Agency Control Mechanism Effectiveness and Decision Making in an Executive's Final Year with a Firm *

Abstract

An agency problem can arise when the preferences of managers and owners differ. The magnitude of the agency problem is mitigated by various control mechanisms including: the market for corporate control (Manne [1965]), the managerial labor market (Fama [1980]), the amount of the manager's wealth tied directly to firm value, monitoring by owners (Jensen and Meckling [1976]), and compensation contracts. The effectiveness of the firm's set of agency control mechanisms might decrease in a year of a corporate executive departure. For example, the firm itself is unable to penalize the executive after his departure for actions that later appear not to have been in the firm's best interests; the market for corporate control will not be effective since any potential takeover would likely occur after the date of departure due to the time needed to detect suboptimal behavior and then to execute a takeover; and for those executives retiring, there cannot be full ex post settling up by the labor market since the executives are leaving this market. If there is a decrease in the effectiveness of the set of control mechanisms, then managers are more likely to act opportunistically. However, the firm might offset decreases in the effectiveness of some control mechanisms with increases in the effectiveness of other mechanisms. Or control mechanisms unaffected in the year of an executive departure such as monitoring might be effective at motivating the executive not to act opportunistically. This paper investigates the issue of whether there is a decrease in the effectiveness of the firm's set of agency control mechanisms in preventing certain types of opportunistic behavior from taking place in an executive's final year with a firm.