Agency and Conflicts of Interest

Defining Agency Conflicts

Agency conflicts can occur when the incentives of the agent do not align with those of the principal.

Learning Objectives

Explain how agency conflicts can influence corporate governance

Key Takeaways

Key Points

  • The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager to act in shareholders ‘ interests. Control systems in corporate governance can help align managers’ incentives with those of shareholders and other stakeholders.
  • The principal – agent problem concerns the difficulties in motivating one party (the “agent”), to act on behalf of another (the “principal”). The two parties have different interests and asymmetric information. Moral hazard and conflict of interest may thus arise.
  • The deviation from the principal’s interest by the agent is called “agency costs. ” Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control, and the different objectives (rather than shareholder maximization) of the managers.
  • Much recent interest in corporate governance is concerned with mitigation of the conflicts of interests between stakeholders. These occur when an individual or organization is involved in multiple interests that may lead to conflicts in their ability to act in the best interest of one party.

Key Terms

  • agent: One who acts for, or in the place of, another (the principal), by authority from him; one intrusted with the business of another; a substitute; a deputy; a factor.
  • principal: One who directs another (the agent) to act on one′s behalf.
  • moral hazard: The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.

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 parties’) interests. Partly as a result of this separation, corporate governance mechanisms include a system of controls intended to help 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 (the “principal”). The two parties have different interests and asymmetric information (the agent having more information), such that the principal cannot directly ensure that the agents are always acting in its (the principals’) best interests, particularly when activities that are useful to the principal are costly to the agent, and where elements of what the agent does are costly for the principal to observe. Moral hazard and conflict of interest (COI) may thus arise.

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Conflict of Interest: Principal-agent problems – which arise when managers act on the behalf of a firm and its investors – include potential conflicts of interest.

The deviation from the principal’s interest by the agent is called “agency costs. ” Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control, and the different objectives (rather than shareholder maximization) of the managers. When a firm has debt, conflicts of interest can also arise between stockholders and bondholders, leading to agency costs on the firm. Examples of agency costs include that borne by shareholders (the principal), when corporate management (the agent) buys other companies to expand its power instead of maximizing the value of the corporation’s worth; or by the constituents of a politician’s district (the principal) when the politician (the agent) passes legislation helpful to large contributors to their campaign rather than helpful to voters.

Much of the contemporary interest in corporate governance is concerned with mitigation of the conflicts of interests between stakeholders. A conflict of interest occurs when an individual or organization is involved in multiple interests that may lead to conflicts in their ability to act in the best interest of one party. In addition to conflicts of interest between managers, shareholders, and bondholders, conflicts of interest can also occur among other stakeholders of a company, such as the board of directors, employees, government, suppliers, and customers. COI is sometimes termed “competition of interest” rather than “conflict”, emphasizing a connotation of natural competition between valid interests rather than violent conflict. At other times, conflicts of interest are confused with cases that might better be termed “corruption”, such as bribe-taking or fraud.

Managers, Shareholders, and Bondholders

Three parties key to the corporation’s functioning are managers, shareholders, and bondholders, each of which can have different interests.

Learning Objectives

Describe the reasons why there may be agency costs in an organization

Key Takeaways

Key Points

  • Three parties key to the functioning of the corporation are the managers, shareholders, and bondholders. 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, for example voting rights and forms of financial return.
  • Shareholders, managers, and bondholders have different objectives. For example, shareholders have an incentive to take riskier projects than bondholders do and may prefer that the company pay more out in dividends. Managers may also be shareholders or prefer risk-averse, empire-building projects.

Key Terms

  • 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).
  • moral hazard: The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.

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. Partly as a result of this separation, corporate governance mechanisms include a system of controls intended to help align managers’ incentives with those of shareholders and other stakeholders.

