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Question

Principal-Agent Problems and Potential Mitigation Mechanisms

 

Subject Business Pages 7 Style APA

Answer

Introduction

The increased prevalence of non-transparent systems of business ownership and corporate governance issues have made the business environment volatile and susceptible to corporate scandals. This trend is manifested by the collapse of organizations deemed ‘too big to fail’ such as WorldCom, Enron, Tyco and Parmalat (Dibra 2016). All these companies disregarded good corporate governance practices thus allowing corrupt dealings which led to their downfall. According to Monks and Minow (2011) a common trend exhibited by the failed organizations is that they paid less attention in addressing the agency problem between shareholders (principals) and the management (agent). The agency problem, also known as the agency-principal problem is explained under the agency theory. Panda and Leepsa (2017) note that the agency theory explains the complex between business agents and principals. This theory points at the inevitability of the agency problem, since both parties have vested interests. The paper purposes to discuss the principal-agent problems and evaluate various mitigation mechanisms to overcome those problems.

Principal-Agent Problems

As defined by Price et al. (2018) corporate governance denotes processes, and structures of rules and practices used to control, manage and direct an organization. It entails balancing needs and interests of all the stakeholders. Corporate governance is intended to provide a framework through which organizations can achieve their objectives (Monks & Minow 2011). It is enforced by boards of directors whose roles are determined by national regulatory frameworks (Clarke & Chanlat, 2009). USA and UK have strong regulations, but there are exceptional instances where powerful executives interfere with the board’s autonomy. On the contrary, Asian firms have opaque disclosure regimes which make it hard for the board of directors to access required information.  Failure to regulate the agent-principal relationship could cause financial crisis as it was the case with the 2008 Global Economic Crisis (Friedland 2016). Secondly, it could facilitate collapse of the firm as seen with WorldCom, Tyco, Parmalat and Enron (Dibra 2016).

As summarized in figure 1 below, an intersection between the agency theory, prospect theory, trust theory and lemon market theory points at three principal-agent problems. Devos et al. (2012) explains that the agency theory highlights issues of opportunistic behavior and self-interest existent between agents and principals. The prospect theory evaluates the behavior of players in a relationship involving uncertainty and risks. The agents are likely to engage in high risk decisions in uncertain conditions, with the hope of optimizing profits. The trust theory emphasizes the need for commitment from agents and principals for their relationship to be mutually beneficial. The lemon market theory notes that the quality of services and goods traded in a given market can degrade when there is asymmetry in information between seller and buyer (Rutherford 2018). The interactions among different elements mentioned in these theories highlight agency problems such as moral hazard (opportunistic behavior), information asymmetry and adverse selection.

Figure 1: The link of the Agency Theory, Prospect Theory, Trust Theory and Lemon Market Theory (Devos et al. 2012)

According to Devos, et al. (2012) moral hazard arises when agents take irresponsible risks because they are exempted from financial liabilities. Through a contractual agreement, the principal delegates managerial duties to an agent. The agreement allows the agent to access and control all information and resources within the firm. This privilege advantages the agent over the principal who is oblivious of the motive for the decisions by the agent. As much as the principal expects the agent’s decisions to maximize their returns, the agent could instead, act in their self-interest thus creating agency costs (Chen & Jia 2015). An example of moral hazard is the Great Recession where ‘too big to fail’ American companies engaged in risky lending behavior leading to oversupply of cash which in return triggered a recession (Friedland 2016). To salvage the economy from collapse, the federal government was forced to bail out JP Morgan Chase and AIG (Sorkin, 2008). This example affirms that the agents could easily take aggressive risks because they are not liable for the outcome. Assuming that the risks paid off, the executives would built their reputation as good agents. However, the failure resulted into massive losses for the shareholders of JP Morgan Chase as stock prices dropped by more than 10% (Sorkin, 2008). This example affirms how careless the executives can be when making decisions on behalf of the shareholders.

                The second principal-agent problem is adverse selection. Devos et al. (2012) note that the adverse selection problem arises when the principal has limited ability to measure and predetermine competencies of an agent at the time of hiring. The inability to hire the right agent could result from lack of vetting skills. Secondly, the principals cannot foretell the agent’s intentions while hiring because personality tests and other evaluation conducted during hiring are not adequate in foreseeing opportunistic behavior (Ulbricht 2016). Thirdly, human nature is unpredictable in the sense that people easily divert from contractual agreements if they perceive a given deal might make them better off. Because of these shortcomings, the principal could end up selecting agents who are not perfectly suited for the job. The ensuing challenges in managing a business could potentially cause misconduct and massive losses for the principals. An example is the failure of Tyco International where the principal vetted and appointed a greedy agent – CEO Dennis Kozlowski (Freifeld 2013). However, after the company collapsed, the ex-CEO confessed to being driven by pure greed.

