Agency Relationship problems

Topics: Stock, Management, Principal-agent problem Pages: 452 (2657 words) Published: May 28, 2014
There are instances reported in the newspaper where the CEOs are sent to jail due to serious lapse in Agency-relationship problem. You are one of the board members of a public listed company. Discuss how, you would implement the necessary safeguards to prevent such instances happening in your company.

1.0 Suggestions to resolve Agency relationship problems.
An agency relationship arises whenever individuals, known as principals, hire individuals, known as agents, to perform services and delegate decision-making authority to the agents. The primary agency relationships in business are generally: (1) between stockholders and managers and (2) between debt holders and stockholders. When agency occurs it also tends to give rise to agency costs, which are expenses incurred in order to sustain an effective agency relationship (e.g. offering management performance bonuses to encourage managers to act in the shareholders' interests). Accordingly, agency theory has emerged as a dominant model in the financial economics literature, and is widely discussed in business ethics texts. (

Agency theory raises a fundamental problem in organizations—self-interested behavior. A corporation's managers may have personal goals that compete with the owner's goal of maximization of shareholder wealth. Since the shareholders authorize managers to administer the firm's assets, a potential conflict of interest exists between the two groups. (Ref : Human Resource Management (Gaining a Competitive Advantage). 3rd Edition. By Noe, Hollenbeck, Gerhart, and Wright. Page 423 to 424) 1.1.2 SELF-INTERESTED BEHAVIOR

Suggests that, in imperfect labor and capital markets, managers will seek to maximize their own utility at the expense of corporate shareholders. Agents have the ability to operate in their own self-interest rather than in the best interests of the firm because of asymmetric information (e.g., managers know better than shareholders whether they are capable of meeting the shareholders' objectives) and uncertainty (e.g., myriad factors contribute to final outcomes, and it may not be evident whether the agent directly caused a given outcome, positive or negative). Is there any evidence for self-guilt of interested managerial behavior includes the consumption of some corporate resources in the form of perquisites and the avoidance of optimal risk positions, whereby risk-averse managers bypass profitable opportunities in which the firm's shareholders would prefer they invest. Outside investors recognize that the firm will make decisions contrary to their best interests. (Ref: Financial Management, Principles and Applications. 9th Edition. By Keown, Martin, Petty, and Scott Jr. Page 15)

Jensen and Meckling (1976) define the agency relationship as a contract under which one party (the principal) engages another party (the agent) to perform some service on their behalf. The agency problem emanates from the arrangement where the interests of the agent differ substantially from those of the principal because of the impossibility of perfectly contracting for every possible action of an agent whose decisions affect both his own welfare and the welfare of the principal (Brennan, 1994). Emanating from this problem is how to induce the agent to act in the best interests of the principal. MECHANISMS FOR DEALING WITH

There are two polar positions for dealing with shareholder-manager agency conflicts. At one extreme, the firm's managers are compensated entirely on the basis of stock price changes. In this case, agency costs will be low because managers have great incentives to maximize shareholder wealth. It would be extremely difficult, however, to hire talented managers under these contractual terms because the firm's earnings...
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