What is principal and agent in agency?

Any person who has the legal capacity (meaning that they are not insane, or in certain circumstances a minor) to perform an act may be a principal and empower an agent to carry out that act. Persons, corporations, partnerships, not-for-profit organizations, and government agencies may all be principals and appoint agents.

Who can be an Agent?

Any individual capable of comprehending the act to be undertaken is qualified to serve as an agent.

What is the purpose of this relationship (called �Agency�)?

A contract to be made by an agent on behalf of a principal is considered to be the contract of the principal and not that of the agent. It allows the principal to authorize somebody to carry out her duties, either for a specific purpose (i.e., purchasing a house) or generally (i.e., to conduct many transactions). The agency relationship is usually entered into by informal agreement, but also can occur by formal agreement (in certain cases, the agency relationship must be specified in writing). The acts must be legal (i.e., principal can not hire agent to kill the professor).

What is the basis of the Agency relationship?

Inherent in the Principal-Agent (P-A) relationship is the understanding that the agent will act for and on behalf of the principal. The agent assumes an obligation of loyalty to the principal that she will follow the principal�s instructions and will neither intentionally nor negligently act improperly in the performance of the act. An agent cannot take personal advantage of the business opportunities the agency position uncovers. A principal, in turn, reposes trust and confidence in the agent. These obligations bring forth a fiduciary relationship of trust and confidence between P and A.

What are the obligations of the Agent to the Principal?

An agent must obey reasonable instructions given by the P. The A must not do acts that have not been expressly or impliedly authorized by the P. The A must use reasonable care and skill in performing the duties. Most importantly, the A must be loyal to the P. The A must refrain from putting herself in a position that would ordinarily encourage a conflict between the agent�s own interests and those of the principal (note: one might reflect on the role of certain Enron executives on �outside� limited partnerships that did business with Enron in the early 2000s). The A must keep the P informed as to all facts that materially affect the agency relationship.

As a small business owner, it's likely that you routinely employ other people to perform tasks and make decisions on your behalf. Delegating responsibility can take a lot of weight off your shoulders and bring in expertise that you may not have yourself. For the relationship to work, however, you must ensure that the agent will make optimal decisions on behalf of the business – something that sounds simple, but can be incredibly challenging.

Tip

Agency theory describes the relationship between you (the principal) and the person you appoint to act on your behalf (the agent). The agent has a duty to act in the best interests of the principal.

What Is an Agency Relationship?

Agency is the relationship that's created when you (the principal) appoint another person (the agent) to act on your behalf. An agent can be an individual such as an employee or business partner, or an entity such as an accountancy firm or an outsourcing company.

The key part of an agency relationship is that the agent must be authorized before she can act on your behalf. Usually, this authorization is written down into a contract which details exactly what an agent can and cannot do, but it doesn't have to be. You can give authorization orally, and an agency relationship may be implied in certain circumstances.

The relationship itself is called a fiduciary relationship. This means the principal is placing special trust and confidence in the agent to act for the benefit of the principal at all times.

Principal Agent Relationship Examples

The easiest way to explain agency is to look at some common examples of a principal-agent relationship.

Shareholders and Executive Officers

The owners of a company are called shareholders. In small companies, the shareholders might also run the company. In large companies however, shareholders (principals) often appoint corporate managers (agents) to run things on their behalf.

The manager's objective is usually to make decisions that increase the shareholders' wealth. The managers are expected to act in the best interest of shareholders by earning profits that are returned to the shareholders as dividends, rather than pursue their own self-interest – such as awarding themselves a private jet.

Investors and Fund Managers

Whenever you buy into an index fund, you are the principal, and the fund manager becomes your agent. It's the fund manager's job to make buy and sell decisions and manage the fund in a way that will maximize the return on your investment for the level of risk specified in the fund's prospectus.

Because this is a principal-agent relationship, the manager is expected to act in your best interest, and those of other investors, rather than pursue his own objectives, such as seeking the biggest commission.

Employers and Employees

Hiring an employee to perform some form of physical service on the company's behalf is not always an agency relationship. But if the employee is authorized to make decisions and enter into contracts that bind the company, for instance, ordering supplies on behalf of the company, then you have created a principal (the company)-agent (the employee) relationship.

Individual and Contractor

Imagine that your car breaks down, so you take it to a mechanic. The mechanic inspects the car and says you need a number of repairs. The mechanic knows far more about cars than you do, so you trust her judgment to make repair decisions on your behalf. Whether you sign a contract or not, you've made the mechanic your agent by agreeing to pay for the repairs she recommends.

The Common Thread

What each of these examples has in common is a gap between the knowledge level of the agent and the principal. This is a common feature of agency. Most times, the principal will be seeking out advice or services from a professional who knows more about the task than the principal does.

From this, you get an idea of how common agency relationships are in business. Whenever you hire a lawyer, an accountant or a digital marketing agency, or whenever you permit an employee to sign checks or write supplier agreements on your behalf, you're creating an agency relationship.

How Is an Agency Relationship Created?

The principal-agency relationship is created in one of four ways:

Express agency: The principal and the agent sign a contract, or make an oral contract, whereby the principal instructs the agent to make decisions on his behalf. Signing a retainer with an attorney is a good example of express agency. As long as the agent stays within the scope of the contract, you (the principal) will be bound by the agent's decisions.

Implied agency: A principal-agency relationship is inferred from the conduct of the parties. The mechanic scenario is a classic example of implied agency.

