2.4 Agency Issues: Shareholders and Corporate Boards
4 min read•june 18, 2024
addresses conflicts between shareholders and managers, aiming to align their interests. , , and shareholder rights are key issues. Mechanisms like board oversight, , and auditing help minimize agency problems and protect shareholder interests.
evaluate a company's environmental, social, and governance practices. These factors impact risk management, reputation, and financial performance. While ESG initiatives may have short-term costs, studies generally show a neutral to positive relationship with long-term stock performance.
Agency Issues and Corporate Governance
Agency costs in corporate governance
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- Agency costs arise when there are conflicts of interest between principals (shareholders) and agents (managers) in a company
- Shareholders aim to maximize their wealth and returns on investment, while managers may prioritize personal benefits, perks, or (expanding the company beyond optimal size)
- Types of agency costs include:
- : Expenses incurred by shareholders to oversee and control managerial behavior (hiring auditors, implementing reporting systems)
- : Expenses incurred by managers to assure shareholders that they will act in the shareholders' best interests (contractual obligations, performance guarantees)
- : The reduction in shareholder value due to divergent interests between shareholders and managers, despite monitoring and bonding efforts
- mechanisms help minimize agency costs by aligning the interests of shareholders and managers
- Board of directors serves as a representative of shareholders' interests and monitors management's actions and decisions
- is crucial to ensure effective oversight and protect shareholder interests
- Executive compensation packages align managerial incentives with shareholder objectives through stock options and performance-based pay (bonuses tied to stock price or profitability)
- External auditors provide independent verification of financial statements to ensure transparency and accountability to shareholders
- Board of directors serves as a representative of shareholders' interests and monitors management's actions and decisions
Stakeholder conflicts of interest
- Shareholders vs. Managers
- Shareholders seek to maximize their returns and the value of their investments, while managers may prioritize job security, perks (corporate jets, lavish offices), or empire building
- Managers may engage in risk-averse behavior to protect their positions, potentially forgoing valuable investment opportunities that could benefit shareholders
- Shareholders vs. Bondholders
- Shareholders prefer higher-risk, higher-return projects that can increase stock prices, while bondholders prefer lower-risk projects to ensure timely interest and principal payments
- Shareholders may support excessive dividend payouts or share repurchases, reducing the assets available to repay bondholders in case of financial distress
- Majority vs. Minority Shareholders
- Majority shareholders may exploit their control over the company to benefit themselves at the expense of minority shareholders
- Examples include related-party transactions (deals with companies owned by majority shareholders), insider trading, or diverting corporate resources for personal gain (using company funds for private expenses)
Shareholder Rights and Corporate Control
- involves investors using their ownership rights to influence company policies and practices
- allows shareholders to participate in corporate decision-making without attending meetings in person
- Hostile takeovers occur when an acquiring company attempts to gain control without the target company's management approval
- initiatives aim to balance profit-making activities with actions that benefit society and the environment
Environmental, Social, and Governance (ESG) Criteria
Components of ESG criteria
- consider a company's impact on the natural environment and its efforts to mitigate negative effects
- Climate change mitigation and adaptation strategies (reducing carbon footprint, investing in renewable energy)
- Greenhouse gas emissions reduction targets and performance
- Energy efficiency measures and renewable energy usage in operations
- Waste management and pollution control practices (recycling, proper disposal of hazardous materials)
- Water management and conservation efforts (reducing consumption, treating wastewater)
- assess a company's relationships with its employees, customers, and the communities in which it operates
- Labor standards and working conditions (fair wages, safe workplaces, no child or forced labor)
- Diversity, equity, and inclusion initiatives (hiring practices, equal opportunities, anti-discrimination policies)
- Human rights and community relations (respecting indigenous rights, supporting local development)
- Product safety and liability considerations (quality control, recall procedures)
- Data privacy and security measures to protect customer and employee information
- evaluate a company's leadership, decision-making processes, and accountability to stakeholders
- Board composition and independence (diverse backgrounds, no conflicts of interest)
