Loading the player...

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.

BREAKING DOWN 'Agency Problem'

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. Agents are commonly engaged by principals due to different skill levels, different employment positions or restrictions on time and access. For example, a principal will hire a plumber — the agent — to fix plumbing issues. Although the plumber‘s best interest is to collect as much income as he can, he is given the responsibility to perform in whatever situation results in the most benefit to the principal.

The agency problem arises due to an issue with incentives and the presence of discretion in task completion. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way. For example, in the plumbing example, 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.

Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries; board members and shareholders; and lawyers and clients. These relationships can be stringent in a legal sense, as is the case in the relationship between lawyers and their clients due to the U.S. Supreme Court's assertion that an attorney must act in complete fairness, loyalty and fidelity to their clients.

Minimizing Risks Associated with the Agency Problem

Agency costs are a type of internal cost that a principal may incur as a result of the agency problem. They include the costs of any inefficiencies that may arise from employing an agent to take on a task, along with the costs associated with managing the principal-agent relationship and resolving differing priorities.

While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk of agency costs. Principle-agent relationships can be regulated, and often are, by contracts, or laws in the case of fiduciary settings. 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 agency problem may also be minimized by incentivizing an agent to act in better accordance with the principal's best interests. For example, a 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 or the threat of takeovers. Principals can also alter the structure of an agent's compensation. If, for example, an agent is paid not on an hourly basis but by completion of a project, there is less incentive to not act in the principal’s best interest. In addition, performance feedback and independent evaluations hold the agent accountable for their decisions.

Historical Example of the 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.

RELATED TERMS
  1. Agency Theory

    The agency theory is a supposition that explains the relationship ...
  2. Principal-Agent Problem

    The principal-agent problem occurs when a principal creates an ...
  3. Agent

    An agent is any person who has been legally empowered to act ...
  4. Actual Authority

    Actual authority refers to specific powers, expressly conferred ...
  5. Shareholder Services Agent

    A shareholder services agent is a third party that partners with ...
  6. Real Estate Agent

    A real estate agent is a licensed professional who represents ...
Related Articles
  1. Financial Advisor

    A Day in the Life of a Real Estate Agent

    There are no set hours and no set days. While every day is unique for a real estate agent, there are some activities that may be typical.
  2. Investing

    How To Find The Best Real Estate Agent

    Most people don't have the time, expertise or motivation to go it alone and finding a good real estate agent becomes essential to enjoying a smooth real estate transaction.
  3. Investing

    Understanding Real Estate Commissions: Who Pays?

    When you set out to buy or sell a house, one factor worth considering is the real estate agent's fees.
  4. Investing

    Would You Make A Good Real Estate Broker?

    How to tell if you'd be good in this field. It is a common second career for many people, but isn't a good match for everyone.
  5. Managing Wealth

    Medical Power of Attorney: Which Child to Choose?

    Don’t compromise for the sake of family harmony when you pick an adult child to fill this role. But be sure you fully explain your decision to all.
  6. Investing

    How to Choose the Right Real Estate Broker

    Buying or selling a home can be the major financial transaction of your life. Here's how to choose the right real estate broker or agent.
  7. Investing

    8 reasons to sell your home with an agent

    The standard real estate agent cost you 6% of the total house sales, learn what value do they bring you. See if it is worth to hire a sales agent in a housing sales.
  8. Investing

    Career Comparison: Real Estate Agent or Mortgage Broker

    If you're considering one of these careers, this article is designed to help you make a logical choice between the two.
  9. Insurance

    Becoming a Life Insurance Agent

    Few careers match the opportunity for as quick and large a paycheck as being a life insurance agent, but it takes the right personality.
  10. Investing

    The Lowdown On Low-Fee Real Estate Agents

    Find out how the services of low-commission real estate agents comapare to full-service realtors.
RELATED FAQS
  1. What is the role of agency theory in corporate governance?

    Understand how businesses use agency theory in corporate governance. Learn how moral hazard problems may be addressed using ... Read Answer >>
  2. How is the principle agent problem manifested in the government?

    Learn more about the principal-agent problem and challenges this problem may create in the relationship between government ... Read Answer >>
  3. These famous scandals demonstrate the agency problem

    The agency problem occurs when agents do not appropriately represent the best interests of principals. Here you'll learn ... Read Answer >>
  4. What does "agency cost of debt" mean?

    Agency cost of debt is an increase in debt costs as shareholder and management interests diverge. Find out why restrictions ... Read Answer >>
  5. What are some examples of fiduciary duty?

    Understand what it means to be a fiduciary, when fiduciary duties arise. Learn some common examples of fiduciary duty in ... Read Answer >>
Hot Definitions
  1. Capital Asset Pricing Model - CAPM

    Capital Asset Pricing Model (CAPM) is a model that describes the relationship between risk and expected return and that is ...
  2. Return On Equity - ROE

    The profitability returned in direct relation to shareholders' investments is called the return on equity.
  3. Working Capital

    Working capital, also known as net working capital is a measure of a company's liquidity and operational efficiency.
  4. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  5. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  6. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
Trading Center