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Agency is a common problem. An agent is supposed to represent the interests of a principal, and the compensation for the agent should align his/her interests with those of the principal. The classic case is that of a CEO who represents the interests of the owners (i.e. the shareholders of the company). A significant part of the CEO’s total compensation usually consists of stock options and/or shares in order to motivate the CEO to try to increase the value of the company.

There are other examples where the form of compensation creates problems. Auditors verify the financial data of companies. Auditors act as agents for everyone in the capital markets who rely on audited statements when deciding whether or not to invest in a company’s equity or debt. However, auditors are paid by the companies whose financial statements they review and verify, and the companies are not the principals.

Auditors will try to satisfy the companies in order to have their assignments renewed. As well, since most auditing firms also have thriving consulting practices, auditors are further motivated to satisfy corporate “clients” in order to get additional, and highly lucrative, consulting assignments.

It is not surprising that some auditors have been willing to test the limits of Generally Accepted Accounting Principles (GAAP) on behalf of their “clients”. The users of the financial information, who are the principals, do not pay the auditors, nor do they hire them for other consulting projects.

The threat of lawsuits for negligence tends to keep most auditing firms “honest”.

Credit rating agencies function in a similar manner to auditors. These companies act as agents for everyone in the capital markets who rely on the credit ratings when deciding whether or not to invest in a company’s or a country’s debt. But the users of the ratings do not pay the credit rating agencies. They are paid by the issuers of the debt.  Hence, they too try to satisfy their “clients” in order to generate future assignments. Unlike auditors who can be and have been sued, credit rating agencies have been exempt from lawsuits in the U.S. and elsewhere. Reform of the the financial system has taken away this protection in the U.S., and may change the behavior of the credit rating agencies.

In both cases, it would be preferable if investors paid directly for the services of auditors and credit rating agencies. Governments could charge all investors a levy to pay for such services.

A final example involves inspections of vehicles being returned at the end of leases. Annually, millions of people in North America face the dreaded inspections and the resulting claim for damages by the leasing companies. Lease finance companies have outsourced inspections and pay directly for such inspections. The companies and people retained by the leasing companies act as agents of the leasing companies who are the principals in these cases. Obviously, the inspectors are motivated to find as much damage as possible in order to satisfy the principals and be awarded more work. It is unlikely that the leasing companies actually do the repairs listed in the reports, and thus, the payments for damages provide another source of revenues and profits for the leasing companies.

The problem in this case is that the lessees have limited ability to challenge the inspection reports. If they demand a second opinion, they have to pay the costs, and the second opinion is offered by another employee of the company used for the initial inspection. It is surprising that no government has enacted legislation that requires both the leasing companies and lessees to share the costs of inspections and establishes an agency to select inspectors with no links whatsoever to leasing companies.

Crafting the best compensation packages for agents is not clear-cut. Many of the current practices leave a lot to be desired.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.


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