2 4 Agency Issues: Shareholders and Corporate Boards Principles of Finance
The agency problem occurs when there is a separation of ownership and control within an organization, creating a level of moral hazard. This means that the person or group responsible for making decisions on behalf of the principal may act in their own self-interest rather than in the best interest of the principal. It is crucial to understand and address the agency problem to ensure the long-term sustainability and success of a business. Ultimately, individual corporate management is disciplined by other competitive managers.
Madoff put their money into a bank account and funded redemption requests with newly invested money. These normally take place when people or entities serve their personal interests rather than keeping up with their professional responsibilities. Put simply, a conflict of interest arises when someone puts their own personal gain ahead of their own duties to the corporation.
- If a CEO was worried that a potential takeover would result in being fired, the CEO might try to prevent the takeover, which would be an agency problem.
- It generates profits for early investors at the expense of late investors’ money.
- A major problem with tournaments is that individuals are rewarded based on how well they do relative to others.
- An agency problem arises when individuals, such as management, fail to work efficiently and make decisions that primarily serve their interests rather than the organization.
- The duty of management or agency is to look after the interest of the stockholders.
It generates profits for early investors at the expense of late investors’ money. To illustrate real-life agency conflicts, the Enron Scandal and the Bernie Madoff cases will be tackled below as agency problem example. A firm’s stakeholders may include employees, communities, customers, and suppliers, who have different interests and may want to keep an eye on the management and equity holders’ behavior. A major problem with tournaments is that individuals are rewarded based on how well they do relative to others. Co-workers might become reluctant to help out others and might even sabotage others’ effort instead of increasing their own effort (Lazear 1989, Rob and Zemsky 1997). Firstly, because—especially given compression rating problems—it is difficult to determine absolutely differences in worker performance.
Contract design
In addition, any decision taken by management that is not in the more significant interest of the organization will ultimately have a bearing on stockholders’ wealth. To promote the organization’s and stockholders’ interests over their own, it is crucial to implement measures that minimize https://1investing.in/s and motivate management. However, if the management makes decisions that do not favor the business, conflicts between them and the owners can arise, which is an agency problem. An agency problem arises when individuals, such as management, fail to work efficiently and make decisions that primarily serve their interests rather than the organization. Financial managers can be viewed as agents of the owners who have hired them and given them decision-making authority to manage the firm.
Ponzi schemes represent many of the better-known examples of the agency problem. Agency theory claims that a lack of oversight and incentive alignment greatly contribute to these problems. Agency problems are common in fiduciary relationships including those between trustees and beneficiaries, and board members and shareholders.
This conflict arises when separate parties in a business relationship, such as a corporation’s managers and shareholders, or principals and agents, have disparate interests. Are these laws and regulations, and the regulatory authorities, effective at mitigating the horizontal agency problem in China? According to anecdotal evidence and academic research, the answer seems to be mostly yes, and especially recently. For example, it is now difficult for controlling shareholders to engage in favorable related party transactions, and this is because of a regulation that allows minority shareholders to vote on these transactions.
Agency Theory
The stakeholders of an organization (e.g., suppliers, employees, and customers) may have different interests from those of stockholders. An example of this conflict of interest is that often, employees ask for an increase in salaries. If this request is rejected and not fulfilled by stockholders, agency problems occur between the two parties.
Heyer, who was awarded an exorbitant executive salary, was also allowed to sink the company into further debt. But this example should serve as a cautionary tale of what can happen when stockholders are able to put their interests ahead of those of other stakeholders in a corporate environment. This additional risk could also result in creditors taking steps to devalue such debts, which in most cases refers to company bond issues. In the end, if these riskier projects end up failing and the company loses money, investors (bondholders) may also experience financial risk as bonds go into default or otherwise lose market value. This then becomes a potential agency problem between bondholders (investors) and creditors.
How Do Modern Corporations Deal With Agency Problems?
If the company executive acts negatively and reduces the worth of the shareholder’s stock, it will spark a disadvantageous relationship. It is because the shareholder invests in an executive’s business, in which the executive is responsible for making decisions that affect the shareholder’s investment. To avoid agency problems, one must ensure appropriate incentives to the agent / authorized representatives to compensate them for their efforts.
The horizontal agency problem and how China deals with it
His current main research interests are corporate governance and corporate finance in China. Fuxiu Jiang is a Professor of Finance at Renmin Business School at Renmin University of China. agency problem His research and areas of interest are in corporate governance and corporate finance in China. On 18 December 2020, the United States passed the Holding Foreign Companies Accountable Act.
ABC Co. used to sell organic shampoo for $15, but the stockholders of ABC lobbied for an increase in the selling price of the shampoo from $15 to $18. This was to increase earnings and, ultimately, their own personal wealth through an uptick in stock price. However, as a result of this unnecessary rise in the price of the shampoo, customers were disappointed, and a majority of them wound up boycotting the product. Additionally, some of the consumers who continued to purchase the product noticed a decline in the overall quality of the shampoo and were also very disappointed. In this scenario, agency problems surfaced between stockholders and loyal customers of the company.
Stockholders vs. Other Stakeholders
Therefore, we feel that Western criticisms of state-owned firms, especially when it comes to China, may be misplaced. Throughout the 1990s and early part of the 2000s, controlling shareholders of listed-firms would simply take money from the firm. They claimed that these were “intercorporate loans,” but these loans were interest-free and almost never paid back. On the balance sheets, they were booked as “other receivables.” This outright theft from minority shareholders was not a trivial amount.
If the fund manager were to invest in volatile stocks and yield a return less than expected from the investor, a negative relationship begins to form. It can be avoided by compensating each group so that the incentive or compensation keeps them motivated to work for a more significant interest. The striking insight of Alchian and Demsetz (1972) and Jensen and Meckling (1976b) is in viewing the firm as a set of contracts among factors of production. He was sentenced to serve a 150-year prison sentence and died behind bars at the age of 82 in April 2021. Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more.
An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way. 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. Principal-agent relationships can be regulated, and often are, by contracts, or laws in the case of fiduciary settings.