Relationships in Corporate Governance

Relationships in Corporate Governance

The term ‘Principal-agent relationship’ or just simply, ‘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 the company (the principals).

Shareholder and Manager or Director Relationships

Directors and managers (agents) are expected to act in the best interests of the shareholders (principal) by maximizing the 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 to better 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 the 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.

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 usually 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.

Creditor Versus Shareholder Interests

Creditors’ interest is to have a company undertake activities that promote stable financial performance and maintain default risk at an acceptable level. This essentially guarantees a safe return of their principal and payment of interest by the company. Shareholders, on the other hand, prefer to have the 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.

Other Stakeholder Conflicts

Examples of other conflicts between stakeholders include conflicts between customers and shareholders, customers and suppliers, and shareholders and governments or regulators.

Question

Which of the following statements about principal-agency relationships is most likely accurate?

A. Shareholders and creditors tend to have similar risk tolerance with respect to the investments that a company should undertake.

B. In a principal-agent relationship one entity, the agent, appoints another entity, the principal, to act on its behalf.

C. Managers typically have greater access to information about the company’s affairs than the shareholders.

Solution

The correct answer is C.

Shareholders and creditors tend to have different risk tolerance with respect to the investments that a company should undertake.

Option A is incorrect. The interest of creditors is to have a company undertake activities that promote stable financial performance. Shareholders, on their part,  prefer to have the company undertake riskier activities that have high return potential.

Option B is incorrect. In a principal-agent relationship one entity, the principal, appoints another entity, the agent, to act on its behalf.

Reading 31 LOS 31c:

Describe principal-agent and other relationships in corporate governance and the conflicts that may arise in these relationships

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep


    Sergio Torrico
    Sergio Torrico
    2021-07-23
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    diana
    diana
    2021-07-17
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    2021-07-16
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    2021-06-28
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Marwan
    Marwan
    2021-06-22
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    2021-05-10
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.