The Agency Problem

The underlying problem is that the owners of a company (shareholders) are not the same people that run the company (directors). This gives rise to the agency problem: the shareholders are the principals who appoint the directors to run the company on their behalf as agents. (An executive director is defined as a director who works on a full time basis for his or her company).

The potential issue is that if the shareholders pay the directors to do something for them, how do they know that they will do the job properly and in the shareholders’ best interests and will not act solely for their own personal gain.

In large organisations, owners may have such small individual shareholdings that they are not interested in what the organisation does or they have limited power or desire to challenge the directors. The gap between owners and directors is getting larger as companies can have thousands of small investors and it is not possible for the directors to communicate and build up a relationship with all of these investors. As companies get larger the likelihood of directors owning a significant share is also falling. If directors have little or no ownership, their personal desire for the company to be successful may be reduced.

The biggest shareholders are often institutional shareholders such as pension funds. Even these may only own 2 or 3% of the company’s shares so it can be difficult for them to challenge the directors. Additionally, they are investing money on behalf of others and can be inactive in their relationship with the company.

As a result of globalisation, companies/organisations have become even larger than in the past which is making the above issues even more important. Additionally, recent corporate disasters and the apparent increase in corporate fraud and unethical business behaviour have led to a lack in trust in directors.

Other sources of potential influence on the directors are also waning. Many customers or suppliers are not large enough to exert influence on the directors and in some situations even governments are not large enough to stop a company from taking a particular course of action.

The agency problem is getting worse, particularly in the UK and US, for the following reasons:

1. As companies have grown larger there is a bigger gap between directors and shareholders;
2. Even the largest shareholders have a small percentage shareholding so cannot force the directors to do anything;
3. The emergence of institutional shareholders in the UK and US means investors who are completely external to the company and have no links to the board of directors.