Principal-agent problems

Shareholders and Corporations

Think about the last time you entrusted something important of yours to someone else. Perhaps you left an ailing pet with a veterinarian. Perhaps you let a younger sibling drive you in your own vehicle for the first time because you needed a ride to the airport. Or perhaps you confided some sensitive information to a friend, looking for advice.

Now think about how you felt in this situation. You’re probably remembering how you felt vulnerable to them—to a busy veterinarian absent-mindedly misdiagnosing your pet’s condition, to a younger sibling too nervous to drive well on the freeway, or to a gossipy friend who divulges your secret to someone else. What you’re imagining here are potential betrayals of trust—potential wrongful violations of obligations that others held to you in virtue of accepting responsibility for what you entrusted with them.

A similar kind of obligation lies at the heart of many business organizations, specifically, those that are organized as corporations. Investors purchase shares, or stock, that grant them the right to exercise control over the organization (in part by electing directors on a board of directors) and also to receive the residual returns from the organization’s earnings. In turn, they entrust directors and managers to lead the organization on their behalf, in ways that promote their interests. This means that directors and managers have obligations to shareholders for how they manage corporations. But what are these obligations, and what are some common ways that these obligations go unmet?

Principals and agents

To understand these obligations,^[1] we need to familiarize ourselves with a couple of key terms. The shareholders function as principals, who have entrusted some of their interests—that is, their financial interests—to the care of others. The leaders of the corporation, especially its executives, are the agents to whom these interests are entrusted, and who thus are obligated to the shareholders-as-principals for running the corporation in ways that adequately serve and protect their relevant interests, again meaning their financial investments. Note that this does not entail that the only obligation of management is to serve relevant shareholder interests, but simply that some of their obligations concern shareholder interests. (We’ll return to this issue when we introduce the idea of stakeholders in business decision-making.)

What exactly do managers-as-agents owe to shareholders-as-principals? There is room for some reasonable disagreement about how exactly to formulate these duties. And there is disagreement, including amongst lawmakers, about how to understand them. All we need here is a general construal of some of the main duties, to capture some widely accepted ideas and build upon our earlier reflections about what it’s like to entrust something of value to someone else.

Most basically, managers generally are obligated to run the company in ways that serve shareholders’ interests as investors, central among which are financial interests. Shareholders have purchased shares of the company, with an eye to financially benefiting from this investment. Sometimes this is put as the obligation to “maximize shareholder value,” where the idea is that a company’s resources should be deployed so as to increase shareholder returns (from profits) as much as possible. But this is a particularly strong claim that, while useful for (among other things) various forms of financial modeling, may not be the best way of articulating the actual contours of the moral obligations held by managers-as-agents. For our purposes in this course, we can stick with the more general idea that managers are obligated to promote shareholders’ financial interests.

But this may not be the only obligation that managers-as-agents hold toward shareholders-as-principals. Any kind of principal will have moral interests—that is, interests in having some of their moral responsibilities fulfilled, as they pertain to the matters they entrusted to agents. (Mejia 2021) Each of us is responsible, for instance, for helping those in dire need when it is relatively costless for us to do so and we are in a better position than others to do so. Sometimes corporations are in this position (to help those in dire need), and when we are shareholders of those corporations, it is plausible to think that the executives are responsible, as agents, for discharging these responsibilities on behalf of us, as principals.

Agency Problems

Return to your memory of entrusting something important of yours to the care of someone else and feeling vulnerable as a result. This feeling of vulnerability assumes that there is no guarantee that those to whom you’ve entrusted your interests will protect them. They might take advantage of the discretion you’ve left to them and use their position to benefit themselves at your expense. Similarly, it is far from guaranteed that executives will fulfill their responsibilities as agents of shareholders, and there is a risk that they might use their position of power in corporations to benefit themselves at the expense of protecting shareholder interests. These risks are commonly understood as agency problems.

The law has an important role to play in curbing agency problems. One way it does so is by allowing shareholders to sue executives when they have grounds for thinking that executives have clearly ignored their responsibilities as agents. For instance, if an executive were to hire some of their children and give them big salaries in a corporation, and these children were clearly incompetent in their roles, and the executive did nothing to improve their performance or remove them from the corporation, then this would be a clear failure of some of their agent-responsibilities and they could be legally liable for this failure. (Take a look at this shareholder lawsuit against Rupert Murdoch over nepotism and a $675M deal.) This legal power is in addition to the control rights (mentioned above) that shareholders have over corporations, for instance, to appoint members of the corporation’s board of directors who, in turn, can hire and fire executives.

But as we’ve already discussed in the Ethics and the Law section, the law cannot protect us from all forms of wrongdoing, in business or elsewhere. This is certainly true of agency problems. We cannot count on the law to guarantee that executives never abuse their positions to their own advantage. This is one of the many forms of managerial moral responsibility that have to be treated as a matter of trust—as dependent on executives and those with influence over them taking seriously the importance of agency responsibilities.

An Example of Agency Problems

Let’s think through how these ideas apply to the Purdue Pharma case. Purdue’s shareholders were members of the Sackler family, some of whom played a role in leading the corporation. Did their actions in developing and selling OxyContin, and suppressing information about its addictiveness, satisfy or violate their responsibilities as agents of their shareholders-as-principals? One consideration is whether OxyContin was profitable for Purdue Pharma, and, in turn, its shareholders. It was, in the short term. But given its evident risks to patients, it is not clear that it was profitable over the long term for Purdue to market this drug as aggressively and in as misleading a way as Purdue did. And beyond these profitability considerations, it is clear that Purdue executives neglected some of the moral interests of Purdue shareholders (even if the shareholders themselves didn’t take these interests very seriously).

References

Mejia, S. (2021). Which duties of beneficence should agents discharge on behalf of principals? A reflection through shareholder primacy. Business Ethics Quarterly, 31(3), 421-449.