Simone Lawson
An agency problem is a conflict of interest that arises when an agent does not fully represent the best interests of the principal. Agency problems occur when individuals act in their own self-interest instead of in the best interests of the company. This issue is significant because it can lead to decisions that favour the agent's interests over those of the principal. Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries, board members and shareholders, and lawyers and clients. While it is not possible to eliminate agency problems, they can be minimized by incentivizing agents to act in accordance with the principal's best interests.
| Characteristics | Values |
|---|---|
| Definition | A conflict of interest inherent in any relationship where one party is expected to act in another's best interests. |
| Type of relationship | Principal-agent |
| Examples of relationships | Trustees and beneficiaries, board members and shareholders, lawyers and clients, financial advisors and their clients, managers and shareholders, CEOs and stockholders, politicians and their constituents |
| Cause | Agency costs, which arise due to the principal's inability to constantly monitor the agent's work. |
| Solutions | Changing the system of rewards to align priorities, improving the flow of information, offering incentives for strong performance and ethical behaviour, awarding decision-makers with stock packages and other long-term compensation packages, penalising poor performance and unethical behaviour, providing oversight, threatening a hostile takeover |
| Famous examples | Enron, Bernie Madoff's Ponzi scheme |
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What You'll Learn
Conflict of interest
An agency problem is a conflict of interest inherent in any relationship where one party, the agent, is expected to act in the best interest of another party, the principal. This problem arises when the agent is motivated by self-interest and does not act in the principal's best interest.
In corporate finance, an agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, is supposed to make decisions that will maximise shareholder wealth. However, it is in the manager's self-interest to maximise their own wealth. For example, management may be incentivised to act in a way that benefits them financially, even if it is not in the best interest of the shareholders.
Agency problems can also occur in fiduciary relationships, such as between trustees and beneficiaries, board members and shareholders, and lawyers and clients. In these relationships, the agent is legally or ethically bound to act in the principal's best interest. For example, a lawyer is expected to act with complete fairness, loyalty, and fidelity to their clients.
The agency problem can be mitigated by regulating principal-agent relationships through contracts or laws. For example, the Fiduciary Rule regulates the relationship between financial advisors and their clients, requiring advisors to act in their clients' best interests and protect them from potential conflicts of interest. Additionally, agency problems can be reduced by providing incentives for agents to act in accordance with the principal's interests, such as performance-based compensation or the threat of firing.
Overall, an agency problem occurs when there is a conflict of interest between an agent and a principal, where the agent is expected to act in the principal's best interest but is motivated by self-interest. This problem can have significant implications in various sectors, including corporate finance and fiduciary relationships.
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Principal-agent relationships
An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in the best interest of another. This conflict arises when agents do not fully represent the best interests of principals. Principals hire agents to represent their interests and act on their behalf. Agents are frequently hired to allow principals to obtain new skill sets or to accomplish work for investors.
In the business world, this relationship is represented by a company's management team and the corporation's shareholders. In other cases, the agent is the head of an investment firm while investors are the principals. Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries, board members and shareholders, and lawyers and clients.
The primary cause of the principal-agent problem is known as agency costs. These costs arise due to the inability of the principal to constantly monitor the work of the agent, which could result in the agent avoiding responsibilities, making poor decisions, or acting in a way contrary to the interests of the principal. As with any principal-agent problem, the issue arises when a constituent, or principal, disagrees with the actions of an elected politician, or agent.
There are a number of remedies for the principal-agent problem, and many of them involve clarifying expectations and monitoring results. Principals can also provide incentives that motivate the agent to work in the best interest of the principal. For example, a manager can be incentivized to act in the shareholders' best interests through performance-based compensation, direct influence by shareholders, the threat of firing, or the threat of takeovers.
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Fiduciary duty
A fiduciary duty is an obligation to act in the best interest of another party, and it arises from a relationship of confidence and trust between a principal and an agent. The agent is given the legal authority to act on the principal's behalf, and in doing so, they incur a fiduciary duty to the principal. This duty includes obligations such as duty of care, loyalty, good faith, confidentiality, prudence, and disclosure.
In the context of agency problems, fiduciary duties are particularly important. An agency problem is a conflict of interest that arises when one party, motivated by self-interest, is expected to act in the best interest of another. This conflict is inherent in any principal-agent relationship and can occur in various contexts, such as between a company's management and its shareholders or between a lawyer and their client. For example, in corporate finance, a manager acting as an agent for the shareholders is supposed to make decisions that maximise shareholder wealth, even though it may be in their own interest to maximise personal wealth.
