The Most Important Theory in Corporate Law is Useless: Agency Cost Theory Explains Anything and Predicts Nothing

Abstract

Agency cost theory provides the conceptual scheme most often used to understand the governance of corporations and the proper relationship of various corporate actors. It is, by far, the most important theory of the firm in corporate law and finance. Thousands of law review and finance articles take it as an article of faith and use it to explain almost everything that occurs in business corporations. But in practice, the theory functions as a retrospective “just so” story, capable of providing ad hoc explanations of any outcome. Its attempts at predicting behavior over the past forty or so years have largely ended in failure.

This paper looks at the recent empirical literature on almost twenty governance practices (everything from takeovers to say on pay voting) that bear on the major predictions historically drawn from agency cost theory. A large body of empirical evidence calls each of these predictions into question, suggesting that agency cost theory is not actually getting at anything important to corporate law and governance. In other words, it does not tell us anything about how corporations should be regulated or run.

Keywords: Corporate Governance, Agency Cost, Corporate Law, Executive Compensation, Independent Director, Institutional Shareholder, Proxy Contest, Shareholder Voting, Shareholder Proposals, Dual Class Shares, Say on pay, Board of Directors, Equity Incentives, Takeovers, Takeover Defences, Fiduciary Duties,

JEL Classification: G20, G30, G34, G35, G38, K22, N20,