principal

In simple legal terms

An agent is someone who acts on behalf of another person known as the principle. As a result, the agent meddles in the principal’s name, and whatever the agent expresses is interpreted as the principal’s stance. In corporate law, for example, the corporation is the sole principal, and the stakeholders, such as management and employees, who are expected to act in its best interests, are the agents (Armour, 2009). The corporate law establishes the insider-outsider relationships that build a firm, and the agent always has more information than the principal. Therefore, as much as it is desirable to eliminate the agency problem, the law only provides for a chance to reduce its likely occurrence and the possible adverse effects it may bring to the company.

A good example

is where the manager who is the companies agent expected to act in the best interest of the business, yet he is also desirous of improving his wealth status. As such, a conflict of interest always exists where an agency relationship is created (Jerzemowska, 2006). As already indicated the agent is always better placed compared to the principal on the ability to alter the contractual obligations on paper since he or she has better information compared to the principal (Armour, 2009). Also, the agency problems become more complicated where there is varied interest, and the company is big to warrant such numerous and divergent relations (Armour, 2009). Therefore, it was difficult to eliminate the agency problem, but the managers can be motivated to act in the best interest of the shareholders (Jerzemowska, 2006). The agency relationship is justified due to several factors such as skills and knowledge, restriction to access of the business and holding different positions within or without the enterprise. Thus, an agent who can bridge the issues mentioned above offers to help.

In most cases

the agency problem is caused by low compensation/incentive to acting in good faith (Jerzemowska, 2006). In other cases, it is caused by greed. An example of the agency problem was witnessed in 2001 when Enron executives falsified trading accounts to show that the company was doing well when indeed it was becoming insolvent. The effect was that the management floated part of their stocks in exchange for financial gain. In the meantime, the company’s share prices witnessed an upward trend until the theft was discovered. In the case of Enron, the management (who are the agents), acted maliciously and with greed at the expense of the shareholder’s interests. In a more personal example, is the caretaker of my rented apartment hired a plumber to fix some fixtures in the estate and offered to pay him 20 percent less pay than the market offers. In retrospect, the plumber overcharged the quotation of components and the labor hours. In such a case, the agent acted in bad faith by paying less than necessary to attract the fraudulent acts of the plumber so as to maintain his pecuniary benefit. In such a case, the principal, who is the owner of the estate had to suffer loss due to the acts of commission of the agent.

Jerzemowska (2006) suggests multiple solutions to the agency problem

noting each and every possible conflict of interest between the managers and the shareholders, and between managers and creditors. For instance, Jerzemowska (2006) suggests reducing the free cash flow under the directors’ care and also compensation in the form of shares (p.11-2). In such a case, the management is restricted and also made to be part of the company and hence increase their sense of stewardship. Therefore, the agency problem has no final solution, but rather precise mechanisms put in place can help reduce its adverse effects on the company’s balance sheet.

References

Armour, J. (2009). Agency problems, legal strategies and enforcement (Doctoral dissertation, Harvard Law School).

Jerzemowska, M. (2006). The main agency problems and their consequences. Acta Oeconomica Pragensia, 2006(3), 9-17.