A CFO approves a corporate jet for weekend personal use while the share price slides. One decision touches every governance question on the exam: whose interest, which conflict, which mechanism failed, and what does it cost the providers of capital.
A principal hires an agent to act on the principal's behalf. The agent typically has more information than the principal and may pursue personal interests instead of the principal's. The costs of monitoring, bonding, and residual misalignment are agency costs.
In a corporation, shareholders are principals and managers are agents. The board sits between them as a delegated monitor. Creditors lend capital and become a second class of principal, watching managers from a different angle.
KEY: Stakeholders are any group with a claim on the firm: shareholders, managers, board directors, creditors, employees, customers, suppliers, regulators, and the broader community. Governance is the system that balances those claims.
Shareholder vs Manager. Managers may pursue perks, empire-building, low-risk strategies to protect jobs, or short-term EPS to hit bonus targets. Shareholders want long-term value maximization.
Common mistakes
- Treating governance as ethics rather than allocation of cost. Governance is about who bears agency cost. Trap answer: "governance is corporate social responsibility." Correct: governance allocates risk between principals and agents through structures and incentives.
- Calling external auditors an internal mechanism. External auditors are an EXTERNAL mechanism even though they review internal records. Internal audit is the internal mechanism. Trap: confusing the audit function with the audit committee of the board.
- Reducing shareholder-creditor conflict to "risk preference." Specific patterns include asset substitution, dividend recapitalization, and issuing senior debt that subordinates existing lenders. Trap: answering only "shareholders want risk, creditors want safety."
Bottom line
- Principal hires agent; agent has more information and may pursue self-interest. The classic conflict is shareholder (principal) vs manager (agent).
- Six conflicts to know: shareholder-manager, shareholder-board, controlling-minority, shareholder-creditor, manager-board, and friction with employees/customers/suppliers/regulators.
- Stakeholders span shareholders, managers, board, creditors, employees, customers, suppliers, regulators, and community.
- Internal mechanisms: independent board, key committees, aligned pay, shareholder voting, internal controls.
Exam shortcut
Memorize six conflicts and pair each with its primary mechanism: shareholder-manager gets compensation design, controlling-minority gets independent related-party approval, shareholder-creditor gets debt covenants. Classify every mechanism as internal (inside the firm: board, committees, pay, controls) or external (outside the firm: law, external auditors, takeovers, lenders, activists, ratings).
The full lesson (about 2,064 words, 14 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- corporate governance
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