What is the agency’s problem?
The agency problem is a conflict of interest inherent in any relationship in which one party is expected to act in the best interest of another. In corporate finance, the agency problem generally refers to a conflict of interest between the management of a company and its shareholders. The manager, acting as an agent of shareholders or officers, is expected to make decisions that will maximize the wealth of shareholders, even if it is in his interest to maximize his own wealth.
Key points to remember
- The agency problem is a conflict of interest inherent in any relationship in which one party is expected to act in the best interest of another.
- An agency problem arises when an incentive or motivation arises for an agent not to act in the best interest of the principal.
Understanding the agency problem
The agency problem does not exist without a relationship between a principal and an agent. In this situation, the agent performs a task on behalf of the principal. Agents are generally recruited by managers due to different skill levels, different job positions or time and access restrictions. For example, a manager will hire a plumber – the agent – to fix plumbing problems. While the plumber’s best interest is to collect as much income as possible, he is responsible for dealing with all of the situations that provide the most benefit to the principal.
The agency problem arises due to a problem of incentives and discretion in carrying out tasks. An agent can be motivated to act in a way that is not favorable to the principal if he is prompted to act in this way. For example, in the plumbing example, the plumber can earn three times more money by recommending a service that the agent does not need. An incentive (three times the salary) is present, which causes the agency problem.
Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries; directors and shareholders; and lawyers and clients. These relationships can be strict in the legal sense, as is the case between lawyers and their clients due to the assertion of the United States Supreme Court that a lawyer must act fairly, fairly and loyalty to their customers.
Minimize the risks associated with the agency problem
Agency fees are a type of internal fee that a principal may incur due to the agency problem. They include the costs of any ineffectiveness that may result from using an agent to take on a task, as well as the costs associated with managing the principal-agent relationship and resolving different priorities.
While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk of agency costs. Principle-agent relationships can be, and often are, regulated by contract or law in the case of fiduciary officials. The fiduciary rule is an example of an attempt to resolve the agency problem that arises in the relationship between financial advisers and their clients.
The agency problem can also be minimized by inducing an agent to act in better accordance with the best interest of the principal. For example, a manager may be motivated to act in the best interests of the shareholders through incentives such as performance-based compensation, direct shareholder influence, threat of termination, or threat of redemption. Directors can also modify the remuneration structure of an agent. If, for example, an agent is paid not on an hourly basis but at the end of a project, there is less incentive not to act in the best interest of the principal. In addition, performance reviews and independent evaluations hold the officer accountable for his decisions.
Historical example of the agency problem
In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated to suggest that the company had more money than it actually earned. These falsifications allowed the company’s share price to rise at a time when executives were selling portions of their shares. Although management has the responsibility to ensure the best interests of the shareholder, the agency’s problem has led management to act in its own interest.