- Executive compensation structures that align with long-term shareholder interests
- Shareholder rights and activism (voting rights, ability to propose resolutions)
- Business ethics and anti-corruption measures (code of conduct, whistleblower protections)
- Risk management and internal controls to prevent fraud and ensure compliance
ESG policies vs stock performance
- Positive effects of ESG on stock performance:
- Improved risk management: Considering ESG factors helps identify and mitigate long-term risks (reputational, regulatory, environmental), leading to more stable returns over time
- Enhanced reputation and customer loyalty: Companies with strong ESG practices may attract and retain customers who value sustainability and social responsibility, boosting sales and profitability
- Lower cost of capital: Investors may perceive ESG-focused companies as less risky, resulting in lower borrowing costs and higher valuations
- Potential negative effects of ESG on stock performance:
- Short-term costs: Implementing ESG initiatives may require upfront investments (upgrading equipment, training employees), temporarily reducing profitability
- Reduced investment universe: Strict ESG screening may limit portfolio diversification and potential returns by excluding certain sectors or companies
- Empirical evidence on the relationship between ESG and stock performance is mixed but generally positive
- Many studies suggest a positive relationship between strong ESG performance and long-term stock returns, though results vary across industries and regions
- Meta-analyses indicate that the majority of studies find a non-negative (neutral to positive) relationship between ESG and corporate financial performance, with few showing a negative impact
Key Terms to Review (28)
(ESG): ESG stands for Environmental, Social, and Governance. It is a set of criteria used to evaluate a company's operations and performance in these three areas important to stakeholders.
Agency Costs: Agency costs refer to the expenses and potential losses that arise from the inherent conflict of interest between a company's management (the agent) and its shareholders (the principal). These costs stem from the separation of ownership and control, where managers may make decisions that prioritize their own interests over those of the shareholders they are meant to serve.
Agency problem: The agency problem arises when there's a conflict of interest between the management (agents) and the shareholders (principals) of a corporation. This issue can lead to managers making decisions that benefit themselves at the expense of shareholders.
Agency theory: Agency theory explains the relationship between principals (e.g., shareholders) and agents (e.g., corporate executives). It focuses on resolving conflicts that arise when agents do not align with the interests of principals.
Agency Theory: Agency theory is a framework that examines the relationship between a principal (such as a shareholder) and an agent (such as a company's management) in the context of decision-making and goal alignment. It explores the potential conflicts of interest that can arise when the agent is not fully incentivized to act in the best interests of the principal.
Agent: An agent is an individual or entity authorized to act on behalf of another person, known as the principal, in business transactions. In corporate finance, agents typically refer to company executives and managers working for shareholders.
Board Independence: Board independence refers to the degree to which the members of a company's board of directors are free from undue influence or conflicts of interest that could compromise their ability to make objective and impartial decisions in the best interests of the organization and its shareholders. It is a crucial aspect of corporate governance that helps ensure effective oversight and accountability.
Bonding Costs: Bonding costs refer to the expenses incurred by a company when it issues bonds to raise capital. These costs are associated with the process of selling bonds to investors and ensuring the company meets its obligations to bondholders over the life of the bonds.
Corporate governance: Corporate governance is the system of rules, practices, and processes by which a company is directed and controlled. It involves balancing the interests of a company's many stakeholders, such as shareholders, management, customers, suppliers, financiers, government, and the community.
Corporate Governance: Corporate governance refers to the system of rules, practices, and processes by which a company is directed and controlled. It encompasses the relationships between a company's management, its board of directors, its shareholders, and other stakeholders, and provides the structure through which the company's objectives are set and the means of attaining those objectives are determined.
Corporate Social Responsibility: Corporate social responsibility (CSR) refers to the ethical and philanthropic obligations that businesses have towards their stakeholders, the community, and the environment. It encompasses a company's voluntary efforts to integrate social and environmental concerns into their operations and interactions with their stakeholders.
