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Principal-agent and other relationships in corporate governance

The principal-agent relationship (agency relationship) is prone to conflict of interest.

Shareholders and director/manager relationships

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.

Controlling shareholders and minority shareholders

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.

Shareholder vs creditor interests

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.

Other stakeholder conflicts

These include:

  • Shareholders and customers: shareholders might want a company to charge higher prices, but customers do not.
  • Customers and suppliers: when a company offers too lenient credit policy to customers, payments to suppliers might be delayed.
  • Shareholders and government/regulators: shareholders might want to adopt accounting policies that minimize their tax burden.

by Obaidullah Jan, ACA, CFA on Wed Feb 26 2020

This article can help you prepare for Reading 31 LOSc.

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