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 interests 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 interests of the shareholders of the 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 the company’s equity value. These two groups, however, tend to diverge on issues related to the risks that a company should undertake. Managers and directors tend to act in a more risk-averse manner in order to better protect their employment status, whereas shareholders would want for directors and managers to accept more risk in order to maximize equity value.
Additionally, 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 management and 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 wherein the opinions or desires of the minority shareholders are overshadowed 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 desire a company to undertake activities which promote stable financial performance and maintain default risk at an acceptable level to essentially guarantee a safe return of their principal and payment of interest. Shareholders, on the other hand, prefer for the company to undertake riskier activities which have strong earnings potential and are more likely to enhance equity value. There is, therefore, a divergence in risk tolerance between these two groups.
Other Stakeholder Conflicts
Examples of other conflicts between stakeholders include: conflicts between customers and shareholders, conflicts between customers and suppliers, and conflicts between shareholders and governments or regulators.
Which of the following statements about principal-agency relationships is 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.
The correct answer is C.
Shareholders and creditors tend to have different risk tolerance with respect to the investments that a company should undertake. In a principal-agent relationship one entity, the principal, appoints another entity, the agent, to act on its behalf.
Reading 34 LOS 34c:
Describe principal-agent and other relationships in corporate governance and the conflicts that may arise in these relationships