1.

Agency Problem

Agency problem also sometimes referred to as the principal-agent problem. The difficult
but extremely important and recurrent organizational design problem of how
organizations can structure incentives so that people (“agents”) who are placed in control
over resources that are not their own with a contractual obligation to use these resources
in the interests of some other person or group of people actually will perform this
obligation as promised — instead of using their delegated authority over other people's
resources to feather their own nests at the expense of those whose interests they are
supposed to be serving (their “principals”). Enforcing such contracts will involve
transaction costs (often referred to as agency costs), and these costs may sometimes be
very high indeed.

Directors, managers and employees of business corporations are supposed to use their
delegated authority to maximize the total financial returns from the business to its
owners, the shareholders. Physicians, nurses, clinical psychologists, teachers, lawyers,
CPAs, financial advisors and other service-oriented professionals are supposed to use
their specialized knowledge and skills solely in the best interests of the patients, students
or clients who have placed themselves (and some of their resources) in professional
hands in exchange for the professionals' promises to act on their behalf. Government
officials, judges and politicians in countries embracing the concept of popular
sovereignty are instructed to use the power granted them to make public policy decisions
that further some reasonable concept of “the public interest” (usually conceived as the
common interests of their constituents or of the country's citizenry at large). Trustees,
managers, and employees of non-profit charitable institutions are supposed to use their
control over their organization and its resources to promote the general purposes for
which the institution was chartered and endowed. Yet if agents are really to perform
consistently in the manner they are supposed to do (that is, in the interests of other
people), they will need to be suitably motivated by some combination of material
incentives, moral incentives, and/or coercive incentives that will make it seem worth their
while to attend faithfully to their service obligations and fiduciary duties. The more
autonomy that agents have to have in order to do their particular kind of work effectively
and efficiently, the less useful coercive sanctions are likely to be, and the more important
it becomes for agents' moral and material incentives to be appropriately aligned with their
broader obligations to their principals. That is, organizations need to be structured in such
a way, so the agent will expect that diligently serving the interests of his or her principals
will also be in his or her own long-run best interests. In order to accomplish this, the
principals need to be reasonably clever in setting up the initial rules of the game that are
set in the employment contract, sufficiently vigilant in keeping track of their agents'
quality of performance over time, and willing to bear at least some minimum level of
“agency costs” in order to provide the necessary incentives.

2. Reasons Why Agency Problem Arises

Almost any contractual relationship, in which one party (the ‘agent’) promises
performance to another (the ‘principal’), is potentially subject to an agency problem. The
core of the difficulty is that, because the agent commonly has better information than
does the principal about the relevant facts, the principal cannot easily assure himself that
the agent’s performance is precisely what was promised. Consequently, the agent has an
incentive to act opportunistically, skimping on the quality of his performance, or even
diverting to himself some of what was promised to the principal. This means, in turn, that
the value of the agent’s performance to the principal will be reduced, either directly or
because, to assure the quality of the agent’s performance, the principal must engage in
costly monitoring of the agent. The greater the complexity of the tasks undertaken by the
agent, and the greater the discretion the agent must be given, the larger these ‘agency
costs’ are likely to be.

One of the reason that agency problem may occurs is due to remuneration issues. Most
managers are paid fixed salaries irrespective of profit made during the year. This may
demotivate the managers to work for the full potential of the company.

Besides, another reason the agency problem may arise can be due to risk profile
differences. Shareholders prefer high risk high return investments since they may have
diversified investment portfolios. The managers prefer low risk investments which have
low returns. Thus, the profit generated by the company reflects the managers
performance. High risk investment gone bad can lead to managers loss of job hence
preference to low risk low returns investments.

Moreover, difference in valuation horizon also may be the reasons for agency problem.
Managers prefer projects with profits in the short run so that they can get credit for their
work. On the other hand, shareholders prefer long term investment which are consistent
with going concern accounting concept.

