Chapter 2

Agency problems

Arise when

• One party (principle) relies on another (agent) to act on their behalf

• The agent may act in self-interest, not in the principle’s best interest

• These problems are worsened by asymmetric information and agent discretion leading to agency costs

Three main agency problems

1. Shareholders vs managers

2. Controlling shareholders vs minority shareholders

3. Corporation vs thirs parties

Shareholders vs managers agency problems

Classic principle-agent relationship, managers may act in their own interest rather than maximizing shareholder value

Controlling shareholders vs minority shareholders

Majority owners may extract private benefits at the expensen of minorities

Corporation vs third parties

Firms might exploit non-shareholder stakeholders, creditors, employees, etc.

Coordination costs among principals

Multiple principals increase coordination costs. Heterogenous preferences hinder collective action, making governance more difficult. Law reduces these costs via rules that align interests.

Goal of corporate law

• Improce social welfare by minimizing agency problems

• Optimize outcomes for both agents and principals

Legal strategies to reduce agency costs

1. Agent constraints

2. Affiliation terms

3. Incentive alignment

4. Control of agents

5. decision rights

Agent constraints

• Ex ante: Rules: specific legal commands, restrictions, and takeover rules

• Ex post: Standards, general principles as good faith, fairness, etc.

Affiliation terms

• Ex ante: entry, legal disclosure requirements before investments

• Ex post: Exit, rights to leave the firm, transfer right, etc.

Incentive alignment

• Ex ante: Trusteeship, neutral agents like indepdent directors or auditors, expected to act with consciense/ reputation.

• Ex post: reward, align agent interests with principals.

Control of agents

• Ex ante: Appointment, right to choose management, such as electing board members

• Post ante: Removal, right to fire underperforming agents, such as directors or managers

decision rights

• Ex ante: Initiation, right of principals to propose major decisions

• Ex post: ratification, right to approve / reject major decisions, such as mergers.

disclosure

means making relevant information available. Usually from agents to principals. It is crucial for transparency and reduces information asymmetry.

Disclosure in legal strategies

• Supports agent constraints and governance

• Underpins nearly all other legal strategies by ensuring informed decisions

Types of disclosure

1. Prospectus disclosure: ex ante, helps new shareholders asses whether to invest

2. periodic disclosures: Regular reports, financials, board, composision

3. Ad hoc disclosure: Specific, event-driven updates, mergers, lawsuits, etc.

How does disclosure support other strategies

• regulatory enforcement: Helps identify violations (e.g., self-dealing).

• Governance: Allows principals to evaluate management, vote meaningfully, or exit (sell shares).

• Trusteeship: Builds reputational pressure on directors/auditors.

3 types of enforcment

• public enforcement: SEC, regulatory bodies

• Private enforcement: shareholder lawsuits, class actions

• Gatekeepers: Auditors, lawyers

differences across jurisdications

• Jurisdictions with concentrated ownership use governance strategies.

• Jurisdictions with dispersed ownership (like the U.S.) rely more on regulatory strategies.