Should Agents Operating in the U.S. Financial Markets Have “Skin in the Game”?

The Literature on agency theory is largely focused on relationships in which one party (the principal) engages another party (the agent) to perform some service on the principal’s behalf, the performance of which involves delegating some decision making authority to the agent. This literature explains that when the principal and the agent do not share the same interests, a conflict may arise; an “agency problem.”[1] Generally speaking, two main governance devices have been suggested to help align the interests of principals and agents in order to eliminate conflicts of interest and thereby enhance the welfare of principals. The first device, termed “monitoring,” refers generally to any efforts exerted by the principal to track the agent’s behavior and ensure that the agent is acting in the principal’s interests. Such efforts, of course, generate monitoring costs, which can be significant. The second device, termed “bonding,” refers to the placement of contractual restrictions on the agent’s activities, or incentive structures somehow tied to the principal’s value. In contrast to monitoring, described above, these bonding costs associated with tracking the agents’ behavior are borne by the agents themselves through self-monitoring. Agents will typically bear these costs, since effective self-monitoring creates confidence on behalf of principals that the agents will not act inappropriately.[2] To complete the picture, there is another element called “residual loss,” which reflects the costs that monitoring and bonding do not prevent. The sum of monitoring costs, bonding costs and residual loss represents the total agency cost.[3]

Traditionally, most corporate-law scholarship has been focused on agency problems in-house; that is, conflicts of interest between managers and shareholders, conflicts among shareholders, and conflicts between shareholders and the corporation’s other constituencies.[4] However, scant literature and very little theory, if any at all, exist regarding potential agency problems between a corporation’s stakeholders (mainly shareholders and bondholders) and “outside” agents of the corporation, such as credit rating agencies, proxy advisory firms, and a specific type of shareholder activists (widely known as “corporate gadflies”,) that operate in today’s financial markets on behalf of stakeholders.

These outside agents dominate the U.S. capital market today, and the increasing reliance of public companies and their stakeholders on these agents has become a hotly debated topic in corporate governance. In particular, the endemic reliance on these agents, according to some commentators, results in significant agency problems arising when agents pursue personal interests at odds with stakeholders’ interests. A major concern voiced by many is that while stakeholders possess an actual stake in public companies, the outside agents do not have a vested interest in the success or failure of the company, except to the extent that the company represents to them a source of revenue, so they largely do not bear the costs of their bad decisions. Therefore, the argument goes, when agents’ incentives are not aligned with those of stakeholders, the stakeholders will be directly harmed by any loss in the value of their investment resulting from agents’ bad decisions, while agents will frequently suffer no ill effects from a decline in a company’s value. This discrepancy is argued to result in a misalignment of interests between corporate stakeholders and outside agents. In other words, outside agents have been increasingly criticized for not having skin in the game – a device that is meant to incentivize agents to exert effort and to make the right decisions, ultimately for the sake of stakeholders. In this paper the skin in the game can be conceptualized as a bonding device; it is a mechanism that connects the principals to the agents through contractual and property interests, and does not rely upon the principals’ ability to monitor the agents’ performance.

The skin in the game debate has been argued in reference to almost all of the outside agents in the U.S. capital market. Credit rating agencies have been persistently criticized for offering rating while having “only reputational capital at risk” based on their performance;[5] proxy advisory firms have been accused of significantly influencing shareholder voting in the companies about which they provide voting advice without “having an actual economic stake” in those companies, and therefore no pecuniary interest in the actual outcome of a shareholder vote;[6] and certain type of shareholders activists—equity shareholders who hold a relatively small number of shares (if any at all) for the purpose of gaining access to shareholder meetings and proxy materials in an effort to influence the corporation’s activities, frequently termed “corporate gadflied”– have been heavily criticized for using the “loose rules” that allow them to act without sufficient economic stake in companies, to “hijack the shareholder proposal system,”[7] and to hold Corporate America “hostage.”[8] Similar arguments have been raised with respect to external auditors,[9] mortgage originators (including S&Ls, commercial banks, mortgage banks or unregulated brokers);[10] and even financial regulators.[11] In short, all of these outside agents are subject to criticism because they have no stake in the corporations that are affected by their actions; they have no skin in the game.

I propose that the debate over the ‘skin in the game’ notion has suffered from the lack of a general theory describing when having skin in the game may be valuable to an agency relationship and when, in contrast, it may be worthless or even harmful. It seeks to help fill that void by attempting to answer the question:–When does giving agents skin in the game have significant value? Building upon agency theory foundations, combined with organizational and psychological perspectives and important theoretical extensions, I propose a set of criteria which could be used to predict the value of giving agents skin in the game in any particular circumstance.

