The agency problem (idea)

Financial managers frequently are faced with what can become a major legal and ethical concern, called the Agency problem. Because the goal of a financial manager is to maximize the wealth of the firm's owners, it is often possible for him to be faced with double-bind scenarios. (see Kobayashi Maru)

An agent, having the authority to act on another's behalf, can come into conflict with the principal on who's behalf he is supposedly acting. This can present a major ethical challenge to the financial manager, who is supposed to act as an agent of the stockholders/owners.

A Conflict of Interest:

You can think of the firm as the interaction of two parties, the stockholders, who wish to see a maximal return on their investment and long-term success, corresponding to increased stock prices, and the managers, who are directly concerned with short-term profits of the firm which are needed to meet liquidity needs and immediate financial obligations, as well as to promote growth of the company.

  stockholders                     management
  |--> * stock price        |      |--> * growth
  |--> * long-term success  |      |--> * short-term profits
  |--> * firm value         |      |--> * liquidity needs
  |--> * low risk           |      |--> * high, immediate, risk

In theory, it's a very simple matter: Financial decisions should always be made in the interest of stockholders. Unfortunately, the situation is not always a simple one to resolve. When the interests of principals and agents conflict, an agency problem results.

A common example would be the desirability of undertaking a high-risk project. Management, which could suffer serious personal financial loss if the project failed, and would be far less willing to undertake it than the shareholders, who stand a substantially smaller chance of sustaining a critical loss, since the stock is only a fraction of their finances, and the company is not a provider for their livelihood.

In practice, the idea of tying managers' compensation to firm performance and stock price. This - not defrauding employees and stockholders or creating instant millionaires - was the original rationale behind giving a substantial part of executive-level compensation packages in the form of stock options. It was thought that if top executives were also made stockholders, it would substantially reduce the agency problem, because they would have incentive to act in the long-term best interest of the firm and would be more likely to consider their personal stake in major financial decisions.