**2.1 Agency theory**

Agency theory was introduced into management literature by Jensen and Meckling (1976). The theme is based on economic theory and it describes a principal-agent relationship between owners (such as stockholders) and executives, with top executives acting as agents whose personal interests do not naturally align with shareholder interests.

The principal-agent relationship involves a transfer of trust and duty to the agent while assuming that the agent is opportunistic and will pursue interests, including executive fraud, which are in conflict with those of the principal. This potential conflict of interests is often referred to as "the agency problem" (Davis et al. 1997). A typical solution to the agency problem is to structure executive incentives, such as stock options, in such ways that they align executive behavior with stockholder goals. Another common solution to the agency problem is for the board of directors to control and curtail the "opportunistic behavior" of the executives by, for example, the audit committee (Donaldson and Davis 1991).

However, the studies cited in Davis et al. (1997) indicate corporate executives are extremely complex human beings and the agency problem persists. Recent studies by Daily et al. (2003) and Sundaramurthy and Lewis (2003) also show that, in practice, corporate executives have power to counteract the board's control over them. For example, the corporate executives can exercise influence over the board because they are more in tune with daily operations of the company, or they exercise influence over succession of the board to ensure that board members who agree with them are appointed. Finally, Bebchuk and Fried (2004) argue that corporate executives' influence over the board of directors on pay setting can explain a wide range of compensation practices and patterns. This includes ones that have long been viewed as puzzles by economists such as why pay is higher and less sensitive to bad performance, including fraud, in corporations in which executives are more entrenched or have more power vis-à-vis the board.
