Do you ever feel like people are constantly trying to rip you off? From aggressive salespeople to bombardments of marketing tactics, it’s hard sometimes to feel like whoever is offering you a good or service is genuinely concerned for your well being.
At the end of the day, everyone is trying to make a living and to put food on the table, and in order to do so, this involves the constant transaction of goods and services between people. I buy a product from Company A that is supposed to better my life. After I buy it, it turns out that the product doesn’t work. As a result, I either return the item or simply never buy from Company A again. I will find an alternative product from a different company that does better my life. Obviously, my example is quite simplified, but this is the essence of a competitive economy where society will find and flock towards the product alternative that best suits their purpose and betters their life so to speak.
Even in this example of a somewhat perfectly competitive environment, there still runs the risk that the provider of a good or service may not perform up to standard or in the best interests of the customer they are meant to represent. This could happen intentionally, or unintentionally, and materialize slowly over time or simply begin at the onset of the customer – provider interaction. In a more sophisticated sense, the successful transfer of ownership from one party to another relies on the continued mutual working relationship between both parties in order to produce benefits for one another. However, this isn’t always the case, and in a non utopian world, priorities between both parties often conflict.
The principal agent problem is defined as a conflict in priorities between an asset owner (principal) and the person who controls the asset (agent) or to whom asset control has been delegated to. This problem can occur in any situation in which the ownership of an asset, or a principal, delegates direct control over that asset to another party, or agent.
A common example is a group of executives at a publicly traded company making company decisions that will ultimately impact the shareholders of the company. The shareholders in this case (the public) have delegated control of the company to the executives to make decisions on how best to run the company. For publicly traded companies, the existence of an elected board of directors is meant to mitigate the likelihood of a principal agent problem. The board, elected by shareholders, acts on behalf of the shareholders for important company decisions being put forward by the company executives. The board is meant to more or less keep the executives “in check” and ensure that company decisions aren’t being made solely for the benefit of the executives themselves. Board members, including the chairperson, are typically selected as independent members from the company to eliminate the chance of a conflict of interest. However, it is not unusual to see company executives also serving on the board of directors for the same company, and it is not unusual to see the CEO also acting as the chairman of the board. Many argue (including me) that this negates the conflict-of-interest barrier that an independent board is supposed to provide, and in fact opens the door to the principal agent problem amongst executives and shareholders.
Other examples of parties where principal agent problems may occur between include:
Shareholders and company executives/CEO
Lawyer and client
Homeowner and city council
Home buyer and realtor
Privatized city ordinances/public providers and tax payers
As you can see, the principal agent problem usually comes in the form of one party putting personal financial gain ahead of their professional duty owed to the party they represent. Both the agent and principal may implement strategies to mitigate the risks of a principal agent problem. These risks are referred to as agency costs. Any risk mitigation will involve cost, either in the form of time, resources, and/or money. For example, executive compensation may be tied to a company metric such as the annual earnings per share growth, or connected to share buybacks, in which both the agent (executives) and principle (shareholders) would benefit or suffer together depending on the metric performance. A realtor’s commission may be dependent on the successful completion of a real estate transaction for their client as opposed to a flat hourly rate applied independently of a successful transaction. A newly introduced government program may encourage the public to participate by providing tax break incentives. And so on and so forth.
Ultimately, mitigating the risk of, or resolving, a principal-agent problem will require either:
A change in the system of rewards or incentive structure in order to align agent and principal priorities,
An improvement in the flow of information between the agent and principal, or
Both.
From an investor’s standpoint, the decision to invest in a particular company should depend on whether the board of directors is truly an independent party from the senior executive level. This structure of board independence is not only a cheap and effective agency cost mitigation strategy, but it should give investors confidence that executive decisions are being made to optimize the company’s long-term resiliency to unknown yet inevitable macroeconomic headwinds, as well as to optimize owners’ return in exchange for providing their capital over the same time period.