A FIRST ORDER PROBLEM

There are some issues, which are also fundamental and deep-rooted, I refer them as "first order problems". In other words, the few root causes that are in turn responsible for so many of the issues that we face today as society.

If we ask ourselves, what is the fundamental underlying principle, upon which we run our companies; the idea that is so widespread and implicit that we never actually think about it, that idea would be the agency theory of management, otherwise known as shareholder primacy.

Over the course of the last 40 years this idea has become so deeply embedded in modern corporate governance, it never even gets questioned. The interest of bringing this idea out of the shadows and into the light, we're going to discuss:

Where did this idea come from in the first place?
How did it become so deeply embedded in how we do business?
What are the unintended consequences that society has been asked to shoulder?
What are the ethical frameworks that help us situate these ideas?
What are the alternatives ways of running companies to balance social interests?

THE SEED OF AN IDEA

Back in the 1970's, two eminent academics both arrived (separately and independently) at the realisation that there is a fundamental disconnect between those who "own" companies and those who "operate" companies.

Whether companies are public or private, the "principal" is the party who legally owns the company, and must live with the positive or negative consequences of business outcomes; it could be the private owner(s) of a company, or the collective shareholders in a publicly listed company.

The 'principal' delegates authority for everyday decision-making to an 'agent', who in this case would be the organisation's management team - responsible for developing and executing strategy on behalf of the owners. At its most reductive, the role of the agent is to maximise the value created for the Principal.

The tricky part comes, when the incentives of these two groups are not well-aligned. Whilst agents may have a "fiduciary responsibility" to the owners, the sometimes problematic interplay between these two parties, has become known as the 'principal-agent problem'.

The theory was codified in a groundbreaking 1976 paper by Michael C. Jensen and William H. Meckling, who described the ways in which agency problems arise and how they might be mitigated through monitoring, incentives, and bonding mechanisms. The idea gained traction quickly, transforming corporate governance with a clear message: managers must be watched and incentivised to ensure they act in the owners’ interests.

THE SEED DISEMINATES

By the late 1970s, business schools around the world (and especially in the United States) had adopted agency theory as part of their core curricula. It became a fundamental lesson in MBA programs, embedded in courses on corporate finance, management, and organisational behaviour. The theory’s appeal was in no small part due to its simplicity—it offered a tidy framework for understanding the separation between ownership and control, without having to deal with the complexities of weighing-up potentially conflicting interests between multiple stakeholders.

Shareholders reigned supreme, all other interests came a distant second....

As graduates from these programs moved into senior positions in industry, and the theory caught the imagination of consultants at McKinsey, BCG, Bain et al; these principles took hold in the boardrooms of companies across all industries. Corporate governance structures were reshaped, often with an intense focus on aligning the interests of managers with those of shareholders; performance-based pay, stock options, and executive bonuses became the new norms, designed to tether managerial ambitions to company performance.

A purely economic problem, with a simple and elegant economic solution. Align all incentives to the principal.

UNINTENDED CONSEQUENCES

By the 1990's, Agency Theory had become ubiquitous and went unchallenged; but like any idea taken to an extreme, its flaws started to surface through the unintended consequences it created:

Short-Termism and Tunnel Vision

Whether intentional or not, the emphasis on maximising value for shareholders has driven short-term thinking and a myopic focus on share price.

Executives under pressure to meet quarterly earnings targets often prioritise actions that boost immediate results (i.e., cost-cutting, share buybacks, or even strategic mergers that look good on paper but might not add long-term value) rather than decisions that may not pay dividends (literally) for year to come, but are nonetheless in the long-term interest of the business.

This approach has all kinds of negative consequences, not least of which is the dramatically increased risk of disruption from new market entrants. Companies that fail to invest and place bets on long-term innovation are doomed to fail.

2. Excessive Executive Compensation

According to the Economic Policy Institute, CEO compensation rose 1,400% above inflation between 1978 and 2021, while the average worker’s pay increased by just 18% over the same period. This stark contrast highlights a growing imbalance that has deepened economic inequality more than anyone anticipated. While it’s true that top executives have significant leverage to create value, the widening gap between their compensation and that of their employees raises important questions about fairness and sustainability.

