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Principal-Agent Relationship:
What It Is, How It Works
By JAMES CHEN Updated April 05, 2022
Reviewed by MARGARET JAMES
Fact checked by VIKKI VELASQUEZ

What Is the Principal-Agent Relationship?

The principal-agent relationship is an arrangement in which one entity legally
appoints another to act on its behalf. [1] In a principal-agent relationship, the
agent acts on behalf of the principal and should not have a conflict of interest in
carrying out the act. The relationship between the principal and the agent is
called the "agency," and the law of agency establishes guidelines for such a
relationship.

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Principal-Agent Relationship

KEY TAKEAWAYS
A principal appoints an agent to act on their behalf and in their best
interest. Examples include an investor picking a fund manager or
someone hiring an attorney for legal work. 
There should be no conflict of interest between the two, if there is, this
creates a principal-agent problem. 
The principal-agent relationship is expressed clearly through a written
contract or is implied through actions.

Understanding a Principal-Agent Relationship

A principal-agent relationship is often defined in formal terms described in a
contract. For example, when an investor buys shares of an index fund, he is the
principal, and the fund manager becomes his agent. As an agent, the index fund
manager must manage the fund, which consists of many principals' assets, in a
way that will maximize returns for a given level of risk in accordance with the
fund's prospectus.

Important: Agents have an obligation to perform tasks with a certain

level of skill and care and may not intentionally or negligently
complete the task in an improper manner. [2]

The principal-agent relationship can be entered into by any willing and able
parties for the purpose of any legal transaction. In simple cases, the principal
within the relationship is a sole individual who assigns an agent to carry out a
task; however, other relationships under this guise have a principal that is a
corporation, a nonprofit organization, a government agency or a partnership.

The agent is most often an individual capable of understanding and ultimately

carrying out the task assigned by the principal. Common examples of the
principal-agent relationship include hiring a contractor to complete a repair on
a home, retaining an attorney to perform legal work, or asking an investment
advisor to diversify a portfolio of stocks. In each scenario, the principal is the
individual seeking out the service or advice of a professional, while the agent is
the professional performing the work.

Special Considerations
Whether the principal-agent relationship is expressed clearly through a written
contract or is implied through actions, the principal-agent relationship creates
a fiduciary relationship between the parties involved. This means the agent
acting on behalf of the principal must carry out the assigned tasks with the
principal's best interest as a priority. [3]

The agent is responsible for completing tasks given by the principal so long as
the principal provides reasonable instruction. Additionally, the agent has an
obligation to perform tasks that will not intentionally harm the principal. A duty
of loyalty is also implied within the principal-agent relationship, which requires
the agent to refrain from putting himself in a position that creates or
encourages conflict between his interest and the interest of the principal, also
known as the principal-agent problem. [3]

ARTICLE SOURCES

Related Terms
Principal-Agent Problem Causes, Solutions, and Examples
Explained
The principal-agent problem is a conflict in priorities between a person or a group and
the representative authorized to act for them. more

What Is an Agent? Definition, Types of Agents, and Examples

An agent is a person who is empowered to act on behalf of another. Read about different
agent types, such as real estate, insurance, and business agents. more

Attorney-in-Fact: Definition, Types, Powers and Duties

An attorney-in-fact is a person who is authorized to represent someone else in business,
financial, and private matters. more

Fiduciary Definition: Examples and Why They Are Important

A fiduciary is a person or organization that acts on behalf of a person or persons and is
legally bound to act solely in their best interests. more

Agency Problem: Definition, Examples, and Ways To

Minimize Risks
An agency problem is a conflict of interest where one party, motivated by self-interest, is
expected to act in another's best interests. more

Agency Theory: Definition, Examples of Relationships, and

Disputes
Agency theory is an economic principle used to explain disputes between principals and
agents. more

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