Agency and Conflicts of Interest
Conflicts of Interest Between Shareholders and Bondholders
The shareholders and bondholders have different rights and returns, leading to potential conflicts of interest.
LEARNING OBJECTIVE
- Describe the conflict of interest between a company's shareholders and its bondholders
KEY POINTS
- 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.
- Stockholders have an incentive to take riskier projects than bondholders do. Other conflicts of interest can stem from the fact that bonds often have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely but can also be sold at any point.
- Bondholders may put contracts in place prohibiting management from taking on very risky projects or may raise the interest rate demanded, increasing the cost of capital for the company. Conversely, shareholder preferences - for example for riskier growth strategies - can adversely impact bondholders.
TERMS
- shareholder
One who owns shares of stock. - bond
A documentary obligation to pay a sum or to perform a contract; a debenture. - maturity
Date when payment is due.
The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager (the agent) to act in the principals' interests.
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. For example, 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. Shareholders have voting rights at general meetings, while bondholders do not. If there is no profit, the shareholder does not receive a dividend, while interest is paid to debenture-holders regardless of whether or not a profit has been made. Other conflicts of interest can stem from the fact that bonds often have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely but can also be sold at any point.
Because bondholders know this, they may create ex-ante contracts prohibiting the management from taking on very risky projects that might arise, or they may raise the interest rate demanded, increasing the cost of capital for the company. For example, loan 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.