In brief summation, skin in the game is typically needed when two factors are present: First, the agent’s behavior and amount of effort are unobservable by the principal, or when information about the agent’s work is difficult and costly to obtain. Second, the outcome of an agent’s behavior is not difficult to measure. My article identifies several other factors which tend to indicate that skin in the game would be beneficial: when the agent’s competitiveness is not significantly dependent on its reputation, when the corporation (and not the stakeholders themselves) is responsible for selecting and compensating the agent, when the agent is not expected to act as a completely objective and disinterested third party, and when the agent is expected to exercise a significant amount of proactivity and discretion. It is only after analyzing all of these potential factors that a complete picture emerges of the potential efficacy of employing a skin in the game device with regard to an outside agent; my article’s explanation and application of those factors is intended to guide corporations and policy makers in their own efforts to determine whether to give outside agents skin in the game.

To demonstrate how such an analysis should be undertaken, my article applies these factors to determine whether skin in the game would generally be appropriate with regard to two kinds of outside agents: credit rating agencies and proxy advisory firms. The article concludes that while skin in the game would likely be beneficial in the context of credit rating agencies, it should probably not be employed with regard to proxy advisory firms.

It is worth noting at the outset that in general, skin in the game can be any direct economic interest of the agent. It can be the agent’s ownership of the shares or debt of a public company, the value or success of which may be affected by the agent’s behavior and output;[12] or some kind of requirement that an agent must disgorge profits that the agent received in exchange for subpar services.[13] It is important to note that in much of the economic literature the notion of skin in the game can also include potential indirect economic interests, such as reputational damage resulting from poor performance.[14] This is because such harm to an agent’s indirect economic interests can cause the agent to suffer significant loss.[15]

My treatment of the subject, however, restricts the definition of “skin in the game” to situations in which the agent has an actual ownership interest in the principal company. The definition is restricted in this manner to focus analysis on the most frequent criticism leveled at outside agents: that they are not accountable because they have no vested interest in their principal’s value. The extent to which an outside agent’s indirect economic interests will tend to keep it acting in the corporation’s interests, and the relative effectiveness of such indirect interests in comparison to the direct interests discussed in this article, are important topics for further research but are beyond the scope of the present inquiry.


[1] Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305, 308 (1976). In fact, the notion of “agency theory” can be traced back to Adolf Berle & Gardiner Means, The Modern Corporation and Private Property (1932) (concerning the separation of ownership and control), and in its most general, undeveloped form, to Adam Smith, The Wealth of Nations 741 (1776) (“…[B]eing the managers rather of other people’s money than of their own, it cannot well be expected, that they will watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own”).

[2] Jensen & Meckling, supra note 1.

[3] Id.

[4] See, e.g., Kathleen M. Eisenhardt, Agency Theory: An Assessment and Review, 14(1) Academy of Mgmt. Rev. 57, 59 (“Also, positivist researchers have focused almost exclusively on the special case of the principal-agent relationship between owners and managers of large, public corporations.”); John Armour et al., What is Corporate Law, in The Anatomy of Corporate Law 1,2 (Reinier Kraakman et al. eds., 2d ed., 2009); Zohar Goshen & Richard Squire, Principal Costs and Governance Structures in the Theory of the Firm, (“Most corporate-law scholarship focuses on conflict between managers (broadly defined to include directors) and shareholders”). Recently, a progress has been made by Ronald J. Gilson and Jeffrey N. Gordon, who has extended corporate discipline to include “a new agency problem that results from the gap between the interests of institutional record owners and beneficial owners.” See Ronald J. Gilson & Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, 113 Colum. L. Rev. 863 (2013).

[5] Daniel Bergstresser, Randolph Cohen & Siddharth Shenai, Skin in the game: The performance of insured and uninsured municipal debt (2010), See also Credit Rating Agency Survey Results, CFA Institute (June, 2014), (This is a summary of a survey that was conducted among 20,379 CFA Institute members on 20 May 2014, that agreed that rating agencies need to have skin in the game).