Other reasons for why agency problem may arise are unnecessary perks (these are
incurred by management in high salary perks and fringe benefits that the management
award themselves), creative accounting system (this involves manipulation of accounting
policies in order to report high profits e.g. by changing stock valuation and depreciation
methods) and pursuing power and self-esteem goals (it may be referred as empire
building through so as to enlarge the company through mergers and acquisitions thus
increasing rewards to managers. This might be beneficial to managers at the expense of
shareholders)

3. Example of Agency Problems

a. The Fall of Enron

The collapse of energy giant Enron in 2001 showed how catastrophic the agency problem
can be. The company's officers and board of directors, including Chairman Kenneth Lay,
CEO Jeffrey Skilling and CFO Andy Fastow, were selling their Enron stock at higher
prices due to false accounting reports that made the stock seem more valuable than it
truly was. After the scandal was uncovered, thousands of stockholders lost millions of
dollars as Enron share values plummeted.

b. Goldman Sachs and the Real Estate Bubble

Another agency problem occurs when financial analysts invest against the best interests
of their clients. Investment giant Goldman Sachs and other stock brokerage houses
developed mortgage-backed securities, known as collateralized debt obligations, then
sold them "short," betting that the mortgages would undergo foreclosures. When the
housing bubble hit in 2008, the values of the CDO's dropped and the short-sellers made
millions of dollars. Meanwhile, millions of investors and homeowners lost nearly
everything in the collapse.

c. The Boeing Buyback

Aerospace leader Boeing offers an instructive example of how the agency problem occurs
in capital markets. From 1998 to 2001, Boeing had more than 130,000 shareholders.
Most of those shareholders were Boeing employees who purchased company stock
through their 401(k) retirement plans. At the same time, Boeing was planning on buying
back much of its stock, driving down its share price. The actions of the executives in
charge of caring for the company damaged the value of its employees' retirement
accounts.

d. Executive Compensation and WorldCom

When an executive uses company assets to underwrite personal loans, the agency
problem occurs as the company takes on debts to provide its executives with higher
incomes. In 2001, WorldCom CEO Bernard Ebbers took out over $400 million in loans
from the company at the favorable interest rate of 2.15 percent. WorldCom did not report
the amount on its executive compensation tables in its annual report. Details of the loans
did not come out until the company's accounting scandal hit the news late that year.

4. Consequences of Agency Problems

The agency view of the corporation posits that the decision rights (control) of the
corporation are entrusted to the manager to act in shareholders ‘interests. Control systems
in corporate governance can help align managers’ incentives with those of shareholders
and other stakeholders.

The agency problem concerns the difficulties in motivating one party (the “agent”), to act
on behalf of another (the “principal”). The two parties have different interests and
asymmetric information. Moral hazard and conflict of interest may thus arise.
The deviation from the principal’s interest by the agent is called “agency costs.” Agency
costs mainly arise due to contracting costs and the divergence of control, separation of
ownership and control, and the different objectives (rather than shareholder
maximization) of the managers.

Much recent interest in corporate governance is concerned with mitigation of the

conflicts of interests between stakeholders. These occur when an individual or
organization is involved in multiple interests that may lead to conflicts in their ability to
act in the best interest of one party.

5. How to Reduce Agency Problems in a Company

Conflict of interest between the shareholders and managers can be resolved through the
mechanism of agency costs and market forces that reward the managers for their good
performance and punish them for poor performance. The performance of managers
should be evaluated through the market price of shares. Higher the market price of the
shares, better the performance of managers and vice versa. Some of the specific
mechanisms to resolve the agency problem between managers and shareholders are
briefly described below:

a. Monitoring

Monitoring is a mechanism that can be used by the board to align the incentives of the
shareholders and the managers. Within the agency problem, the difficulty is choosing the
appropriate monitoring and bonding control mechanisms to align interests and optimize
performance (Jones & Butler, 1992). Firms seek to structure their boards of directors to
ensure sufficient monitoring of managerial behavior (Randolph & Edward, 1994). Fama
and Jensen (1983) confirm this by arguing that effective corporate boards would be
composed largely of outside independent directors holding managerial positions in other
companies. The reason for that is that effective boards must separate the problems of
decision management and decision control. However, if the CEO was able to dominate
the board, separation of these functions would be more difficult, and shareholders would
suffer as a result. But they contend, that since reputational concerns and perhaps any
equity stakes come into view, this provides them with sufficient incentive to separate
these functions and exercise decision control. So, corporate boards should act as monitors
in disagreements amongst internal managers and carry out tasks involving serious agency
problems, such as setting executive compensation and hiring and firing managers
(McColgan, 2001). As said before, the monitoring of managerial actions can, in part, be
part of a board’s obligation to be vigilant against managerial malfeasance felon (Adam et
al., 2010). A Good control systems and monitoring by intelligent people of integrity in a
well-designed governance system are always necessary for effective control of corporate
agency problems (Jensen, 2005). Yet, being realistic, it is difficult to see a board being
able to detect managerial malfeasance directly (Adam et al., 2010). The problem here is
that we do not now know how to create a well-functioning governance system (Jensen,
2005). Monitoring is currently too difficult and expensive to solve the entire agency
problem, it can only help to mitigate. Jones and Butler (1992) agree in this, in the
entrepreneurial context, monitoring entrepreneurial behavior and the outcomes of that
behavior to align interests is very expensive and not effective on short term. Only
monitoring is not going to solve the agency problem, also other practices should be
conducted

