What is the principal-agent relationship?
The principal-agent relationship is an agreement in which one entity legally designates another to act on its behalf. In a principal-agent relationship, the agent acts on behalf of the principal and should not have a conflict of interest in the performance of the act. The relationship between the principal and the agent is called “the agency,” and agency law establishes guidelines for such a relationship.
Key points to remember
- A principal appoints an agent to act on his behalf and in his best interest. Examples include an investor who chooses a fund manager or someone who hires a lawyer for legal work.
- There should not be a conflict of interest between the two, if it does, this creates a principal-agent problem.
- The principal-agent relationship is clearly expressed by a written contract or is implied by actions.
Understanding a principal-agent relationship
A principal-agent relationship is often defined in formal terms described in a contract. For example, when an investor buys shares of an index fund, he is the principal and the manager of the fund becomes his agent. As an agent, the index fund manager must manage the fund, which includes the assets of many principals, so as to maximize returns for a given level of risk in accordance with the fund’s prospectus.
Officers are required to perform tasks with a certain level of skill and care and cannot inappropriately or negligently perform the task.
The principal-agent relationship may be concluded by all the willing and capable parties for the purposes of any legal transaction. In simple cases, the principal within the relationship is a single person who appoints an agent to perform a task; however, other relationships under this guise have a principal which is a corporation, a non-profit organization, a government agency or a partnership.
The agent is most often an individual capable of understanding and, ultimately, of carrying out the task assigned by the principal. Common examples of the principal-agent relationship include hiring a contractor to repair a house, hiring a lawyer to do legal work, or asking an investment counselor to diversify an equity portfolio. In each scenario, the principal is the person seeking the services or advice of a professional, while the agent is the professional carrying out the work.
Whether the principal-agent relationship is clearly expressed in a written contract or is involved in actions, the principal-agent relationship creates a fiduciary relationship between the parties involved. This means that the agent acting on behalf of the principal must carry out the assigned tasks with the best interest of the principal in priority.
The agent is responsible for carrying out the tasks given by the principal as long as the principal provides reasonable instructions. In addition, the agent has the obligation to perform tasks that will not intentionally harm the principal. A duty of loyalty is also involved in the principal-agent relationship, which obliges the agent to refrain from putting himself in a position which creates or encourages a conflict between his interest and the interest of the principal, also known as principal-agent problem.