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The principal-agent relationship (agency relationship) is prone to conflict of interest.
Shareholders appoint directors and management to maximize their return (as per the shareholder theory) but management may act to maximize their remuneration. Management may be more risk-averse than shareholders because shareholders might be holding a stock in a diversified portfolio. This may hurt a company’s value creation. Further, management often has access to information that shareholders do not have (referred to as information asymmetry) and they may take strategic decisions that are not necessarily in the best interest of shareholders. Similarly, (external) directors rely on management for obtaining an understanding of operations and may be misled if they do not have independent review available.
In straight voting (one vote per share) the controlling shareholders may overshadow the minority shareholders in almost all corporate decisions. They may use their control to receive a better deal during takeover and/or make a company enter into a transaction with a related party of the controlling group (to the detriment of the company and mainly, the minority shareholders). This problem may be more pronounced in dual-class structure, in which two different classes of shares have different voting rights.
Shareholders are willing to take on high risk in the hope of generating superior residual returns but creditors are not comfortable with high risk projects because they increase default risk. Shareholders might want to raise additional debt capital for new projects, but creditors do not want a company to increase debt. Distribution of excessive dividends also does not sit well with creditors.
by Obaidullah Jan, ACA, CFA on Wed Feb 26 2020
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