Question #15
Reading: Reading 16 Environmental, Social, and Governance (ESG) Considerations in Investment Analysis
PDF File: Reading 16 Environmental, Social, and Governance (ESG) Considerations in Investment Analysis.pdf
Page: 5
Status: Unattempted
Correct Answer: A
Question
Which of the following best describes the principal–agent problem? An example of the principal–agent problem is when:
Answer Choices:
A. a lawyer recommends protracted legal proceedings to her client
B. a board of directors take advantage of their position at the expense of the shareholders
C. owners of the firm gain at the expense of the employees
Explanation
Lawyers (the agent) are incentivized to recommend protracted legal proceedings to their
clients (the principal) because this will generate income for the lawyer. The principal-agent
relationship (PAR) arises when one group delegates decision making or control to another
group. The PAR can create problems because the group receiving the power (the agent)
generally has an asymmetric information advantage over the group making the delegation
(the principal). The PAR problem begins if the agent uses the information advantage for
their own best interests to the detriment of the interests of the principal. It is
compounded as the asymmetric information makes it difficult for the principal to know
enough to detect the problem and evaluate the agent's actions. Modern corporations are
built on shareholders (principals) who delegate authority to run the business to executive
officers of the company (agents). The board of directors are charged with overseeing the
executives of the firm. It is possible for the board of directors to align themselves too
closely with the executives of the firm thus contributing to the PAR problem.