What is an Agency Problem?
An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests. In the realm of corporate finance, an agency problem typically refers to the conflict between a company’s management and its shareholders. Managers, acting as agents for the shareholders, are expected to make decisions that maximize shareholder wealth. However, managers may act on incentives that prioritize their own interests over those of the shareholders.
Key Takeaways
- An agency problem is rooted in the conflict of interest in any relationship where one party is expected to act in the best interest of another.
- Agency problems arise when different incentives prompt an agent to prioritize their interests over those of the principal.
- Implementing regulations and aligning incentives with the principal’s interests can help mitigate agency problems.
Understanding Agency Problems
Agency problems occur within relationships defined by a principal and an agent. While the agent performs tasks on behalf of the principal, agents are frequently hired owing to their specialized skills, differing roles, or limitations in time and resources. A classic example is a homeowner (the principal) hiring a plumber (the agent) for repairs. Despite the plumber’s goal of maximizing income, they should act in ways that best benefit the homeowner.
Problems arise when there are potential discrepancies in objectives. For instance, the plumber might recommend unnecessary fixes to increase earnings, creating an agency issue.
Agency problems are especially prevalent in fiduciary relationships—trustees and beneficiaries, board members and shareholders, lawyers and clients. These relationships are legally binding, with agents required to act in complete fairness and loyalty to their clients.
Minimizing Risks Associated With the Agency Problem
Agency costs are internal costs incurred by the principal from the agency problem. These costs encompass inefficiencies from hiring an agent and the management of the principal-agent relationship with conflicting priorities. While eliminating the agency problem entirely is challenging, measures can be taken to reduce associated risks.
Regulations
Principal-agent relationships can be legally bound via contracts or comprehensive laws, particularly in fiduciary roles. The Fiduciary Rule serves as one example, mandating financial advisors to prioritize client interests over their own. This regulation aims to safeguard investors from advisors who might otherwise prioritize higher-commission funds over client needs.
Incentives
Mitigating agency problems also involves aligning incentives—encouraging agents to act in the principal’s best interests. For instance, managers can be motivated through performance-based compensation, direct shareholder influence, or the threat of termination or takeovers. By tying CEO compensation to share performance, shareholders ensure that both managerial and shareholder interests align, leading to mutually beneficial outcomes.
Flexible compensation structures (e.g., project-based rather than hourly pay) help align agent actions with principal interests. Regular performance evaluations and independent reviews further instill accountability.
Real-World Example of an Agency Problem
In 2001, energy giant Enron faced bankruptcy following accounting falsifications intended to project false financial health. This led to significant stock value increases and concurrent stock sales by executives. Subsequently, Enron’s shareholders suffered tremendous losses, with estimated losses amounting to $74 billion and assets of $63 billion—representing the biggest U.S. bankruptcy at the time. The agency problem in Enron was evident as management prioritized personal gain over shareholder interests.
Frequently Asked Questions
What Causes an Agency Problem?
Agency problems arise when discrepancies in skill levels, roles, or resources provoke a relationship between a principal and an agent. They occur due to incentives and the freedom of discretion in completing tasks, potentially engaging agent behavior that isn’t aligned with the principal’s best interests.
What Is an Example of an Agency Problem?
The Enron scandal is a definitive example. Executives manipulated accounting records to inflate the company’s financial status artificially. These actions culminated with major financial losses for shareholders and public scrutiny of executive malfeasance.
How to Mitigate Agency Problems?
Though eliminating the agency problem entirely is challenging, steps like regulatory frameworks and incentive alignment are effective. Agency issues can be controlled through well-crafted contracts or laws in fiduciary settings. Agents incentivized by outcomes rather than hourly work, regular performance evaluation, and aligning executive compensation with firm success help minimize aberrant behavior and align interests effectively.
Related Terms: principal-agent relationship, fiduciary duty, performance-based compensation, corporate governance.
References
- American Bar Association. “ABA Model Code of Professional Responsibility”, Page 49.
- U.S. Securities and Exchange Commission. “Regulation Best Interest: The Broker-Dealer Standard of Conduct”, Pages 4-5.
- Federal Bureau of Investigation, Archives. “A Look Back at the Enron Case”.
- U.S. Securities and Exchange Commission. “SEC v. Andrew S. Fastow”.
- National Library of Medicine National Institutes of Health. “Steps to Strengthen Ethics in Organizations: Research Findings, Ethics Placebos, and What Works”.
