In this lesson, you will learn how to identify the nature of agency conflicts and the associated costs for an organization. Specifically, this lesson will cover the following:
The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager to act in shareholders’ and other stakeholders’ interests. Because of this separation, corporate governance includes controls intended to align managers’ incentives with those of shareholders and other stakeholders.
The principal–agent problem, or agency dilemma, developed in economic theory, concerns the difficulties in motivating one party, the agent, to act on behalf of another party, the principal. The two parties have different interests, and it is difficult to ensure that the agent is always acting in the best interests of the principal. Conflicts of interest may arise.
The Principal–Agent Problem
hint
Decision rights (control) of the corporation are entrusted to the managers.
While managers control the corporation and make strategic decisions, shareholders are owners, and bondholders are creditors. While all three parties have an interest, whether direct or indirect, in the financial performance of the corporation, each of the three parties has different rights and rewards, such as voting rights and forms of financial return.
Shareholders, managers, and bondholders have different objectives. Stockholders have an incentive to take on riskier projects than bondholders do as bondholders are more interested in strategies that will increase the chances of them getting their investment back. Shareholders also prefer that the company pay more out in dividends than bondholders would like. Managers may also be shareholders and reap the profits of more risky strategies or may prefer risk-averse, empire-building projects.
terms to know
Agent
One who acts for, or in the place of, another (the principal) by authority from them; one entrusted with the business of another; a substitute; a deputy; a factor.
Principal
One who directs another (the agent) to act on one’s behalf.
Shareholder
One who owns shares of stock.
Dividend
A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).
2. Conflicts Between Managers and Shareholders
The term “agency costs” refers to instances when an agent’s behavior has deviated from the principal’s interest. In this case, the principal would be the shareholder. These types of costs mainly arise because of contracting costs or because individual managers might only possess partial control of corporation behavior. They also arise when managers have personal objectives that are different from the goal of maximizing shareholder profit.
Agency Costs
Typically, the CEO and other top executives are responsible for making decisions about high-level policy and strategy. Shareholders, on the other hand, are individuals or institutions that legally own shares of stock in a corporation. Typically, these people have the right to sell those shares, the right to vote on the directors nominated by various boards, and many other privileges. This being said, shareholders usually concede most of their control rights to managers. In turn, top executives have fiduciary duties to shareholders to make decisions in their best interests.
The relationship between business management and shareholders is a fiduciary relationship. Fiduciary duty refers to the legal and ethical obligations that agents have to principals when entrusted with managing assets, making decisions, or acting on the principal’s behalf. There are four pillars of fiduciary duties in corporations.
Duty of good faith: Business managers have a duty to adhere to corporate bylaws and comply with the law. When company bylaws conflict with the law, the law takes precedence.
Duty to disclose: Business managers must provide accurate and necessary information to shareholders. Misleading shareholders about business success violates the duty of information.
Duty of loyalty: Managers must act in the best interests of shareholders, avoiding conflicts of interest (see examples below).
Duty of care: Managers must exercise reasonable care and diligence in decision-making by analyzing risks, considering alternatives, and making informed decisions so as not to be negligent in their duties.
The following are examples of managers making decisions in conflict with their fiduciary duties:
A manager might engage in self-dealing, entering into transactions that benefit themselves over shareholders.
Managers might purchase other companies to expand individual power or spend money on wasteful pet projects instead of working to maximize the value of corporation stock.
Venturing into fraud, managers may even manipulate financial figures to optimize bonuses and stock-price-related benefits.
Another important goal is to evaluate whether a corporate governance system hampers or improves the efficiency of an organization. Research of this type is particularly focused on how corporate governance impacts the welfare of shareholders. After the recent instances of accounting fraud, there is renewed public interest in how corporations practice governance and accurate accounting.
Advocates of governance typically encourage corporations to respect shareholder rights and to help shareholders learn how and where to exercise those rights. Disclosure and transparency are intertwined with these goals.
big idea
The chief goal of current corporate governance is to eliminate instances where shareholders have conflicts of interest with one another.
term to know
Fiduciary Duty
Legal and ethical obligations that agents have to principals when entrusted with managing assets, making decisions, or acting on the principal’s behalf.
3. Conflicts of Interest Between Shareholders and Bondholders
Deviations from the principals’ interests by the agents are called agency costs, which are often described as existing between managers and shareholders, but conflicts of interest can also exist between shareholders and bondholders.
The shareholders are individuals or institutions that legally own shares of stock in the corporation, while the bondholders are the firm’s creditors. The two parties have different relationships with the company, accompanied by different rights and financial returns.
Stockholders have an incentive to take riskier projects than bondholders do as bondholders are more interested in strategies that will increase the chances of them getting their investment back.
Shareholders also prefer that the company pay more out in dividends than bondholders would like.
Shareholders have voting rights at general meetings, while bondholders do not.
If there is no profit, the shareholder does not receive a dividend, but interest is paid to debenture holders regardless of whether or not a profit is made.
Other conflicts of interest can stem from the fact that bonds often have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely but can also be sold at any point. Because bondholders know this, they may create ex ante contracts prohibiting the management from taking on very risky projects that might arise, or they may raise the interest rate demanded, increasing the cost of capital for the company.
EXAMPLE
Loan covenants can be put in place to control the risk profile of a loan, requiring the borrower to fulfill certain conditions or forbidding the borrower from undertaking certain actions as a condition of the loan. This can negatively impact the shareholders. Conversely, shareholder preferences—for instance, riskier strategies for growth—can adversely impact bondholders.
terms to know
Bond
A documentary obligation to pay a sum or to perform a contract; a debenture.
Maturity
Date when payment is due.
summary
In this lesson, you learned that agents and principals can have different and sometimes competing interests. Corporate governance attempts to mitigate such agency conflicts by balancing the incentives of managers against those of shareholders and other stakeholders such as bondholders. Conflicts between managers and shareholders create agency costs that good corporate governance can minimize. To mitigate these conflicts, agents have a fiduciary duty to make sure that they conduct themselves in the best interests of their principals. Conflicts of interest between shareholders and bondholders can also occur, especially with respect to risk and the payment of dividends.
One who acts for, or in the place of, another (the principal) by authority from them; one entrusted with the business of another; a substitute; a deputy; a factor.
Bond
A documentary obligation to pay a sum or to perform a contract; a debenture.
Dividend
A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).
Fiduciary Duty
Legal and ethical obligations that agents have to principals when entrusted with managing assets, making decisions, or acting on the principal’s behalf.
Maturity
Date when payment is due.
Principal
One who directs another (the agent) to act on one’s behalf.
