2.1 Three Agency Problems
Corporate law performs two general function:
1. Establishes the structure of the corporate form as well as ancillary housekeeping
rules necessary to support this structure
2. Attempts to control con icts of interest among corporate constituencies,
including those between corporate “insiders”, such as controlling shareholders and
top managers, and “outsiders”, such as minority shareholders or creditors
The con icts are called “agency problems” or “principal-agent”, and arises
whenever one party, termed the “principal,” relies upon actions taken by another
party, termed the “agent,” which will a ect the principal’s welfare
Any contractual relationship, in which one party (the “agent”) promises performance
to another (the “principal”), is potentially subject to an agency problem.
The principal cannot easily assure himself that the agent’s performance is precisely
what was promised. The agent has an incentive to act opportunistically, skimping on
the quality of his performance, or even diverting to himself some of what was
promised to the principal.
The three generic agency problems:
1. Between owners and mangers: the manager should be responsive of the owner’s
interest and not pursing her/his own interest.
2. Between majority/controlling owners the interest rms and minority/non
controlling owners: it appears whenever some subset of a rm’s owners can control
decisions a ecting the class of owners as a whole, it can give rise to a species of this
second agency problem. Similar problems can arise between ordinary and
preference shareholders, and between senior and junior creditors in bankruptcy.
3. Between the rm itself and the other parties with whom the rm contracts
(creditors, employees, customers).
Law can play an important role in reducing agency costs. Examples are rules and
procedures that enhance disclosure by agents or facilitate enforcement actions brought
by principals against dishonest or negligent agents, or in the corporate context, rules of
law that protect creditors from opportunistic behavior on the part of corporations should
reduce the interest rate that corporations must pay for credit, thus bene ting
corporations as well as creditors.
It follows that the normative goal of advancing aggregate social welfare.
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fl ff fi fl ff fi fi fi fi
Corporate law performs two general function:
1. Establishes the structure of the corporate form as well as ancillary housekeeping
rules necessary to support this structure
2. Attempts to control con icts of interest among corporate constituencies,
including those between corporate “insiders”, such as controlling shareholders and
top managers, and “outsiders”, such as minority shareholders or creditors
The con icts are called “agency problems” or “principal-agent”, and arises
whenever one party, termed the “principal,” relies upon actions taken by another
party, termed the “agent,” which will a ect the principal’s welfare
Any contractual relationship, in which one party (the “agent”) promises performance
to another (the “principal”), is potentially subject to an agency problem.
The principal cannot easily assure himself that the agent’s performance is precisely
what was promised. The agent has an incentive to act opportunistically, skimping on
the quality of his performance, or even diverting to himself some of what was
promised to the principal.
The three generic agency problems:
1. Between owners and mangers: the manager should be responsive of the owner’s
interest and not pursing her/his own interest.
2. Between majority/controlling owners the interest rms and minority/non
controlling owners: it appears whenever some subset of a rm’s owners can control
decisions a ecting the class of owners as a whole, it can give rise to a species of this
second agency problem. Similar problems can arise between ordinary and
preference shareholders, and between senior and junior creditors in bankruptcy.
3. Between the rm itself and the other parties with whom the rm contracts
(creditors, employees, customers).
Law can play an important role in reducing agency costs. Examples are rules and
procedures that enhance disclosure by agents or facilitate enforcement actions brought
by principals against dishonest or negligent agents, or in the corporate context, rules of
law that protect creditors from opportunistic behavior on the part of corporations should
reduce the interest rate that corporations must pay for credit, thus bene ting
corporations as well as creditors.
It follows that the normative goal of advancing aggregate social welfare.
Page 1 of 8
fl ff fi fl ff fi fi fi fi
