Principal Agent Problem

This reading describes principal-agent relationships and the conflicts that arise between shareholders and managers or directors, between groups of shareholders, and between creditors and shareholders. It then sets out corporate governance and the mechanisms each stakeholder group uses, including the board and its committees, and the risks of poor governance and the benefits of effective governance.

LOS 22.a — Principal-agent relationships and conflicts

When one party (the principal) hires another (the agent) to act on its behalf, they are in a principal-agent relationship. A principal-agent conflict can arise because the agent's own interests may differ from the principal's. Example: a sales agent paid per contract signed has an incentive to sign up poor-quality customers the firm would rather refuse; the firm responds with acceptance standards and by dropping agents who act against it. Agency costs are the costs of such conflicts. Direct agency costs include the cost of monitoring the agent; indirect agency costs include business lost because of the conflict.

Shareholders vs. managers and directors

In a corporation, shareholders are the principals, and managers and directors are their agents. Conflicts also arise when inside directors side with management against shareholders, or when directors favor one group of shareholders over another. Typical conflicts:

Information asymmetry, the fact that managers know more about the firm than shareholders do, makes monitoring harder. It is more severe for large, multi-business or multinational firms, firms with complex products, and firms with low institutional ownership or low free float.

Between groups of shareholders

Controlling shareholders hold most of the votes and may act against minority shareholders. A controlling owner with most of his wealth in the firm may want it to diversify into unrelated businesses; already-diversified minority owners would rather it did not waste resources doing so. A dual-class structure gives one share class (often founders') more votes than its economic claim. CFA Institute opposes dual-class voting structures: they let one group of shareholders pursue its own interests at the expense of the others.

Creditors vs. shareholders

Creditors' upside is capped while shareholders' is not, so shareholders may want the company to take more business risk than creditors would like. Actions that shift value from creditors to shareholders include issuing new debt that raises existing lenders' default risk, or paying larger dividends that shrink the asset base. The risk is greatest for long-term debtholders.

LOS 22.b — Corporate governance and stakeholder mechanisms

Corporate governance is the set of internal controls and procedures that governs how a company is run: a framework defining the rights, roles and responsibilities of groups within the organization, aimed at managing and minimizing conflicts of interest among stakeholders. Stakeholder management means understanding stakeholders' interests and communicating with them effectively. Public companies report through annual reports, proxy statements and public notices (performance, related-party transactions, executive pay, governance structure); transparency reduces information asymmetry. Private companies have lighter reporting requirements and usually give information to their investors directly.

Shareholder mechanisms

• The annual general meeting (AGM) is held after fiscal year-end: audited statements presented, questions answered, votes cast. Corporate law sets when the meeting is held and how shareholders are notified; any shareholder may normally attend, speak and vote. Proxy voting is the main shareholder mechanism: a shareholder who does not attend assigns her vote to another person (often a director, a manager or her adviser), either with instructions on each issue or at that person's discretion.
• Ordinary resolutions, such as appointing the auditor or electing directors, need a simple majority of votes cast.
• Extraordinary general meetings are called for major decisions: changes to the bylaws, mergers and takeovers, special board elections requested by shareholders, and liquidation.
• Activist shareholders, increasingly hedge funds with large stakes, push for change through lawsuits, board seats, shareholder resolutions, a proxy contest, or a tender offer for a controlling stake. Shareholders can replace both senior managers and directors when they think performance would improve. The threat of a hostile takeover (one management does not support) disciplines management but may prompt takeover defenses such as a staggered board or a poison pill (rights that let existing shareholders other than the bidder buy extra shares at a low price, diluting the bidder).

Creditor mechanisms

The bond indenture sets out bondholders' rights and the issuer's obligations, including covenants (required or prohibited actions); bonds may be backed by collateral; a trustee monitors compliance. Creditor committees protect bondholders when the issuer is in distress; some countries require one in bankruptcy, and bondholders may form an ad hoc committee that does not represent every holder but shares their interests.

Board of directors and its committees

The board, which shareholders elect to represent them, is responsible for:

• selecting senior managers, setting their pay and evaluating their performance, and planning management and CEO succession;
• setting the company's strategic direction;
• approving changes in capital structure, significant acquisitions and large investment outlays;
• reviewing company performance and taking corrective action;
• setting up and supervising risk management and internal controls;
• making sure that financial reporting and internal audit are of high quality.

It delegates work to committees but keeps overall responsibility. How many committees a board needs, and how large they are, depends on the scale and complexity of the business; regulation often requires an audit committee.

Audit, compensation and governance committees are often made up only of nonexecutive or independent directors.

Other mechanisms

• Employees: labor laws, employment contracts, unions, employee board representatives (some countries), employee stock ownership plans (ESOPs).
• Customers and suppliers: contracts; increasingly, social media pressure.
• Governments: regulation and regulatory agencies; corporate governance codes (often "comply or explain"); exchange listing requirements.

LOS 22.c — Risks of poor governance, benefits of good governance