Agency Problem

What Is an Agency Problem?

A agency problem is a conflict of interest inherent in any relationship where one party is expected to act to another's greatest advantage. In corporate finance, an agency problem normally alludes to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, should settle on choices that will amplify shareholder wealth even however it is in the manager's best interest to augment their own wealth.

Grasping Agency Problems

There is no such thing as the agency problem without a relationship between a principal and a agent. In this situation, the agent performs a task for the benefit of the principal. Agents are commonly connected by principals due to various expertise levels, different employment positions, or limitations on time and access. For instance, a principal will hire a handyman — the agent — to fix plumbing issues. Albeit the handyman's best interest is to collect however much income as could reasonably be expected, they are given the responsibility to perform in anything that situation brings about the most benefit to the principal.

The agency problem arises due to an issue with incentives and the presence of prudence in task completion. An agent might be spurred to act in a way that isn't positive for the principal assuming the agent is given an incentive to act along these lines. For instance, in the pipes model, the handyman might get three times as much cash-flow by suggesting a service the agent needn't bother with. An incentive (three times the pay) is available, making the agency problem arise.

Agency problems are common in fiduciary relationships, for example, among trustees and recipients; board individuals and shareholders; and legal advisors and clients. A fiduciary is an agent that acts in the principal's or alternately client's best interest. These relationships can be severe from a legal perspective, just like the case in the relationship among attorneys and their clients due to the U.S. High Court's statement that an attorney must act in complete fairness, loyalty, and fidelity to their clients.

Limiting Risks Associated With the Agency Problem

Agency costs are a type of internal cost that a principal might cause because of the agency problem. They incorporate the costs of any failures that might arise from utilizing an agent to take on a task, alongside the costs associated with dealing with the principal-agent relationship and settling contrasting priorities. While it is preposterous to expect to wipe out the agency problem, principals can do whatever it takes to limit the risk of agency costs.

Regulations

Principal-agent relationships can be regulated, and frequently are, by contracts, or laws on account of fiduciary settings. The Fiduciary Rule is an illustration of an endeavor to direct the emerging agency problem in the relationship between financial advisors and their clients. The term fiduciary in the investment advisory world means that financial and retirement advisors are to act to the greatest advantage of their clients. At the end of the day, advisors are to put their clients' interests over their own. The goal is to shield investors from advisors who are hiding any expected conflict of interest.

For instance, an advisor could have several investment funds that are accessible to offer a client, however rather just offers the ones that pay the advisor a commission for the sale. The conflict of interest is an agency problem by which the financial incentive offered by the investment fund prevents the advisor from working for the client's best interest.

Incentives

The agency problem may likewise be limited by boosting an agent to act as per the principal's best interests. For instance, a manager can be propelled to act in the shareholders' best interests through incentives, for example, performance-based compensation, direct influence by shareholders, the threat of terminating, or the threat of takeovers.

Principals who are shareholders can likewise tie CEO compensation directly to stock price performance. Assuming a CEO was concerned that a potential takeover would bring about being terminated, the CEO could try to prevent the takeover, which would be an agency problem. Be that as it may, in the event that the CEO was compensated based on stock price performance, the CEO would be boosted to complete the takeover. Stock prices of the target companies regularly rise because of an acquisition. Through appropriate incentives, both the shareholders' and the CEO's interests would be adjusted and benefit from the rise in stock price.

Principals can likewise change the structure of an agent's compensation. In the event that, for instance, an agent is paid not on an hourly basis but rather by the completion of a project, there is less incentive to not act in the principal's best interest. What's more, performance feedback and independent assessments hold the agent accountable for their choices.

True Example of an Agency Problem

In 2001, energy monster Enron petitioned for financial protection. Accounting reports had been manufactured to cause the company to seem to have more money than what was actually earned. The company's executives utilized fraudulent accounting methods to conceal debt in Enron's auxiliaries and exaggerate revenue. These distortions permitted the company's stock price to increase during when executives were selling segments of their stock holdings.

In the four years leading up to Enron's bankruptcy filing, shareholders lost an estimated $74 billion in value. Enron turned into the biggest U.S. bankruptcy around then with its $63 billion in assets. Despite the fact that Enron's management had the responsibility to care for the shareholder's best interests, the agency problem brought about management acting in their own best interest.

Features

• Through regulations or by boosting an agent to act as per the principal's best interests, agency problems can be diminished.
• An agency problem is a conflict of interest inherent in any relationship where one party is expected to act to the greatest advantage of another.
• Agency problems arise when incentives or inspirations introduce themselves to an agent to not act in the full best interest of a principal.

FAQ

How to Mitigate Agency Problems?

While it is beyond the realm of possibilities to expect to wipe out the agency problem, principals can do whatever it may take to limit the risk, known as agency cost, associated with it. Principal-agent relationships can be regulated, and frequently are, by contracts, or laws on account of fiduciary settings. Another method is to boost an agent to act as per the principal's best interests. For instance, on the off chance that an agent is paid not on an hourly basis but rather by the completion of a project, there is less incentive to not act in the principal's best interest.

What Causes an Agency Problem?

Agency problems arise during a relationship between a principal and an agent. Agents are commonly connected by principals due to various expertise levels, different employment positions, or limitations on time and access. The agency problem arises due to an issue with incentives and the presence of caution in task completion. An agent might be persuaded to act in a way that isn't great for the principal in the event that the agent is given an incentive to act along these lines.

What Is an Example of Agency Problem?

In 2001, energy goliath Enron sought financial protection. Accounting reports had been created to cause the company to seem to have more money than what was actually earned. These distortions permitted the company's stock price to increase during when executives were selling parts of their stock holdings. At the point when Enron declared bankruptcy, it was the biggest U.S. bankruptcy around then. In spite of the fact that Enron's management had the responsibility to care for the shareholder's best interests, the agency problem brought about management acting in their own best interest.