Principal-Agent Conflict of Interest
The 2008-2010 financial crisis shone a spotlight on how prioritizing short-term shareholder value led to lapses in corporate governance and accountability. Since the crisis, the principal-agent conflict of interest, as defined in the agency theory, has further increased due to the rise of passive management, as well as other trends. The widening conflict is playing out while broader society increasingly recognizes that companies are not just responsible for running their businesses; rather they have responsibilities to society and should operate in a way that promotes long-term sustainability.
The EU Shareholder Rights Directive II is a direct response to the financial crisis and structural impediments to shareholder engagement. The EU SRD coupled with the EU’s initiative on standard and transparent non-financial will have a significant impact on corporate accountability within the EU and globally. A critical and significant issue remains. In commingled investment management, the true shareholders will still have limited ability to express their values or interests, thus these elements cannot be incorporated into analysis or voting decisions.
What is Agency Theory?
Agency theory is a principle that explains issues in the relationship between principals and their agents, such as the relationship between shareholders, as principals, and company executives, as agents. Agency theory assumes that principals’ and agents’ interests are not always aligned. Asymmetric information between the two parties further exacerbates agency problems. For example, corporate management generally has better and more detailed information about what is happening in a given company than the shareholders. Consequently, shareholders cannot assess whether management is working in its best interests, long- or short-term.
The Legacy of Investment Manager Principal-Agent Conflict of Interest
Using investments managers and commingled funds adds additional agency risks. Investment managers are only agents of the true shareholders, the investors in the fund. Investment managers represent the true shareholders, but they do not know what those shareholder / investors want. Historically, the default assumption has been that maximizing value serves the principal shareholders’ best interests, which has led investment managers to emphasize financial returns over social responsibilities or corporate sustainability. For example, by focusing on share value, investment managers have allowed executive compensation packages to be aligned with short-term profits as opposed to risk-adjusted performance or longer-term business success. Investment managers, particularly index managers, do not receive many benefits from engaging in stewardship activities, but they incur most of the costs. Consequently, their incentives may be de-aligned from their underlying investors and their engagement on behalf of the true shareholders not aligned to the shareholders’ interests.
Resolving the Conflicts
As Caleb Griffin argued[1] individual index fund investors need to be empowered and enabled to influence the proxy voting process. He proposes three potential approaches: indirect democracy, informed discretion and pass-through voting. With indirect democracy, individual investors express their interests and the investment managers vote in accordance with the investor’s indirect share ownership. With informed discretion, the investment manager solicits information about the investors’ values and interests, enabling better alignment between investors interests and voting decisions. Pass-through voting would give individual investors the opportunity to participate in shareholder voting, similar to how Employee Stock Ownership Plans are handled today. Each scenario involves the investor and reduces the principal-agent conflicts of interest. Each approach also reduces fiduciary or regulatory liability for responsible for voting.
In addition to greater investor involvement, we need regulations focused on ensuring shareholder engagement and codifying shareholders’ rights; similar to the EU SRD. To further improve engagement, promote investors’ capabilities in assessing corporate proposals and understand the impact of their decisions; standard and comparable non-financial disclosures must be adopted globally.
[1] Griffin, Caleb N., “We Three Kings: Disintermediating Voting at the Index Fund Giants Giant”. Maryland Law Review, Vol. 79, Issue 4, Article 3.