To address agency problems, regulations and incentives can be put in place to align the interests of the principal and the agent. The Fiduciary Rule, for instance, aims to regulate the relationship between financial advisors and their clients, ensuring that advisors act in their clients' best interests and disclose all relevant information. This helps to protect investors from advisors who may conceal conflicts of interest.
Fiduciary duties are also relevant in other relationships, such as between a trustee and a beneficiary. In this context, the trustee has legal ownership of the property and controls the assets held in trust. They are obligated to make decisions that are in the best interest of the beneficiary, who holds equitable title to the property.
Additionally, fiduciary duties can apply to the directors of corporations. These directors have a duty of care, which requires them to inform themselves of all material information before making business decisions. They also have a duty of loyalty, which means they must act without personal economic conflict and advance the interests of the corporation without violating the law.
Overall, fiduciary duty is a critical concept in addressing agency problems. By imposing legal obligations on agents to act in the best interests of their principals, fiduciary duties help to minimise conflicts of interest and protect the rights and interests of all parties involved.
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Incentives and compensation
Agency problems arise when there is a conflict of interest between two parties, where one party is expected to act in the best interest of the other. This conflict occurs when incentives or motivations are presented to the agent to act in a way that is not favourable to the principal.
Performance-based compensation
Linking compensation to performance provides incentives for agents to act in the best interests of the principal. For example, managers can be incentivised to act in the shareholders' best interests by tying their compensation to stock price performance. This alignment of interests encourages managers to work towards increasing shareholder wealth, as their own wealth increases as a result.
Altering compensation structure
Changing the way agents are compensated can also reduce agency problems. For instance, instead of paying agents on an hourly basis, compensating them upon the completion of a project reduces the incentive to act against the principal's interests. This structure ensures that agents are motivated to complete the task at hand, rather than drawing out the process to increase their pay.
Providing concrete incentives
Offering incentives for good performance can encourage agents to act in a way that benefits the principal. For example, salespeople can be incentivised to sell work that the agency can deliver by paying sales commissions after clients pay each invoice, rather than upfront. Performance bonuses for timely project completion can also encourage employees to work efficiently without sacrificing quality.
Direct influence by shareholders
In the context of corporate finance, agency problems can be mitigated by allowing shareholders to have direct influence over managers. This can take the form of the threat of firing or the threat of takeovers. For instance, if a CEO fears that a potential takeover could result in their dismissal, they may work to prevent the takeover, creating an agency problem. However, if the CEO's compensation is tied to stock price performance, they would be incentivised to complete the takeover, as the stock price typically rises after an acquisition.
Communicating expected results
Clearly communicating expected results at the start of the principal-agent relationship can help avoid agency problems. By setting clear expectations and providing incentives for meeting those expectations, principals can motivate agents to work in their best interests. This clarity helps to align the interests of both parties and reduces the likelihood of conflicts arising.
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Monitoring and verification
To address this issue, principals can implement monitoring and verification procedures to ensure that agents are acting in accordance with their expectations. One procedure is monitoring, which occurs while the agent is choosing their action. The other is auditing, which takes place after the agent has taken their action and provides supplementary information to the principal. Auditing can be costly to implement and may require steeper incentive schemes, while monitoring can be preferred if the principal cannot commit to verifying the agent's efforts.
In the context of agency theory, monitoring is crucial as it provides detailed information about the realization of stipulated preferences and relevant procedures. This helps address the issue of hidden information and hidden actions, which can lead to agency problems. On the other hand, stewardship theory suggests a more relaxed approach to monitoring, assuming that principals and agents operate based on shared goals and aligned interests.
To minimize agency problems, principals can take several steps. Firstly, they can provide clear communication of expected results at the start of the agreement. This helps align the interests of the principal and the agent, reducing the risk of conflicting goals. Secondly, principals can implement incentive structures that motivate agents to act in the principal's best interest. For example, performance-based compensation, direct influence by shareholders, or the threat of firing can encourage agents to prioritize the principal's interests over their own.
Overall, monitoring and verification play a critical role in addressing agency problems by providing oversight, ensuring alignment of interests, and creating incentives for agents to act in the principal's best interest.
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Frequently asked questions
An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests but instead act in their own self-interest.
Agency problems occur when agents do not fully represent the best interests of principals. This can be due to a conflict between the goals of the principal and agent, or when it is difficult/costly for the principal to verify the agent's actions.
Agency problems arise when agents are incentivised to act in a way that benefits them at the expense of the principal. This can occur when there is a lack of oversight and incentive alignment.
Agency problems can be resolved by incentivising agents to act in the principal's best interests, improving monitoring and communication, and changing the system of rewards to align priorities.
