Putting Agency and Integrity to the Test Daniel G. Arce* This article examines recent claims about the necessity of integrity in agency relationships by putting agents with preferences that reflect integrity in an evolutionary competition with opportunistic agents. Corporate culture is modeled through a process of assortative matching between principal and agent types (via industry or group effects). This leads to a characterization of corporate governance where integrity is linked with value creation. JEL Classification: G30, L20, C72, M52, M12 1. Introduction The agency-theoretic approach to corporate governance emphasizes the incongruence between shareholders and management stemming from the separation of ownership and control. Within a principal-agent framework, this dichotomy is addressed through the proper design of compensation incentives. However, during the past decade, misaligned managerial incentive programs have been credited by the popular press with being at the root of failures in corporate governance ranging from the management of returns to backdating options. Moreover, there is an emerging academic literature on the incentive problems created by the operationalization of the agency-theoretic approach. 1 For example, Jensen (2007) discusses the case of an agent who realizes that the firm is currently overvalued but whose incentive pay will be adversely affected by market reactions if this fact becomes public. For opportunistic agents who operate under a bonus structure, this can result in gaming (e.g., income smoothing and earnings management) that destroys long-term value. According to Jensen, one solution is to recognize and address the role that managerial integrity plays in value creation. He asserts that integrity is something that financial economists tend to avoid or neglect because of the association of integrity with normative considerations. We add that integrity is particularly important in management training at the graduate level, which is overwhelmingly causal. For example, Ghoshal (2005) and Khurana (2007) assert that the emphasis on agency theory within the Master’s in Business Administration (MBA) curriculum creates an expectation among future managers that their behavior must be properly incentivized and that the nexus of incentive contracts is the point of reference for making managerial decisions. 2 The predominant assumption underlying the agency-theoretic approach to corporate governance is that agents are opportunistic to the extent that they may also be characterized as * Economics Program (GR 31), University of Texas at Dallas, 800 W Campbell Road, Richardson, TX 75080, USA; E-mail darce@utdallas.edu. Received May 2009; accepted May 2010. 1 See Bebchuck and Fried (2004), Osterloh and Frey (2004), and Harris and Bromiley (2007). 2 ‘‘According to Jensen and his colleagues, students exposed to agency theory increasingly used this approach as their primary way of framing managerial, organizational, and social issues’’ (Khurana 2007, p. 322). See also Gentile (2004) and Donaldson (2008). Southern Economic Journal 2011, 77(4), 843–855 843