Presented by Joe, Erin, Rich, Arthur, Yihan.

Principal-agent Equity contracts- share in the profit of business The principals are stockholders who own the majority of a company’s equity An agent would be the firms manager’s

The Dilemma: The managers(agents) have less incentive and motivation to maximize profits than the stockholders. Why? The manager’s own less of the companies equity and therefore would have less profit than the shareholders.

SOLUTIONS!!!

Solutions cont… Production of Information- Monitoring Fact 1 Costly state verification

Solutions cont… Government Regulation to Increase Information Fact 5 Laws

Solutions cont… Financial Intermediation Fact 3 Venture Capital Firm

Moral Hazard Debt markets- fixed amounts periodically Safer Less need to monitor

The Dilemma Borrowers have an incentive to take on more risky investments

SOLUTIONS!!!

Solutions cont… Net Worth and Collateral Fact 6&7 Incentive Compatible

Solutions cont… Financial Intermediation Fact 3 & 4 Banks/ Investment firms

Solutions cont… Monitoring & Enforcement of Restrictive Covenants Fact 8 Discourage undesirable Behavior Encourage desirable behavior Keep collateral valuable Provide Information

The Real World: Enron 7 th largest US company Leader of energy market Owned 25% Estimated worth of $77 billion

Rumblings and Grumblings October 2001 announced a loss of $681 million Disclosed accounting “mistakes” Led to a formal SEC investigation Uncovered a huge complex web of lies and deception

How does this happen? Enron created many shell corporations that would consume these debts and contract on their balance sheets Arthur Andersen was being paid $1 million a day and did not want to loose it’s biggest client Shareholders just assumed everything was fine based on upper management’s word

The Fallout Top executives charged Some went to jail 1,000’s of employees lost retirements and 401k’s Both Enron and Arthur Andersen collapse At the time it was the largest bankruptcy in the history of the US