5.

1- Agency Problems and Accountability of

Corporate Governance
 Agency problem is a conflict of interest inherent
in any relationship where one party is expected
to act in the best interest of another.
 Agency problem arises when incentives or
motivations present themselves to an agent to
not act in the full best interest of a principal.
 Through regulations or by incentivizing an
agent to act in accordance with the principal's
best interests, agency problems can be
reduced.
When does Agency Problems occur?

 When the interest of stockholders, the

board of directors/or the management of
the company are not perfectly aligned or
when these entities conflict.
 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
 What Is the 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.
 Agency Problem in Corporate Governance
Agency Theory– suggests that the firm can be
viewed as a loosely defined contract between
resource providers and the resource controllers, it
is a relationship that came into being
occasioned by the existence of one or more
individuals called principals, employ one or more
other individuals called agents to carry out some
service and then entrust decision-making rights to
the agents
 Understanding the Agency Problem
 The agency problem does not exist without a
relationship between a principal and
an agent.
 Inthis 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.
 Understanding the Agency Problem
 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.
 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.
Minimizing Risks Associated With the
Agency Problem
 Agency costs are a type of internal cost that a
principal may incur as a result of the agency
problem.
 They include the costs of any inefficiencies that
may arise from employing an agent to take on
a task, along with the costs associated with
managing the principal-agent relationship and
resolving differing priorities.
 While it is not possible to eliminate the agency
problem, principals can take steps to minimize
the risk of agency costs.
 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.
 Regulations
 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.
 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.
 Real World Example of the Agency
Problem
 In 2001, energy giant Enron filed for bankruptcy.
 Accounting reports had been fabricated to
make the company appear to have more
money than what was actually earned.
Real World Example of the Agency
Problem
 The company's executives used fraudulent
accounting methods to hide debt in Enron's
subsidiaries and overstate revenue.
 These falsifications allowed the company’s stock
price to increase during a time when executives
were selling portions of their stock holdings.
 When Enron declared bankruptcy,
shareholders lost nearly $75 billion in value.
Enron became the largest U.S. bankruptcy at
that time with its $63 billion in assets.
 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.
 Related Terms
 Principal-Agent Problem Definition
 The principal-agent problem is a conflict in
priorities between a person or a group and the
representative authorized to act for them.

 Agency Cost of Debt

 Agency cost of debt is a problem arising from
the conflict of interest created by the
separation of management from ownership in
a public company.
 Principal-Agent Relationship
The principal-agent relationship refers to an
arrangement in which one entity legally
appoints another to act on its behalf.
 Agency
Costs Are Internal Expenses Paid to
Compensate Agents for Work
Agency Costs are an internal cost which
arises from, and requires payment, to an
agent who acts on behalf of a principal in
some situations.
 Related Terms
 Fiduciary
A fiduciary is a person or organization that acts on
behalf of another person or persons to manage
assets, executing in care, good faith, and loyalty.

 Understanding Agency Theory

 Agency theory is an economic principle used to
explain disputes between principals and agents.
It is most often relevant to shareholders and
corporations.