Principals-Agents’ Conflict of Interest

Jensen and Meckling (1976) define the agency relationship as “a contract under which one party (the principal) engages another party (agent) to perform the some services on their behalf. As part of this, the principal will delegate some decision making authority to the agent “. However, it is important to mention that this relationship is not always peaceful and harmonious; rather, it usually raises some agency problems commonly called conflict of interests between shareholders and managers of the company.

These conflicts occur when a person i. . the manager has an obligation not to act in his own personal interest but in another person’s interest i. e. the shareholders. This means that in whatever situation, managers must prioritise shareholders’ benefits. But is this commitment always respected in principals-agents relationships? Hopefully, between these two groups, is the board of directors; directors who are elected by shareholders to act as their representatives by monitoring and controlling managers tasks and ensuring they are in line with shareholders’ expectations.

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With clear evidence that conflicts of interest are almost unavoidable in any agency relationships, an attempt will be made will be made to get an insight into that issue with regards to board of directors duties. Brennan (1994) states that “ agency problems emanate from the arrangement where the interests of the agents differ substantially from those of the principals because of the impossibility of perfectly contracting for every possible action of the agents whose decisions affect both his welfare and the welfare of the principal “.

Therefore, this raises the issue of finding ways to motivate managers to solely act in the best interest of shareholders. However, in a world where the labour market is becoming more and more imperfect and competitive, managers will be more concerned with their personal benefits at the expense of shareholders’ benefits. Since they are the one taking care of the day-to-day activities of the company, they know better than anyone any single details about how the various tasks are being performed and how that affects the company.

Therefore, they might be tempted to take advantage of that by consuming some of the organisation’s resources in the form of lavish perquisites such as airplanes. Agency conflicts imply that shareholders wealth maximisation is being subordinated in managers’ goals for the company. Clear evidence of this assumption could be that top level managers are more worried about increasing their salaries, raising their status within the company, creating more opportunities for lower managers or assuring their job security and to achieve all this, their main objective could rather be to enlarge the firm by creating more subsidiaries.

Such an action could produce results that do not necessarily maximise the value of the organisation for shareholders, rather, management welfare. We can notice that in conflict of interest, agents are mostly interested in achieving objectives that they feel will be profitable to them, but which are not necessarily or directly for the sake of shareholders.

This occurs as a result of the distance created between the shareholders and the management team which prevent the former to effectively monitor and control managers’ behaviour. If agents do things that hurt principals, why don’t they take strong actions against that? In order to remedy to this situation, shareholders rely among others on the board of directors which they elect to look out for their interests and protect them for financial losses due to inadequate managerial actions.

Bonazzi L. , Islam (2007) defines the function of the board as a “ collective responsibility to determine the company’s purpose and “ethics”, to decide the direction, i. e. the strategy; to plan; to monitor and control managers and CEO activities, then to report and make recommendations to shareholders “. To achieve this, they are expected to act in accordance with their four main duties which involve: the fiduciary duty, the duty of loyalty, the duty of confidentiality and the duty of care.

In performing their fiduciary duties, directors assumes two roles, the first one as an “agent” which means acting on behalf of shareholders and the second one as a “trustee” which means they are in charge of controlling the organisation assets so they have to act “ bona fide “ which means in good faith towards the company; acting only within the scope of their powers and uniquely for the purpose that benefits the business and to avoid being involved in conflict between personal and the company’s interest.

First and foremost, the board has as duty to govern the organisation by designing broad policies, and objectives which are intended to provide managers with guidance on how they are expected to run the business, i. e. prioritizing principals’ benefits, and, where they are expected to take the firm to in terms of increasing its value. They must continuously review the performance of the chief executive to ensure that managerial actions are in line with shareholders wishes and given that they are accountable to the former, they have to report to them about the overall organisational performance.

Regarding their duty of loyalty, directors must prevent conflict of interest by avoiding transactions which may generate a potential conflict; those transactions according to Professor Bernard S. Black of Standford Law School in an article entitled The principal Fiduciary Duties of Boards of Directors are called “ self-dealing “ transactions.

Representing at the same time the boss to one extend and the subordinate to another extend, directors must make sure never to act in ways that will harm either the shareholders or the executives, treat both parties with care and respect and try to make good decisions i. . that will compromise none of the parties, but which will be profitable to the firm. Also, board members have the duty to keep private all dealings, matters and information from the board meeting and the company in order to avoid the disclosure or misuse of information which may lead to a conflict. From the study of board members duties, we can state that companies’ corporate governance rests mostly on their shoulders.

So, when effective, it permits the realisation of corporate objectives, risk management, the reduction of agency problems and an increase in the value of the firm. Despite the fact that conflict of interest is quite an obvious issue between shareholders and managers, it is important to keep in mind that the former are the owners of the business and thus, have great powers on the company; for instance through their voting rights at the annual shareholders meeting where they might decide “to vote with their feet” i. . selling their shares, exposing the organisation to a potential takeover that will lead managers to lose their job. Consequently, managers must at least try to satisfy their principals by aligning their actions and decisions with shareholders expectations; as well as must principals induce their agents to work for their best interest. To achieve this, they must incur some agency costs.

In the 1976 Journal of Finance paper by Michael Jensen and William Meckling, it is stated that “there are three major types of agency costs: (1) expenditures to monitor managerial activities, such as audit costs; (2) expenditure to structure the organisation in a way that will limit undesirable managerial behaviour, such as appointing outside members to the board of directors or restructuring the company’s business units and management hierarchy; and (3) opportunity costs which are incurred when shareholder-imposed restrictions, such as requirements for shareholder votes on specific issues, limit the ability of managers to take actions that advance shareholder wealth”.

In a nutshell, conflict of interest is a real fact in every business. Principal-agent relationship can be viewed as complex in terms of how exactly agents are expected to act towards their principals. Obviously, their acts must always be aimed at serving shareholders interest, but this statement seems to imply that either principals’ interests are always morally acceptable or managers might act unethically provided they fulfil shareholders’ expectations.

Virtually, all corporate code of ethics addresses conflict of interest because it interferes with the ability of employees to act in the best interest of the firm. The fact is that, the agent is expected to act solely for the benefit of the principal in all matters and situations, yet, the kind of situation or dilemma the agent might be called upon to act in his principal interest are not easily predictable or identified. As optimal solution, it would be advantageous for both parties if they could work in concert prioritising the success of the organisation, and trying to satisfy as much as possible each group’s benefits, because it would help avoiding or at least reducing potential conflict of interest.