what is an agency problem 
an agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another s best interests in corporate finance an agency problem usually refers to a conflict of interest between a company s management and the company s stockholders the manager acting as the agent for the shareholders or principals is supposed to make decisions that will maximize shareholder wealth even though it is in the manager s best interest to maximize their own wealth investopedia lara antalunderstanding agency problemsthe agency problem does not exist without a relationship between a principal and an agent in this situation the agent performs a task on behalf of the principal agents are commonly engaged by principals due to different skill levels different employment positions or restrictions on time and access for example a principal will hire a plumber the agent to fix plumbing issues although the plumber s best interest is to collect as much income as possible they are given the responsibility to perform in whatever situation results in the most benefit to the principal the agency problem arises due to an issue with incentives and the presence of discretion in task completion 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 for example in the plumbing example the plumber may make three times as much money by recommending a service the agent does not need an incentive three times the pay is present causing the agency problem to arise agency problems are common in fiduciary relationships such as between trustees and beneficiaries board members and shareholders and lawyers and clients a fiduciary is an agent that acts in the principal s or client s best interest these relationships can be stringent in a legal sense as is the case in the relationship between lawyers and their clients due to the u s supreme court s assertion that an attorney must act in complete fairness loyalty and fidelity to their clients 1minimizing risks associated with the agency problemagency costs are a type of internal cost that a principal may incur as a result of the agency problem they include the costs of any inefficiencies that may arise from employing an agent to take on a task along with the costs associated with managing the principal agent relationship and resolving differing priorities while it is not possible to eliminate the agency problem principals can take steps to minimize the risk of agency costs principal agent relationships can be regulated and often are by contracts or laws in the case of fiduciary settings the fiduciary rule is an example of an attempt to regulate the arising agency problem in the relationship between financial advisors and their clients the term fiduciary in the investment advisory world means that financial and retirement advisors are to act in the best interests of their clients 2 in other words advisors are to put their clients interests above their own the goal is to protect investors from advisors who are concealing potential conflicts of interest for example an advisor might have several investment funds that are available to offer a client but instead only offers the ones that pay the advisor a commission for the sale the conflict of interest is an agency problem whereby the financial incentive offered by the investment fund prevents the advisor from working on behalf of the client s best interest 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 principals who are shareholders can also tie ceo compensation directly to stock price performance 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 however if the ceo was compensated based on stock price performance the ceo would be incentivized to complete the takeover stock prices of the target companies typically rise as a result of an acquisition through proper incentives both the shareholders and the ceo s interests would be aligned and benefit from the rise in stock price principals can also alter the structure of an agent s compensation if for example an agent is paid not on an hourly basis but by the completion of a project there is less incentive to not act in the principal s best interest in addition performance feedback and independent evaluations hold the agent accountable for their decisions real world example of an agency problemin 2001 energy giant enron filed for bankruptcy 3 accounting reports had been fabricated to make the company appear to have more money than what was actually earned the company s executives used fraudulent accounting methods to hide debt in enron s subsidiaries and overstate revenue these falsifications allowed the company s stock price to increase during a time when executives were selling portions of their stock holdings 4in the four years leading up to enron s bankruptcy filing shareholders lost an estimated 74 billion in value 5 enron became the largest u s bankruptcy at that time with its 63 billion in assets 6 although enron s management had the responsibility to care for the shareholder s best interests the agency problem resulted in management acting in their own best interest 