Reading 22

When one party hires another to carry out a task, the two parties are said to have a principal-agent relationship. A principal-agent conflict has the potential to arise because an agent is hired to act in the interests of the principal, but the agent's interests might not coincide exactly with those of the principal.

For example, an insurance agent paid a commission on policies written has an interest in writing policies on poor risks to maximize commission income. The principal (insurance company owner) does not want bad-risk policies. Companies mitigate this conflict by imposing underwriting standards and continuing to work only with agents who consistently act in the company's best interest.

Agency costs are the costs of a principal-agent conflict — direct (hiring employees to monitor the agent) or indirect (opportunity cost of lost business).

Conflicts Between Shareholders and Managers/Directors

In a corporation, shareholders are the principals (owners), and management and board members are their agents. Managers and directors may choose a lower level of business risk than shareholders would. Managers have their employment income tied to the firm and stand to lose it if the firm fails; shareholders can diversify cheaply and may prefer more risk.

Conflicts may also arise if inside directors favor management interests at the expense of shareholders, or if directors favor one group of shareholders over another. Information asymmetry means managers have more and better information than shareholders about the firm's functioning and strategy — decreasing shareholders' or nonexecutive directors' ability to monitor whether managers are acting in shareholders' interests. Information asymmetry is more acute for larger companies operating across many businesses and geographies, companies with complex products, and companies with lower institutional ownership and free float.

Common principal-agent conflicts:

• Insufficient effort: poor evaluation of investments and risks → higher total costs.
• Option grants and risk-taking: managers with options may want to ratchet up risk because options have no downside; managers paid mostly cash may be inadequately motivated to take risk.
• Empire building: compensation tied to company size creates incentives for poor/unnecessary acquisitions.
• Entrenchment: managers may take inadequate risk, mimic competitors, or pursue projects requiring their specific knowledge to entrench themselves; directors may go along with management rather than questioning.
• Self-dealing: managers exploiting firm resources for personal benefit.

Conflicts Between Groups of Shareholders

Controlling shareholders (single shareholder or group with most votes) may act against minority shareholders. A controlling shareholder with concentrated ownership (large portion of personal wealth in the company) might want the company to diversify into different businesses to mitigate risk; minority shareholders may already hold diversified portfolios and prefer the company not squander resources on less desirable diversification.

Some firms have a dual-class structure with different classes of common stock having different voting power. This can give a group of shareholders (e.g., founders) effective control even with claims to less than 50% of earnings and assets. CFA Institute advocates against dual-class voting structures because they allow one group to further their interests at the expense of others.

Conflicts Between Creditors and Shareholders

Shareholders may prefer more business risk than creditors because creditors have a limited upside from good results. Management actions that favor equity owners over creditors include issuing new debt (increasing default risk faced by existing debtholders) or increasing dividends (decreasing company assets as collateral, increasing default risk). This is a greater risk for long-term debtholders.

Corporate governance is the system of internal controls and procedures by which individual companies are managed. It defines the rights, roles, and responsibilities of various groups within an organization. The objective is to manage and minimize conflicts of interest between stakeholders.

Stakeholder management is based on having a good understanding of stakeholder interests and maintaining effective communication. Standard practices for shareholder relations are required by corporate laws and are similar in many jurisdictions.

Stakeholders gather information from public reports filed by the company: annual reports, proxy statements, public notices. These cover financial performance, related-party transactions, executive remuneration, and governance structure. Private companies have more limited reporting requirements but typically provide information directly to investors. Transparency reduces information asymmetry and helps stakeholders evaluate alignment with their interests.

Shareholder Mechanisms

Corporations typically hold an annual general meeting after the end of the fiscal year. Management provides audited financial statements, addresses performance and significant actions, and answers shareholder questions. Corporate laws dictate when and how the meeting must occur.

Anyone owning shares may attend, speak/ask questions, and vote. A shareholder who does not attend can vote by proxy, assigning the right to vote to another person — often a director, a member of management, or the shareholder's investment advisor. A proxy may specify votes on specific issues or leave to the proxy holder's discretion.

Ordinary resolutions (e.g., approval of auditor, election of directors) require a simple majority of votes cast. Other resolutions are addressed at extraordinary general meetings, called when a matter requires a shareholder vote — amendments to bylaws, mergers/takeovers, shareholder-proposed special board elections, or liquidation.

