The Agency Problem: Two Infamous Examples

This section can also be explored from the perspective of the trust game which captures the key elements of principal–agent problems. This game was first experimentally implemented by Berg, Dickhaut, and McCabe in 1995.[29] The setup of the game is that there are two players – trustor/principal (investor) https://1investing.in/ and agents (investee). The trustor is endowed with a budget and come transfer some of the amounts to an agent in expectation of return over the transferred amount in the future. Most of the studies find that 45% of the endowment was transferred by the principal and around 33% transferred back by an agent.

1. The most frequent example of market discipline for corporate managers is the hostile takeover.
2. These types of conflicts create an agency problem in the relationship between stockholders and shareholders.
3. Up in the hierarchy, the board of directors is represented by the principal because their financial position and status are decided by the CEO.

Thus, with investors increasingly using ESG scores to form their investment strategies, the consequences of a poor rating can have a negative impact on a firm’s share price and result in substantial problems. In any case, it is important to note that ESG is only a starting point from which it is possible to gather indicators on a business and its direction. Any investment decisions about the company in question should include a significant amount of additional data. ESG measurements and assessments have become very important to firms, as they often become the basis of formal and informal buy recommendations by investment professionals. Because of the nature of these factors, firms that are rated with high ESG metrics are believed to represent superior investments and to have proactive management teams focused on creating long-term value of company stock. However, the most important factor leading to the company’s failure was the actions of Steven Heyer, who was a friend of the new owners and had been hired as CEO.

In the context of law, principals do not know enough about whether (or to what extent) a contract has been satisfied, and they end up with agency costs. The solution to this information problem—closely related to the moral hazard problem—is to ensure the provision of appropriate incentives so agents act in the way principals wish. Disaster started to unfold in 2001, when common stock prices fell from $90 to under $1 per share. The company filed for bankruptcy in December 2001, and criminal charges were brought against several key Enron employees, including former CEO Kenneth Lay and former CFO Andrew Fastow. Jeffrey Skilling was subsequently named CEO in February 2001, but he ended up resigning six months later.

An agent is supposed to act in the principal’s best interest and maximize his benefit. A dispute mainly arises when the agent puts his interest ahead of his professional one. Here, the problem can arise when the owners may make confident decisions that entail a high risk to earn higher rewards.

The returns he promised were higher than what most investment firms and banks were offering—so promising that almost all of his investors ignored any concerns they may have had and basically looked the other way. Madoff paid for any redemption requests with money that had been newly invested. Large corporations typically have a substantial number of stockholders forming their ownership.

– Agency problems and the theory of the firm

When Enron declared bankruptcy, it was the largest U.S. bankruptcy at that time. Although Enron’s management had the responsibility to care for the shareholder’s best interests, the agency problem resulted in management acting in their own best interest. In the West, there are many potential solutions to the vertical agency problem. For example, securities analysts, institutional investors, large lenders such as banks, independent auditors, and boards of directors, can serve as corporate monitors.

What is Agency Problem?

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. 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.

In moderation this can offset the greater risk aversion of agents vs principals because their social capital is concentrated in their employer while in the case of public companies the principal typically owns its stake as part of a diversified portfolio. Successful innovation is particularly dependent on employees’ willingness to take risks. In cases with extreme incentive intensity, this sort of behavior can create catastrophic organizational failure. If the principal owns the firm as part of a diversified portfolio this may be a price worth paying for the greater chance of success through innovation elsewhere in the portfolio. If however the risks taken are systematic and cannot be diversified e.g., exposure to general housing prices, then such failures will damage the interests of principals and even the economy as a whole.(cf. Kidder Peabody, Barings, Enron, AIG to name a few). Ongoing periodic catastrophic organizational failureis directly incentivized by tournament and other superstar/winner-take-all compensation systems (Holt 1995).

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. In addition to recognizing the horizontal agency problem and identifying the potential solution, there is a third important question when it comes to Chinese firms and their stocks.

The horizontal agency problem and how China deals with it

Throughout the 1990s and early part of the 2000s, it was common for scholars to criticize China’s laws and institutions. Today, it is more appropriate to say that China’s laws and institutions have dramatically improved. To summarize the whole discussion, the agency problem is simply a difference of opinion between the people who help operate and manage the organization and its owners. The people who manage the organization, including management, employees, and lenders, serve the organization’s best interest. They work towards achieving maximum benefits for their owners while receiving compensation for their efforts. The concern or problem arises when these people focus on their interests instead of maximizing owners’ wealth.

In fear of a fall in share prices, the management used tricky accounting to misrepresent losses (e.g., special purpose entities and special purpose vehicles) which led to confusion in financial statements. In 2001, problems and questions arose about a potential overvaluation of the company, rendering the share prices to drop from $90 to less than $1. Enron filed for bankruptcy, and many key players were faced with criminal charges.

Subjective performance evaluation allows the use of a subtler, more balanced assessment of employee performance, and is typically used for more complex jobs where comprehensive objective measures are difficult to specify and/or measure. Whilst often the only feasible method, the attendant problems with subjective performance evaluation have resulted in a variety of incentive structures and agency problem supervisory schemes. One problem, for example, is that supervisors may under-report performance in order to save on wages, if they are in some way residual claimants, or perhaps rewarded on the basis of cost savings. This tendency is of course to some extent offset by the danger of retaliation and/or demotivation of the employee, if the supervisor is responsible for that employee’s output.

Finally, Chinese companies not only have a responsibility to investors, they have a responsibility to all stakeholders, including society at large. Therefore, another important question is whether corporate social responsibility (CSR) matters in China. Chinese citizens and consumers care about social issues, but right now, they are relying on the government to carry out CSR initiatives and programs. However, while there is still a long way to go for Chinese firms to be truly interested in CSR, we think the future is bright. Agency problem is a situation in which the interests of the principal (shareholder or owner of a business) and the agent (a manager or board of directors) are not aligned.

Agency Problem

Note that this form of expropriation from minority shareholders is almost impossible to detect. Therefore, this gives rise to the crucial question of how China is dealing with this agency problem. When college students take their first finance course, they are taught that there are two major costs that can hinder the firm’s valuation.