Agency problem

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Agency problem
/ˈeɪʤənsi ˈprɒbləm / (n.)

The intrinsic conflict of interest any agent faces that, as long as it gets its commission, it doesn’t really care a hill of beans what its principal gets, however much it might protest to the contrary.

Being little more than an illustration of the prisoner’s dilemma, this shouldn’t surprise anyone. It should be cured where the agency has a repetitive, undated nature:[1] clients have long memories and will remember when you rip them off.

But the prisoner’s dilemma has some natural limits: one is that it relies on repeated interactions with no, or least an indeterminate, end-point: the promise of another opportunity, on another day, to clip her ticket keeps an agent, literally, honest. Until the sky is falling on her head, at which point it looks like a final interaction, and the calculus is different. It is a regrettable, but inevitable, fact that agents behave differently at the end of days.

Second, it takes no account of “convexity” effects that can arise during an agency relationship: I can build up my reputation incrementally, faithfully carrying out thousands of small transactions — I can make myself look like a consistent, five-star collaborator — only to whip away the rug the one time I enter a big transaction. I can sell ten thousand ball-point pens in utmost good faith, but run off with the money the one time I go to sell a Ferrari.

When that one outsized “defection” drowns out all the thousands of penny-sized collaborations, an iterated game of prisoner’s dilemma effectively becomes a single round game, for which the option payoff is markedly different. This is what Nassim Nicholas Taleb calls the “Rubin Trade”.

Thus, the agency problem is the classic “skin in the game” problem: an agent gets paid, no matter what. The investment manager puts no capital up, takes a small slice of yours, by way of a fee, no matter what.

Nice work if you can get it. A lot of people in the city can get it.

The agency problem and corporate personality

This tension, between the overriding life goals of an agent and those of her principal is the crux of the agency problem. They do align — but only so far.

Theory: the “legal revolution” theorists — academics, GCs, COOs and thought leaders generally — make the category error of assuming the interests of client corporations drive the market. This aligns with legal theory: a corporation is a person and has its own personality, interests and desires. But the corporation as a “res legis” — a legal thing — is only a “thinking thing” through the agency of its representatives, each of whom is a thinking thing in her own right.

The critical difference between human person and corporate person is that a corporation cannot speak for itself. A human principal, being a thinking, animate thing, can apprehend the conflicts of interest of which he may be a casualty, and police them. A pile of papers filed at companies house cannot. It can only crowd-source defence of its own interests to its “friends” who are animate, but who have interests of their own. It can seek to nullify any one agent’s conflicting interest by asking the aggregated weight of its other agents to represent its against that one agent in a kind of “wisdom of crowds” way — their individual interests disappearing through some kind of phase cancellation effect to which their common interest — furthering the interest of their mutual principal the corporation — is immune. This works as long as the self-interests of each of the other agents do cancel themselves out: if all the agents have a common self-interest which conflicts with the corporation’s interests, this crowdsourcing strategy won’t work.

So do all its agents have such a common conflicting interest? Yes.

Any one of its agents is charged with protecting the principal’s interests, but two overriding considerations will inevitably take priority: (i) their wish to protect and perpetuate their own role as agent, and its accompanying income stream — their need to persuade the principal that their role is needed whether or not it is needed — no turkey votes for Christmas; and (ii) their wish to not fuck up — to demonstrate that not only is the role necessary but I am the best person to carry out that role.

Big law and the agency problem

All the world’s a stage,
And all the men and women merely players;
They have their exits and their entrances;
And one man in his time plays many parts,
His acts being seven ages.

As You Like It, II vii

Just as one can make the case that humans did not domesticate wheat so much as wheat domesticated humans,[2] so might one argue that investment banks did not domesticate big law firms as much as big law — okay, and big consultancy — cultivated the investment banks. Our IB GC genealogy refers.

