Agency and Conflicts of Interest

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Introduction to the Field and Goals of Financia... > Agency and Conflicts of Interest
Agency and Conflicts of Interest
Defining Agency Conflicts

Managers, Shareholders, and Bondholders
Conflicts Between Managers and Shareholders
Conflicts of Interest Between Shareholders and Bondholders
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Defining Agency Conflicts

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 principalagent 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.
Conflict of Interest
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Managers, Shareholders, and Bondholders

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.
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Conflicts Between Managers and Shareholders

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.
Two Businessmen Having a Discussion

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Conflicts of Interest 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.
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.
Wall Street bull
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Appendix
Introduction to the Field and Goals of Financia...
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.
bond A documentary obligation to pay a sum or to perform a contract; a debenture.
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).
maturity Date when payment is due.
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.
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.
principal One who directs another (the agent) to act on ones behalf.
shareholder One who owns shares of stock.
shareholder One who owns shares of stock.
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Flickr. "Welcome to Flickr - Photo Sharing." CC BY http://flickr.com View on Boundless.com
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.
Flickr. "All sizes | Navy admiral talks with radio show host in Wisconsin.| Flickr - Photo Sharing!." CC BY http://www.flickr.com/photos/usnavy/5445949984/sizes/l/
Two Businessmen Having a Discussion

These two businessmen could represent a manager and shareholder discussing the operation of the business.
Flickr. "01 (45) | Flickr - Photo Sharing!." CC BY http://www.flickr.com/photos/76029035@N02/6829388895/ View on Boundless.com
Wall Street bull

The bull on Wall Street is an iconic image of the New York Stock Exchange.
Flickr. ""Wall Street Bull" | Flickr - Photo Sharing!." CC BY http://www.flickr.com/photos/thenails1/3407072012/ View on Boundless.com
Which of the following is NOT an example of an agency cost?

A) Management buys a subsidiary to expand its personal power instead
of maximizing the company's value.
B) Employees are paid an hourly wage.
C) Management is compensated with stock options in the company.
D) Auditing a company's financial statements to prevent fraud.
Which of the following is NOT an example of an agency cost?

A) Management buys a subsidiary to expand its personal power instead
of maximizing the company's value.
B) Employees are paid an hourly wage.
C) Management is compensated with stock options in the company.
D) Auditing a company's financial statements to prevent fraud.
Boundless - LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/
Which of the following is a source of agency costs in an

organization.
A) The managers of the organization have different objectives than the
other shareholders.
B) The people who make the day-to-day decisions are not the owners.
C) Parties associated with the organization have different risk
preferences.
D) All of these answers.
Which of the following is a source of agency costs in an

organization.
A) The managers of the organization have different objectives than the
other shareholders.
B) The people who make the day-to-day decisions are not the owners.
C) Parties associated with the organization have different risk
preferences.
D) All of these answers.
A manager enters into a transaction that benefits himself more

than his shareholders. This is an example of ____.
A) fraud.
B) contracting costs.
C) corporate governance.
D) self-dealing.
A manager enters into a transaction that benefits himself more

than his shareholders. This is an example of ____.
A) fraud.
B) contracting costs.
C) corporate governance.
D) self-dealing.
Which of the following is a factor that contributes to the conflict of

interest between a company's bondholders and its shareholders?
A) Shareholders have a vote in how the company conducts its business;
bondholders generally do not.
B) Shareholders are only paid if the company makes a profit,
bondholders are paid regardless.
C) All of these answers
D) Shareholders generally want the company to pursue riskier projects;
bondholders do not.
Which of the following is a factor that contributes to the conflict of

interest between a company's bondholders and its shareholders?
A) Shareholders have a vote in how the company conducts its business;
bondholders generally do not.
B) Shareholders are only paid if the company makes a profit,
bondholders are paid regardless.
C) All of these answers
D) Shareholders generally want the company to pursue riskier projects;
bondholders do not.
Attribution
Wikipedia. "Financial capital." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Financial_capital
Wikipedia. "Conflict of interest." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Conflict_of_interest
Wikipedia. "Bondholder." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Bondholder
Wikipedia. "Ceo." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Ceo
Wikipedia. "Corporate governance." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Corporate_governance
Wikipedia. "Shareholder." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Shareholder
Wikipedia. "Principal agent." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Principal_agent
Wikipedia. "Agency costs." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Agency_costs
Wiktionary. "moral hazard." CC BY-SA 3.0 http://en.wiktionary.org/wiki/moral+hazard
Wiktionary. "bond." CC BY-SA 3.0 http://en.wiktionary.org/wiki/bond
Wiktionary. "dividend." CC BY-SA 3.0 http://en.wiktionary.org/wiki/dividend
Wikipedia. "Ceo." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Ceo
Wiktionary. "shareholder." CC BY-SA 3.0 http://en.wiktionary.org/wiki/shareholder

Wikipedia. "Loan covenant." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Loan_covenant
Wikipedia. "Financial capital." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Financial_capital
Wikipedia. "Bondholder." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Bondholder
Wiktionary. "maturity." CC BY-SA 3.0 http://en.wiktionary.org/wiki/maturity
Wiktionary. "shareholder." CC BY-SA 3.0 http://en.wiktionary.org/wiki/shareholder
Wiktionary. "bond." CC BY-SA 3.0 http://en.wiktionary.org/wiki/bond
Wiktionary. "moral hazard." CC BY-SA 3.0 http://en.wiktionary.org/wiki/moral+hazard
Wiktionary. "agent." CC BY-SA 3.0 http://en.wiktionary.org/wiki/agent
Wiktionary. "principal." CC BY-SA 3.0 http://en.wiktionary.org/wiki/principal

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Agency and Conflicts of Interest

Defining Agency Conflicts

Defining Agency Conflicts

Managers, Shareholders, and Bondholders

Conflicts Between Managers and Shareholders

Two Businessmen Having a Discussion

Conflicts of Interest Between Shareholders and Bondholders

Introduction to the Field and Goals of Financia...

Introduction to the Field and Goals of Financia...

Introduction to the Field and Goals of Financia...

Introduction to the Field and Goals of Financia...

Two Businessmen Having a Discussion

Introduction to the Field and Goals of Financia...

Wall Street bull

Introduction to the Field and Goals of Financia...

Which of the following is NOT an example of an agency cost?

C) Management is compensated with stock options in the company.

D) Auditing a company's financial statements to prevent fraud.

Introduction to the Field and Goals of Financia...

Which of the following is NOT an example of an agency cost?

C) Management is compensated with stock options in the company.

D) Auditing a company's financial statements to prevent fraud.

Introduction to the Field and Goals of Financia...

Which of the following is a source of agency costs in an

Introduction to the Field and Goals of Financia...

Which of the following is a source of agency costs in an

Introduction to the Field and Goals of Financia...

A manager enters into a transaction that benefits himself more

Introduction to the Field and Goals of Financia...

A manager enters into a transaction that benefits himself more

Introduction to the Field and Goals of Financia...

Which of the following is a factor that contributes to the conflict of

Introduction to the Field and Goals of Financia...

Which of the following is a factor that contributes to the conflict of

Introduction to the Field and Goals of Financia...

Introduction to the Field and Goals of Financia...

Wiktionary. "shareholder." CC BY-SA 3.0 http://en.wiktionary.org/wiki/shareholder

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