Corporate Governance, Executive Compensation, and Agency Problems

Abstract

The separation of ownership and control in the modern corporation creates agency problems: managers (agents) whose interests may not perfectly align with those of shareholders (principals) may pursue strategies that benefit themselves at shareholders’ expense, including excessive perquisite consumption, empire-building acquisitions, earnings management, and risk-aversion that sacrifices expected returns for personal job security. Jensen and Meckling’s (1976) foundational paper in the Journal of Financial Economics established the agency cost framework and motivated the design of compensation contracts that align managerial and shareholder incentives through stock-based pay. This paper reviews agency theory and its applications to executive compensation design, evaluates the evidence on whether stock-based compensation effectively reduces agency costs or creates new problems of incentive misalignment and excessive pay, and examines governance mechanisms—boards of directors, institutional investors, say-on-pay votes, and activism—that monitor and constrain executive behavior.