LOS C requires us to:
describe principal–agent and other relationships in corporate governance and the conflicts that may arise in these relationships
The principal-agent relationship is a relationship created due to an arrangement between two parties, where one party legally appoints others to act on its behalf. Here, the principal hires an agent to act on its behalf. The agent is expected to act in the best interest of the principal, and there should be no conflict of interest in carrying out the act.
Some of the important examples of principal-agent relationship are:
1.1. Shareholders & Managers / Directors
The shareholders are the owners of the company who appoints the managers or the directors to work on their behalf, in managing the affairs of the companies. Here, the shareholders are the principals who appoint managers/directors as their agents.
The agents are expected to work in the best interest of the company and the shareholders; however, they may seek to maximize their personal benefits to the detriment of the shareholders. Some of the potential problems that may arise in the principal-agent relationship between the shareholders and managers are:
a. Risk Tolerance. The management may be more risk-averse (thus restricting the number of returns to the shareholders), in order to protect their positions.
b. Information Asymmetry. It may, at times, be difficult for the shareholders to judge the soundness of strategic decisions.
c. The Board Composition. The board may be comprised of too many insiders, such as executive directors.
1.2. Controlling & Minority Shareholders
Controlling shareholders are those shareholders that own more than fifty percent of the company’s shares and control the composition of the board of directors and thus the affairs of the company. Minority shareholders, on the other hand, are those shareholders who own less than half of the company’s shares and do not have control over the affairs of the company. There exists a principal-agent relationship between the controlling and minority shareholders by the virtue of the ability to control shareholders to control the affairs of the company on the behalf of the minority.
Generally, the opinions of the minority shareholders are outweighed by the influence of the controlling shareholders. Thus, a few issues that could be a cause of conflict between the principal-agent relationships between these two parties are:
a. Related Party Transactions. Controlling shareholders have an interest in the transaction between the company and the third-party suppliers, which may be a detriment to the interest of the minority shareholders.
b. Dual Class Shares. There are two classes of shares, i.e. the voting shares (typically belonging to the management) and non-voting shares. The voting shareholders may be biased in their decisions, creating a conflict of interest.
1.3. Managers & Board of Directors
The managers are responsible for the actual affairs of the company, and the board of directors relies on the information provided by the managers.
The Board of director’s oversight can be compromised if management limits the information provided to them (especially to the non-executive directors).
1.4. Shareholders & Creditors
Creditors usually have no control over the affairs of the company; it is usually controlled by the shareholders. The main reasons for conflict between the shareholders and creditors are:
a. The shareholders prefer higher returns even if it means greater potential risks. Whereas, creditors prefer stable performance & lower-risk activities.
b. Also, the presence of debt or creditors in the capital structure may either add to the leverage effects or lower the levels of shareholders’ payout.
1.5. Other Stakeholders
There is a conflict of interest between other stakeholders as well. Some of them are:
a. Customers vs. Creditors. There is a continuous conflict in respect of cutting costs and the quality of goods and services provided to the customers.
b. Customers vs. Suppliers. There is a conflict with regards to the lenient credit terms to the customers vs. timely payment to the suppliers.
c. Shareholders vs. Government Regulator. The shareholders face issues with respect to the costly regulation and tax minimization strategies.