Apparent agency: Apparent agency is a bit tricky. It arises when the principal leads a third party to believe that an agent has authority to act on behalf of the principal, but the principal has not actually given the agency such authority.

Suppose, for example, you're negotiating the sale of a photocopier to Ms. Buyer, and you tell Ms. Buyer to talk to Mr. Agent about finalizing the sale, even though you've not asked Mr. Agent to sell the photocopier. That would be an example of apparent agency. If Mr. Agent and Ms. Buyer sign a sale agreement, you, the principal, would be bound by the terms of the deal.

Agency by ratification: Agency by ratification is actually the opposite of what most people understand agency to be, because it happens when someone misrepresents himself as another's agent. Agency arises when the principal approves (ratifies) the deal after the fact.

For instance, if you ask Mr. Agent to sell the photocopier, but Mr. Agent signs a sale contract for a printer instead, you have two choices. You can refuse to go ahead with the deal because you did not authorize it. Or, you can sell the printer anyway and ratify the sale by continuing with it. In the second scenario, you will be bound by the deal under the laws of ratification.

What Is the Principal Agency Problem?

Returning to the car mechanic example: The mechanic advises that you need $5,000 worth of repairs. Do you really need them? The mechanic definitely knows more about engines than you do, but what if she's exploiting your lack of knowledge to make a quick buck? It's hard to know if she's telling the truth, and you certainly don't want to pay for repairs that you don't need.

This, in a nutshell, is the agency problem – the agent could be acting solely in his or her own self interest to the detriment of the principal. Here, the problem arises because the incentives of the principal and the agent are not aligned. Your incentive is to get your car fixed and not waste too much money. The mechanic's incentive may be to squeeze as much money out of you as possible. Because your incentives are misaligned, the potential for a ripoff is high.

The principal-agent problem is fundamentally one of information asymmetry. Asymmetric information occurs when one party to transaction possesses a greater knowledge than the other party. In a principal-agent relationship, it's usually the agent who has the superior knowledge – which is the reason you're appointing the agent in the first place.

The Cost of the Agency Problem for Businesses

The principal-agent problem is broad enough that it can arise in almost any context, and your daily operations may be fraught with these types of problems. Suppose, for example, that you hire an external accountant to look after the company's books. By hiring the accountant, you trust that he will perform the work to the best of his ability. The accountant trusts that you will pay him the agreed rate for the work he has performed.

But what if you pay the accountant by the hour? It's possible you're incentivizing the accountant to work slowly, taking as much time as possible, to gain the maximum value from the task because this is in the accountant's interest. He might also opt for luxury travel whenever he visits your offices because you're the one picking up the bill.

This creates a number of problems for the business:

Costs go up: Because of information asymmetries, you may be unaware how much time it should take to complete a task, or how much a task should cost. You may end up paying more than is necessary for the agent's services.

Inefficiency: The principal-agent problem could enable agents to produce less than optimal work, especially if you've no idea what quality work looks like because it's not your area of expertise.

Cost of incentives. To overcome the principal-agent problem, you almost certainly will have to spend time and money on monitoring the problem and motivating the agent to make optimal decisions on your behalf.

How to Overcome the Principal-Agency Problem

In an organizational context, the agency problem concerns how the business can motivate or incentivize its agents (which may include its employees) to make decisions in the best interests of the business rather than pursuing their own self-interest.

For internal agents, that is, agents who are employed by the business, profit sharing and performance-related pay strategies might help to overcome the agency problem. This simple solution gives agents an incentive to work hard in furtherance of the company's goals – for example, employees receive cash or holiday bonuses if the team meets its performance indicators. For senior executives, stock options and other long-term incentives provide a solution to aligning the manager's interest to the financial performance of the business, essentially placing the manager in the same profit-motivated boat as the shareholders.

For external agents such as consultants and contractors, use clear and intentional contract language to overcome the agency problem. Linking the agent's level of compensation to the accomplishment of specific tasks or outcomes can help align your interests, and you must be very clear about the scope and limitations of the agent's authority. Generally, the onus is on the principal to incentivize the agent to ensure she acts as the principal wants.

What Is the Law of Agency?

Sometimes, taking steps to incentivize an agent to act in your best interests in not enough, because the temptation to profit from the relationship is simply too great. The law of agency recognizes this risk, and provides a set of rules designed to stop a bad agency relationship from happening. It does this by providing a number of duties that agents, and principals, must follow:

Agent's duties:

• Duty of loyalty. The agent must act according to the principal's wishes, put the principal's interests first and not benefit from the relationship at the principal's expense.
• Duty of care, competence and diligence. The agent must exercise authority carefully and diligently.
• Duty of good conduct/good faith. The agent should act ethically and professionally at all times.

Principal's duties:

• Duty to compensate. The principal must pay the agreed-upon fee for the agent's services.
• Duty to indemnify. The principal must pay back the agent for any liability incurred in the course of her duties. 
• Duty to deal fairly and in good faith. The principal should not do anything that could harm or cause loss to the agent.

If either party violates a duty, they could wind up on the wrong end of a civil lawsuit. For instance, if an independent contractor in charge of submitting tenders begins working with a competitor organization, submitting bids for both companies on the same jobs, then he may be in breach of his duty of loyalty. The principal could sue the agent for any losses the principal suffers as a result.

What is a principal and an agent?

Who is the principal and agent in a contract?

What does principle mean in agency?

What is the relationship between agent and principal?