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What is the 'Agency Problem'

The agency problem is a conflict of interest inherent in any relationship where one party
is expected to act in another's best interests. In corporate finance, the 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,
or principals, is supposed to make decisions that will maximize shareholder wealth even
though it is in the manager’s best interest to maximize his own wealth.

While it is not possible to eliminate the agency problem completely, the manager can be
motivated to act in the shareholders' best interests through incentives such
as performance-based compensation, direct influence by shareholders, the threat of
firing and the threat of takeovers.

Principal-Agent Relationship
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. This may
arise due to different skill levels, different employment positions or restrictions on
access.

For example, a principal will hire a plumber — the agent — to fix plumbing issues.
Although the plumber‘s best interest is to make as much income as he can, he is given
the responsibility to perform in whatever situation results in the most benefit to the
principal.

Incentives
The agency problem arises due to an issue with incentives. An agent may be motivated
to act in a manner that is not favourable for the principal if the agent is presented with an
incentive to act in this way. For example, in the plumbing example earlier, the plumber
may make three times as much money by recommending a service the agent does not
need. An incentive (three times the pay) is present, and this causes the agency problem
to arise.

Reducing and Eliminating the Agency Problem


The agency problem may be minimized by altering the structure of compensation. If the
agent is paid not on an hourly basis but by completion of a project, there is less incentive
to not act on the principal’s behalf. In addition, performance feedback and independent
evaluations hold the agent accountable for their decisions.

Historical Example of Agency Problem


In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated
to make the company appear to have more money than what was actually earned.
These falsifications allowed the company’s stock price to increase during a time when
executives were selling portions of their stock holdings. Although management had the
responsibility to care for the shareholder’s best interests, the agency problem resulted in
management acting in their own best interest.

An agency relationship occurs when a principal hires an agent to perform some duty. A
conflict, known as an "agency problem," arises when there is a conflict of interest
between the needs of the principal and the needs of the agent.

In finance, there are two primary agency relationships:

 Managers and stockholders


 Managers and creditors

1. Stockholders versus Managers

 If the manager owns less than 100% of the firm's common stock, a potential
agency problem between mangers and stockholders exists.
 Managers may make decisions that conflict with the best interests of the
shareholders. For example, managers may grow their firms to escape a takeover
attempt to increase their own job security. However, a takeover may be in the
shareholders' best interest.

2. Stockholders versus Creditors

 Creditors decide to loan money to a corporation based on the riskiness of the


company, its capital structure and its potential capital structure. All of these
factors will affect the company's potential cash flow, which is a creditors' main
concern.
 Stockholders, however, have control of such decisions through the managers.
 Since stockholders will make decisions based on their best interests, a potential
agency problem exists between the stockholders and creditors. For example,
managers could borrow money to repurchase shares to lower the corporation's
share base and increase shareholder return. Stockholders will benefit; however,
creditors will be concerned given the increase in debt that would affect future
cash flows.

Motivating Managers to Act in Shareholders' Best Interests

There are four primary mechanisms for motivating managers to act in stockholders' best
interests:

 Managerial compensation
 Direct intervention by stockholders
 Threat of firing
 Threat of takeovers
1. Managerial Compensation
Managerial compensation should be constructed not only to retain competent managers,
but to align managers' interests with those of stockholders as much as possible.

 This is typically done with an annual salary plus performance bonuses and
company shares.
 Company shares are typically distributed to managers either as:
o Performance shares, where managers will receive a certain number
shares based on the company's performance
o Executive stock options, which allow the manager to purchase shares at a
future date and price. With the use of stock options, managers are aligned
closer to the interest of the stockholders as they themselves will be
stockholders.

2. Direct Intervention by Stockholders


Today, the majority of a company's stock is owned by large institutional investors, such
as mutual funds and pensions. As such, these large institutional stockholders can exert
influence on mangers and, as a result, the firm's operations.

3. Threat of Firing
If stockholders are unhappy with current management, they can encourage the existing
board of directors to change the existing management, or stockholders may re-elect a
new board of directors that will accomplish the task.

4. Threat of Takeovers
If a stock price deteriorates because of management's inability to run the company
effectively, competitors or stockholders may take a controlling interest in the company
and bring in their own managers.