In many publicly-listed companies, executive pay is directly linked to share price performance. On the surface, this seems reasonable; after all, it aligns the interests of CEOs with those of shareholders. However, this approach oversimplifies what should be a nuanced set of incentives. It often drives executives to prioritise short-term stock price gains, even when those decisions come at the expense of long-term stability, growth, or the well-being of employees.

This pay structure has contributed to a significant shift in corporate culture, reinforcing a system where executive enrichment and shareholder returns come first, while the contributions and well-being of other stakeholders often take a back seat. The result is not only a wider economic divide but a diminishing sense of shared purpose within organisations. Addressing this imbalance is essential for building a more inclusive and sustainable corporate landscape, one that values all contributors and measures success by more than just the numbers on a stock ticker.

3. Increased Risk-Taking

When incentive structures become extreme, they can drive excessive risk-taking as executives strive to meet ambitious performance targets. These structures, often tied heavily to short-term stock performance, can create a mindset where immediate gains outweigh sustainable growth or long-term health. This focus can lead executives to prioritise high-stakes strategies that may boost short-term metrics but introduce significant vulnerabilities into the business model.

We saw the consequences of this behaviour play out dramatically during the 2008 financial crisis. Financial institutions pursued risky products and leveraged complex financial instruments to inflate profits and meet targets, driven by a culture where executive compensation was closely tied to immediate performance. In this environment, long-term risks were overlooked, and the ripple effects of these choices were underestimated or ignored. The relentless chase for short-term rewards ultimately contributed to widespread economic destabilisation.

4. Neglect of Broader Stakeholders

One of the most significant issues with agency theory is its focus on shareholder primacy, often sidelining other vital stakeholders. When companies concentrate solely on boosting short-term profits, employees are frequently affected through cost-cutting measures like layoffs and reduced benefits. While these strategies may temporarily inflate earnings, they erode trust, loyalty, and innovation—essential elements for long-term growth. A disengaged workforce isn’t just a number on a balance sheet; it’s a missed opportunity for creativity and resilience.

The environmental impact is another overlooked consequence. Companies driven by profit-first thinking might meet the bare minimum of environmental regulations but skip genuine, impactful sustainability efforts. This approach leads to practices that can harm ecosystems and contribute to climate change—problems society at large must then address. Similarly, community interests can suffer when businesses make decisions that, while profitable in the short term, lead to job losses or reduced economic stability in their local areas.

This narrow approach risks alienating employees, communities, and even loyal customers, chipping away at the trust that sustains a business. The antidote lies in embracing frameworks like stakeholder theory and Confucian ethics, which encourage leaders to value people and the planet alongside profit. Companies that weave these principles into their practices don’t just create shareholder value—they build robust, lasting legacies that thrive on integrity and care for all.

ADDING NUANCE TO THE CONVERSATION

If agency theory has taught us anything, it’s that simplicity can be seductive—but dangerous when taken too far. The laser focus on shareholder primacy has given us short-term wins and, let’s be honest, plenty of headaches. So, where do we go from here? Thankfully, we're spoilt for choice with a host of thinkers who offer richer, more balanced ways to lead. Enter Confucian ethics, Rawls’ theory of justice, social contract theory, and stakeholder theory—ideas that nudge us to zoom out and see the bigger picture.

Confucian Ethics calls on leaders to think beyond their own bottom line and lead with virtues like benevolence and integrity. Imagine a corporate world where decisions aren't just measured in quarterly gains but in trust built and relationships nurtured. That’s not just feel-good fluff; it's long-term strategy. Companies rooted in these values make choices that sustain growth without sacrificing the well-being of employees, customers, or the broader community. A leader with a Confucian mindset understands that sustainable success is about creating a harmonious whole, not just scoring wins at the expense of others.

Then we have Rawls’ Theory of Justice, which shines a spotlight on fairness. Rawls argued that inequalities are only justifiable if they lift up those who are worst off. Now, look at today’s executive pay scales—it's hard not to see a disconnect. In a Rawlsian world, we'd be talking about capping excessive executive compensation and crafting pay structures that don’t just benefit a handful at the top but spread success more evenly. The ripple effect? A more balanced workplace that feels less like a gladiatorial arena and more like a community working toward shared goals.

