Relationships in Corporate Governance | CFA Level I Corporate Issuers

Welcome back as we examine the relationships between the various stakeholders in a company.

Principal-Agent Relationship

Let’s begin by learning what a principal-agent relationship is.

Also known as an agency relationship, a principal–agent relationship is created when a principal hires an agent to perform a particular task or service. An agent is obliged to act in the best interests of the principal. Conflicts arise when an agent’s interests may not coincide exactly with those of the principal.

We’ll discuss some of these principal-agent relationships and the potential conflicts amongst the stakeholders of a firm.

Shareholder and Manager/Director Relationship

The first relationship we’ll look at is between shareholders and managers or directors. Shareholders are the principals as they are firm owners, while the firm management and directors can be considered agents hired to run the firm.

According to traditional shareholder theory, the primary duty of directors and managers is to act in the best interests of shareholders. However, in certain circumstances, managers may prioritize their personal compensation over shareholders’ interests.

Some conflicts in this relationship include:

• Risk tolerance: Shareholders usually have diversified investment portfolios, so their concentration risk in the firm may not be that high. Managers, on the other hand, have high concentration risk in the firm’s performance. As such, while shareholders desire higher returns from the company’s stock, managers can be more risk-averse in their corporate decision to protect their jobs.
• Information asymmetry: Managers typically have greater access to information about the business and are more knowledgeable about its operations. Such information asymmetry makes it more difficult for shareholders to monitor and determine whether the managers are acting in their best interests.
• Board conflicts: Conflicts of interest might arise between shareholders and directors when the board itself has directors that are executives within the company. In this case, the board may be less effective in monitoring and controlling management actions and compensation.
• Favouritism: Sometimes, the board of directors may favor certain influential shareholders over other shareholders. This creates a conflict between the board and shareholders who did not receive preferential treatment.

Conflicts Between Shareholder Groups

Conflicts can also occur between groups of shareholders, such as when a single shareholder or group of shareholders holds a majority of the votes or shares in the company and disregards the interests of minority shareholders.

Examples of conflicts between shareholder groups include:

• Acquisitions: In the event of an acquisition of the company, controlling shareholders may be in a position to get better terms or rewards for themselves, while minority shareholders’ interests can be neglected.
• Related party transactions: Some controlling shareholders may have interests in other companies and exert their influence on the company to do business with them. Such non-competitive arrangements may harm the company, to the detriment of minority shareholders.
• Stock classes: Conflicts can also occur when firms have different classes of common stock, some with more voting power than others. This may result in a group of shareholders having effective control of the company even if they hold less than 50% of the outstanding shares.

Shareholder and Creditor Conflicts

Another potential source of conflicts is between the shareholders and creditors of the company.

Returns to shareholders increase as the company grows, whereas returns to creditors are mainly the fixed interest paid by the company. As such, shareholders may prefer more business risk than creditors do.

Examples of conflicts between shareholders and creditors include:

• New debt: New debt is often issued as the company takes on higher-risk projects to increase shareholder wealth. This can increase the default risk faced by existing creditors.
• Excessive dividends: The distribution of excessive dividends to shareholders might also conflict with creditors’ interests if it impairs the company’s ability to pay interest and principal.

Other Stakeholder Conflicts

Other less major conflicts also exist between some of the stakeholder groups, such as:

• Customers and shareholders: A company may decide to raise prices or reduce product safety features to reduce costs. This can please shareholders, but the customers are surely not pleased!
• Shareholders and government: A company may adopt accounting and reporting practices that reduce its tax burden. This benefits the shareholders, but there is less revenue for the government.