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One type of conflict is the agency problem, which involves both a company’s agents and its principals. Read on to find out more about the basics of the agency problem and two of the most famous scandals of this kind. Agency theory is a concept used to explain the important relationships between principals and their relative agent. In the most basic sense, the principal is someone who heavily relies on an agent to execute specific financial decisions and transactions that can result in fluctuating outcomes. The cost incurred by stockholders to minimize agency problems is called agency cost. Agency cost arises by shareholders to prevent or minimize agency problems and to work towards the maximization of shareholders’ wealth.

The directors at Enron were legally obliged to promote and protect the interests of its investors with only a few incentives. Numerous analysts state how the board of directors at Enron failed to respect the firm’s regulatory role and overlooked its responsibilities. This has led the company to fall into illegal activity and a scandal costing loss in billions of dollars.

  1. The reason why a party would prioritize its personal interests over professional duties is because of the conflict of interest.
  2. A powerful force in every voluntary market, the reputation mechanism provides an incentive for coordinating the actions of parties with limited information and trust.
  3. The trustor is endowed with a budget and come transfer some of the amounts to an agent in expectation of return over the transferred amount in the future.
  4. As with most problematic issues in business, agency problems can be resolved, but only if organizations are willing to take the appropriate steps to resolve them.

Conclusively, their studies indicated business owner (principal) and business employees (agents) must find a middle ground which coincides with an adequate shared profit for the company that is proportional to CEO pay and performance. In doing this risk aversion of employee efforts being low can be avoided pre-emptively. Some Ponzi schemes simply take advantage of consumer suspicions and fears about the banking industry even though established financial institutions reduce risk by providing oversight and enforcing legal practices. These investments create an environment where the consumer cannot properly ensure that the agent is acting in the principal’s best interest.

Executives, hired by shareholders to represent the best interests of the company and therefore the best interests of investors, must pay attention to issues impacting the company’s health and long-term growth. Apple believes this effort to address the principal-agent problem can improve profitability for investors and keep the company competitive for the future. Creating incentives that encourage hard work on projects benefiting the company generally encourages more employees to act in the business’s best interest. By aligning agent and principal goals, agency theory attempts to bridge the divide between employees and employers created by the principal-agent problem.

Therefore, although we cannot eliminate the agency problem, as stockholders need professional people to manage the organization, both parties should work on this problem and minimize it to the extent possible. Another means of resolving agency problems is through a hostile takeover of the organization. Even the threat of such a takeover may be effective in reducing or eliminating these conflicts of interest. A hostile corporate takeover tends to unify and discipline a management or agent group, thus fostering a union of agent and shareholder interests. When such a potential threat or outright ownership change is introduced to a company, its managers are more likely to act in the best long-term interests of the shareholders in order to maintain their leadership positions within the company. This is explained by the fact that there is no path for hundreds of thousands of stockholders to be engaged actively in the management of the corporation.

Impacts of Agency Problem

The most cited reference to the theory, however, comes from Michael C. Jensen and William Meckling.[13] The theory has come to extend well beyond economics or institutional studies to all contexts of information asymmetry, uncertainty and risk. In the four years leading up to Enron’s bankruptcy filing, shareholders lost an estimated $74 billion in value. Enron became the largest U.S. bankruptcy at that time with its $63 billion in assets.

An agency problem can occur in any relationship where one party (e.g., manager of a company) fails to act in the best interest of the other party (e.g., investor). In finance, it takes place when the agent (manager) doesn’t work towards the protection and the best interests of the company’s stockholders (investors). This problem is explained by a conflict of interest between managers, who want to maximize their personal wealth, and stockholders who seek wealth maximization. Incentives are given to managers to minimize the agency conflict, which can be monetary compensation, a direct influence of stockholders (hire new managers or be directly involved), or threats to be fired. In corporate finance, the agency problem definition is given, such as the conflict of interest that arises between stockholders and the management of a company.

Performance evaluation

SOEs make up the majority of the market capitalization of the Chinese stock markets. State ownership of enterprises is often criticized by Western scholars because of their underperformance and because the government might extract resources from the firm (that is, the government may be a “grabbing hand”). For example, the government sometimes provides SOEs with favorable bank loans and other subsidies.

The constant threat of a takeover would motivate management to act in the best interests of the owners despite the fact that techniques are available to define against a threat takeover. The fall of Enron and the Boeing Buyback are two better-known examples explained below. Under the terms of the licence agreement, an individual user may print out a PDF of a single entry from a reference work in OR for personal use (for details see Privacy Policy and Legal Notice).

Usually, people at a higher managerial level make decisions or draft the steps to be taken and followed by all. There is a high possibility that people at lower or base levels may have a conflict here. Incompatibility arises when two parties must act in each other’s best interest, creating a conflict. It can arise when the incentives received by the agent are not compensatory enough for them to stay motivated to continue acting in the principal’s best interest.

For instance, owners might want to pay inadequate wages and allowances, whereas employees are more interested in increasing their allowances and salary to a sufficient degree. Moreover, all customers want to purchase goods and services at lower prices, which contradicts the owners’ desire to sell at higher prices. These types of conflicts create an agency problem in the relationship between stockholders and shareholders. Despite being a multi-billion dollar company, Enron began losing money in 1997. Fearing a drop in share prices, Enron’s management team hid the losses by misrepresenting them through tricky accounting—namely special purpose vehicles (SPVs), or special purposes entities (SPEs)—resulting in confusing financial statements. Principals who are shareholders can also tie CEO compensation directly to stock price performance.

What Is an Example of Agency Problem?

However, not long after her initial investment, there arose a conflict between management and many of the stockholders. You see, the managers were no longer working in the best interest of the stockholders, but rather they began working in their own best interest. Not knowing what to do with her new found wealth, Sue’s first instinct was to look at ways to invest her money. After countless weeks of researching and speaking to financial advisors, Sue decided to purchase stock in a company called Fun Futons. Because Sue works a full time job, she relies on the management team of Fun Futons to work in the best interest of her money.

Incentivizing Employees

The Fiduciary Rule is an example of an attempt to regulate the arising 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 in the best interests of their clients. The goal is to protect investors from advisors who are concealing potential conflicts of interest.

Definition of the Agency Problem

By increasing risk, the required ROR of the firm’s debt becomes higher, and the pending debts’ value might fall. This allows stockholders to maximize their profits if the risk project is effective. On the other hand, losses will be shared with bondholders if the project fails, resulting in agency problems between stockholders and creditors. Madoff came up with an elaborate fake business in 2009 that cost investors $16.5 billion.