Question

Define agency problems in general. And then give the following:

One example of such problem resulting from a separation of ownership and management:

one example of such problems resulting from the conflicts of interest between debtholders and shareholders during financial distress:

two corporate governance mechanisms to mitigate agency problems, one internal and one external:

Answer 1

Agency Problems in general

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.

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 possible, 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, causing 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. A fiduciary is an agent that acts in the principal's or client's best interest. 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.

In general, an agency problem in finance usually happens when an agency (the management of a financial company) does not work in the best interests of the stockholders, (the investors).

You see, because management is hired as the agent for stockholders, it's supposed to make decisions that will benefit stockholders, which in most cases is to maximize the stockholders' wealth. However, when a manager decides to work in his own best interest instead, an agency problem occurs. Sometimes this happens when the agency, or management, encounters costs or a conflict of interest. The agency might then ignore what is best for the stockholders and do what is best for the agency instead.

Like most working individuals, managers want to maximize their own wealth, but this causes conflict between managers and stockholders. So, in order to minimize these types of conflicts, often times, managers are encouraged to work in the best interest of stockholders via incentives. Incentives can be in the form of money, threats of being fired, or by direct influence of stockholders themselves, which can be anything from hiring their own managers to becoming directly involved.

Examples of such problem resulting from a separation of ownership and management

The “agency view” of corporations argues that the decisions rights (or control) of a corporation should be entrusted to a manager, so that the manager can act in the interest of shareholders. Partly as a result of this, mechanisms of corporate governance include a system of controls that are intended to align the incentives of managers with those of shareholders.

The term “agency costs” refers to instances when an agent ‘s behavior has deviated from a principal ‘s interest. In this case, the principal would be the shareholder. These types of costs mainly arise because of contracting costs, or because individual managers might only possess partial control of corporation behavior. They also arise when managers have personal objectives that are different from the goal of maximizing shareholder profit.

Typically, the CEO and other top executives are responsible for making decisions about high-level policy and strategy. Shareholders, on the other hand, are individuals or institutions that legally own shares of stock in a corporation. Typically, these people have the right to sell those shares, to vote on directors nominated by various boards, and many other privileges. This being said, shareholders usually concede most of their control rights to managers.

While attempting to benefit shareholders, managers often encounter conflicts of interest. For example, a manager might engage in self-dealing, entering into transactions that benefit themselves over shareholders. Managers might also purchase other companies to expand individual power, or spend money on wasteful pet projects, instead of working to maximize the value of corporation stock. Venturing onto fraud, they may even manipulate financial figures to optimize bonuses and stock-price-related benefits.

The chief goal of current corporate governance is to eliminate instances when shareholders have conflicts of interest with one another. Another important goal is to evaluate whether a corporate governance system hampers or improves the efficiency of an organization. Research of this type is particularly focused on how corporate governance impacts the welfare of shareholders. After the high-profile collapse of a number of large corporations in the past two decades, several of which involved accounting fraud, there has been a renewed public interest in how modern corporations practice governance, particularly regarding accounting.

Advocates of governance typically encourage corporations to respect shareholder rights, and to help shareholders learn how and where to exercise those rights. Disclosure and transparency are intertwined with these goals.

Examples of such problems resulting from the conflicts of interest between debtholders and shareholders during financial distress:

The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager (the agent ) to act in the principals ‘ interests.

The deviation from the principals’ interests by the agent is called ‘agency costs’, which are often described as existing between managers and shareholders; but conflicts of interest can also exist between shareholders and bondholders.

The shareholders are individuals or institutions that legally own shares of stock in the corporation, while the bondholders are the firm’s creditors. The two parties have different relationships to the company, accompanied by different rights and financial returns. For example, stockholders have an incentive to take riskier projects than bondholders do, as bondholders are more interested in strategies that will increase the chances of getting their investment back. Shareholders also prefer that the company pay more out in dividends than bondholders would like. Shareholders have voting rights at general meetings, while bondholders do not. If there is no profit, the shareholder does not receive a dividend, while interest is paid to debenture-holders regardless of whether or not a profit has been made. Other conflicts of interest can stem from the fact that bonds often have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely but can also be sold at any point.

Because bondholders know this, they may create ex-ante contracts prohibiting the management from taking on very risky projects that might arise, or they may raise the interest rate demanded, increasing the cost of capital for the company. For example, loan covenants can be put in place to control the risk profile of a loan, requiring the borrower to fulfill certain conditions or forbidding the borrower from undertaking certain actions as a condition of the loan. This can negatively impact the shareholders. Conversely, shareholder preferences–as for example riskier strategies for growth–can adversely impact bondholders.

Examples of two corporate governance mechanisms to mitigate 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’ (and other parties’) interests. Partly as a result of this separation, corporate governance mechanisms include a system of controls intended to help align managers’ incentives with those of shareholders and other stakeholders.

The principal–agent problem or agency dilemma, developed in economic theory, 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 (the agent having more information), such that the principal cannot directly ensure that the agents are always acting in its (the principals’) best interests, particularly when activities that are useful to the principal are costly to the agent, and where elements of what the agent does are costly for the principal to observe. Moral hazard and conflict of interest (COI) 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. When a firm has debt, conflicts of interest can also arise between stockholders and bondholders, leading to agency costs on the firm. Examples of agency costs include that borne by shareholders (the principal), when corporate management (the agent) buys other companies to expand its power instead of maximizing the value of the corporation’s worth; or by the constituents of a politician’s district (the principal) when the politician (the agent) passes legislation helpful to large contributors to their campaign rather than helpful to voters.

Much of the contemporary interest in corporate governance is concerned with mitigation of the conflicts of interests between stakeholders. A conflict of interest occurs 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. In addition to conflicts of interest between managers, shareholders, and bondholders, conflicts of interest can also occur among other stakeholders of a company, such as the board of directors, employees, government, suppliers, and customers. COI is sometimes termed “competition of interest” rather than “conflict”, emphasizing a connotation of natural competition between valid interests rather than violent conflict. At other times, conflicts of interest are confused with cases that might better be termed “corruption”, such as bribe-taking or fraud.