Empire Building: Empire building refers to the actions taken by company management to expand their control over resources and operations, often at the expense of shareholder interests. This can involve pursuing growth strategies that may not align with the best financial interests of shareholders, leading to conflicts between management objectives and shareholder value maximization. Such behavior can create agency problems where managers prioritize personal ambitions over the company's profitability and efficiency.
Environmental Factors: Environmental factors refer to the external conditions and influences that can affect the operations, decision-making, and overall performance of an organization, particularly in the context of agency issues between shareholders and corporate boards.
ESG Criteria: ESG criteria, or Environmental, Social, and Governance criteria, are a set of standards used to evaluate a company's sustainability and ethical impact. These criteria are increasingly important for investors and stakeholders in assessing a company's long-term viability and responsible business practices.
Executive Compensation: Executive compensation refers to the financial rewards and incentives provided to top-level managers and leaders of a company, including the CEO, CFO, and other C-suite executives. It is a crucial aspect of the relationship between shareholders and company management, as well as a key factor in addressing agency issues that can arise between these two parties.
Fiduciary Duty: Fiduciary duty is a legal obligation for an individual or organization to act in the best interest of another party. It is a fundamental principle that governs the relationship between those who manage or control assets on behalf of others, such as shareholders, clients, or beneficiaries.
Governance Factors: Governance factors refer to the policies, procedures, and practices that guide and control the management and oversight of a corporation. These factors are crucial in aligning the interests of shareholders and corporate boards, addressing agency issues that can arise between these two key stakeholders.
Hostile Takeover: A hostile takeover is a corporate action in which an investor or group of investors acquire a controlling stake in a company without the consent or cooperation of the company's management. This is in contrast to a friendly takeover, where the target company's management supports the acquisition.
Monitoring Costs: Monitoring costs refer to the expenses incurred by a principal, such as shareholders, to oversee and ensure that the agent, such as corporate managers, are acting in the best interests of the principal. These costs are part of the agency costs that arise due to the separation of ownership and control in a corporation.
Ponzi scheme: A Ponzi scheme is a fraudulent investment scam that promises high returns with little risk to investors. It generates returns for older investors by acquiring new investors' funds rather than from profit earned by the operation of a legitimate business.
Principal-Agent Model: The principal-agent model is a framework used to analyze the relationship between a principal, who delegates work to an agent, who performs that work. This model explores the challenges that can arise when the interests of the principal and agent are not fully aligned, leading to potential conflicts and suboptimal outcomes.
Proxy Voting: Proxy voting is the process by which shareholders of a company authorize someone else, typically the company's management or a third-party, to vote on their behalf at shareholder meetings. This allows shareholders who are unable to attend the meeting in person to still have a voice in the company's decision-making process.
Residual Loss: Residual loss refers to the remaining or unresolved agency costs that persist even after implementing various governance mechanisms to align the interests of shareholders and corporate managers. It represents the unavoidable divergence between the actions of corporate executives and the optimal outcomes for shareholders.
Shareholder Activism: Shareholder activism refers to the actions taken by shareholders to influence the decisions and policies of a company in which they hold shares. It involves shareholders actively engaging with the management and board of directors to promote changes that they believe will enhance the company's performance and maximize shareholder value.
Shareholder Primacy: Shareholder primacy is the principle that the primary goal of a corporation should be to maximize shareholder wealth and returns. It holds that the interests of a company's shareholders should be the central consideration in corporate decision-making.
Social Factors: Social factors refer to the various societal and interpersonal elements that can influence an individual's behavior, decisions, and outcomes, particularly in the context of corporate governance and the relationship between shareholders and corporate boards.
Stakeholder Conflicts: Stakeholder conflicts refer to the competing interests and goals among different parties with a vested interest in the operations and decision-making of a company. These conflicts can arise between shareholders, corporate boards, management, employees, customers, suppliers, and the broader community.
Stakeholder Theory: Stakeholder theory is a framework that emphasizes the importance of considering the interests and well-being of all parties affected by a company's actions, not just the shareholders. It suggests that a company's decision-making should balance the needs and concerns of various stakeholders, including employees, customers, suppliers, communities, and the environment, in addition to shareholders.