0

Table of Content

1.0 Introduction ..................................................................................................................... 1

What is Agency Relationship ................................................................................................. 1
1.1 Definition ................................................................................................................................ 1
2.0 Agency problems ............................................................................................................. 2
2.1 Example................................................................................................................................... 2
3.0 Agency cost ..................................................................................................................... 4
Monitoring cost ............................................................................................................................. 4
Bonding cost.................................................................................................................................. 4
Residual loss.................................................................................................................................. 5
4.0 How to reduce agency problems ...................................................................................... 6
Competition between agents ......................................................................................................... 6
Agent's participation in the results of joint activities ...................................................................... 6
Profit sharing ................................................................................................................................. 7
Suggestion ............................................................................................................................ 7

ILKHOMOV ANVAR | TP043148

1.0 Introduction 1

The first scientists who directly proposed to create the theory of Agency and actually began its
creation, were Stephen Ross and Barry Mitnick, independently and approximately at the same
time. Ross is responsible for the origin of the Agency's economic theory, and Mitnick is
responsible for the Agency's institutional theory, although the basic concepts underlying these
approaches are similar (The Theory of Agency, 1974).

What is Agency Relationship?

1.1 Definition
Agency relationship divided into two sides. The first one is an agent – a person who acts on
behalf, the Manager of the company. On the one hand, he is also interested in the results of the
company that hired him. On the other hand, their achievement in some cases involves
infringement of the interests of shareholders. In other words, the principal is the one who gives
the order, and the agent is the one who carries out this order. In the third point shown who is an
agent in that case

The principal – the owner, that is, the shareholder of the company, which is directly interested in
the results of the company – depends on its current income – the amount of the dividend.
Both the principal and the agent can be: an individual, a firm, an organization and a public
institution. Agency relations – relations between two participants, one of which
(customer/principal) transfers its functions to another (Manager/agent). In the example below
shown that principal is University. (Dietmar Braun, 2003)

In financial management, Agency relationship or relationship of the "principal - agent" arises

when the owners of capital (the principals) delegate the making investment and financial
decisions of managers (agents). Managers are rewarded for achieving the goals set by the
principal. In this case, the interests of the principal and the agent may not coincide.
For instance: Asia Pacific University make a contract with an agent from other countries to
involve international students and agent gets bonus for that. In this case APU is a principle who
need students for their university and agent is a person or some special organization where team
of people responsible to find out students for the university and deal with them. Here students
are third part.

ILKHOMOV ANVAR | TP043148

2.0 Agency problems 2

Explanation
The possibility if conflict of interest between the stockholders and management of a firm. The
agency problems encountered in the ordinary course of business are often subtle and mundane.
But agency problems do arise whenever managers think just a little less hard about spending
money that is not their own
2.1 Example
Suppose that your hire someone to sell your car and that you agree to pay that person a flat fee
when he/she sells the car. The agent’s incentive in this case is to make the sale, not necessarily to
get you the good price. If you offer a commission of, say, 10 percent of the sale price instead of a
flat fee, then this problem might not exist. This example illustrates that the way in which an
agent is compensated is one factor that affects agency problems. Agency problems sometimes
lead to outrageous behaviour like the cases which is given below.

 Tyco
When American ex-director Dennis Kozlowski, the former CEO of Tyco, threw a 2$
million birthday bashes for his wife, he charged half the cost to the company. These of
course are extreme problems but, it shows that agency problem can lead to like this
situation.

 Boeing
American company Boeing give an actual example of how the agency problems can
happen in the martket. From 1998 to 2001, Boeing had more than 130K shareholders
many of this shareholders were their workers who bought Boeing’s stock through their
401(k) retirement plans. Also, at that time the company was planning on purchasing back
many of its stock, by reducing the share price. (Hanks, G, 2019).

 Goldman Suchs
The following agency problem happened when financial analysts invest money against to
the interests of their clients. Goldman Sachs Group one of the leading investment bank
other stock brokerage houses developed mortgage-backed securities known as
collateralized debt obligations then sold them "short" betting that the mortgages would
undergo foreclosures. In 2008 the value of the CDO’s decreased and the short-sellers got

ILKHOMOV ANVAR | TP043148

 millions of dollars. That time millions of investors and homeowners lose huge money. 3
(Hanks, G, 2019).
 The Fall of Enron
In 2001 Energy company shows how agency problems can be terrible. Enron’s board
directors Chairman Kenneth Lay, CEO Jeffrey Skilling and CFO Andy Fastow. The
company were selling its stocks, there was incorrect accounting reports and company sell
their stocks more expensive because it seems more valuable than it truly was. After a
while the scandal was found. Many of stockholders lost millions of dollars. (Hanks, G,
2019).
 Hollinger International
There is also one case not so extreme like other cases which mentioned before. It is when
Conrad Black, the former boss of Hollinger International company, used the company’s
private jet for a trip with his wife to Bora Bora.

