ABSTRACT
In Chapter 4, we studied the relationship between large, controlling shareholders and small, outside shareholders, based on the theory of corporate control rights and associated private benefits. A related corporate governance issue is the ‘agency problem’ arising from the conflict of interests between the firm’s management, as the agent, and its shareholders as the principals. This is caused by the separation of ownership by the investors, and effective control by the management, in publicly listed corporations. Furthermore, the agency problem is exacerbated when ownership is widely dispersed, due to the inability and/or the unwillingness of relatively small shareholders to police the behaviour of the management. The monitoring of management is also weakened by the ‘free-rider problem’ – the monitoring shareholders have to pay 100 per cent of the monitoring costs, but only gain an increased return in proportion to their shareholdings. Other, usually small, shareholders enjoy the rest of the improved gain but without making any effort. A consequence is that the residual control rights fall into the hands of management, instead of the residual cash flow claimants.
