The agency problem occurs when agents do not appropriately represent the best interests of principals. Principals hire agents to represent their interests and act on their behalf. Agents are frequently hired to allow businesses to obtain new skill sets that the principals lack or to accomplish work for the firm's investors.
These employees, from rank-and-file workers up to corporate executives, may all potentially misrepresent the firm and act in ways described by the principal-agent problem.
The Enron Scandal
One particularly famous example of this problem is that of Enron. Ponzi schemes represent many of the better-known examples of the agency problem, including Bernie Madoff and Luis Felipe Perez's scams. In the case of Ponzi schemes, the agency problem can have very real legal and financial consequences for both perpetrators and investors.
Enron's board of directors, many analysts believe, failed to carry out its regulatory role in the company and rejected its oversight responsibilities, causing the company to venture into illegal activity. Company leadership, including boards of directors and the executive team, does not necessarily have the same interests as shareholders. Investors benefit from the corporate success and expect executive employees to pursue the best interest of shareholders.
Many companies, however, do not require executives to own shares. Positive company performance does not always directly benefit executives. Enron directors had a legal obligation to protect and promote investor interests but had few other incentives to do so. A lack of alignment between shareholders and directors may be the final cause of Enron's demise.
Bernie Madoff's name is also almost synonymous with the principal-agent problem. Madoff created an elaborate sham business that ultimately cost investors nearly $16.5 billion in 2009. Many small investors lost all of their savings in this scandal. Ultimately, Madoff was criminally charged and convicted for his actions. He is now serving a 150-year prison sentence.
That same year, however, more than 150 Ponzi schemes perpetrated against American investors also collapsed. Substantial investment wealth was lost in the process.
Agency theory claims that a lack of oversight and incentive alignment greatly contribute to these problems. Many investors fall into Ponzi schemes, thinking that taking fund management outside a traditional banking institution reduces fees and saves money. Established banking institutions reduce risk by providing oversight and enforcing legal practices.
Some Ponzi schemes simply take advantage of consumer suspicions and fears about the banking industry. These investments create an environment where the consumer cannot properly ensure that the agent is acting in the principal's best interest. Many examples of the agency problem occur away from the watchful eye of regulators and are often perpetrated against investors in situations wherein oversight is limited or completely nonexistent.