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65-421: The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory

130-628: A Communist sympathizer. For nearly a decade, Berle served as chairman of the Liberal Party. His main goal was to fight off far-left and Communist influences. He also chaired the Twentieth Century Fund for the two decades following World War II. Berle briefly returned to government service for the first half of 1961, serving under President John F. Kennedy as head of an interdepartmental task force on Latin American affairs. During that time, he

195-404: A company's shareholder and the board of directors is generally considered to be a classic example of a principal–agent problem . The problem arises because there is a division between the ownership and control of the company, as a result of the residual loss. In such case, traditional mechanisms of corporate governance such as shareholder activism and proxy contests may be less effective due to

260-658: A groundbreaking work on corporate governance , a professor at Columbia University , and an important member of US President Franklin Roosevelt 's " Brain Trust ." Berle was born in Boston , Massachusetts, the son of Mary Augusta (Wright) and Adolf Augustus Berle. He entered Harvard College at age 14, earning a bachelor's degree in 1913 and a master's degree in 1914. He then enrolled in Harvard Law School . In 1916, at age 21, he became

325-549: A loss of value for the employer. The agency cost could increase if the employees' abilities do not match their job requirements, which reduces productivity and increases costs for their employers. As a result, many employers are implementing various human resource management strategies to reduce these agency costs. For example, they design fair and transparent compensation and incentive schemes, provide training and career development opportunities, and establish clear communication channels between employees and management. The ultimate goal

390-441: A potential constitutional law for the new economic state, while business practice is increasingly assuming the aspect of economic statesmanship." Berle was an original member of Franklin D. Roosevelt 's " Brain Trust ", a group of advisers who developed policy recommendations. Berle's focuses ranging from economic recovery to diplomatic strategy during Roosevelt's 1932 election campaign. Roosevelt's " Commonwealth Club Address ",

455-522: A respected member of the State Department , were members of a Soviet "apparatus" designed to influence US policy and pass classified documents and information to the Soviets. Chambers's autobiography asserts that Berle and the journalist who set up the meeting, Isaac Don Levine , met with Roosevelt and conveyed what Chambers told them, but Roosevelt unequivocally refused to take any action. Hiss remained at

520-548: A shareholder ). Because bondholders know this, they often have costly and large ex-ante contracts in place prohibiting the management from taking on very risky projects that might arise, or they will simply raise the interest rate demanded, increasing the cost of capital for the company. Labour agency costs refer to the costs arising when there is a conflict of interest between employers and employees. These conflicts can be caused by employees who may act to maximise their own interests rather than those of their employers, thus causing

585-525: A small stake in ownership, having interests differing from those of firm's owners. Instead of making the company more efficient and profitable, the CEO may be tempted into: Information asymmetry contributes to moral hazard and adverse selection problems. Much of modern company law has evolved in order to limit the effects of agency costs. Company directors in common law jurisdictions owe fiduciary duties to their company. Notably these duties are not owed to

650-445: A speech written by Berle on government involvement in industrial and economic policy, was ranked in 2000 as the second-best presidential campaign speech of the 20th century by public address scholars. While remaining an informal adviser of Roosevelt after the election, Berle returned to New York City and became a key consultant in the successful mayoral election campaign of reformer Fiorello LaGuardia . From 1934 to 1938, Berle managed

715-527: A time when Berle was a Liberal Party leader in New York working for Truman's election , was to defuse, if possible, the influence of anti-Communist sentiment and of the case itself in that election year." In 1943, Berle's duties in the State Department involved political supervision of the various clandestine activities necessitated by the war. Working with his assistant Charles W. Yost , Berle liaised with

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780-531: Is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc.). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. The empirical relevance of

845-454: Is another example of agency cost. Bondholders typically value a risk-averse strategy since they do not benefit from higher profits. Stockholders on the other hand have an interest in taking on more risk. If a risky project succeeds shareholders will get all of the profits themselves, whereas if the projects fail the risk may be shared with the bondholder (although the bondholder has a higher priority for repayment in case of issuer bankruptcy than

910-457: Is noted by Adolf A. Berle , in his now famous work on company law, this issue is exacerbated in companies where each shareholders has only a small interest in the company. Such diversity in shareholder interests makes it unlikely that any one shareholder will exercise proper control over the board. The classic case of corporate agency cost is the professional manager—specifically the CEO—with only

975-431: Is often set up as a competitor theory to the pecking order theory of capital structure . A review of the trade-off theory and its supporting evidence is provided by Ai, Frank, and Sanati. An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity . It states that there is an advantage to financing with debt, the tax benefits of debt and there

