Agency and Conflicts of Interest

Conflicts naturally occur between owners and managers, and companies must have policies to ensure that employees are working for the benefit of the owners.

Defining Agency Conflicts

Agency conflicts can occur when the incentives of the agent do not align with those of the principal.


LEARNING OBJECTIVE

  • Explain how agency conflicts can influence corporate governance


KEY POINTS

  • The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager to act in shareholders' interests. Control systems in corporate governance can help align managers' incentives with those of shareholders and other stakeholders.
  • The principal–agent problem concerns the difficulties in motivating one party (the "agent"), to act on behalf of another (the "principal"). The two parties have different interests and asymmetric information. Moral hazard and conflict of interest may thus arise.
  • The deviation from the principal's interest by the agent is called "agency costs". Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control, and the different objectives (rather than shareholder maximization) of the managers.
  • Much recent interest in corporate governance is concerned with mitigation of the conflicts of interests between stakeholders. These occur when an individual or organization is involved in multiple interests that may lead to conflicts in their ability to act in the best interest of one party.


TERMS

  • moral hazard
    The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.

  • agent
    One who acts for, or in the place of, another (the principal), by authority from him; one intrusted with the business of another; a substitute; a deputy; a factor.

  • principal
    One who directs another (the agent) to act on one′s behalf.

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 parties') interests. Partly as a result of this separation, corporate governance mechanisms include a system of controls intended to help 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 (the "principal"). The two parties have different interests and asymmetric information (the agent having more information), such that the principal cannot directly ensure that the agents are always acting in its (the principals') best interests, particularly when activities that are useful to the principal are costly to the agent, and where elements of what the agent does are costly for the principal to observe. Moral hazard and conflict of interest (COI) may thus arise.

The deviation from the principal's interest by the agent is called "agency costs". Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control, and the different objectives (rather than shareholder maximization) of the managers. When a firm has debt, conflicts of interest can also arise between stockholders and bondholders, leading to agency costs on the firm. Examples of agency costs include that borne by shareholders (the principal), when corporate management (the agent) buys other companies to expand its power instead of maximizing the value of the corporation's worth; or by the constituents of a politician's district (the principal) when the politician (the agent) passes legislation helpful to large contributors to their campaign rather than helpful to voters.

Much of the contemporary interest in corporate governance is concerned with mitigation of the conflicts of interests between stakeholders. A conflict of interest occurs when an individual or organization is involved in multiple interests that may lead to conflicts in their ability to act in the best interest of one party. In addition to conflicts of interest between managers, shareholders, and bondholders, conflicts of interest can also occur among other stakeholders of a company, such as the board of directors, employees, government, suppliers, and customers. COI is sometimes termed "competition of interest" rather than "conflict", emphasizing a connotation of natural competition between valid interests rather than violent conflict. At other times, conflicts of interest are confused with cases that might better be termed "corruption", such as bribe-taking or fraud.



Source: Boundless
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