b. Managerial Compensation

Besides monitoring, another way of mitigating the conflict of interest between managers
and the shareholders is aligning their interests through the managers’ compensation
policy. That is, by tying compensation to performance, the shareholders effectively give
the managers an ownership in the firm by giving the management the chance to buy
shares. These practices might be called the share options in executive compensation
plans. Under this approach, often labelled as ‘optimal contracting approach,’ boards are
assumed to design compensation schemes to provide managers with efficient incentives
to maximize shareholders value (Bebchuk & Fried, 2003). In practice, company stock can
now be bought by the management at a fixed price at a given time in the future. Result is
that the ownership of the company increases by inside mangers, therefore it is likely that
their incentive to invest in a positive NVP is much larger and that the private
consumption on behalf of the firm will reduce. The higher the value of the firm, the
higher the value of the options and the profit managers can make upon exercising them.
(Pasternack & Rosenberg, 2003). Agrawel and Mandelker (1987) argue that stock options
encourage management to make investment and financing decisions which increase the
variance of the firm’s assets and is therefore traded in the meaning of the shareholders. In
fact, McColgan (2001) even states that the most important mechanisms, to align the
interest of shareholders and managers, are executives’ compensation plans and their
equity holdings. A payoff structure comprising stock options can also be used to reduce
the managerial risk aversion. This is expected to motivate risk – taking as profits
progressively accrue to managers when a firm flourish (Suh, 2011). When a manager
owns common stock and stock option in the firm, a variance-increasing investment by the
firm can have three effects on his personal welfare: the value of his common stock and
option holdings in the firm increases; the value of his human capital decreases; and the
variability of his total wealth changes. When a manager has a large stock and options
holding in the firm, the effect of an increase is stock and option holdings is more likely.
This because he will make every effort to accomplish that increase in stock value,
because it affects his own money. Therefore, large stock and option holdings by a
manager induce him to select variance-increasing corporate investments (Agrawel &
Mandelker, 1987). Additionally, Denis, Denis and Sarin (1997) find that executive
ownership is associated with greater corporate focus, indicating that the severity of the
managerial risk aversion problem may be reduced through higher equity stakes. Amihud
and Lev (1981) argue that, when the manager’s income is tied to changes in firm values,
an increase in the variance of the returns on the firm’s total assets will take place. An
increase in the variance and a reduction of the certainty equivalent of the stream of his
employment income will follow. The manager obviously dislikes such decreases in his
human capital and therefore has an incentive to reduce the variance of returns on the
firm’s total assets (Agrawal & Mandelker, 1987). This provides better alignment between
the managers and the shareholders.
 c. Shareholder control and interference

Shareholders can influence the company's management in two ways. Firstly, they can
influence management directly as to how the company should be managed. Secondly, any
shareholder can make a proposal which is voted on at the annual general meeting (AGM).

d. Threat of dismissal

In the past it seldom happened that a senior manager or chief executive officer was
dismissed by shareholders. The reason for this was possibly that the ownership of a great
number of companies was dispersed, as well as the fact that the agency problem was only
brought to the attention of shareholders (and management) over the past two decades.

e. Threat of take-overs

The threat of a take-over serves to monitor the actions of management. If the actions or
decisions of management decrease the future earnings or value of shareholders, the share
price usually decreases as well. In some instances, the company can become a take-over
target. If the management of such a company is replaced, the move can benefit the
shareholders. The threat of take-overs can thus serves as an external control mechanism
which ensures that the decisions and actions of management maximize shareholders'
wealth.