Activist shareholders pressure companies for changes they believe will increase shareholder value. They may initiate shareholder lawsuits or seek representation on the board. Other tactics: propose shareholder resolutions for a vote, raise issues to all shareholders or the public. Hedge funds have engaged increasingly in shareholder activism.

A shareholder activist group may initiate a proxy contest (seeking proxies to vote in favor of alternative proposals) or make a tender offer for enough shares to gain control. Both senior managers and boards can be replaced. The threat of a hostile takeover (one not supported by company management) can act as an incentive for management and boards to pursue policies aligned with shareholders. It may also cause the current management or board to adopt takeover defenses such as staggered board elections or poison pill provisions (low-price additional share offerings to current shareholders).

Creditor Mechanisms

When a company issues a bond, it specifies the rights of bondholders and the company's obligations in a legal document called a bond indenture. An indenture typically includes covenants that may require the company to take certain actions or restrict it from taking certain actions. A bond can be backed by collateral (specific assets pledged against the bond). A financial institution may act as trustee to monitor compliance with covenants.

Creditor committees may form among bondholders to protect their interests when an issuer experiences financial distress. Some countries require such committees in bankruptcy. Ad hoc committees may form when a company is struggling to meet obligations.

Board of Directors and Management Mechanisms

The board of directors is elected by shareholders to act in their interests. A board typically has committees made up of members with particular expertise. Committees report to the board, which retains overall responsibility.

Audit committee: oversight of financial reporting and accounting policies; effectiveness of internal controls and internal audit; recommending an external auditor and its compensation; proposing remedies based on audit reviews.

Nominating/governance committee: oversight of the corporate governance code including board elections; setting nomination policies; implementing the code of ethics and conflict-of-interest policies; monitoring changes in relevant laws; ensuring compliance with laws and governance policies.

Compensation/remuneration committee: recommends amounts and types of compensation for directors and senior managers; may also oversee employee benefit plans and evaluate senior managers. Because managers should not evaluate or compensate themselves, this committee should (and in many countries must) be composed of independent directors only.

Other industry-specific committees: a risk committee (financial services) informs the board about risk policy and tolerance and oversees enterprise risk management; an investment committee (insurance) reviews prudent investment and capital management policies.

The composition of a board committee is often based on its function — audit, compensation, and governance committees are often made up of only nonexecutive or independent directors.

Employee, Customer, and Supplier Mechanisms

For employees: labor laws, employment contracts, and the right to form unions. Some countries require boards of large companies to include employee representatives. Employee stock ownership plans (ESOPs) may help align company and employee interests. For customers and suppliers: contracts are the primary mechanism. In recent years, customers and other stakeholders have increasingly used social media to influence company behavior.

Government Mechanisms

Governments enact and enforce regulations. They may establish agencies to regulate industries (e.g., financial markets) or monitor specific issues (workplace safety, environmental protection). Some countries develop corporate governance codes that companies must adopt or explain why they have not. In some countries, corporate governance regulations are specified by stock exchanges as listing requirements.

Risks of Poor Governance and Stakeholder Management

When corporate governance is weak, the control functions of audits and board oversight may be weak as well. Some stakeholders can gain an advantage to the disadvantage of others. Accounting fraud or poor recordkeeping has negative implications for company performance and value.

When governance is weak and managers are not monitored, they may serve their own interests by choosing less-than-optimal risk, reducing company value. Without proper monitoring, management may be given incentive compensation that allows them to pursue their own benefit rather than the company's interests. They may engage in related-party transactions that benefit friends or family at the expense of shareholders.

Poor compliance procedures with respect to regulation and reporting can easily lead to legal and reputational risks. Violating stakeholder rights can lead to stakeholder lawsuits. Failure to comply with government regulations can damage company reputation. Failure to manage creditors' rights can lead to debt default and bankruptcy.

Benefits of Effective Governance and Stakeholder Management

Effective corporate governance can improve operational efficiency by ensuring that management and board incentives align well with shareholders. Effective governance implies effective control and monitoring. A strong system of controls and compliance can avoid many legal and regulatory risks.

Formal policies regarding conflicts of interest and related-party transactions can lead to better operating results. Proper governance with respect to creditors can reduce the risk of debt default or bankruptcy, thereby reducing the cost of debt financing. Alignment of management interests with shareholders leads to better financial performance and greater company value.