Final answer:
Agency problems arise in corporate governance because managers may place their interests over those of shareholders. Mechanisms like the board of directors, auditing firms, and large institutional investors are in place to protect investor interests, but they can fail, as seen with Lehman Brothers.
Step-by-step explanation:
Agency problems are a central issue in corporate governance because managers, who are hired by shareholders to run the company, may prioritize their own interests over the interests of shareholders. The conflict of interest that arises is due to the separation of ownership and control in modern corporations. Managers may pursue personal gain through higher compensation, job security, or work-life balance, which may not always align with the goal of maximizing shareholder value.
There are several mechanisms in place to mitigate agency problems. The board of directors, appointed by shareholders, serves as the primary oversight body to protect investor interests. Auditing firms are employed to review financial statements and ensure that the information provided to shareholders is accurate. Large institutional investors like pension funds may also exercise significant influence and oversight due to their substantial holdings. However, failures in corporate governance, such as in the case of Lehman Brothers, demonstrate that these mechanisms are not foolproof, and investors can sometimes be misled about a company’s financial health.