Question

Define agency problems in general. Offer one example of such problems resulting from the separation of ownership and management. Offer another example of such problems resulting from the conflicts of interest between debtholders and shareholders during financial distress. Also provide two corporate governance mechanisms to mitigate agency problems, one internal and the other external.

Answer 1

Agency problem occurs when one party acts on behalf of another party to perform a service or function. In this the party acting on behalf of another party has to ensure that the best interests are served for the one who he is performing the service for. This leads to a conflict of interest as he might be more interested in working for his own interest.

Example of problem from separation of ownership and management can be seen in companies as the management has to act in such a way that the shareholders' wealth is maximised, however, the management might like to maximise their own wealth. Like in the Enron fraud of 2001, Enron filed for bankruptcy in 2001 on account of bankruptcy fraud. The accounting profits of the firm were fabricated to paint a rosy picture of the Company which ensured that the stock prices kept increasing. The top management executives of the firms kept selling their shares at high prices to book profits. As the firm collapased due to the fraud, the investors lost billions of their money due to the losses. This was because management wanted to maximise their wealth and that lead to agency problem.

The debtholders and shareholders also face such problems during the times of financial distress. The bondholders want a fixed return with less risk while shareholders want higher returns from business as their risk is more. Thus, the shareholders will want the business to invest in riskier assets so as to increase their returns while the bondholders will not want the funds to be deployed in risky assets to ensure less riskiness for the business. This leads to an agency problem between the debtholders and shareholders.

One external way of mitigating the agency problem is the regulations by the government. The Fiduciary rule governing the relationship between client and financial advisors where the advisor has to act in a way to maximise the wealth of the client. Under the rule, it is an obligation of the advisor to keep the interests of the clients above his own interests to protect Client from fraud

An internal way of mitigating the problem is to offer incentives to the management. The management can be offered performance based pay to ensure that they act in ways that is in the best interest of the shareholders.