What is Agency Theory?

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What is agency theory

What is Agency Theory?

Agency is the relationship where one person appoints another person, delegates him some authority to carry out the tasks on behalf of him. The appointed person is “agent” and the person who appoints is “Principal.” In the context of corporate governance, Directors are agents of shareholders.

Duties of a Good Agent;

  • To remain accountable to the principal of all the actions and work performed on principal’s behalf.
  • Fiduciary duty, which means ‘duty of trust/utmost faith’ and maintains high degree of trust as perceived by the principal and avoiding any conflict of interest.
  • To act on the instructions by the principal by obeying them provided that instructions are lawful and should refuse to actions which are illegal.
  • An agent is paid by the principal; therefore agents are required to show reasonable skills, care, and professionalism in his work.
  • Not to further delegate the duty to anyone, without the permission from the principal, agents should personally remain responsible for the tasks.
  • Agents are in the position of secret or inside information, therefore maintaining the high degree of trust, they are not supposed to disclose to any third party – maintaining confidentiality.
  • Benefits received from the business should be handed over to principal; any benefit should not be concealed by an agent or should not accept any material gift from the third party.
  • If there is any personal interest in the proposed transaction, it should be disclosed to the principal.

What is Agency Problem?

Due to the separation of ownership, agency problems may arise in the context of listed companies, if directors breach the duty of trust for their personal benefits, either intentionally or unintentionally, or omission of information. If the objectives of the said two parties (shareholders and directors) are conflicting with each other, agency problems may arise. This addressed issue should be solved.

Solving agency problem:

Solving the agency problem through “alignment of interest” which means bringing the interest of the agents and principal on the same track. In a more general wordings, this is the attempt to reconcile the interest of both parties or taking such actions to make both parties happy. For example by giving them additional incentives/shares.

  • Profit/performance related pay (PRP)
  • Rewarding managers with shares
  • Executive share option plans (ESOP)

Agency cost:

The cost incurred from the side of principal to monitor the activities of the agent. In the context of corporate governance, shareholders usually incur expenses to monitor the activities of directors such as:

>appointing external auditors >cost of NEDS >time to attend AGM >analysis/research

Other agency relationship:

  • External auditors and NEDs are agents of shareholders.
  • Internal auditors are agents of directors.
  • Management of charities is agents of donors.
  • Government is an agent of the public.
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