The deviation from the principal ‘s interest by the agent is called ‘agency costs. ‘ Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control and the different objectives of the managers and other stakeholders. Three parties key to the functioning of the corporation are the managers, shareholders, and bondholders. These three parties have different interests and asymmetric information, such that the principals cannot directly ensure that the agents are always acting in its (the principals’) best interests. Moral hazard and conflict of interest may arise.

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Working on Assignments

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, for example voting rights and forms of financial return. Shareholders, managers, and bondholders have different objectives. For example, stockholders have an incentive to take riskier projects than bondholders do, as bondholders are more interested in strategies that will increase the chances of 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.

Conflicts Between Managers and Shareholders

Agency costs mainly occur when ownership is separated, or when managers have objectives other than shareholder value maximization.

Learning Objectives

Discuss different examples of a conflict of interest between managers and shareholders

Key Takeaways

Key Points

  • The agency view of the corporation suggests that the decision rights of the corporation should be entrusted to a manager to act in shareholders ‘ interests. Agency costs mainly occur when ownership is separated, or when managers have objectives other than shareholder value maximization.
  • 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 corporation stock. Shareholders typically concede control rights to managers.
  • There are various conflicts of interest that can impact manager’s decisions to act in shareholders’ interests. Management may, for example, buy other companies to expand power. Venturing onto fraud, they may even manipulate financial figures to optimize bonuses and stock-price-related options.
  • Contemporary discussions of corporate governance argue that corporations should respect the rights of shareholders and help shareholders to exercise those rights. Disclosure and transparency are intimately intertwined with these goals.

Key Terms

  • shareholder: One who owns shares of stock.

The “agency view” of corporations argues that the decisions rights (or control) of a corporation should be entrusted to a manager, so that the manager can act in the interest of shareholders. Partly as a result of this, mechanisms of corporate governance include a system of controls that are intended to align the incentives of managers with those of shareholders.

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Two Businessmen Having a Discussion: These two businessmen could represent a manager and shareholder discussing the operation of the business.

The term “agency costs” refers to instances when an agent ‘s behavior has deviated from a 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.

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, to vote on directors nominated by various boards, and many other privileges. This being said, shareholders usually concede most of their control rights to managers.

While attempting to benefit shareholders, managers often encounter conflicts of interest. For example, a manager might engage in self-dealing, entering into transactions that benefit themselves over shareholders. Managers might also 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 onto fraud, they may even manipulate financial figures to optimize bonuses and stock-price-related benefits.

The chief goal of current corporate governance is to eliminate instances when shareholders have conflicts of interest with one another. 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 high-profile collapse of a number of large corporations in the past two decades, several of which involved accounting fraud, there has been a renewed public interest in how modern corporations practice governance, particularly regarding 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.

Conflicts of Interest Between Shareholders and Bondholders

The shareholders and bondholders have different rights and returns, leading to potential conflicts of interest.

Learning Objectives

Describe the conflict of interest between a company’s shareholders and its bondholders

Key Takeaways

Key Points

  • 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 to the company, accompanied by different rights and financial returns.
  • Stockholders have an incentive to take riskier projects than bondholders do. 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.
  • Bondholders may put contracts in place prohibiting management from taking on very risky projects or may raise the interest rate demanded, increasing the cost of capital for the company. Conversely, shareholder preferences–for example for riskier growth strategies –can adversely impact bondholders.

Key Terms

  • bond: A documentary obligation to pay a sum or to perform a contract; a debenture.
  • maturity: Date when payment is due.
  • shareholder: One who owns shares of stock.

The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager (the agent ) to act in the principals ‘ interests.

The deviation from the principals’ interests by the agent is 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 to the company, accompanied by different rights and financial returns. For example, stockholders have an incentive to take riskier projects than bondholders do, as bondholders are more interested in strategies that will increase the chances of 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, while interest is paid to debenture-holders regardless of whether or not a profit has been 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.

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Wall Street bull: The bull on Wall Street is an iconic image of the New York Stock Exchange.

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. For 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–as for example riskier strategies for growth–can adversely impact bondholders.