For there are certain pillars of bank activity — the conduct of litigation being one, the execution corporate advisory business another and let us throw in the wheel-spinning “industry” of industry associations for a third — whose conduct so depends upon, and is in thrall to, the memetic interests and commercial imperatives of law firms, to the outright detriment of anyone else, that they are hard to see as anything other than a kind of extended phenotype for the private practice of commercial law.

The in-house legal department — a bank function all but unknown thirty years ago, but now so monstrous that it needs its own chief operating officer[3] — really only exists to make life as easy as possible for the law firms to optimise the recording and recovery of chargeable time.

The neat evolutionary trick big here was to weaponise the agency problem by imposing structural intermediation between those who instruct the lawyers, and those who ultimately pay for them.

In an organisation big enough to have its own legal function, this is straightforward enough to describe. The decision to instruct a law firm (a corporate agent) — i.e., what it is required to do and how much it should be paid for doing it — is handled by the legal department (staffed by human agents), but paid for, ultimately, by shareholders (principals).

If the legal department is evaluated at all for the quality of its counsel management, it will be impressionistically, by people lacking technical chops to know whether wheels are being spun, and its performance is unlikely be reflected in the Christmas bonus.[4]

But in bigger organisations this disintermediation becomes ever more baroque. Once a firm appoints a bank to advise it, all bets, and controls, are off. Here is the scenario:

Corporation, represented by its legal department (human agents) — appoints its own law firm (a corporate agent),[5] but also an advisory bank (a corporate agent), itself represented by its legal department (human agents), who appoints its own law firm (another corporate agent) itself represented by its staff (human agents) — to advise on a transaction between the first corporation and another corporation, similarly represented.

There arises therefore a delicate chain of agencies — six would be standard in the simplest bilateral transaction — between those who instruct the firms and those who are, ultimately, expected to pay for the services rendered. By design, none of the intermediaries — agents — have personal skin in the infinite game and have only one uniting interest: to keep playing the game.[6] But it is a powerful interest indeed.

On this view, then, investment bankers are the Zaphod Beeblebroxes and Vogons of the galaxy; not the masters of the universe they imagine, but lowly pawns in a chess game playing at an abstract level they cannot even see. These unseen hands, run the blasted furnace not for earthly gain or economic progress, but the oblique objectives of the hyper-intelligent pan-dimensional mice who actually control the universe. These uber-beings present in our dimension not as mice or dolphins but Sullivan and Cromwell partners.


Another “tell” is for the size of money at stake to be so large that even a legal bill in the tens of millions will amount to a rounding error.

So, to take our three examples:

Advisory M&A, DCM, ECM etc.

The business of advising on mergers and acquisitions and primary transactions in the debt and equity capital markets is generally handled on behalf of target and acquiror by appointed investment banks.

Each bank will appoint its own law firm to advise it — the target will have its own independent counsel too — principally on the underwriting, regulatory and reputational risks posed by just being involved. The bank’s legal advisors will conduct due diligence, negotiate contracts, shareholders agreements, draft prospectuses, advise on all kinds of competition issues that may arise, and will issue batteries of legal opinions — enforceability opinions, true sale opinions, fairness opinions, security opinions, 10b5 opinions — you name it — all of which are designed to give the arranger and syndicates — the banks — comfort that their risk of shareholder action or regulatory censure is minimal. Who pays for all this legal advice? The bank’s client, of course. This, on top of the underwriting fee, will be in the first blushing exchanges of the engagement letter.

Once the client has agreed to this — and, for the most part, clients have no choice — the bank’s internal lawyers have little incentive, beyond basic compassion for defenceless multinationals, to constrain their legal spend, and will allow themselves to be led down every open manhole cover that any deal lawyer can contrive to fall into.

Inhouse advisory teams are often exempt, what’s more, from the usual internal audit rubber glove inspection — requiring competitive tenders, law firm panels, methodological justifications for even talking to lawyers — that follow requests from other parts of the legal department to incur “own legal spend”, even in nugatory amounts, because “the bank isn’t paying for it, so why get bent out of shape about it?”


