Agency Problem Definition

The agency problem can be better defined as a conflict taking place when the agents
who are entrusted with the responsibility of looking after the interests of the principals
chose to use the power or authority for their personal benefits and in corporate finance,
it can be explained as a conflict of interest taking place between the management of a
company and its stockholders.
It is a very common problem and it can be observed in almost every organization
irrespective of the fact that whether it is a church, club, company or any government
institution. It is a conflict of interest taking place that takes place when people who are
interested in responsibilities misuse their authority and power for personal benefits. It
can be resolved only if the organizations are willing to resolve it.
 
Types of Agency Problems
Every organization has its own set of long-term and short-term goals and objectives that
it wishes to achieve in a pre-determined period of time. In this context, it must also be
noted that the goals of the management may not necessarily align with that of the
stockholders.
The management of an organization may have goals that are most likely derived with
the motive of maximizing their personal benefits while on the other hand, the
stockholders of an organization are most likely interested in their wealth maximization.
This contrast between the goals and objectives of the management and stockholders of
an organization may often become a basis for agency problems. Precisely speaking
there are three types which are discussed below;

 Stockholders vs. Management – Large companies may have a huge number of

equity holders. It is always crucial for an organization to separate the
management from ownership since there is no reason for them to form a part of
management. Segregating ownership from management has endless
advantages as it does not have any implications upon the regular business
operations and the company will hire professionals for managing the key
operations of the same. But hiring outsiders may become troublesome for
stakeholders. The managers hired may take unjust decisions and might even
misuse the shareholders’ money and this can be a reason for the conflict of
interests between the two and hence, agency problems.
 Stockholders v/s Creditors – the stockholders might pick up risky projects for
making more profits and this increased risk might elevate the required ROR on
the company’s debt and hence, the overall value of the pending debts might fall.
If the project sinks, the bondholders will supposedly have to participate in losses
and this can result in agency problems with the stockholders and the creditors.
 Stockholders v/s other Stakeholders – The stakeholders of a company may
have a conflict of interests with other stakeholders like customers, employees,
society, and communities. For example, the employees might be asking for a
hike in their salaries which if rejected by the stakeholders then there are
probabilities of agency problems to take place.
 
Examples
ABC Limited sells gel toothpaste at $20. The stockholders of the company raised the
selling price of the toothpaste from $20 to $22 in order to maximize their wealth. This
sudden unnecessary rise in the price of the toothpaste disappointed the customers and
they boycotted the product sold by the company. Few customers who bought the
product realized a fall in the quality and were utterly disappointed. This resulted in the
agency problems between the stockholders and the loyal and regular customers of the
company.
Causes
There can be various causes of agency problems. These causes differ from the position
of an individual in the company. The root cause of these problems is the same in all
cases that are mismatch or conflict of interests. When the agenda of
the stockholder clashes with the other groups then the agency problem is definitely
going to take place. In the case of employees, the reason would be the failure of
stockholders to meet employees’ expectations with respect to salary, incentives,
working hours, etc.
In the case of customers, the cause would be the failure of stockholders to meet
customers’ expectations like the sale of poor quality goods, poor supply, high-pricing,
etc. In the case of management, the causes of agency problems could be the
misalignment of goals, separation of ownership and management, etc.
 
Solutions to Agency Problems
The agency problems existing between the stockholders and the management of the
company can be resolved by means of offering stock packages or commission to the
decisions taken by the management and their outcomes on the shareholders. The
companies can try to resolve these problems that can exist between its stockholders
and management/ creditors/ other stakeholders (employees, customers, society,
community, etc) by means of taking instituting measures like tough screening
mechanisms, offering of incentives for good performance and behavior and likewise
penalizing for poor performance and bad behavior, and so on. However, it is not
possible for an organization to get completely healed from agency problems since the
costs associated have the tendency to outweigh the total outcomes sooner or later.
Agency Problem in Corporate Governance
An agency problem in corporate governance is large institutional shareholders who tend
to support management.3 min read
An agency problem in corporate governance is large institutional shareholders who tend
to support management. This leads to little democracy in voting and absences in annual
meetings. Activists and trade-union shareholders are those who attend the meetings
and give an incentive to corporate managers to not take meetings seriously.

 Agency Problems in Corporate Governance

Meetings are more than likely held by groups with their own interests, used by
management as a way to avoid reforms that make them more accountable like a vote
on the executive pay.
One important reason institutional shareholders are not interested is because they are
looking for short-term gains, even though being good owners would help the company
in the long-term.
Some issues with corporate governance include high pay for CEO's, executives picking
directors, and indirect resistance to regulations. The CEO pay is not equal to their value
to the company. Board members may get too comfortable in their positions. Financial
matters are not transparent and directors are selected without a majority vote .

Causes of Agency Problems in Corporate Governance

The modern corporation was created as a response to regulation and not as an
advantage to the company or shareholders. The board of director structure is not equal
to the essence of a corporation, as the company doesn't need the directors to continue
its operations.
The agency costs don't have a positive impact on corporate governance in many
countries. Corporate governance mechanisms are used in various degrees in different
countries. Corporate governance risk and agency costs are obvious in the non-finance
sector.

Examples of Corporate Agency Problems

  Enron Fall - The fall of the energy giant in 2001 showed the world how an agency
problem arises. The company's chairman Kenneth Lay, the CFO, and CEO
Jeffrey Skilling were selling shares based on false accounting reports which
made it seem as though the stock was more valuable. Many stockholders lost
millions as the value of Enron shares plummeted.
 Real Estate Bubble and Goldman Sachs - When financial analysts invest against
the interests of their clients, it's another agency problem. Goldman Sachs and
other agencies created debt obligations and sold them short, with the thought
that the mortgages would be foreclosed. In 2008, when the housing bubble
occurred the short sellers made millions and many people including homeowners
lost money.
 Boeing Buyback - During 1998 to 2001, Boeing had about 130,000 shareholders,
and most were employees who bought stock through their retirement plans.
Boeing was buying back the stock which drove prices lower. The executive
actions damaged the employees' retirement account value.
 WorldCom and Executive Pay - In 2001, CEO Bernard Ebbers took out $400
million in loans at a rate of interest of 2.15 percent. The company didn't report
this in its annual report. The news of the accounting scandal came out later that
year, and the company took on debt to pay its executive.

Conclusion
Agency problems are nothing but the mismatch of interests between the company’s
management/ creditors/ other stakeholders (employees, customers, society, community,
etc) and its stockholders which may sooner or later result in a conflict of interest. It is
highly crucial for companies to address the underlying problems to ensure that its
regular business operations are not getting impacted. This type of problem can exist
anywhere whether it is a company, club, church or even government institutions.
The three types of agency problems are stockholders v/s management, stockholders v/s
bondholders/ creditors, and stockholders v/s other stakeholders like employees,
customers, community groups, etc. It can be resolved by companies with the help of
measures like offering incentives for good performance and behavior and likewise
penalizing for poor performance and bad behavior, tough screening mechanisms, and
so on. It is almost impossible for companies to completely eliminate agency problems
but it can still minimize the implications of the same.