[6] SEC Concept Release on the U.S. Proxy System (Release Nos. 34-62495, IA-3052, IC-29340; File No. S7-14-10, 75 Fed. Reg. 42,982) 43,011 (July 14, 2010) [hereinafter: SEC Concept Release], available at See also Examining the Market Power and Impact of Proxy Advisory Firms, Hearing before the Subcommittee on Capital Markets and Government Sponsored Enterprises of the Committee on Financial Services U.S. House of Representatives 9 (June 5, 2013) [hereinafter Hearing before the House of Rep.], available at (“It feels like we are giving power over the board to a consultant without a horse in the race.”).

[7] Commissioner Daniel M. Gallagher, Remarks at the 26th Annual Corporate Law Institute, Tulane University Law School: Federal Preemption of State Corporate Governance (March 27, 2014), [hereinafter: Gallagher speech] (“Requiring a sufficient economic stake in the company could lead to proposals that focus on promoting shareholder value rather than those championed by gadflies with only a nominal stake in the company […] This could be an opportunity to address the practice of ‘proposal by proxy’ where the proponents of the resolution – typically one of the corporate gadflies – has no skin in the game, but rather receives permission to act ‘on behalf’ of a shareholder that meets the threshold […] Making adjustments along these lines will go a long way towards ensuring that the proposals that make it onto the proxy are brought by shareholders concerned first and foremost about the company – and the value of their investments in that company – not their pet projects.”).

[8] The New York Times, Grappling With the Cost of Corporate Gadflies (Aug. 19, 2014). It is worth noting that while many of the outside agents mentioned above work directly for either the corporation or on behalf of corporate stakeholders, the loyalties of shareholder activists as corporate gadflies are less clear. Ostensibly, these people advocate on behalf of other stakeholders, attempting to persuade them to take certain initiatives. However, they often act in their own interests as well, pursing personal agendas or pushing for corporate action that will benefit them disproportionately to, or even at the expense of, their fellow stakeholders. It is nonetheless appropriate to consider this group of extremely influential corporate constituents when analyzing the concept of “skin in the game” because, as will be demonstrated, that particular bonding device may have similar implications in the context of corporate gadflies as in the cases of the other outside agents examined in this Article.

[9] Sharon Hannes, Compensating for Executive Compensation: The Case for Gatekeeper Incentive Pay, 98 Cal. L. Rev. 385, 390 (2010).

[10] Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, Submitted by the Financial Crisis Inquiry Commission xxiv (Jan. 2011), [hereinafter: The Crisis Inquiry Report]. See also Securities and Exchange Commission, Skin in the Game: Aligning the Interests of Sponsors and Investors (Oct. 22, 2014), (with regard to asset-backed sponsors).

[11] Todd Henderson & Frederick Tung, Pay for Regulator Performance, 85 S. Cal. L. Rev. 1003 (2012) (offer a pay-for-performance approach for bank regulators in order to help reducing the incidence of future regulatory failures).

[12] Such an interest could be, for instance, ownership of shares in the principal corporation. In the case of a proxy advisory firm, for example, skin in the game could be ownership of shares in the company for which the firm provides voting advice. In the case of a credit rating agency, skin in the game could be ownership of debt securities issued by a company that the agency is rating. See infra Section I.

[13] See, e.g., John Patrick Hunt, Credit Rating Agencies and the “Worldwide Credit Crisis”: The Limits of Reputation, The Insufficiency of Reform, and a Proposal for Improvement, Colum. Bus. L. Rev. 109 (2009) (suggesting that credit rating agencies’ incentive problem could be corrected by “requiring an agency to disgorge profits on ratings that are revealed to be of low quality by the performance of the product type over time, unless the agency discloses that the ratings are of low quality.”). It should be noted in advance that although the majority of outside agents provide services for a fee, corporate gadflies represent a unique class of outside agents who do not receive revenue—at least from the principal corporation—in exchange from their activities. They will be discussed infra.

[14] See, e.g., Jensen & Meckling, supra note 1, at 308 (refer to bonding costs as both “non-pecuniary as well as pecuniary” costs); Nassim N. Taleb & Constantine Sandis, The Skin in the Game Heuristic for Protection Against Tail Events, 1 Review of Behavioral Economics 1, 4 (2014) (“Note that our analysis includes costs of reputation as skin in the game…”).

[15] In fact, reputational damage—considered secondary to the primary risk—can be more costly than direct damage. See, e.g., Jonathan M. Karpoff, D. Scott Lee & Gerald S. Martin, The Cost to Firms of Cooking the Books, 43 J. Fin. & Quant. Analysis 581, 582 (2008).

The preceding post comes to us from Asaf Eckstein, a post-doctoral fellow at Bar Ilan University Law School and Bar-Ilan University Business Administration School.