Agency problem

The design of organisations and products Go Premium Making legal contracts a better experience Index — Click ᐅ to expand: Design Comments? Questions? Suggestions? Requests? Insults? We’d love to 📧 hear from you. Sign up for our newsletter.

The agency problem addresses the intrinsic conflict of interest any agent working on a commission faces — any introducing broker, broker/dealer, asset manager, architect, building contractor — and that is that once it have received its commission, it doesn’t really care a hill of beans what its principal gets, however much it might protest to the contrary. In a sense, this is a basic articulation of the prisoner’s dilemma and so shouldn’t surprise anyone — and should be cured by repeat interactions — your clients have memories and will remember when you ripped them off.

But the iterated prisoner’s dilemma has a couple of natural limits. One is that it relies on repeated interactions with an indeterminate end. When the sky is falling on your head, it looks like a final interaction, and the calculus is different. Second, it takes no account of convexity effects. I can build up my reputation incrementally with thousands of small transactions — I can look like a five-star collaborator — only to bit on a big position and defect. This is what Nassim Nicholas Taleb calls the “Rubin Trade”.

Skin in the game problem: Agents paid no matter what. Investment managers take a slice of your pie - a small(ish) slice, admittedly, but they put no capital up, and they take out their fee first, whatever the performance.

The agency problem and corporate personality

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 is, of course, fully aligned with axiomatic legal theory: a corporation is a person, has its own personality, interests and desires. But the corporation as a res legis — a legal thing — is only a res cogitans — a thinking thing — through the agency of its representatives, each of whom is a res cognitans in her own right. This tension, between the interests of an agent and her principal is the crux of the agency problem.

Note the critical difference here: in this agency dilemma a corporation cannot speak for itself. A principal who is a thinking thing himself can apprehend the conflict of interest and police it. A pile of papers filed at companies house cannot. It can only crowd-source the defence of its actual interests, by asking the aggregated weight of a whole lot of its other agents to represent its interests against any given one agent in a kind of “wisdom of crowds” way. This works as long as the self-interests of each of the other agents sort of 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 defend the income stream it provides — 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 — not only is the role necessary but I am a suitable person to carry out that role.

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 do not just with legal protections delivered in a convenient format and by a less expensive source, but 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?

See also

• Drills and holes
• Agency paradox
• Shift the axis of dispute