Principal-Agent Relationships

The term ‘principal-agent relationship’ or simply just ‘agency relationship’ is used to describe an arrangement where one entity, the principal, legally appoints another entity, the agent, to act on its behalf by providing a service or performing a particular task.

The agent is expected to act in the best interest of the principal. It is, however, not unusual for principal-agent relationships to lead to conflicts. The most common example of this occurs when managers, acting as agents, do not act in the best interest of the shareholders of a company (the principals).

Shareholder and Manager/Director Relationships

Directors and managers (agents) are expected to act in the best interests of the shareholders (principal) by maximizing a company’s equity value. These two groups, however, tend to have conflicting interests on issues related to the risks that a company should undertake. Managers and directors tend to act in a more risk-averse manner so as to protect their employment status. On their part, shareholders would want directors and managers to accept more risk to maximize equity value.

In addition, managers usually have greater access to information and are more knowledgeable about a company’s affairs than the shareholders. This information asymmetry makes it easier for managers to make strategic decisions that are not necessarily in the best interests of shareholders.

Managers’ and stockholders’ interests are rarely perfectly aligned. Examples of conflicts include:

• Entrenchment: Excessive pay can lead to the avoidance of risk in order for one to hold onto one’s position. Similarly, directors could refrain from criticizing management so as to be able to maintain their positions.
• Empire building: Managers are encouraged to pursue acquisitions even though they might not boost shareholder value when directors’ and management’s remuneration is based on the size of the company.
• Excessive risk-taking: A compensation plan that heavily relies on stock grants and options may encourage management to take excessive risks.

Agency Theory

According to agency theory, managers are supposed to carry out their responsibilities with the intention of increasing business value and fulfilling the interests of shareholders.

Agency Costs

When an agent takes action on behalf of a principal, there may be conflicts of interest that may increase expenses related to trying to reduce these conflicts. These costs are known as agency costs.

Controlling and Minority Shareholder Relationships

Minority shareholders usually have limited or no control over the management. Similarly, they have limited or no voice in director appointments or in major transactions that could directly impact shareholder value. As a result, conflicts between minority and controlling shareholders can occur. Such conflicts arise when the opinions or desires of the minority shareholders are eclipsed by the influence of the controlling shareholders.

Manager and Board Relationships

Whereas managers are involved in the day-to-day operations of a company, the board of directors, especially the non-executive board members, are not. This leads to information asymmetry and makes it difficult for the board to effectively carry out its functions.

Shareholder vs. Creditor (Debtholder) Interests

Creditors’ interest is to have a company undertake activities that promote stable financial performance. This guarantees the maintenance of default risk at an acceptable level. Further, it essentially guarantees a safe return of their principal and payment of interest by the company. Shareholders, on the other hand, prefer to have a company venture into riskier activities that have high return potential and are, as such, more likely to enhance equity value. There is, therefore, a divergence of interest in risk tolerance between these two groups.

Question

Which of the following instances of conflict of interest between managers and shareholders is most likely a result of managers’ compensation being tied to the size of the company?

1. Entrenchment.
2. Empire building.
3. Excessive risk-taking.

The correct answer is B.

Under empire building, managers are encouraged to pursue acquisitions even though they might not boost shareholder value. This happens when directors’ and management’s remuneration is based on the size of the company.

A is incorrect. Entrenchment is where excessive pay leads to the avoidance of risk in order for one to hold onto one’s position. Directors refrain from criticizing management so as to be able to maintain their positions.

C is incorrect. Excessive risk-taking is where a compensation plan that heavily relies on stock grants and options encourages management to take excessive risks.