1040-407: Is readily observable, e.g. sharpened sugar cane stalks ready for planting. Where effort quality is difficult to observe, e.g. the uniformity of broadcast seeds or fertilizer, wage rates tend to be used. Allen and Lueck (2004) have found that farm organization is strongly influenced by diversity in the form of moral hazard such that crop and household characteristics explain the nature of the farm, even

1105-529: Is the most quoted text in corporate governance studies. Berle and Means showed that the means of production in the US economy were highly concentrated in the hands of the largest 200 corporations, and within the large corporations, managers controlled firms despite shareholders' formal ownership. Berle theorized that the facts of economic concentration meant that the effects of competitive-price theory were largely mythical. While some advocated trust busting , breaking up

1170-422: Is to create a more engaged and motivated workforce to reduce potential labour agency costs. Labour is sometimes aligned with stockholders and sometimes with management. They too share the same risk-averse strategy, since they cannot diversify their labour whereas the stockholders can diversify their stake in the equity. Risk averse projects reduce the risk of bankruptcy and in turn reduce the chances of job-loss. On

1235-543: The Enron Scandal still remains as one of the key studies of the principal-agent problem. Another potential example of the agency-cost problem (which also gives rise to questions of corporate social responsibility ) arose with respect to the James Hardie Scandal, where James Hardie Industires sought to avoid payment of settlements to those former employees suffering from by asbestos related illnesses. Ultimately,

1300-784: The National Lawyers Guild (NLG). According to the NLG's A History of the National Lawyers Guild 1937-1987 , two factions arose as early as 1940. External events heightening these tensions included the Hitler-Stalin Pact of September (1939), the Russian invasion of Finland (1940). One faction, led by Berle and Morris Ernst , supported New Deal policies. The other, led by Osmond Fraenkel and Thomas I. Emerson , supported freedom of speech and press as well as Anti-Fascism (seen at

1365-749: The OSS , and with the Joint Intelligence Committee of the Joint Chiefs of Staff. Berle also was a major architect in the development of federal farm and home owners' mortgage programs and in the expansion of the Reconstruction Finance Corporation . He was elected a Fellow of the American Academy of Arts and Sciences in 1944. After the war, Berle served as Ambassador to Brazil from 1945 to 1946. In October 1945, two days after

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1430-568: The Paris Peace Conference , advocating for smaller nations' rights of self-determination. In 1919, Berle moved to New York City and became a member of the law firm of Berle, Berle and Brunner. Berle became a professor of corporate law at Columbia Law School in 1927 and remained on the faculty until retiring in 1964. He is best known for his groundbreaking work in corporate governance that he co-authored, with economist Gardiner Means , The Modern Corporation and Private Property . It

1495-614: The deposition of president Getúlio Vargas , Berle pledged for the freedom of the Brazilian communists who were being incarcerated by the government since the beginning of the month. He then returned to his academic career at Columbia. Berle was a founding member of the Liberal Party of New York , a breakaway faction of the American Labor Party , which had lost support as a result of its sponsorship of Congressman Vito Marcantonio ,

1560-590: The Committee, leading to his trial and conviction for perjury. Berle provided incorrect and misleading testimony before the House Committee about his meeting with Chambers, which was contradicted by both his notes taken subsequent to the meeting and a personal diary entry that acknowledged that Chambers had implicated Hiss in espionage. Explaining Berle's evasive testimony, Allen Weinstein wrote in his book Perjury: The Hiss-Chambers Case : "His major concern in 1948, at

1625-755: The NLG's 1940 convention, newly elected president Robert W. Kenny of California and secretary Martin Popper of New York sought to persuade members to return. During a phone call from Kenny, Berle gave him a short list of lawyers to leave as a simple matter of "cleaning house": Kenny rejected the request. During his tenure as Assistant Secretary of State, Berle rented Woodley Mansion , which had once been owned by Grover Cleveland and Martin Van Buren , from secretary of war Henry Stimson in 1939. On September 2, Whittaker Chambers arrived at Woodley to tell Berle that several senior government officials, including Alger Hiss ,

1690-707: The State Department during and after the war in positions, including as Roosevelt's principal adviser on Soviet affairs at the Yalta conference, as a delegate to the Dumbarton Oaks Conference and as Secretary General of the San Francisco conference establishing the United Nations. In 1948, Chambers repeated his accusations to the House Committee on Un-American Activities . Hiss denied the accusation in testimony to

1755-439: The bonus is still an agency cost, but the company will profit from paying this cost so long as the avoided residual cost (as defined above), is greater than the bonus. Another key method by which agency costs are reduced is through legislative requirements that companies undertake audits of their financial statements. Publicly listed companies must also undertake disclosure to the market. These requirements seek to mitigate

