Agency relationship and conflicts between business managers and shareholders

An agency relationship arises whenever a person or a group of persons hire another person or a group of persons to perform some service on behalf of the former.  The Principal, on whose behalf the Agent performs the particular service, delegates the decision making authority to the agent.

In large firms, shares are likely to be diversely held. In such circumstances, the actions of shareholders are likely to be restricted in practical terms. Therefore, the responsibility of running the business will be with the board of directors. The directors may own only a small percentage of the share capital of the company. When ownership is so separated from the day-to-day management of the firm, a possible conflict can arise. The managers of the firm are essentially agents of shareholders. They are appointed for running the firm in the shareholders’ best interests. However shareholders have little opportunity to assess whether the managers are acting in the shareholders’ best interests.

Managers may be encouraged to behave in ways that are not most favourable to the shareholders of the company. Shareholders can spread their risk by investing in a number of firms. But the managers may be averse to investing in risky investments. Although shareholders wealth is maximized by investing in projects with positive net present values, managers may be more interested in short term payback in order to help further their own promotional prospects. Managers of firms which are subject to takeover bids often try to resist the predator. When the takeover bid succeeds, the managers of the acquired company often lose their jobs and status while the shareholders of the acquired company often receive large gains in the value of their shares. Managers may be motivated to award themselves and the staff better terms and conditions of service which will incur costs and reduce profits. If shareholders are losing as a result, they may sell their shares and the market value of the firm will fall. 

Therefore the agency relationship between shareholders and managers has agency conflicts, or conflicts of interest between agents and principals. It has implications for corporate governance and business ethics. It also has agency costs which are costs incurred in order to maintain an effective agency relationship such as management performance bonuses to persuade managers to act in the shareholders' interests.

Agency theory attempts to explain elements of organizational behaviour through an understanding of the relationship between principals and agents. According to agency theory there may be conflicts between the actions undertaken by agents in furtherance of their self interest and those required to promote the interests of the principals. Agency theory suggests that managers may seek to maximize their own benefit at the expense of shareholders.

One way of dealing with shareholder-manager agency conflicts is that managers are compensated on the basis of changes of the value of the business. Since managers have great incentives to maximize shareholder wealth, the agency costs are low in this case. The other method of dealing with the problem is shareholders monitoring every managerial action. This method is extremely costly and inefficient. The most favourable solution lies between these two extremes where managers compensation is coupled with the performance while monitoring their actions. Large companies employ performance shares schemes where shares of the company are offered to managers on the basis of financial performance such as earnings per share, return on assets, return on equity, and share price. These compensation schemes are designed to ensure managers take actions that will enhance shareholder wealth and to facilitate companies attract and retain the best managers.

In a profit-making organization, it is essential for all members of the management team and their staff work together and achieve the strategic objectives of the organization. The situation which leads the individuals or groups to take actions which are in their self-interest and also in the best interest of the organization is called Goal Congruence.

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