Social Contract Theory, that age-old reminder that businesses don’t exist in a vacuum, feels more relevant than ever. Rousseau would tell us that there’s an unspoken agreement between businesses and the society that sustains them. Companies that prioritize short-term profit at the expense of their communities are breaking that contract. Picture a world where businesses invest in fair labor practices, meaningful sustainability efforts, and community support—not just to check a box, but because they see themselves as partners in society’s long game.

And let’s not forget Stakeholder Theory, brought into the spotlight by R. Edward Freeman. This isn’t just a theory; it’s a call to action. It suggests companies should aim to create value for all stakeholders—employees, customers, suppliers, even the environment—not just shareholders. What would this look like in practice? It’s more transparent reporting, boardrooms that look like the world they serve, and decisions that weigh social and environmental impacts as heavily as financial ones. It’s about asking not just “How will this affect our stock price?” but “How will this affect everyone who has a stake in our future?”

We’ve clung to agency theory as if it were the only story worth telling. But the world is shifting, and our playbook should too. Drawing on these rich perspectives doesn’t just add color to the grey areas; it changes the entire landscape. Because when we lead with empathy, fairness, and a genuine respect for all stakeholders, we don’t just create profitable companies—we build legacies worth celebrating.

So what can we do differently?

The good news is, there are plenty of companies who are actively working to balance out their incentive structure so management are taking a broader and more holistic view of success.

1. Redesign Incentive Structures for the Long Haul

Rethink compensation packages to go beyond quick wins. For instance, instead of only tying bonuses to quarterly earnings, introduce metrics that reward sustained progress, such as customer retention, employee engagement scores, and reduction in carbon emissions. Companies like Unilever have done this by linking executive pay to their Sustainable Living Plan targets, which include environmental and social benchmarks. This encourages leaders to prioritise actions that create long-term value, not just immediate profit.

2. Redefine Success to Look Beyond the Balance Sheet

Expand what it means to be successful by incorporating measurable non-financial outcomes. For example, Patagonia consistently reports on its impact on local communities and environmental projects, showcasing its commitment to the planet. Companies can start small by including employee satisfaction surveys, community impact metrics, or sustainability reports in their annual disclosures. These tangible measures build trust and prove that success is about more than numbers on a balance sheet.

3. Cultivate Ethical Leadership That Walks the Talk

To instill ethical leadership, build programs that go beyond theory and focus on real-world application. For instance, launch a mentorship initiative where senior leaders coach managers on how to make decisions that balance profit with integrity. Danone has introduced a leadership framework that includes training on social responsibility, ensuring that leaders are equipped to make empathetic, fair, and community-minded choices. This tangible approach reinforces that leadership is about more than just results—it’s about leading with purpose.

4. Champion Transparency Like It’s a Competitive Advantage

Adopt transparency as a core value, not an afterthought. For example, Salesforce provides clear disclosures on its diversity statistics and progress toward equality goals, which has strengthened stakeholder trust. Companies could also follow the lead of Bank of America, which includes detailed executive compensation reports and rationales in their annual proxy statements. These actions demystify decision-making processes and help bridge the trust gap between executives and other stakeholders.

Ultimately though, board culture is the greatest determinant of whether these issues get onto the agenda. Having a collaborative and diverse board leads to higher-quality conversations that bring in critical perspectives that are often lacking. The companies that will win in the long-term, are those that are infusing this thinking into the DNA of the organisation so whether consciously or not, executives are building for the long-term benefit of all stakeholders.

to sum up (the TLDR)

Agency theory's focus on shareholder primacy has driven short-term gains but has contributed to deep-rooted problems like economic inequality, short-termism, and the neglect of broader stakeholder groups.
The theory gained widespread influence through business schools and corporate consultants in the 1970s and 1980s, embedding it deeply in modern corporate governance.
This narrow focus has fuelled excessive executive compensation, increased risk-taking, and eroded trust within organisations, with significant societal and environmental impacts.
We can draw on Confucian ethics, Rawls' theory of justice and social contract theory, develop more nuanced and balanced approach for sustainable results
Boards should consider incentive structures, greater employee participation in wealth creation, redefining success to include social outcomes, fostering ethical leadership, championing transparency, and ensuring board diversity for long-term stakeholder value.

Balancing Interests: The Agency Theory of Management