The Agency Problem: Two Infamous Examples

The business world is full of conflicts of interest. These normally take place when people or entities serve their personal interests rather than keeping up with their professional responsibilities. Put simply, a conflict of interest arises when someone puts their own personal gain ahead of their own duties to the corporation. One type of conflict is the agency problem, which involves both a company’s agents and its principals. Read on to find out more about the basics of the agency problem and two of the most famous scandals of this kind.

Key Takeaways

• The agency problem is a conflict of interest that occurs when agents don’t fully represent the best interests of principals.
• Enron’s demise was caused by management hiding losses from shareholders and the general public through accounting tricks.
• Bernie Madoff’s scam is one of the most famous examples of a Ponzi scheme, which takes advantage of consumer suspicions and fears about the banking industry.

What Is the Agency Problem?

The agency problem is a conflict of interest that occurs when agents don’t fully represent the best interests of principals. Principals hire agents to represent their interests and act on their behalf. Agents are frequently hired to allow businesses to obtain new skill sets that the principals lack or to accomplish work for the firm’s investors. In the business world, this relationship is represented by a company’s management team and the corporation’s shareholders. In other cases, the agent is the head of an investment firm while investors are the principals.

Important

Agency problems are common in fiduciary relationships including those between trustees and beneficiaries, and board members and shareholders.

Investors benefit from a corporation’s success and expect executive employees to pursue the best interest of shareholders. The company’s leaders do not necessarily have the same interests as shareholders. Although they may be driven by the company’s success, the motivation is usually different—namely their income. The more successful the company, the more they’re likely to earn.

These agents or employees, from rank-and-file workers up to corporate executives, may all potentially misrepresent the firm and act in ways described by the principal-agent problem, which can be seen in day-to-day situations in the financial sector as well as other industries including the legal world.

The Enron Scandal

One particularly famous example of the agency problem is that of Enron. Enron’s directors had a legal obligation to protect and promote investor interests but had few other incentives to do so. But many analysts believe the company’s board of directors failed to carry out its regulatory role in the company and rejected its oversight responsibilities, causing the company to venture into illegal activity. The company went under 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 began losing money in 1997. The company also started racking up a lot of debt. Fearing a drop in share prices, Enron’s management team hid the losses by misrepresenting them through tricky accounting—namely special purpose vehicles (SPVs), or special purposes entities (SPEs)—resulting in confusing financial statements.

The problems started to unfold in 2001. There were questions about whether the company was overvalued, leading to a drop in share prices from over $90 to under $1. The company ended up filing for bankruptcy in December 2001. Criminal charges were brought up against several key Enron players including former chief executive officer (CEO) Kenneth Lay, chief financial officer (CFO) Andrew Fastow, and Jeffrey Skilling, who was named CEO in February 2001 but resigned six months later.

Bernie Madoff

Ponzi schemes represent many of the better-known examples of the agency problem. Agency theory claims that a lack of oversight and incentive alignment greatly contribute to these problems. Many investors fall into Ponzi schemes thinking that taking fund management outside a traditional banking institution reduces fees and saves money.

Some Ponzi schemes simply take advantage of consumer suspicions and fears about the banking industry even though established financial institutions reduce risk by providing oversight and enforcing legal practices. These investments create an environment where the consumer cannot properly ensure that the agent is acting in the principal’s best interest. Many examples of the agency problem occur away from the watchful eye of regulators and are often perpetrated against investors in situations wherein oversight is limited or completely nonexistent.

Bernie Madoff’s scam is probably one of the most notable examples of a Ponzi scheme. Madoff created an elaborate sham business that ultimately cost investors nearly $65 billion in 2009. But It isn’t easy to determine when Madoff began to defraud his investors. The returns he promised his investors were higher than what most investment firms and banks were offering at the time. They were so promising that almost all of his investors looked the other way. Madoff put their money into a bank account and funded redemption requests with newly invested money.

His scheme unraveled when he could no longer pay his investors and confessed. Ultimately, Madoff was criminally charged and convicted for his actions. He was sentenced to serve a 150-year prison sentence and died behind bars at the age of 82 in April 2021.

Read the original article on Investopedia.