1820-412: The books' and essentially meaning Enron was falsifying information. Enron had reached the point where it was overstating profits by $ 1.2 billion and eventually lead to its collapse. In Enron's collapse it also took down its accounting counterpart firm, Arthur Andersen , who were certifying Enron's books to be clean, when they very obviously weren't. In the case of Arthur Andersen again reiterating

1885-558: The city's fiscal affairs as its last Chamberlain . Then, from 1938 to 1944, Berle was Assistant Secretary of State for Latin American Affairs. Throughout the Roosevelt administration, Berle consulted on important international and industrial New Deal projects, such as the creation of the St. Lawrence Seaway , the development of the administration's Good Neighbor Policy toward Latin America, and

1950-462: The company and can therefore influence critical decisions, such as the election of directors and the adoption of significant corporate policies. These decisions could increase the agency cost because large shareholders may decide to get maximum profit for themselves, which is not usually the best decision for the company's long-term survival. Enron , a U.S. energy giant operated for decades trading large and highly demanded commodities. However, 2001 saw

2015-455: The company as well as cause conflicts of interest between concentrated and other shareholders. For instance, concentrated shareholders may prioritise their profits and rights over those of other shareholders, thus increasing agency costs. For example, concentrated shareholders can make decisions that are more beneficial to themselves, such as higher dividend payouts or short-term, high-repayment business decisions. Such decisions may adversely affect

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2080-461: The company, but they prevented dividends being paid in the short term. This was beneficial to long-term shareholders, such as Mr Ford, but Mr Dodge may not have held his shares for long enough to reap the benefit. As such, he brought a successful action in minority oppression in order to force the payment of dividends by the Ford Motor Co. Mr Dodge's inability to receive a dividend without litigation

2145-709: The concentrations of firms into smaller entities to restore competitive forces, Berle believed that that would be economically inefficient. Instead, he argued for government regulation and became identified with the school of business statesmanship, which advocated that corporate leadership accept (and theorized that they had, to a great extent, already accepted) that they must fulfill responsibilities toward society in addition to their traditional responsibilities toward shareholders. Corporate law should reflect this new reality, he wrote in The Modern Corporation : "The law of corporations, accordingly, might well be considered as

2210-429: The director and the company, given the operation of the privity doctrine. Instead, companies often opt for incentive schemes based on the performance of the company. These schemes provide bonuses to company directors when the company performs well. The director is therefore given an incentive to ensure the proper performance of the company, thereby aligning their interests with that of the shareholders. The costs of paying

2275-426: The effectiveness of incentives in firms, such as incentive programmes, the characteristics of the workers subject to the programmes, and the level of competition in the labour market. In the end, the authors concluded that incentives could effectively improve firm performance. However, the design of each incentive programme is critical to its success. For instance, incentive programmes must be carefully structured to meet

2340-777: The establishment of the International Civil Aviation Organization . Outside of Latin America, Berle argued "that control of the incomparable energy reserves of the Middle East would yield 'substantial control of the world. ' " by 1941, Berle had charge of the intelligence activities in the State Department, working with the FBI in Latin America and the OSS in Europe. He was in touch with anti-fascist and anti-Communist Europeans, with

2405-485: The executive compensation design should consider the potential of creative risk-taking and agency costs. Moreover, boards should carefully monitor the activities of managers to ensure that they are acting to achieve the best profit returns for shareholders. The article “Large shareholders and corporate control” was published in the Journal of Political Economy in 1985. The paper provides a theoretical framework that illustrates

2470-412: The fall of the giant as a result of poor management, and a deeply rooted principal-agent problem. Typically speaking, chiefs and management are paid large salaries in the hope that these salaries deter from participation in high risk business. Yet Enron's board of directors decided to pay its managers in the form of stocks and options . In a very simplistic sense, this meant that managements compensation

2535-410: The fragmented nature of ownership. The shareholders appoint the board to manage their asset but often lack the time, expertise or power to directly observe the actions of the board. In addition the shareholders may not be placed to understand of the repercussions of the board's decisions. As such, the board may be capable of acting in their own best interests without the oversight of the shareholders. As

2600-493: The general tax-paying public who may want it used elsewhere on things such as health care and education. The literature however mainly focuses on the above categories of agency costs. While complete contract theory is useful for explaining the terms of agricultural contracts, such as the sharing percentages in tenancy contracts ( Steven N. S. Cheung , 1969), agency costs are typically needed to explain their forms. For example, piece rates are preferred for labor tasks where quality

