7.2 Agency and incomplete contracts perspectives on governance

Governance is important in any circumstance where the management of an organisation is separate from those who provide the funding for it. In fact, the critical role of governance is to provide suppliers of funds to the organisation with sufficient confidence that the management of the organisation is consistent with their interests so that they are willing to go on providing funding for the organisation. In these generic terms, governance is important whether funding is sourced from taxpayers and provided by Parliament for a government department or Crown entity, or is sourced from shareholders and creditors and provided to a corporation.

The role of governance (Zingales, 1998) is to:

• increase the incentives for value-enhancing investments, while reducing inefficient power-seeking. A governance system will provide a check that management is investing in activities that are value-enhancing for the firm rather than for the managers, including encouraging firm-specific investments and discouraging activities that add more value for management than they do for the firm
• minimise ex post inefficiency in bargaining about the allocation of surplus. In particular, governance structures reduce the inefficiency associated with free-riding by individual owners when ownership is widely dispersed, and reduce information asymmetries between management and owners
• allocate the residual risk to the least risk-averse party, or in other words, the party that is best able to diversify the risk associated with the activities of the firm.

This definition of governance establishes a requirement for any governance framework to provide for both monitoring opportunistic behaviour in relation to incentive contracts, and provides a mechanism for making decisions in relation to matters about which contracts were not and/or could not be written ex ante.

Until the development of the literature on incomplete contracts, the focus of the literature in economics was on explaining governance in terms of agency theory. For Schleifer and Vishny (1997:738), their “perspective on corporate governance is a straightforward agency perspective, sometimes referred to as separation of ownership and control.” This literature focused on explaining agency problems that arise because ownership is widely dispersed (or otherwise distinct from management) and the incentives of managers are not perfectly aligned with those of the owners. For example, managers may focus on projects in which they are personally interested in rather than on projects that maximise the value of the firm, may avoid difficult decisions or risky projects that would increase the wealth of owners, may seek out or oppose organisational changes that maximise value, and may focus on recruiting staff who fit with an existing (sub-optimal) culture rather than staff who will challenge existing ways of thinking. In agency theory, the primary role of the board is to assure shareholders that agency conflicts of interest are being controlled.

One of the reasons that the agency perspective is limited emerged from the literature on incentive contracts. Incentive contracts solve agency problems where it is possible to anticipate ex ante what the owners of an organisation want the management to maximise, and how they want management to react to different contingencies. But even in respect of a for-profit corporation, it is not possible to anticipate all contingencies in advance, or to anticipate the managerial responses that owners wish to incentivise in different situations. To take one example, relational contracts, which are typically very incomplete and work on the basis of a wide range of decisions made by the parties to the contract interacting over time, are commonly found in the private sector. In respect of a public-sector entity, multiple objectives and intangible output measures make satisfactory ex ante specification of complete incentive contracts even more unlikely.

From an incomplete contracts perspective, the focus of governance shifts from monitoring designed to minimise opportunistic behaviour within management incentive contracts to the necessity for an effective mechanism for ex post decisions about matters that are inefficiently costly or impossible to specify in a contract against future observable variables. In other words, the existence of incomplete contracts is what makes corporate governance distinct from contractual governance (Zingales, 1998:499). When contracts are incomplete, it is necessary to allocate the right to make ex post decisions in relation to contingencies that cannot be specified in advance, and the allocation of those rights to a board of directors provides an efficient form or delegated decision-making on behalf of the owners of the firm as a whole.