The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager to act in shareholders’ and other stakeholders' interests. Because of this separation, corporate governance includes controls intended to align managers’ incentives with those of shareholders and other stakeholders.
The principal-agent problem or agency dilemma, developed in economic theory, concerns the difficulties in motivating one party, the agent, to act on behalf of another party, the principal. The two parties have different interests and it is difficult to ensure that the agent is always acting in the best interest of the principal. Conflicts of interest may arise.
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, such as voting rights and forms of financial return.
Shareholders, managers, and bondholders have different objectives. Stockholders have an incentive to take riskier projects than bondholders do, as bondholders are more interested in strategies that will increase the chances of getting their investment back. Shareholders also prefer that the company pay more out in dividends than bondholders would like. Managers may also be shareholders and reap the profits of more risky strategies or may prefer risk-averse empire-building projects.
The term “agency costs” refers to instances when an agent's behavior has deviated from a principal's interest. In this case, the principal would be the shareholder. These types of costs mainly arise because of contracting costs, or because individual managers might only possess partial control of corporation behavior. They also arise when managers have personal objectives that are different from the goal of maximizing shareholder profit.
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 stock in a corporation. Typically, these people have the right to sell those shares, to vote on directors nominated by various boards, and many other privileges. This being said, shareholders usually concede most of their control rights to managers.
While attempting to benefit shareholders, managers often encounter conflicts of interest. For instance:
Advocates of governance typically encourage corporations to respect shareholder rights, and to help shareholders learn how and where to exercise those rights. Disclosure and transparency are intertwined with these goals.
The deviation from the principals’ interests by the agent is called "agency costs," which are often described as existing between managers and shareholders, but conflicts of interest can also exist 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.
EXAMPLELoan covenants can be put in place to control the risk profile of a loan, requiring the borrower to fulfill certain conditions or forbidding the borrower from undertaking certain actions as a condition of the loan. This can negatively impact the shareholders. Conversely, shareholder preferences–as, for example, riskier strategies for growth–can adversely impact bondholders.
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “AGENCY AND CONFLICTS OF INTEREST” TUTORIAL.