The agency problem: two infamous examples
The business world is full of conflicts of interest. These usually take place when people or entities serve their personal interests rather than fulfilling their professional responsibilities. Simply put, a conflict of interest arises when someone puts their personal gain ahead of their own duties to society. One type of conflict is the agency problem, which involves both a company’s agents and its managers. Read on to learn more about the basics of the agency problem and two of the most notorious scandals of its kind.
Key points to remember
- The agency’s problem is a conflict of interest that arises when agents do not fully represent the best interests of constituents.
- Enron’s demise was caused by management hiding losses from shareholders and the general public through accounting tricks.
- The Bernie Madoff scam is one of the most famous examples of a Ponzi scheme, which takes advantage of consumers’ suspicions and fears of the banking industry.
What is the agency’s problem?
The agency’s problem is a conflict of interest that arises when agents do not fully represent the best interests of constituents. Managers hire agents to represent their interests and act on their behalf. Agents are frequently hired to enable companies to learn new skill sets that executives lack or to do work for the company’s investors. In the business world, this relationship is represented by the management team of a company and the shareholders of the company. In other cases, the agent is the head of an investment firm while the investors are the principals.
Agency issues are common in fiduciary relationships, including those between trustees and beneficiaries, and board members and shareholders.
Investors benefit from the success of a company and expect executive employees to pursue the best interests of shareholders. Company executives do not necessarily have the same interests as shareholders. Although they may be motivated by the success of the business, the motivation is usually different, which is their income. The more successful the business, the more likely it is to win.
These agents or employees, from rank-and-file clerks to corporate executives, can all misrepresent the business and act in the manner described by the principal-agent problem, which can be observed in day-to-day situations in the financial industry. as well as other industries, including the legal world.
The Enron scandal
A particularly famous example of the agency’s problem is that of Enron. Enron directors had a legal obligation to protect and promote the interests of investors, but had little other incentive to do so. But many analysts believe that the company’s board of directors failed to fulfill its regulatory role within the company and rejected its oversight responsibilities, prompting the company to engage in illegal activities. The company went bankrupt following an accounting scandal that resulted in billions of dollars in losses.
Enron was, at one point, one of the largest companies in the United States. Despite being a multi-billion dollar company, Enron started to lose money in 1997. The company also started to accumulate a lot of debt. Fearing a decline in stock prices, Enron’s management team hid the losses by distorting them through tricky accounting – namely Special Purpose Vehicles (SPVs) or Special Purpose Entities (SPEs) – which resulted in confusing financial statements.
The problems began to emerge in 2001. There were questions about whether the company was overvalued, causing the stock price to drop from over $ 90 to under $ 1. The company eventually declared bankruptcy in December 2001. Criminal charges have been laid against several key Enron players, including former CEO Kenneth Lay, Chief Financial Officer (CFO) Andrew Fastow and Jeffrey Skilling, who has been appointed CEO in February 2001 but resigned six months later.
Ponzi schemes represent many of the best-known examples of the agency’s problem. The agency theory claims that a lack of monitoring and alignment of incentives contributes greatly to these problems. Many investors fall for Ponzi schemes thinking that managing funds outside of a traditional banking institution cuts fees and saves money.
Some Ponzi schemes simply capitalize on consumer suspicions and fears about the banking industry, even as established financial institutions reduce risk by providing oversight and enforcing legal practices. These investments create an environment in which the consumer cannot properly guarantee that the agent is acting in the best interest of the principal. Many examples of agency problems arise out of the watchful eye of regulators and are often perpetrated against investors in situations where oversight is limited or non-existent.
The Bernie Madoff scam is probably one of the most notable examples of a Ponzi scheme. Madoff created an elaborate fake business that ultimately cost investors nearly $ 16.5 billion in 2009. But it’s not easy to determine when Madoff first started defrauding his investors. The returns he promised his investors were higher than most investment firms and banks were offering at the time. They were so promising that almost all of its investors looked away. Madoff placed his money in a bank account and funded the redemption requests with newly invested money.
His scheme collapsed when he could no longer pay his investors and confessed. Ultimately, Madoff was criminally charged and convicted for his actions. He was sentenced to 150 years in prison and died behind bars at the age of 82 in April 2021.