Principal Agent Problem
The principals, or owners of the firm hire agents, or managers, to run the firm in the best interests of the principals. But ethical lapses, self-interest, or the owners’ lack of trust in the managers can lead to conflicts of interest and suspicions between the two parties. This problem in corporate governance is called the principal-agent problem. The shareholders of a firm elect a board of directors. In theory, the board’s role is to oversee managers and ensure that they are working in the best interests of the shareholders. In practice, however, the board often has a closer relationship with management than with the shareholders. For example, it is not unusual for the firm’s top executives to sit on the firm’s board of directors, and the firm’s top executives often nominate candidates for board seats. These relationships can obscure loyalties and make the board a toothless watchdog for shareholders’ interest. Managers, acting as agents, may pursue their own self-interest by increasing their salaries, the size of their staffs, or their perquisites (better known as ‘‘perks’’), which might include club memberships and the use of company planes or luxurious company cars. Management, in conjunction with the Board, may seek to fend off takeovers that would allow shareholders to sell their shares at a price above the current market price, or they may try to preempt such merger or acquisition attempts by seeking changes in the corporate charter that would make such takeovers difficult to pursue. Other examples of principal-agent relationships that one may relate to: voters (principals) elect officeholders (agents) to work in the best interest of the public; but political action committee (PAC) contributions to political campaigns may affect politician’s actions if elected. Investors (principals) trust the advice of stockbrokers (agents) when investing their savings; but many stockbrokers earn their paycheck by generating commissions on trading. Accountants and lawyers (agents) often bill their clients (principals) by the number of hours they work, irrespective of whether the client’s tax bill was minimized or the court case was won.