6. Summary

The bottom line, however, is that the agency problem can never be 100% solved in a
world where virtually everyone has a healthy regard for their own self-interest and the
relevant information for evaluating performance is imperfect, costly to obtain and
unequally distributed between the agent and his principals. Indeed, rational principals
will only pursue the available techniques for control to the point that the marginal
increment in “agency costs” rise to equal the marginal benefits to them of the additional
increment in “faithfulness” that they produce. (That is to say, sometimes it is cheaper for
principals to endure a certain amount of dereliction of duty by their agents than it is to
pay for the precautions needed to prevent or punish it.) In some kinds of institutions —
especially those where results are not readily measurable with much precision, those
where the nature of the agents' work is such as to require a very high degree of expert
judgment, those where lines of responsibility and authority are very complex, those
where agents work individually in widely dispersed work places, those where the agent's
activities necessarily involve a lot of “judgment calls” to cope with rapidly changing
circumstances and highly uncertain information, and those where large numbers of
principals have only relatively small individual “stakes” at risk — the incentives for
agents faithfully to represent their principals may easily become so weak as to be largely
ineffective. Experience demonstrates that these kinds of organizations often come to be
run mainly for the benefit of the agents (managers and other employees, service
professionals, politicians, officials) rather than their purported principals (stockholders,
voters, taxpayers, clients, etc.). Two of the important tasks of the academic disciplines of
business administration and public administration are to identify, and then to devise
cheaper substitutes or remedies for, organizational arrangements that are characterized by
costly agency problems.

7. References

Adams, R. B., & Hermalin B. E., & Weisbach, M. S. (2010) The role of Boards of
Directors in Corporate Governance: A conceptual framework and survey. Journal of
Economic Literature, 48 (1), 58 – 107

Agrawal, A, & Mandelker, G. N. (1987) Managerial Incentives and Corporate Investment

and Financing Decisions. Journal of Finance, 42 (4), 823-837.

Amihud, Y., & Lev, B. (1981) "Risk Reduction as a Managerial Motive for
Conglomerate Mergers." The Bell Journal of Economics, 12, 605-17.

Bebchuk, L. A., & Fried, J. M. (2003) Executive Compensation as an Agency Problem.

Journal of Economic Perspectives, 17 (3), 71 – 92.
Chen, C. X., Lu, H., & Sougiannis, T. (2012). The agency problem, corporate
governance, and the asymmetrical behavior of selling, general, and administrative costs.
Contemporary Accounting Research, 29(1), 252-282.

Dalton, D. R., Hitt, M. A., Certo, S. T., & Dalton, C. M. (2007). 1 The fundamental
agency problem and its mitigation: independence, equity, and the market for corporate
control. The academy of management annals, 1(1), 1-64.

Denis, D.J., &. Denis, D.K., & Sarin, A. (1997), Agency Problems, Equity Ownership,
and Corporate Diversification. Journal of Finance, 52, 135-160.

Fama, E.F., & M.C. Jensen. (1983) Separation of Ownership and Control. Journal of Law
and Economics 88 (2), 301-325.

Iqbal-Hussain, H., Shamsudin, M., Ali, A., Salem, M., Sajilan, S., Rahman, N., & Ani, N.
(2015). Agency Problems and Its Impact and Relevance on Firms Borrowings.

Jensen, M. C. (2005) Agency Costs of Overvalued Equity. Financial Managemen, 34 (1),

5 - 19

Jerzemowska, M. (2006). The main agency problems and their consequences. Acta
Oeconomica Pragensia, 14(3), 9-17.

Jones, G. R., & Butler, J. E. (1992) Managing Internal Corporate Entrepreneurship: An

Agency Theory Perspective. Journal of Management, 18 (4), 733 – 749.

Mccolgan, P. (2001) Agency theory and corporate governance. Glasgow: University of

Strathclyde

Pasternack, D. & Rosenberg, M. (2003) What determines stock option contract design?
Meddelanden working papers.

Randolph, P. B., & Edward, J. Z. (1994) Managerial Incentives, Monitoring, and Risk
Bearing: A Study of Executive Compensation, Ownership, and Board Structure in Initial
Public Offerings. Administrative Science Quarterly, 39 (2), 313 – 335.
Suh, J. Y. (2011) Managerial Incentives for Risk-Taking and Internal Capital Allocation.
Sydney: School of Finance and Economics University of Technology

Young Baek, H., Min, S., & Ryu, S. (2006). The effects of agency problems on the
stability of the international joint venture. Multinational Business Review, 14(3), 53-70.