ILKHOMOV ANVAR | TP043148

3.0 Agency cost 4

For the first time the classification of Agency costs suggested by M. Jensen and Meckling.This is
type of transaction cost, which mainly relates to transaction costs of property rights, although it
captures others.
According to Jensen and Meckling 1976, they divide the Agency cost in to three main points and
they say that, the principal can limit divergences from his interest by establishing appropriate
incentives for the agent and by incurring:
1: Monitoring costs.
2: Bonding costs.
3: Residual loss
Monitoring cost

As Jensen and Meckling (1976) says that, this cost can be issued to limit the aberrant activities of
Managers in a company by shareholders “Monitoring costs are expenditures paid by the
principal to measure, observe and control an agent’s behaviour. They may include the cost of
audits, writing executive compensation contracts and ultimately the cost of hiring managers.”
This cost will be totally paid by the Principle, but at the same, it’s argued that, this cost will be
borne by an agent if the compensation is fully adjusted to cover the costs. (Wilkinson, J, 2013).
Bonding cost

This will be issued to guarantee that mangers action will not harm shareholders wealth and to
ensure that principle will be compensated in case if he is harmed by such actions. However, it is
generally impossible for the principle or the Agent at zero cost to ensure that the agent will act to
increase principles welfare, or will take decision from the principle’s point of view.
Bonding costs borne by the agent, such as bonding against malfeasance, contractual limitations
on his power, it limits his ability to take full advantage of profitable opportunities, foregoing
certain non-pecuniary benefits. (Wilkinson, J, 2013).

In most of the agency relationship the agent will incur positive monitoring and bonding costs,
i.e., pecuniary and as well as non-pecuniary, and edition there will be some divergence between
principle and agent’s decision, where this decision would maximize the welfare of principle.

ILKHOMOV ANVAR | TP043148

Denis (2001) argues that optimal boding contract should aim to make managers in to taking all 5
decisions in shareholders’ best interest, however since manger can not be made and practically
not a certain issue to be so and to do everything that shareholders would wish, bonding provides
a mean of making manger do some of the thing the shareholder wants him to do by writing a less
than perfect contract
Residual loss

Beside the two others defined above the third type of cost arising from agency relation on
mangers to control manager’s actions and to align them with basic motive of increasing the
shareholders wealth is, residual loss.

The contract structures of most undertaking Forms, limits the risks undertaken by most agent by
specifying either fixed payoffs or incentive payoffs tied to specific measures of performance. “
The residual risk is the risk of the difference between stochastic inflows of recourses and
promised payment to agent, this is borne by those who contact for the right to net cash flows. We
call these agents the residual claimant or residual risk bearers. Moreover, the contracts of the
most agents contain the implicit or explicit provision that, in exchange for the specified payoff,
the agent agrees that the resources he provides can be used to satisfy the interests of residual
claimants. (Wilkinson, J, 2013).
Or in other words and briefly a residual loss is “The dollar equivalent of the reduction in welfare
experienced by the principal as a result of this divergence is also a cost of the agency
relationship, and we refer to this latter cost as the “residual loss”
This cost arises basically because of the cost of fully enforcing contract between Principle and
Agent would far be more the benefit derived from doing. Since in the time of concluding a
contract, action of the agent is not predictable, unobservable and to fully contract stating every
single action of an agent is something impractical. The solution to prevent this kind of problem
is somehow residual loss, which may represent a trade-off between overly constraining
management and enforcing contractual mechanisms designed to reduce agency problem.

ILKHOMOV ANVAR | TP043148

4.0 How to reduce agency problems 6

As mentioned in section 2.1 employees of the companies become not loyal to their jobs. Agency
problems arising in the process of corporate governance cause huge damages to companies and,
as a result, can slow down the development of industries and the economy as a whole. Regarding
this below will be given three most effective suggestions how to reduce these problems.

