The principal-agent theory emerged in the 1970s by theorists from the fields of economics and institutional theory, Stephen Ross and Mark Mitnick. It states that the agency problem arises when there is a conflict of interest between two or more parties, the first party represented by the agent who acts on behalf of the second party, represented by the principal. If the objectives of the agent do not align with those of the principal, this can create an unfavorable situation where the agent’s actions are based on his own personal gains and not the principal’s goal. Although this theory can be applied to numerous circumstances, and examples of them are universal, in this essay I will be writing about the issue in the context of a company with shareholders, acting as the principals, and managers acting as the agents.
As the theory states, the principal-agent problem, or agency problem for short, occurs when the agent’s goals differ to those of the principal. Within a public company, the shareholders rely on the managers to act on their behalf and ensure that shareholder wealth is maximized. However, within company’s where there is a separation between ownership and control, maximizing shareholder wealth usually does not align with the manager’s personal goals. The shareholder’s primary interest is, as mentioned above, to maximize his wealth and this is achieved by receiving higher dividends and/or increasing earnings per share through rises in stock price or market value. On the other hand, the agents are usually more interested in personal gains such as bonus packages and employee benefits like extravagant company paid business expenses. As well as this, shareholders tend to think in the long-term whereas managers tend to think in the short-term, this can cause additional conflicts of interests. Therefore, without sufficient incentive to meet shareholder goals, the agent may act in his own interest to maximize his own wealth or reach his own goals. It is this discrepancy between the principal and the agent’s interests, that result in issues of moral hazard and information asymmetry, both of which lead to more agency problems.
Moral hazard exists whenever one party exploits the fact that there is a separation between them, the risk taker’s, and another party who bears the cost of those risks. In the context of a company, the managers can decide to take unnecessary risks whilst being exempt from the consequences those may bring. On the other hand, the shareholders bear all of this taken risk and become victims to this moral hazard. The principal’s goals of maximizing their wealth is now in danger due to the agent’s potentially dishonest actions.
This idea of moral hazard is argued to stem from the concept of information asymmetry. Information asymmetry refers to a situation where one party, the agent, is better informed and has more knowledge than the other party, the principal. The manager in this case may use this to his advantage in order to reach his own personal goals rather than those of the shareholder. This can lead to more agency problems and a lack of trust towards the agent.
Agency problems have the capability to lead to detrimental consequences. An example of this is the fall of a large corporation was that of the energy giant Enron in 2001. Many executives at Enron, including the CEO, Chariman and CFO made the catastrophic mistake of selling their Enron shares at higher prices based on deceitful accounting reports that suggested the shares were more valuable than they really were. Enron’s board of directors were believed to have ventured into illegal activities as a result of neglecting their obligations and failing to carry out their regulatory role within the company. As a result, thousands of shareholders lost millions of dollars as the stock values plummeted. In the aftermath of the scandal, new legislation such as the 2002 Sarbanes-Oxley Act was implemented to improve shareholder protection and increase the accuracy of financial reporting for public companies both internally and externally.
In order to avoid or halt the above mentioned agency problems, shareholders have devised many solutions which I will develop upon throughout the rest of this essay. I have categorized these into two groups, internal and external measures.
The first internal measure I will discuss is internal auditing. To ensure the growth and success of the company, internal auditing plays an important role. It helps assess the efficiency of a company and therefore can detect or halt the possible inefficient operations being carried out by managers, as well as safeguard the company’s assets and capital. This mechanism is a form of monitoring and helps the shareholders supervise the managers’ actions. This can be used as a solution to the agency problem by ensuring the managers act in compliance with the shareholder’s orders as well as reduce issues of asymmetric information and moral hazard.
The second internal measure that can be adopted to solve the agency problem is introducing financial rewards and incentive pay schemes for the managers. This is an extremely efficient way of realigning manager and shareholder interests and avoid managers acting on their own behalves. These compensation schemes can include bonuses or reward packages linked to shareholder goals. For example, manager bonuses can be calculated as a percentage of the company’s realized profits or given out according to the growth of earnings per share. This will motivate managers to work towards shareholder goals as their earnings become directly linked to shareholder goals.
The third internal measure used to solve the agency problem is the idea of reducing the separation between ownership and control. Michael Jensen and William Meckling published a paper in 1976 about ownership schemes that outlined this idea and how it could be used to reduce agency problems. It involves offering managers shares in the company in the form of either performance shares or executive stock options. Performance shares are where managers receive a certain number of shares based on the company’s performance and executive stock options are when they are allowed to purchase stocks at a future date and price. These contribute to reducing agency problems by in effect making the managers shareholders. As a result, this aligns interests and ensures both the agent and the principal are also on the same, long-term, timeline. In addition to his, if the managers own shares in the company, they will become more prudent and cautious with what risky investments they take as this may threaten their own interests and so moral hazard can be avoided.
The last internal measure I will be discussing is the implementation of a good system of corporate governance. The principles of corporate governance are the following: transparency, responsibility and control within the decision making process as well as daily reports about the company’s progress. It can be defined as a compilation of control techniques that a company uses to avoid or discourage potentially self-interested managers from undertaking activities seen as detrimental to shareholder welfare.
External measures are also used to prevent agency problems. The first of which is external auditing. This involves hiring external audits to periodically value the reality and objectivity of the company’s financial reports. This is crucial when verifying that the results are fairly stated and the managers have not manipulated them to either conceal bad decision making or for their own personal gains. It is an efficient way of reducing information asymmetry. Having external audits is important when internal auditing fails. In 2001, for example, WordlCom CEO Bernard Ebbers took out close to 400 million dollars in loans from the company at a sympathetic interest rate of 2.15 percent. WorldCom neglected to account for this amount in its annual report and the specifics of the loan did not come to light until the company’s accounting mishap aired on the news later that year.
Another external measure that is adopted in order to avoid conflicts of interest is the proper use of legislation. In 1992, Milgrom and Roberts drafted four principles they thought should be included in contracts to avoid the principal-agent problem. The first is the informativeness principle that was introduced in 1979 and states that the incentive contract should account for all measure that provide information about the agent’s actions. The second is the incentive intensity principle which argues that the most efficient incentives are created whilst considering the following factors: the added profits gained with additional effort, the accuracy with which the agent’s activities can be appraised, the agent’s risks and finally his responsiveness to incentives. The following principle is the monitoring intensity principle which explains that, with more spending on monitoring, the principal can increase the precision with which the agent’s work is measured. And finally, the last principle is the equal compensation principle which says that the either, the principal should assign higher compensation to high priority tasks so the agent knows what to prioritize when engaged in multiple projects, or, state that each task will yield the same amount of reward regardless of what they entail. All of these will help align interests between shareholders and agents as well as introduce transparency and more incentives for the managers.