficient market and perfect
contracting assumptions and predisposition with the wealth creation of a single social
actor effectively rules out other actors involved, other means besides markets to alleviate
the problems and considers solutions to only one considered problem that is
fundamentally a representation of the problem itself.
Applying Wolins (1960, 1981, 2004) sublimation thesis and his idea of a politics
of theory to the field of corporate governance illustrates that the dominant use of agency

29

theory and its predisposition with shareholder interests has both descriptive and
prescriptive powers in pointing out corporate governance problems and proposed
solutions to these problems. Although the theoretical strength of the paradigm is to show
that there are problems when activities are delegated to another party, its application to
the wide range of corporate governance issues is problematic. While the focus of such a
single approach has greatly contributed to our understanding, it carries clear normative
implications.
A certain extent of simplification is inherent in the very idea of theory-building. In
this paper, we have invoked Wolins ideas to show how the presently dominant agency
approach in corporate governance (over)simplifies its object of study and how the agency
lens is normatively biased by its conceptual framework and its problem-setting. The very
name of corporate governance suggests a series of observations, analyses, or comments
on the manner in which modern corporations are being governed. Two very fundamental
questions that arise are: what is the corporate objective and what constitutes the basis of
legitimacy for the corporation? Given that agency theory is founded in neo-classical
economics with its assumptions of maximizing self-interests, complete contracts and
predisposition with shareholder interests, ultimately leads to the inability to raise
normative questions about distributive justice and legitimization arguments. Given the
assumptions of the theory and its application to governing corporations, economic agency
theory in its current usage ultimately rules out even a usable definition of corporate
governance (Zinagales, 1998).
The common applications of the theory a-priori set the principals interests on a
footstool without giving much regard to the interests of the agent or other stakeholders

30

that influence corporate governance. By making the assumption that maximal social
welfare is achieved by maximizing shareholder wealth, it subsequently has the normative
implications in finding solutions to only one agency problem considered. The typical
considered corporate governance mechanisms that should alleviate the agency problem
between shareholders and management (i.e. monitoring and bonding facilitated by market
and pricing mechanisms) are most often assumed to serve the principals interests only.
The assumption of efficient market forces neglects the embeddedness of the different
ways societies construct and develop (other) arrangements to achieve varieties of social
peace to make production possible in the first place. This clearly overlooks the fact that
the agency problem between shareholders and management (and other agency problems
between other stakeholders for that matter) can also be alleviated by other actors and
corporate governance arrangements that are a-priori ruled out by the theory. This can be
illustrated from the literature on comparative corporate governance (e.g. Aguilera and
Cuervo-Cazurra, 2004; Coffee, 1999; Hansmann and Kraakman, 2000; Heugens and
Otten, 2007; Khanna et al., 2006; Pagano and Volpin; 2005), studies that apply the legal
thesis (Roe, 2003) on corporate governance (e.g. the literature on shareholder activism
(e.g. Black, 1998, Romano, 2001), and the numerous studies on executive pay (Bebchuk
and Fried, 2003, 2004; Bruce et al., 2005; Gomez-Mejia and Wiseman, 1997).
The dominant use of a single theory has the possible downside effect of hampering
new theory developments. The focus on the wide-spread application of the theory to
corporate governance may lead to a neglect to employ scholars scarce resources to
investigate potentially more fruitful ways to explore corporate governance as a scientific
field of inquiry. Thereby the commitment to the dominant paradigm could lead to theory

31

stretching. The combination of agency theory with a number of other theories may lead to
stretching the theory beyond the limits of the original theoretical foundations of the
agency paradigm as for instance evidenced by the combination of the theory with
institutional frameworks (e.g. Aquilera and Jackson, 2003; Davis and Thompson, 1994;
Roe, 2003; Zajac and Westhal, 2004). Furthermore, the implications of the dominant
agency approach also did not miss their inferences in practice. The lack of proof of a
positive relationship between pay and performance, a typical assumption derived from
the agency model, is a clear case in point. The theoretical predisposition to find this link
and the lack of convincing results fuels the public outcry over seemingly excessive and
leads to problems in practice to explain and legitimize executive pay arrangements to the
public at large. The dominant use of the theory thus has considerable normative
implications for our contemporary understandings of corporate governance in both theory
and practice.
All in all, an appropriate understanding of the politics of agency theory in corporate
governance goes to show that the seemingly neutral position of agency theory commits us
to many more intended and possibly unintended (normative) implications than is
commonly recognized by scholars using this perspective as a theoretical framework. Ever
since the agency paradigm in corporate governance acquired sufficient legitimacy in the
1970s, it has framed the way corporate governance issues are understood in theory and
practice. Its prescriptive and explanatory powers and the apparent confusion about this
distinction can be clearly observed in the corporate governance literature. Applying these
notions with the previous criticism of the theory in combination with some clear
examples of theory stretching, it seems that we may well be in the middle of a paradigm

32

shift. Possibly, after a number of years we can apply Wolins ideas again. We may then
be able to reconstruct in some detail how a new theory acquired its legitimacy and set out
how its disciples continued the example set by its founder(s) on the basis of a set of
methodological prescriptions specifying the authorized procedure to conduct scientific
inquiry in the field of corporate governance research.

Notes
1

See also North (2005) for the argument that neo-classical economic approaches (such as agency theory)

are not designed to explain the influence from institutions on economic change.
2

See Tosi et al. (2000) for an overview of empirical studies.

Typically this is sought in an explicit complete optimal contract that specifies the monitoring and bonding

mechanisms to ensure agents compliance with the optimal contract based on the principals interests,
embedded in and facilitated by efficient market conditions.

33

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