agency theory is a concept used to explain the important relationships between principles and their relative agents because the principle relies heavily on the agent to make the decision there may be some conflicts or disagreements for example company Executives with an eye toward short-term profitability and elevated compensation may desire to expand a business into new high-risk markets however this could pose an unjustified risk to shareholders who are most concerned with the long-term growth of earnings and share price appreciation the agency theory dives into such relationships in this video I will discuss what agency theory is major types of principal agency relationships real-world examples and strategies to help firms to reduce the chance of Agency problems Section 1 what is agency theory an agency refers to a relationship comprising two parties where one party called the agent represents the other party called the principal an agent is usually hired by the principal to perform an actor service on his behalf by implication sometimes the agent doesn't only use the principal's resources but also makes decisions with the resulting risks to be borne by the principal alone this makes agency relationships complicated as disputes disagreements and conflicts of interest do arise the agency theory explains how to best organize agency relationships to prevent conflicts and other issues that arise between agents and principles there are two key assumptions underlying the agency theory 1. individuals are generally egoists who act in their own self-interest in short both the principal and agent are out for their own benefit 2. agents have access to more information and are usually in a decision-making capacity as a result of the above we see that conflicts result from a clash of interests or from the information gaps between the principles and agents section 2 2 principal agent relationships there are two major types of relationships that are closely intertwined and are faced with some sort of disagreement type 1 shareholders and management teams management teams may be more willing to take on higher levels of risk and operating marketing or investing while shareholders desire maximized returns in the form of capital gains and dividends shareholders are generally risk averse which is often viewed as prudent and conservative this conflict gets even more evident if the management team receives a large portion of its compensation and annual salaries and stock options managers have less to lose because salaries are constant and stock option values rise in response to increased volatility which is embedded with risk type 2 investors and fund managers the fund managers could create the potential connects with investors when they could make a gain or avoid a loss to the firm at a client's expense has an interest in the outcome of a decision that is not the same as the clients has an incentive to favor one client over another has an incentive to favor a service provider that is not the best for the client and is offered gifts or entertainment that may compromise objectivity Section 3 real world examples here are two real world examples of the agency problem example one the Enron scandal one particularly famous example of the agency problem is that of Enron Enron Corporation was an American Energy Commodities and services company based in Houston Texas 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 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 one dollar the company ended up filing for bankruptcy in December 2001. criminal charges were brought up against several key Enron players including former CEO Kenneth lay CFO Andrew Fasto and Jeffrey Skilling who was named CEO in February 2001 but resigned six months later example 2 Bernie Madoff Ponzi schemes represent many of the better known examples of the agency problem agency theory claims that the lack of oversight and incentive alignment greatly contribute to these problems many investors fall into Ponzi schemes because they believe that taking fund management outside a traditional banking institution could reduce costs and receive extra returns Bernie Madoff scam is probably one of the most notable examples of a Ponzi scheme Madoff was former chairman of the NASDAQ Stock Exchange he created an elaborate sham business that ultimately cost investors nearly 65 billion dollars in 2009. 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. section 4 strategies in order to reduce the likelihood of the principal agent conflict here are some measures and principles that can be followed 1. contracts a strong contractual agreement is necessary to pay the groundwork for seamless business operations the contract must be detailed thorough and inclusive regarding incentives performance evaluation and compensation it should also list procedures to oversee all regulatory measures 2. restrictions imposing restrictions is a good way to significantly reduce the effect of agency loss setting specific restrictions on factors such as agency power allows the principal to feel more confident in their relative agent 3. evaluations one can create mechanisms that will evaluate agents Performance Based on their decisions if the agents follow these criteria well they will receive a reward however if it's clear that the agents are acting only in self-interest they may get sanctions for example periodical performance evaluations are excellent Solutions 4. bonuses introducing incentives and bonuses lessens the chances of a relationship that consists of conflicts and disagreements introducing bonuses is a good way to motivate an agent and will allow them to make decisions with the best intentions of the principle in order to achieve their desired incentive 5. transparency to reduce the potential influx of Agency problems it is crucial for both the principal and the agent to be completely transparent with one another once transparency is present conflict is reduced because there is less confusion in decision making and fewer implications that one party is against the other Section 5 summary now let's wrap up today's topic agency theory is a concept used to explain the important relationships between principles and their relative agents because the principle relies so heavily on the agent to make the right decision there may be an assortment of conflicts or disagreements agency theory dives into such relationships the agency theory is based on two fundamental assumptions one individuals are generally egoists 2. agents have access to more information and are usually in a decision-making capacity to better address the potential Agency problems five strategies or principles should be followed those strategies are contract restrictions evaluations bonuses and transparency all right that's all for today's topic if you have any questions regarding this video please leave your thoughts in a comment below I hope that you guys have enjoyed this video and if you did make sure you give it a thumbs up and subscribe to my channel thanks for watching and I will see you next time