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