2665-499: The goal of building a liberal democratic coalition in Europe. Berle became entangled in incessant turf wars among intelligence agencies. Critics on the left accused him of being too hostile toward Moscow, and Secretary of State Cordell Hull was annoyed at his access to Roosevelt. In 1944 he was reassigned to take charge of negotiation with the Allies regarding a postwar commercial aviation agreement. In 1939, Berle became an early member of

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2730-420: The information asymmetry between the board and the shareholders. The requirement to make disclosure reduces monitoring costs, and directors are less able to abuse their position when they will be required to disclose their shortcomings. A concentrated shareholder structure can result in small groups that hold a significant proportion of the company’s shares. These shareholders can exercise significant control over

2795-697: The interests of employees and managers. Published in the Journal of Business Research in 2015, the paper “The Impact of HR Practises on Labour Agency Costs” examines the relationship between human resource management (HRM) practises and labour agency costs. The authors claim that, by providing for the interests of both employees and managers, HR systems can help reduce labour agency costs. Moreover, every company sector increases its interest by increasing company profit. Furthermore, by emphasising communication, employee engagement, and training can help build trust between employees and managers, which can lead to higher employee engagement and lower employee turnover. In conclusion,

2860-404: The interests of one shareholder conflicts with that of another. In the legal dispute Dodge v Ford Motor Co , Henry Ford sought to take Ford Motors in a direction that was disagreeable to one of the minority shareholders, Mr Dodge. Mr Ford's aggressive expansion policies (including his goals of reducing prices and increasing employee wages) were perceived by Mr Ford to be for the long-term benefit of

2925-409: The involvement of a liquidator . This is in part due to the asymmetry of information between the shareholders and the board (as noted above). In addition, as shareholders are not generally owed directors duties, they do not having standing to enforce them (but notably, some shareholders may have action in minority oppression ). Similar issues arise with respect to obligations under a contract between

2990-619: The lack of risk aversion. Roumasset (1995) finds that warranted intensification (e.g. due to land quality) jointly determines optimal specialization on the farm, along with the agency costs of alternative agricultural firms. Where warranted specialization is low, peasant farmers relying on household labor predominate. In high value-per-hectare agriculture, however, there is extensive horizontal specialization by task and vertical specialization between owner, supervisory personnel and workers. These agency theories of farm organization and agricultural allow for multiple shirking possibilities, in contrast to

3055-594: The mechanical change in asset prices that makes up for most of the variation in capital structure . Despite such criticisms, the trade-off theory remains the dominant theory of corporate capital structure as taught in the main corporate finance textbooks. Dynamic versions of the model generally seem to offer enough flexibility in matching the data so, contrary to Miller's verbal argument, dynamic trade-off models are very hard to reject empirically. Agency costs Common examples of this cost include: Though effects of agency cost are present in any agency relationship,

3120-401: The other hand, if the CEO is clearly underperforming then the company is in threat of a hostile takeover which is sometimes associated with job-loss. They are therefore likely to give the CEO considerable leeway in taking risk averse projects, but if the manager is clearly underperforming, they will likely signal that to the stockholders. In 1995, the paper “The Provision of Incentives to Firms”

3185-487: The paper stated that HR practises for reducing labour agency costs could work significantly. However, this will depend on various factors, such as strategies and employee characteristics. Other stakeholders such as the government, suppliers and customers all have their specific interests to look after and that might incur additional costs. Agency costs in the government may include the likes of government wasting taxpayers money to suit their own interest, which may conflict with

3250-462: The power of the principal-agent problem, where the accounting firm (principal) trusts and follows orders from the chiefs (agents), who benefit greatly from the business of a large company like Enron . The collapse of the two giants shook Wall street, and finance around the globe, leading to Enron's CEO Jeffrey Skilling being sentenced to serve 24 years in prison , as a result of various counts of conspiracy, fraud and insider trading. To this day,

3315-402: The principal-agency version of sharecropping and agricultural contracts ( Stiglitz , 1974, 1988, 1988 ) which trades-off labor shirking vs. risk-bearing. Adolf A. Berle Adolf Augustus Berle Jr. ( / ˈ b ɜːr l i / ; January 29, 1895 – February 17, 1971) was an American lawyer, educator, writer, and diplomat. He was the author of The Modern Corporation and Private Property ,

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3380-439: The rate of creative risk-taking, which can lead to better company performance but, at the same time, increase agency costs. The authors used data from the movie industry to illustrate that managers with past successes are more likely to take creative risks and try to bring higher profit returns with higher risks, such as investing in projects with a low probability of success, which can increase agency costs. The paper summarised that

