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Principal Agent Problem

Principal agent problem is a situation arises from different thoughts among people with
different intentions and motives. This comprehensive term is used in political science and
economics. The arrangement that exists when one person or entity (called the agent) acts
on behalf of another (called the principal). For example, shareholders of a company
(principals) elect management (agents) to action their behalf, and investors (principals)
choose fund (agents) to manage the interests. This arrangement works well when the
agent is an expert at making the necessary decisions, but doesn't work well when the
interests of the principal and agent differ substantially. So principal agent problem took
birth1 (http://www.investorwords.com/3840/principal_agent_relationship.html#ixzz0yDM8TOR1)
Asymmetric information is the main reason behind principal agent problem, and it is
usually found in employer and employee relationship. It can be defined as “Principal-
agent problem is a particular game-theoretic description of a situation. There is a player
called a principal, and one or more other players called agents with utility functions that
are in some sense different from the principal's. The principal can act more effectively
through the agents than directly, and must construct incentive schemes to get them to
behave at least partly according to the principal's interests. The principal-agent problem is
that of designing the incentive scheme. The actions of the agents may not be observable
so it is not usually sufficient for the principal just to condition payment on the actions of
the agents.2 . This phenomenon can be understood through the following diagram.

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http://upload.wikimedia.org/wikipedia/en/a/ac/Principal_agent.png

1
http://www.investorwords.com/3840/principal_agent_relationship.html#ixzz0yDM8TOR1
2
http://economics.about.com/od/economicsglossary/g/principalag.htm
3
http://upload.wikimedia.org/wikipedia/en/a/ac/Principal_agent.png
The Enron Collapse and the
Principal Agent Problem
Enron Corporation, an Introduction
In 1985 Houston Natural Gas Company and Internorth the US natural gas pipe line
network formed with the name of Enron. Initially it was a company for regular trade of
gas but later on they shifted to unregulated energy trading markets. Kenneth Lay was the
founder of this corporation. This transformation brought a great success to the Enron.
Enron’s reported annual revenues grew from under $10 billion in the early 1990s to $101
billion in 2000, ranking it seventh on the fortune 5004(Mark Jickling, CRS(Congressional
Research Services) Web, March 28,2002). Enron remained America’s most innovative
company for consecutive six years
History also shows that Enron’s problems took birth when it started investing in other
businesses like internet and communication business etc.

Destruction of Enron Corporation


Jeffrey Skilling was CEO of the Enron Corporation and he is the responsible person for
bankruptcy of Enron Corp. he started to hide billions of debts for which company is liable
to pay, these violations of accounting standards inflated profits of the corporation. Not
only these managers of Enron Corporation misled board of directors and audit committee
on accounting practices but also pressured world famous external auditors firm
“Andrson” to ignore issues.
Due to all these non transparent financial statements operations and finances presented to
share holders and financial analysts were not true. Every stake holder was happy on the
profits presented in annual reports but reality was absolutely opposite to it. Now these
were the few reasons for the destruction.

Principals’ motives
Every investor invests and purchase securities of a company with an aim to earn profit.
When in 2000 Enron’s share was being sold at $90 per share and all leading business
magazines and newspapers were declaring Enron as best corporation in USA, all
investors were being attracted towards Enron. Every one was feeling secure after
investing in Enron.

Agent motives
Board of governors hired best managers for Enron, not only this Enron paid huge
amounts and bonuses to its employees to get maximum from them. These bonuses and
compensations brought greed among the employers of Enron. To get maximum bonuses
employers started to work merely on short term success. Managers started to do as much
transactions as possible while profit and cash flow was absolutely ignored. Only stock
prices became preference of the mangers. “At budget meetings, Skilling would develop target
4
Mark Jickling, CRS(Congressional Research Services) Web, March 28,2002
earnings by asking "What earnings do you need to keep our stock price up?" and that
number would be used even it was not feasible.
This statement of the CEO shows how much pathetic was the administration of Enron
corporation. When Enron’s employers were getting twice and thrice than the other firms’
workers they started to shirk. Managers showed false profits of about $600 million. To
remove the effects of debts owned by the corporation managers started to introduce fake
partnerships. This technique was named as “Special Purpose Entities”. Andrew Fastow
was the first CFO who created such false partnership in 1997. How much executives
were getting can be guessed from the following figures Kenneth former chairperson and
CEO of Enron Corporation earned $1.3 million in base salary and $7 million dollar as
base salary and had 728000 share options. Due to all this failure of Enron Corporation
can be seen through the following graph.

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http://news.bbc.co.uk/furniture/in_depth/business/2002/enron/timeline/graph.gif

5
http://news.bbc.co.uk/furniture/in_depth/business/2002/enron/timeline/graph.gif