6.7 The Principal-agent Problem

Question 1

List the two key areas where separation of ownership could occur.

Answer 1

1. The shareholders of a company (principal) and the management of the company (agent)
2. An investor (principal) and a financial firm, such as an adviser or wealth manager (agent)

Question 2

Give an example of separation of ownership in government.

Answer 2

In government, there is also a separation of this sort between the voters (principals) and the politicians (agents).

Question 3

What is the principal-agent (or agency) problem?

Answer 3

The separation of ownership and control causes a conflict through the division of interests.

• The principal wants to achieve the best overall return from their ownership. This return may be a profitable company, a portfolio that meets specified objectives or a society that allows for a long, happy, productive life.
• The agent wants to achieve the most from the agency. Their return may be the salary they are paid, the commissions they generate or the plaudits they receive from policy decisions.

These interests are not necessarily aligned, and could be in direct conflict with each other: higher salaries for managers reduce the returns available to the shareholders; higher commissions for advisers can lead to unsuitable recommendations for the investor; policy decisions by politicians could simply be vanity projects that do not benefit society.

Question 4

List 2 explicit agency costs.

Answer 4

1. Managers are paid a salary for managing a company. If managers’ remuneration is disproportionate to their contribution, this depletes the company’s profits.
2. Some advisers charge a fee for their advice, giving the investor a clear picture of the cost. Some product providers offer advisers commissions taken from the investor’s contributions. The latter can lead to commission bias, where advisers recommend products that do not meet the investor’s objectives but pay a large commission.

Question 5

List 9 implicit agency costs.

Answer 5

1. The cost of producing company accounts to identify the fundamentals of the company
2. The need to have financial statements audited by an independent body
3. Losses incurred through projects that generate high short-term returns at the expense of long-term stability
4. Perquisites (perks), such as healthcare, company cars, etc., used as incentives for managers are also a drain on the profits of the company
5. Losses incurred through self-dealing, for example, managers appointing an uncompetitive contractor because they own a beneficial interest in that contractor
6. Expropriation of company assets for personal use, such as using company vehicles or labour-force
7. The cost of implementing and enforcing regulations for the financial services
8. The opportunity cost of slow actions of agents
9. The cost of not meeting objectives

Question 6

What do explicit and implicit agency cost do?

Answer 6

They increase the costs and reduce the return owed to the beneficial owners.

Question 7

Which documentation has highlighted major issues caused by the agency problem and suggested ways of reducing them?

Answer 7

The Combined Code and more recently the Stewardship Code

Question 8

What are the recommendations for companies from the Combined Code and more recently the Stewardship Code?

Answer 8

The recommendations range from:

• Assessing the remuneration of the managers in the Combined Code, often linking remuneration to the long-term profits of the company by rewarding managers with shares or options on the shares of the company they manage. This aligns the interests of the managers with those of the shareholders.
• The code suggests that companies appoint executive and non-executive directors that are appropriate to the business.
• The Stewardship Code advocates active participation of all shareholders (shareholder activism), particularly those large institutional shareholders that often passively hold large proportions of a company’s shares.

Question 9

What do many stock exchanges insist on?

Answer 9

Many exchanges, such as the London Stock Exchange, insist that companies trading on their markets comply with the codes or explain non-compliance.

Question 10

Explain what rules are in the place in financial services for agents.

Answer 10

From a financial services perspective, the conduct of business rules govern how the agents should behave. This focuses on the client’s best interests and the need to act honestly, fairly and professionally. More recently, there has been the implementation of the Retail Distribution Review, which prohibited the provision of product provider commission and enforced the need for advisers to subscribe to an established code of conduct, such as the CFA Standards of Professional Practice.

Question 11

How will reducing the agency problem benefit the investment profession and society?

Answer 11

Reducing the agency problem increases the trust in the companies, and the financial firms that give people access to those companies. This trust makes the people more willing to invest, allowing those companies access to more capital at a cheaper cost, thus increasing returns. Where there is an alignment of interests between the principal and agent, the cheaper capital can be used more efficiently and effectively, increasing returns further. If shareholders become more actively involved in the decision-making of the company at general meetings, the beneficial owners become more involved in the controlling of the company. This reduces the need for external controls and the cost incurred through their implementation.