3445-430: The rights of other shareholders or the long-term survival of the company. In jurisdictions outside the US and UK, a distinct form of agency costs arises from the existence of dominant shareholders within public corporations (Rojas, 2014). In 2014, the study “Yesterday’s Heroes: Compensation and Creative Risk-Taking,” was published in the Journal of Finance. The authors explained how executive compensation could increase

3510-419: The role of large shareholders in corporate governance and control. For instance, large shareholders can be crucial in solving agency problems between managers and other shareholders. In addition, they can monitor managers and intervene when necessary in order to protect their profits. Large shareholders can also play an essential role in corporate control. For example, large shareholders hold a significant stake in

3575-521: The second youngest graduate in the school's history, behind only Louis Brandeis . Upon graduation Berle joined the US military . His first assignment as an intelligence officer was to assist in increasing sugar production in the Dominican Republic by working out property and contractual conflicts among rural landowners. Immediately after World War I , Berle became a member of the American delegation to

3640-451: The shareholders were almost unanimous in voting in favor of a compensation scheme for the victims. The interests of the shareholders may have favored funding the compensation scheme earlier than the directors were willing to. This divergence in interest, even where it address an issue of corporate social responsibility rather than strictly monetary concerns, could be considered an example of agency cost. Further difficulties may arise where

3705-552: The shareholders, but to the company. This is because the company is, in law, a legal person, separate from its shareholders. Breaches of duty by directors have the primary effect of causing losses to the company. The fiduciary duty requires the company director to act with due care and skill, in good faith, in the best interests of the company and without conflicts of interest. In some jurisdictions deliberate breaches of directors duties can result in civil or criminal penalties. However, director's duties are difficult to enforce without

3770-647: The term is most used in business contexts. Professor Michael Jensen and the late Professor William Meckling of the Simon School of Business , University of Rochester wrote an influential paper in 1976 titled "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure". Professor Jensen also wrote an important paper with Eugene Fama of University of Chicago titled "Agency Problems and Residual Claims". These works categories agency costs into three main sources: The relationship between

3835-480: The time as a Popular Front stance, thus pro-Communist). Other issues supported by Fraenkel, Emerson, the National Executive Board and many chapters included: support for Loyalist Spain, criticism of J. Edgar Hoover and the FBI, and support for labor unions. Berle and Ernst recommended anti-communist oaths, which Fraenkel and Emerson opposed. Many Berle and Ernst supporters left the NLG by 1940. During

3900-453: The trade-off theory has often been questioned. Miller for example compared this balancing as akin to the balance between horse and rabbit content in a stew of one horse and one rabbit. Taxes are large and they are sure, while bankruptcy is rare and, according to Miller, it has low dead-weight costs. Accordingly, he suggested that if the trade-off theory were true, then firms ought to have much higher debt levels than we observe in reality. Myers

3965-475: Was a particularly fierce critic in his Presidential address to the American Finance Association meetings in which he proposed what he called "the pecking order theory". Fama and French criticized both the trade-off theory and the pecking order theory in different ways. Welch has argued that firms do not undo the impact of stock price shocks as they should under the basic trade-off theory and so

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4030-816: Was elected to the American Philosophical Society in 1965. Adolf Berle married Beatrice Bishop (1902–1993), the daughter of Cortlandt Field Bishop (1870–1935) and Amy Bend (1870–1957), in 1927. Beatrice was the granddaughter George Hoffman Bend (1838–1900), a member of the New York Stock Exchange and prominent in New York Society. Adolf and Beatrice had two daughters and a son. He had ten grandchildren. In 1971, Berle died in New York City , aged 76. His wife edited and published selections from his diaries posthumously in 1973 as Navigating

4095-409: Was pegged to stock performance and would mean any decision they made would be to the benefit of themselves (agents) and principals (shareholders). Whilst in theory the concept was sound, it meant that Enron's management could now deceive the markets for their own monetary gain, and they did just that. Higher management decided to take on high debt and risky activities, leaving these transactions 'off

4160-566: Was primarily involved in forming the US response to a newly communist Cuba, which included both the failed Bay of Pigs invasion and the initiation of the Alliance for Progress , an economic development policy aimed at the region. Berle continued to write academic work related to corporate law. His article on "Property, Production and Revolution" was a key statement of the theory behind the Great Society program of President Lyndon B. Johnson . He

4225-424: Was published in the Journal of Economic Literature and comprehensively reviewed the literature on providing incentives to firms. The authors pointed out that incentives are crucial for employee motivation and improving firm performance. Moreover, incentives can take many forms, including performance-based compensation, promotions, and career development opportunities. The paper also identifies factors that can influence

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