2 Agency Problems and Legal Strategies John Armour, Henry Hansmann, and Reinier Kraakman 2.1 Tree Agency Problems As we explained in Chapter 1,1 corporate law performs two general functions: frst, it establishes the structure of the corporate form as well as ancillary housekeeping rules necessary to support this structure; second, it attempts to control conficts of interest among corporate constituencies, including those between corporate “insiders,” such as controlling shareholders and top managers, and “outsiders,” such as minority share- holders or creditors. Tese conficts all have the character of what economists refer to as “agency problems” or “principal-agent” problems. For readers unfamiliar with the jargon of economists, an “agency problem”—in the most general sense of the term— arises whenever one party, termed the “principal,” relies upon actions taken by another party, termed the “agent,” which will afect the principal’s welfare. Te problem lies in motivating the agent to act in the principal’s interest rather than simply in the agent’s own interest. Viewed in these broad terms, agency problems arise in a broad range of contexts that go well beyond those that would formally be classifed as agency relation- ships by lawyers. In particular, almost any contractual relationship, in which one party (the “agent”) promises performance to another (the “principal”), is potentially subject to an agency problem. Te core of the difculty is that, because the agent commonly has better information than does the principal about the relevant facts, the princi- pal cannot easily assure himself that the agent’s performance is precisely what was promised. As a consequence, the agent has an incentive to act opportunistically,2 skimping on the quality of his performance, or even diverting to himself some of what was promised to the principal. Tis means, in turn, that the value of the agent’s performance to the principal will be reduced, either directly or because, to assure the quality of the agent’s performance, the principal must engage in costly monitoring of the agent. Te greater the complexity of the tasks undertaken by the agent, and the greater the discretion the agent must be given, the larger these “agency costs” are likely to be.3 As we noted in Chapter 1, three generic agency problems arise in business frms. Te frst involves the confict between the frm’s owners and its hired managers. Here the owners are the principals and the managers are the agents. Te problem lies in assuring 1 See Chapter 1.1. 2 We use the term “opportunism” here, following the usage of Oliver Williamson, to refer to self- interested behavior that involves some element of guile, deception, misrepresentation, or bad faith. See Oliver Williamson, The Economic Institutions of Capitalism 47–9 (1985). 3 See e.g. Steven Ross, Te Economic Teory of Agency: Te Principal’s Problem, 63 American Economic Review 134 (1973); Principals and Agents: The Structure of Business (John W. Pratt and Richard J. Zeckhauser eds., 1984). Te Anatomy of Corporate Law. Tird Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock. Chapter 2 © John Armour, Henry Hansmann, and Reinier Kraakman, 2017. Published 2017 by Oxford University Press.