The sorts of litigation banks get into tend to involve claims of art least hundreds of millions of pounds, and typically banks are on the wrong end of them — it is an unusual investment bank that makes a habit of suing its own, solvent clients — meaning that, unless it is prepared to just admit everything and pay up— this happens a lot more than you would think, thanks to an inverted instance of the agency problem — the bank has little control of the process. Unlike a commercial transaction, there is no critical path, since you don't know how the other side will play, so it is hard to fix or even estimate fees, so “time and attendance” tend to be the order of the day.

Anyone who has contemplated litigation — if you’ve ever done a loft conversion, that probably includes you — will know how dismal the experience of seeking legal redress through civil procedure can be. Many phases of civil litigation — pleadings, discovery, interlocutories, counterclaims, requests for further and better particulars, witness statements — are time-sinks that exist only for lawyers to spin each others’ wheels, at their respective clients’ expense — and the result is to render litigation utterly futile for a claim below about £10,000,000 — since the cost of pursuing or defending the claim will outstrip any conceivable dividend of success.

Above that threshold, this no longer holds: there is a hazy interregnum where lawyers know they can be paid handsomely, indefinitely, for carrying on an argument that most likely will never get to court, let alone final adjudication.

Service providers

Especially where you are dealing with investment banks as corporate service providers, you may see this sort of clause:

The Agent may seek and rely upon the advice of professional advisers in relation to matters of law, regulation or market practice, and shall not be deemed to have been negligent or in breach of contract with respect to any action it takes pursuant to such advice.

The airily-advanced explanation is “look, we don’t make much money from this, and we haven’t got skin in the game, so we don’t want to find ourselves facing a claim when we have done the diligent thing and sought legal advice. How can we be blamed?

But your bad advice should not be someone else’s client’s problem. No one is stopping the agent getting whatever advice it wants, on its own dime, and at its own risk. It’s a free country. And no one is stopping the agent relying on whatever advice it gets. That it did get advice may even be (weak) evidence that it diligently discharged its duty and wasn’t, factually, at fault.

But if the advice turns out to be wrong and the agent can disclaim its own liability, then the lawyers it instructed — for whom the client is probably paying — don’t acquire any liability in the first place. But that’s why you pay lawyers: so they can cover the agent’s sorry arse if their advice turns out to be wrong and their client — you, kind sir — goes on the warpath.

Legal industry transformation and the agency problem

The JC humbly submits that any plan to revolutionise the legal industry that does not account for the agency problem will fail.

Everyone who purports to speak for a corporation does so in a way that, above all else, does not prejudice his own agency with the corporation.

This puts our old friend the drills and holes conundrum into perspective: it is true that a corporation desires quick, cheap and effective legal services. In many cases, it does not need any legal services at all — it could get by not just with cheaper, less fulsome legal protections, but with no legal protections at all. What percentage of legal agreements are ever litigated?

But it is hard for an inanimate pile of papers filed at companies registry to have that sort of insight. It relies on its agents to arrive at that conclusion on its behalf. But who, amongst the byzantine control structure that those very agents have constructed to help it make decisions of that sort — its inhouse counsel, outhouse counsel, credit risk management, document negotiators, client onboarding team, compliance or internal audit — who of these people would ever say that? And even if one did, would he not be shut down by the consensus of the others?[7]

See also


  1. In which case the game is an “iterated” prisoner’s dilemma.
  2. A Yuval Noah Harari bon mot that owes something to Richard Dawkins’ idea of the extended phenotype, we feel.
  3. our history of inhouse legal refers.
  4. Trading, another human agent, may complain about the legal bills’ impact on her PNL and therefore her Christmas bonus, but it won’t be an item on the agenda at the AGM.
  5. Once upon a time there was no corporate agency here and individual professional advisers had unlimited personal liability. Just imagine!
  6. See James P. Carse’s Finite and Infinite Games.
  7. Those who don’t believe me should try proposing that you don’t need cross default in trading agreements. You will get bilateral consensus on this, in private conversations, from almost everyone; no-one will say it in public.