Agency Problem: Definition, Examples, and Ways To Minimize Risks
An agency dilemma is a conflict of interest in any relationship where one party is expected to act for another. Agency problems in corporate finance involve a conflict of interest between management and stockholders. As the agent for the shareholders or principals, the manager must maximize shareholder wealth even when it is in their best interest to maximize their wealth.
Understanding Agency Issues
Without principal-agent relationships, the agency problem does not exist. Agents do tasks for principals in this context. Principals often hire agents due to skill levels, job positions, and time and access constraints. A principal may hire an agent plumber to solve plumbing difficulties. Despite their desire to make as much money as possible, plumbers must perform in a way that benefits the principal.
The agency dilemma stems from incentives and task discretion. An incentive to act against the principal may encourage an agent to do so. In the plumbing scenario, proposing a service the agent doesn’t require can earn the plumber three times more. An incentive (three times compensation) causes the agency dilemma.
Agency difficulties are widespread in trustee-beneficiary, board-shareholder, and lawyer-client interactions. Fiduciaries serve their principals or clients. Lawyer-client relationships are strict due to the U.S. Supreme Court’s requirement that attorneys work in complete fairness, loyalty, and integrity.
Minimizing Agency Problem Risks
Agency costs are internal costs a principal may suffer due to the agency problem. They include the costs of maintaining the principal-agent relationship, resolving priorities, and any inefficiencies from using an agent. Principals can reduce agency expenditures but not eliminate the agency problem.
Regulations
Contracts or regulations regulate principal-agent interactions in fiduciary situations. The Fiduciary Rule attempts to address the agency problem in financial advisor-client relationships. In investment advisory, fiduciaries are financial and retirement advisors that serve their customers. In other words, advisors should prioritize clients before themselves. To protect investors against advisors hiding conflicts of interest.
An advisor may have multiple investment funds to offer a customer, but only those that pay a commission. Conflict of interest occurs when the investment fund’s financial motivation hinders the advisor from serving the client’s best interests.
Incentives
Incentives can help reduce the agency problem by encouraging agents to operate in the principal’s best interests. A manager may be driven to behave in the shareholders’ best interests by performance-based compensation, shareholder influence, the prospect of fire, or takeovers.
Shareholders might link CEO pay to stock price performance. The CEO might try to thwart a takeover if they feared being dismissed, which would be an agency problem. Incentives based on stock price success would motivate the CEO to execute the takeover. Acquisitions usually boost target company stock prices. With suitable incentives, shareholders and CEOs would profit from stock price growth.
Principals can also change agent pay. If an agent is paid by project completion rather than hourly, there is less motive to act against the principal. Additionally, performance feedback and independent evaluations make agents accountable for their judgments.
Real-World Agency Problem Example
Energy behemoth Enron declared bankruptcy in 2001. Accounting reports were manipulated to make the corporation appear to have more money than it earned. Enron executives hid subsidiary debt and overstated sales via deceptive accounting. These falsifications raised the company’s stock price as executives sold stock.
Shareholders lost $74 billion in the four years before Enron’s bankruptcy. With $63 billion in assets, Enron was the largest U.S. bankruptcy. The agency problem caused Enron’s executives to operate in their best interests despite their duty to shareholders.
What Causes Agency Issues?
Agency issues develop in principal-agent relationships. Principals often hire agents due to skill levels, job positions, and time and access constraints. The agency dilemma stems from incentives and task discretion. An incentive to act against the principal may encourage an agent to do so.
Example of Agency Problem?
Energy behemoth Enron declared bankruptcy in 2001. Accounting reports were manipulated to make the corporation appear to have more money than it earned. These falsifications raised the company’s stock price as executives sold stock. Enron was the largest U.S. bankruptcy at the time. The agency problem caused Enron’s executives to operate in their best interests despite their duty to shareholders.
Agency Issues: How to Help?
While principals cannot solve the agency’s problem, they may reduce its risk or agency cost. Contracts or regulations regulate principal-agent interactions in fiduciary situations. Another technique is incentivizing an agent to act in the principal’s best interests. If an agent is paid by project completion rather than hourly, there is less motive to act against the principal.
Conclusion
- Agency problems arise in every connection where one party is expected to behave in the other’s best interest.
- Agency difficulties develop when agents are incentivized to work against their principals’ best interests.
- Through rules or by motivating an agent to act in the principal’s best interests, agency difficulties can be reduced.
