Question

Read the assigned book chapters and discuss agency problems in a corporation. Jensen and Meckling (1976) suggest that the ownership (principal) and management (agent) should be separate in a modern corporation. However, the principal–agent problem occurs when the agent is able to make decisions and/or take actions on behalf of the principal. This dilemma exists in circumstances where agents are motivated to act in their own best interest, which is contrary to that of the principals.

Answer 1

WHAT IS 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.

WHAT SEPERATION BETWEEN SHAREHOLDERS (OWNERS) AND MANAGMENT (AGENT) NECESSARY?

1.Regulations

Principal-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.1 The term fiduciary in the investment advisory world means that financial and retirement advisors are to act in the best interests of their clients. In other words, advisors are to put their clients' interests above their own. The goal is to protect investors from advisors who are concealing any potential conflict of interest.

For example, an advisor might have several investment funds that are available to offer a client, but instead only offers the ones that pay the advisor a commission for the sale. The conflict of interest is an agency problem whereby the financial incentive offered by the investment fund prevents the advisor from working on behalf of the client's best interest.

2.Incentives

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 who are shareholders can also tie CEO compensation directly to stock price performance. If a CEO was worried that a potential takeover would result in being fired, the CEO might try to prevent the takeover, which would be an agency problem. However, if the CEO was compensated based on stock price performance, the CEO would be incentivized to complete the takeover. Stock prices of the target companies typically rise as a result of an acquisition. Through proper incentives, both the shareholders' and the CEO's interests would be aligned and benefit from the rise in stock price.

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 the 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.