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Financial Management Case Study ON Agency Problem Agency Problem

The agency problem occurs when agents (executives, managers) do not fully represent the best interests of principals (shareholders, investors). One famous example is Enron, where executives misrepresented financial statements through tricky accounting, hiding losses and racking up debt. This ultimately led to Enron's bankruptcy. Other examples include Goldman Sachs betting against clients during the housing crisis, Boeing planning a stock buyback that hurt employee retirement accounts, and WorldCom loans to executives that put the company in debt. In each case, agents prioritized their own interests over those of principals, leading to losses.

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V SHARAVANI MBA
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168 views3 pages

Financial Management Case Study ON Agency Problem Agency Problem

The agency problem occurs when agents (executives, managers) do not fully represent the best interests of principals (shareholders, investors). One famous example is Enron, where executives misrepresented financial statements through tricky accounting, hiding losses and racking up debt. This ultimately led to Enron's bankruptcy. Other examples include Goldman Sachs betting against clients during the housing crisis, Boeing planning a stock buyback that hurt employee retirement accounts, and WorldCom loans to executives that put the company in debt. In each case, agents prioritized their own interests over those of principals, leading to losses.

Uploaded by

V SHARAVANI MBA
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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V.

SHARAVANI

FINANCIAL MANAGEMENT
CASE STUDY
ON
AGENCY PROBLEM

Agency Problem
The agency problem is a conflict of interest that occurs when agents don't fully
represent the best interests of principals. Principals hire agents to represent their
interests and act on their behalf. Agents are frequently hired to allow businesses
to obtain new skill sets that the principals lack or to accomplish work for the
firm's investors. In the business world, this relationship is represented by a
company's management team and the corporation's shareholders. In other cases,
the agent is the head of an investment firm while investors are the principals.

Agency problems are common in fiduciary relationships including those


between trustees and beneficiaries, and board members and shareholders.

Investors benefit from a corporation's success and expect executive employees


to pursue the best interest of shareholders. The company's leaders do not
necessarily have the same interests as shareholders. Although they may be
driven by the company's success, the motivation is usually different—namely
their income. The more successful the company, the more they're likely to earn.

These agents or employees, from rank-and-file workers up to corporate


executives, may all potentially misrepresent the firm and act in ways described
by the principal-agent problem, which can be seen in day-to-day situations in
the financial sector as well as other industries including the legal world.

The Enron Scandal


One particularly famous example of the agency problem is that of Enron.
Enron's directors had a legal obligation to protect and promote investor interests
but had few other incentives to do so. But many analysts believe the
company's board of directors failed to carry out its regulatory role in the
company and rejected its oversight responsibilities, causing the company to
venture into illegal activity. The company went under following an accounting
scandal that resulted in billions of dollars in losses.

Enron was, at one point, one of the largest companies in the United States.
Despite being a multi-billion dollar company, Enron began losing money in
1997. The company also started racking up a lot of debt. Fearing a drop in share
prices, Enron's management team hid the losses by misrepresenting them

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V.SHARAVANI

through tricky accounting—namely special purpose vehicles (SPVs), or special


purposes entities (SPEs)—resulting in confusing financial statements.

The problems started to unfold in 2001. There were questions about whether the
company was overvalued, leading to a drop in share prices from over $90 to
under $1.

The company ended up filing for bankruptcy in December 2001. Criminal


charges were brought up against several key Enron players including
former chief executive officer (CEO) Kenneth Lay, chief financial officer
(CFO) Andrew Fastow, and Jeffrey Skilling, who was named CEO in February
2001 but resigned six months later.

The Fall of Enron

The collapse of energy giant Enron in 2001 showed how catastrophic the
agency problem can be. The company's officers and board of directors,
including Chairman Kenneth Lay, CEO Jeffrey Skilling and CFO Andy
Fastow, were selling their Enron stock at higher prices due to false accounting
reports that made the stock seem more valuable than it truly was. After the
scandal was uncovered, thousands of stockholders lost millions of dollars as
Enron share values plummeted.

Goldman Sachs and the Real Estate Bubble

Another agency problem occurs when financial analysts invest against the best
interests of their clients. Investment giant Goldman Sachs and other stock
brokerage houses developed mortgage-backed securities, known as
collateralized debt obligations, then sold them "short," betting that the
mortgages would undergo foreclosures. When the housing bubble hit in 2008,
the values of the CDO's dropped and the short-sellers made millions of dollars.
Meanwhile, millions of investors and homeowners lost nearly everything in
the collapse.

The Boeing Buyback

Aerospace leader Boeing offers an instructive example of how the agency


problem occurs in capital markets. From 1998 to 2001, Boeing had more than
130,000 shareholders. Most of those shareholders were Boeing employees who
purchased company stock through their 401(k) retirement plans. At the same
time, Boeing was planning on buying back much of its stock, driving down its
share price.

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The actions of the executives in charge of caring for the company damaged the
value of its employees' retirement accounts.

Executive Compensation and WorldCom

When an executive uses company assets to underwrite personal loans, the


agency problem occurs as the company takes on debts to provide its executives
with higher incomes. In 2001, WorldCom CEO Bernard Ebbers took out over
$400 million in loans from the company at the favorable interest rate of 2.15
percent. WorldCom did not report the amount on its executive compensation
tables in its annual report. Details of the loans did not come out until the
company's accounting scandal hit the news late that year.

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