Competition between agents

The first solution to the principal and agent problem is to promote competition between
agents. In contrast to the usual situation, the reward is not the achievement of a given
level by the agent (for example, production), but the achievement of the highest level
relative to the rest of the agents. The idea of agent competition allows the agents
themselves to be used for mutual control over each other's actions. After all, if the
greatest reward goes only to the agent who has achieved the best relative performance in
achieving the objectives set by the principal, the agents begin to jealously monitor the
success of others — the success of others means reducing the chances of their own
success. On the other hand, overestimated relative to other agents reward "winner" is a
strong incentive to improve performance, because the prospect of a large win with a low
probability is more attractive than a smaller win with a higher probability. However, this
method also has its disadvantages.
- Competition among agents finally destroys the elements of trust between them. Tasks
that require joint efforts of the agents become practically impossible.
- The reward of only the "winner" stimulates the choice of the riskiest strategies by
agents, i.e. there is a "reverse selection" of agents, as a result of which only the riskiest
strategies are used
Agent's participation in the results of joint activities
The second solution is to conclude a contract of employment with the agent, involving
the payment of remuneration is not fixed, and depending on the results of the company
(sharing contract). This includes, for example, various forms of employee participation in
profits, including through their participation in the capital of a joint-stock enterprise. In
the United States for many years there is a program ESOP (Employee Stock Ownership
Plan), according to which employees of more than 10% of industrial enterprises receive

ILKHOMOV ANVAR | TP043148

 benefits for the purchase of shares of their own enterprises. Of the variety of schemes of 7
participation of agents in the results of the company's most effective are the simplest,
assuming a linear dependence of remuneration on results. This is due both to the high
costs of Contracting, which uses non-linear schemes, and with the complication for the
perception of agents depending on the results of remuneration.
- Agent takes a high risk.
Profit sharing

Profit sharing when company distribute a certain part of profit between employees of the
company. For instance, this distribution can be in the form of annual bonuses, depending
on the profits for the previous year, or in the form of part of the monthly or weekly
payments. Less direct forms of profit participation — placing shares of the company
among employees paid from profits, and granting employees the right to purchase shares
at any future time at the current price, provide an opportunity to generate income in the
form of dividends on shares, and in the form of growth in the value of shares as a result
of increasing the profitability of the company. (Bratman, M, 2014) To the system of
participation in profits is often resorted to in order to increase the interest of employees in
improving performance.

Suggestion

In order to prevent the managers to abuse their position and power and protect their interests, the
stockholders may use several different mechanisms. In the text that follows, the suggestions are
divided into two groups first and then analysed as such:
Internal
If we go back to the Hollinger International case there was shown that workers use not their own
belongings so it led to the agency problem if we take others the problems in money. So, the first
suggestion is to change the salaries and payments of the managers to prevent like these issues.
External
According to the Boeing’s case the problem were related with company and people could not do
nothing with the share price like these issues require situation by Law/Legal form controlling.

ILKHOMOV ANVAR | TP043148

References 8
Website
- Spielman, E. (2019). Direct Costs vs. Indirect Costs: Understanding Each. [online] Business
News Daily. Available at: https://www.businessnewsdaily.com/5498-direct-costs-indirect-
costs.html [Accessed 3 May 2019].

- Eichenwald, K. (2002). Corporate Loans Used Personally, Report Discloses. [online]

Nytimes.com. Available at: https://www.nytimes.com/2002/11/05/business/corporate-loans-
used-personally-report-discloses.html [Accessed 3 May 2019].

- Hanks, G. (2019). Examples of Agency Problems in Financial Markets. [online]

Smallbusiness.chron.com. Available at: https://smallbusiness.chron.com/examples-agency-
problems-financial-markets-70962.html [Accessed 3 May 2019].

Worstel, T. (2003). Solving The Principal Agent Problem: Apple Insists That Executives Must
Hold Company Stock. [online] Forbes.com. Available at:
https://www.forbes.com/sites/timworstall/2013/03/01/solving-the-principal-agent-problem-
apple-insists-that-executives-must-hold-company-stock/#25b92d4e6e01 [Accessed 4 May 2019].

Wilkinson, J. (2013). Agency Costs Definition | Types of Agency Costs • The Strategic CFO.
[online] The Strategic CFO. Available at: https://strategiccfo.com/agency-costs/ [Accessed 7
May 2019].

Journals and Books

- Bratman, M. (2014). Shared agency. New York, NY: Oxford University Press.

- The Theory of Agency: The Concept of Fiduciary Rationality and Some Consequence.
Unpublished doctoral dissertation, Department of Political Science, University of Pennsylvania
(1974).

- Dietmar Braun, David H Guston, Principal-agent theory and research policy: An introduction,
Science and Public Policy, Volume 30, Issue 5, October 2003, Pages 302–308,

ILKHOMOV ANVAR | TP043148

 9

ILKHOMOV ANVAR | TP043148