                The third agency problem is information asymmetry. It denotes the study of decisions where one party has more information compared to the other (Panda & Leepsa 2017). The lack of information causes imperfect knowledge for the principal. Normally, it is expected that the agent informs the principal of their decisions and intentions through official channels. However, the principal only learns about the agent’s decisions during annual general meetings. The limited communication between the two parties causes information asymmetry which seconds the lemon market theory. This theory hypothesizes that the quality of goods or business assets degrades when there is information asymmetry between the buyer and the seller. An example is the 2001 case of Enron, an energy giant that went bankrupt because of poor accounting practices and poor leadership (Dibra 2016). The principal was given wrong information about the financial position of the firm while in reality the firm was underperforming. The principal later learnt that the business they thought was performing well was bankrupt. This was after the company lost $75 billion in stock value (Dibra 2016). Assuming that the principal had current information about the financial position of Enron, steps could have been instigated to protect the company from going bankrupt.

Apart from the listed principal-agent problems, some theorists argue that conflict of interest is a leading cause of dissatisfaction between principals and agents. Conflict of interest is a situation where agents pursue multiple goals thereby prioritizing some interests over others (Devos et al. 2012). Naturally, the principal appoints an agent to help optimize wealth, however, they cannot always ascertain that the agent will act in their best interests. Contrary to the principal’s expectations for sustainable growth, the agent might pursue rapid unregulated growth. In the process, they predispose the organization to bigger financial risks. A case in point is Carillion which collapsed because of aggressive growth. The agent pursued rapid growth which sharply contrasts the interests of the shareholders. According to Sadan (2018), the shareholders were initially satisfied with the sustainable growth of the firm. However, the agents pursued rapid growth to boost their reputation and embezzle funds. By January, 2018 Carillion had gone bankrupt with liabilities totaling £7 billion (Sadan 2018). As much as the aggressive growth promised higher returns, official reports hinted that shareholders were opposed to reckless borrowing to finance growth.

Mechanisms to Mitigate the Principal-Agent Problems

The first mechanism is introduction of an effective incentive structure. Chen, Chiang and Li (2018) propose the use of the tournament theory where incentives are designed in a hierarchical manner whereby advancing to the next tournament promises better returns. Adopting the tournament theory means that the agents will be motivated to progress to the next level of performance, so as to gain higher returns. This mitigation approach works by setting goal posts and encouraging the agent to deliver given targets. After achieving one target, the agent is rewarded with a higher incentive and is again given another target with higher returns. By doing this, the agent pursues targets set by the principal thus both parties’ benefit. The agent benefits from higher incentives such as bonus pay, while the principal benefits from the high profitability (Schneider & Scherer 2015). This strategy has consistently been used at Toshiba to encourage the managers and employees to register exemplary performance (Japan Times 2020). This strategy is most effective when complemented by internal control systems such as internal audits to monitor accounts for malicious practices.

The second mechanism is redesigning contractual agreement. Pepper (2019) proposes a contract design that fulfils three principles. First, the contract should grant the principal access to all necessary information to prevent information asymmetry. Second, the contract design should encourage incremental sharing of returns where the agents are rewarded for additional efforts. For instance, the executives can be subjected to performance related executive-pay through offers for stock options, however this can result in short termism. This trend has been on the rise in the UK and USA where the executive salary and bonuses are boosted by equity-based pay. As evident in table 1 below, the CEO’s pay is not only determined by the salaries and bonuses but also by additional incentives such as equity pay as a reward for their additional efforts. Third, redesigning contractual agreement should adhere to the rules of structuring an effective board. This rule is varied across US, UK and Asian countries (Pepper 2019). For instance, the US and UK demand that boards of directors are composed of executive, non-executive and independent directors. In Germany, it is mandatory that the board has representatives for the shareholder and employees, while in Asia, there are no independent shareholders. Instead, the executive directors perform the oversight functions. The contractual agreements have to adhere to these regulations depending on the country.

Table 1: Composition of Median CEO Pay (1980-2008)

 

                The third approach to resolving the principal-agent conflict is through external governance where the government enacts regulations to safeguard the principals. According to Clarke and Chanlat (2009) Europe has made many reforms on their corporate governance structures and processes. For instance, the European governance mechanism has improved after the Vienot report, Draghi reforms, the Olivencia report, UK Cadbury report, The Aldama report, Swiss Code of Best Practices, as well as additional input from the OECD dictating better approaches to corporate governance (Clarke & Chanlat 2009).  Similarly, the UK has adopted regulations such as anti-trust law aimed at fostering corporate control especially during mergers and takeovers as some agents could use the loopholes created through the mergers to engage in corporate fraud, which disadvantage the principal. A case in point is the Olympus fiasco where the agents of the firm paid more than $687 million as advisory fees for acquiring a UK firm valued at $2 billion (Woodford 2012). In addition to safeguarding the interests of the principals, external governance ensures that the government enforces laws that protect all the stakeholders against unrealistic self-interests promoted by the agents.

