the agency problem

principal – agent

The principal – agent relationship arises when one person, the principal, hires someone else, the agent, to act on his behalf in some matter.

agency problem

The agency problem is that the agent may have a different set of economic interests from the principal and may act on them rather than do the best thing for the client.

examples

Studies seem to show that real estate agents behave differently when they sell their own houses than when they sell for a client.  Working for themselves, they take more time and achieve higher prices.  This is also the issue in the current discussion about whether brokerage financial advisors should be fiduciaries, that is, whether they should have a legal obligation to recommend the best investments for their clients.  At present, they aren’t   …and don’t.

for us as investors

If we hold shares of the common stock of individual companies, we are in some sense owners of the company.  (Note:  we can also hold shares of stock  in individual companies indirectly by buying shares of ETFs or mutual funds.  We can hold the shares in, say, a 401k account sponsored by our employer, too.  These create further layers of principal – agent relations.  In this post, I’m going to ignore them.)

The chief power we have as shareholder-owners of a company is that we vote to elect a board of directors to act as our agents.  The board, in turn, selects a management team (another set of agents) to run the operations of the company in our behalf.

an aside:  stakeholders

Management hires employees, makes ties with suppliers and customers and may borrow money from a bank.  The group comprised of this wider net of interested parties plus us as principals and the two sets of our agents is usually referred to as stakeholders.

potential stockholder – agent conflicts of interest

the board

Where do board members come from?  The slate we vote for is typically put together by the management of the company.  The list will consist of some members of top management, plus “outside” directors.  This latter group may include retired managers from other companies in the industry, or executives from suppliers or customers.  But it may also contain prominent political, military or academic figures, who have little knowledge of business generally–and still less of the particulars of the company on whose board they sit.

As agents, the board has its own set of interests and priorities.  More important, though, it can easily have a much closer attachment to the management that nominated them than the anonymous group of shareholders who voted for them and are technically their bosses.   And, of course, management may seek rubber stamps instead of gadflies.

If individual shareholders had a problem with the composition of the board, how would they take effective action?

management

Let’s say a CEO has spent 25 years rising to the top spot in a corporation, where he has, say, five years to collect high salaries and bonuses and cash in on stock option awards.

Suppose our CEO sees a severe structural problem with the business, which can be papered over for a while but which will begin to erode market share and profit margins within, say, six years.  The problem can be fixed, but only by a restructuring that will crush profits (and maybe the stock price) for at least the next two years but which will pay huge dividends toward the end of the decade.

What does he do?    …restructure and risk turning his $60 million five-year day in the sun into $25 million, or simply paper over and collect the higher sum?

 

Tomorrow:  the latest twist.

 

 

 

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