Principal Costs: A New Theory for Corporate Law and Governance
64 Pages Posted: 3 Mar 2015 Last revised: 14 Jun 2017
Date Written: February 28, 2015
The problem of managerial agency costs dominates debates in corporate law. Many leading scholars advocate reforms that would reduce agency costs by forcing firms to allocate more control to shareholders. Such proposals disregard the costs that shareholders avoid by delegating control to managers and voluntarily restricting their own control rights. This Essay introduces principal-cost theory, which posits that each firm’s optimal governance structure minimizes the sum of principal costs, produced when investors exercise control, and agent costs, produced when managers exercise control. Both principal costs and agent costs can arise from honest mistakes (which generate competence costs) and from disloyal conduct (which generates conflict costs). Because the expected costs of competence and conflict are firm-specific, the optimal division of control is firm-specific as well. Thus, firms rationally select from a range of governance structures that empower shareholders to varying degrees. The empirical predictions produced by principal-cost theory are more accurate than those produced by any theory focused solely on agency costs. Principal-cost theory also suggests different policy prescriptions. Rather than banning some governance features and mandating others, lawmakers should permit each firm to tailor its governance structure based on its firm-specific tradeoff between principal costs and agent costs.
Keywords: principal costs, agency costs, governance structure, theory of the firm, dual class, concentrated ownership, dispersed ownership,
JEL Classification: D20, D21, D23, D24, G30, G32, G34, K22, L20, L21, L22
Suggested Citation: Suggested Citation