Conclusion

This essay acknowledges the principal-agent problem as the central issue affecting corporate governance globally. It therefore presents a critical discussion of four agency problems. The first problem is moral hazard where the agent takes aggressive risks because they do not have a financial liability to incur in the event of extreme losses. The second problem is adverse selection where the principal has limited knowledge and ability to hire the most competent agents. Third, information asymmetry where lack of access to important information could disadvantage the principals making them incapable of ascertaining the motive behind certain decisions made by the agents. Fourth, conflict of interest problem could cause mistrust as the agent is likely to pursue different goals from those intended by the principals. The second part of the essay proposes three mechanisms for resolving the agency problems. The three solutions are; introducing incentives to encourage the agents to act in the principals’ best interest. The second mechanism requires the principal to adjust the contract clause to encourage the agents to share information, encouraging incremental pay where executives are entitled to equity-based pay. The third mechanism is external governance where the government enacts regulations to safeguard the principals.

 

 

References

Chen, D., Chiang, S.H. and Li, Y., 2018. Optimal Executive Compensation Dispersion and Product Market Structure. American Journal of Industrial and Business Management, vol. 8, no. 9, pp. 2052.

Chen, W.Q. and Jia, S.H., 2015. Equity Incentive, Agency Costs and Corporate Performance—Based on the Analysis Framework of Double Principal-Agent Problem. Modern Economic Science, 37, pp. 106-113.

Clarke, T. and Chanlat, J.F. 2009. European corporate governance: readings and perspectives. London: Routledge.

Devos, J., Van Landeghem, H. and Deschoolmeester, D., 2012. The theory of the lemon markets in IS research. In Information systems theory (pp. 213-229). New York: Springer. Accessed on: 2 April 2020. Available at: https://www.researchgate.net/publication/226469192_The_Theory_of_the_Lemon_Markets_in_IS_Research

Dibra, R., 2016. Corporate governance failure: The case of Enron and Parmalat. European Scientific Journal, vol. 12, no. 6, pp. 3-33.

Freifeld, K., 2013. Ex-Tyco CEO Kozlowski says he stole out of pure greed, Accessed 2 April 2020. Available at: https://www.reuters.com/article/us-tyco-kozlowski-release/ex-tyco-ceo-kozlowski-says-he-stole-out-of-pure-greed-idUSBRE9B417820131205

Friedland, J., 2016. Directors at too big to fail institutions should be liable. International Journal of Disclosure and Governance, vol. 13, no. 3, pp. 195-203.

Japan Times., 2020. In fresh scandal for Toshiba, subsidiary found to have booked ¥43.5 billion in fictitious sales, Accessed 2 April 2020. Available at: https://www.japantimes.co.jp/news/2020/02/15/business/corporate-business/toshibas-latest-scandal-subsidiary-found-booked-%C2%A543-5-billion-fictitious-sales/

Monks, R.A. and N. Minow., 2011. Corporate Governance. Malden, Mass: Blackwell Publishing.

Panda, B. and Leepsa, N.M., 2017. Agency theory: Review of theory and evidence on problems and perspectives. Indian Journal of Corporate Governance, vol. 10, no. 1, pp. 74-95.

Pepper, A., 2019. Agency Costs, Coordination Problems, and the Remuneration Committee’s Dilemma. In Agency Theory and Executive Pay (pp. 1-14). New York: Palgrave Pivot.

Price, M., Harvey, C., Maclean, M. and Campbell, D., 2018. From Cadbury to Kay: discourse, intertextuality and the evolution of UK corporate governance. Accounting, Auditing & Accountability Journal, vol. 31, no. 5, pp. 1542-1562.

Rutherford, M. (2018). Market Deficiencies: From Veblen to Akerlof and Shiller. Journal of Economic Issues, vol. 52, no. 4, pp. 891-903.

Sadan, S., 2018. Carillion’s collapse exposes deep corporate governance failings, Accessed 2 April 2020. Available at: https://www.ft.com/content/1958fb80-0fe6-11e8-940e-08320fc2a277

Schneider, A. and Scherer, A.G., 2015. Corporate governance in a risk society. Journal of Business Ethics, vol. 126, no. 2, pp. 309-323.

Sorkin, R., 2008. JPMorgan’s $12 Billion Bailout, Accessed 2 April 2020. Available at: https://dealbook.nytimes.com/2008/03/18/jpmorgans-12-billion-bailout/

Ulbricht, R., 2016. Optimal delegated search with adverse selection and moral hazard. Theoretical Economics, vol. 11, no. 1, pp. 253-278.

Woodford, M., 2012. Exposure: From president to whistleblower at Olympus. London: Penguin UK.

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