Blockchain Solutions for Agency Problems in Corporate Governance

As a foundational technology, blockchain creates the infrastructure for decentralized networked governance that, over time, creates the environment that enables the removal of internal and external monitoring mechanisms previously necessitated by agency problems in corporate governance. Blockchain technology facilitates a substantial increase in efficiency in the agency relationship and lowers agency costs by orders of magnitude.

Agency theory is still today the leading theory for governance conflicts between shareholders, corporate managers, and debt holders. A vast literature attempts to explain the nature of the agency conflicts in corporate governance and possible ways to resolve such conflicts. However, the core agency conflicts emanating from the separation of ownership (shareholder principal) and control (manager agent) cannot be fully addressed by the existing theoretical and legal framework. Attempts to monitor agents is inevitably costly and transaction costs abound.

It is important to note that any use of blockchain technology in a corporate governance context necessitates the evolution of blockchain technology. Such evolution is subject to several factors. Similar to the internet itself and perhaps even comparable to electricity, blockchain is not a disruptive technology, it is a foundational technology whose transformational impact takes decades rather than years. Putting  blockchain technology to use involves complex structures that are all interdependent. In other words, development of one area alone cannot be successful without multiple additional support structures. By way of comparison, the use of electricity necessitated wiring and light bulbs, connectors, generators etc. One cannot exist without the others. Even if the infrastructure to support  blockchain technology is being developed, complex discussions about structural changes are needed before the technology can be applied.

The complexity of blockchain technology and its evolution affects its ability to serve in a corporate governance role. In the corporate governance context it requires managers, who probably understand how blackchain might be useful but not the technology behind it, to agree on how and when to implement blockchain  technology

Agency Problems in Corporate Governance

Agency problems derive from the lack of  trust between principals and agents. The agency relationship can be defined as a contract between principals and agent whereby the agent acts on principals’ behalf because the principals delegated decision-making authority to the agent. Because of the delegated authority, the agents’ decisions affect both them and the principals.

The lack of trust in the agent creates the underlying problems in corporate governance. Despite best efforts at monitoring and bonding, the interests of manager agents and shareholder principals in corporate governance are never fully aligned, and agency losses inevitably arise from conflicts of interest between principals and agents, known as residual loss.  Residual loss arises because the cost of enforcing suboptimal contracts between principals and agents always exceeds the benefits of performing the contractual obligations.

Agency costs arise because the principal attempts to control, monitor, and supervise the agent. As a result of the lack of trust in the integrity of the principal-agent relationship, and in an attempt to minimize information asymmetries, principals are forced to create costly mechanisms to align their interest with those of the agent. Most prominently, such mechanisms involve periodic reporting, compensation structures for agents, bonding, among others. In the corporate context, agency costs can be seen as the lost value to shareholders (loss in corporation’s share price) that results from diverging interests between shareholders and corporate managers.  As such, agency costs are the sum of monitoring costs, bonding costs, and residual loss.[1]

Blockchain Solutions for Agency Problems in Corporate Governance

Blockchain technology provides formal guarantees to participating principals and agents that address agency problems in corporate governance. Because of the blockchain guarantees, the technology allows a qualitatively different solution for agency problems in corporate governance, especially if compared with the existing finance infrastructure that is riddled with agency problems (see credit rating, executive compensation etc.).

Smart contracts enabled by blockchain technology allow for the comprehensive, near error-free, and zero transaction/agency cost coordination of agency relationships.  Smart contracts and smart property are blockchain-enabled computer protocols that facilitate, verify, monitor, and enforce the negotiation and performance of a contract between principal and agent. Agency relationships in smart contracts run exactly as coded without any possibility of opportunistic behavior of the agent. All contractual terms are public and fully transparent.  Accordingly, a company’s finances, for instance, are visible on the blockchain to anyone, not just to the company’s accounting department. Smart agency contracts run on a customized  blockchain that enables principals and agents to store registries of debts or promises and create entire markets, among many other aspects that have not yet been considered.

Agency related governance in the blockchain takes place without intermediaries, counterparty risk, or principal’s control mechanisms.  Blockchain technology simply does not require the layers of control and verification that prior financial systems necessitated. Control mechanisms such as regular management meetings with shareholders, financial disclosures, the scrutiny of analysts and the financial press, and pressure on management from stock performance and investors, are no longer part of the blockchain enabled agency relationship in corporate governance.

Blockchain technology substantially increases the efficiency of agency relationships and lowers agency costs. The removal of the need for monitoring agents, audit requirements, disclosure regimes, market pressure, executive-agent compensation schemes, and other checks and balances in corporate governance, provides a qualitative shift in efficiency in the agency relationship and in corporate governance overall.

Self-validating blockchain transactions can help resolve the agency issues between most of the stakeholders and constituents of modern corporations. In addition to addressing the traditional agency problem in corporate governance between shareholder-principals and manager-agents, blockchain-enabled smart contracts allow for the public and fully transparent, secure, and completely networked exchange between the corporation and customers, owners and investors, other stakeholders, staff, regulators, strategic partners, suppliers, and service providers.

Removal of Agents

Blockchain technology can facilitate the removal of agents as intermediaries in corporate governance through code, peer-to-peer connectivity, crowds, and collaboration. While it is still difficult to imagine a world without governance structures facilitated by agency constructs, Decentralized Autonomous Organizations (DAOs) have started to challenge the core belief that governance necessitates agency.

The first DAO, launched in May 2016 as an attempt to set up a corporate-type organization without using a conventional corporate structure, had a governance structure that was entirely built on software, code, and smart contracts that ran on the public decentralized blockchain platform Ethereum.  Because it was computer code, it had no physical address or jurisdiction over which authorties could claim control, and it was not an organization with the hierarchy of traditional corporate structures. The DAO had no directors, managers, or employees. In essence, all the core control mechanisms typically employed by principals in agency relationships were entirely absent in the DAO.

ENDNOTE

[1] Jensen & Meckling, supra note 1.

This post comes to us from Professor Wulf Kaal at the University of St. Thomas School of Law. It is based on his recent article, “Blockchain Solutions for Agency Problems in Corporate Governance,” available here.