Learning Outcomes
This article explains core aspects of agency issues and compensation design for CFA Level 1, including:
- identifying principal-agent relationships across common corporate governance structures and recognizing the roles of shareholders, boards, executives, and creditors;
- distinguishing major categories of agency conflict—shareholder-manager, shareholder-debtholder, and majority-minority shareholder—and linking them to misaligned incentives;
- describing how information asymmetry, risk preferences, and control over resources drive agency problems and generate explicit and implicit agency costs;
- explaining key incentive-alignment tools, including performance-based cash bonuses, stock grants, options, deferred awards, and non-compensation mechanisms such as monitoring and covenants;
- evaluating when specific compensation designs are likely to align or misalign stakeholder interests, with emphasis on risk-taking behavior, short-termism, and potential earnings manipulation;
- assessing the overall impact of agency arrangements on firm value, corporate risk, and stakeholder outcomes in typical CFA Level 1 exam-style vignettes and multiple-choice questions;
- connecting theoretical concepts to practical governance decisions, enabling efficient, exam-focused analysis of agency scenarios under time pressure.
CFA Level 1 Syllabus
For the CFA Level 1 exam, you are expected to understand agency issues in governance and their impact on stakeholder management, with a focus on the following syllabus points:
- Defining principal-agent relationships and agency conflicts within governance
- Explaining how stakeholder groups’ interests may diverge and the sources of conflict
- Recognizing mechanisms, such as compensation design and board oversight, to align interests and mitigate agency costs
- Identifying risks and benefits arising from agency problems, including ineffective governance or incentive structures
- Understanding the implications of agency issues for evaluating corporate issuers
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is the principal-agent problem, and how can incentive compensation help address it?
- Name two typical agency conflicts that can arise between executives, shareholders, and debtholders.
- Why might stock options as a component of executive compensation sometimes create additional risk for shareholders?
- List one non-compensation mechanism that can help mitigate principal-agent problems in corporate governance.
Introduction
Agency issues are pervasive in corporate governance and stakeholder management. When one party (the principal) entrusts another (the agent) to act on its behalf, their interests often diverge. Effective alignment of incentives is central to reducing these conflicts. For CFA Level 1, you must be able to explain the origins, risks, and mitigation approaches for principal-agent problems—especially as they relate to compensation and stakeholder outcomes.
Key Term: principal-agent relationship
A situation in which one party (the principal) hires another party (the agent) to perform a service or make decisions on their behalf.Key Term: agency cost
The economic loss or inefficiency that arises when an agent’s actions deviate from the principal’s interests, including both monitoring expenses and lost value.
Agency Relationships and Conflict in Governance
Corporations create an ecosystem of principals and agents: shareholders hire directors, who hire managers, who in turn supervise employees. Information asymmetry means managers (agents) know more about daily operations than shareholders (principals). This can lead to actions that benefit management over owners or other stakeholders.
Key Term: agency problem
The conflict of interest arising when an agent’s goals differ from those of the principal, leading to suboptimal decisions for the principal.
Common Types of Agency Conflicts
1. Shareholder vs. Manager (Director) Conflicts:
Managers may value personal goals—such as job security, compensation, or prestige—over shareholder value maximization. They may prefer less risky strategies, avoid restructuring, or consume company resources for their own benefit (perquisite consumption).
2. Shareholder vs. Debtholder Conflicts:
Shareholders, as residual claimants, may prefer riskier investments that could increase equity value but increase the chance of default for debtholders. High dividends or share buybacks may also shift value from creditors to shareholders.
3. Majority vs. Minority Shareholders:
In concentrated ownership structures, controlling shareholders may extract private benefits (e.g., related-party transactions) at the expense of minority shareholders.
Incentives and Compensation in Agency Relationships
Aligning interests through well-designed compensation packages is a common mitigation strategy, but structure matters.
Types of Incentive Compensation:
- Performance-based cash bonuses: Directly link rewards to short-term financial or operational results.
- Stock grants and options: Align management with share price appreciation.
Key Term: incentive alignment
The process of designing mechanisms (often through compensation) so agents act in the best interest of principals.Key Term: performance-based compensation
Remuneration contingent on the achievement of specific financial or operational goals, including bonuses, shares, or options.
Worked Example 1.1
A listed company’s CEO has a contract heavily weighted toward stock options. The company faces an opportunity to take on a risky new investment. What are the agency implications?
Answer:
Stock options reward the CEO for share price increases but usually do not penalize for losses. This can incentivize risk-seeking behavior, as the CEO will benefit disproportionately if the gamble pays off, but shareholders will bear the downside risk in case of project failure.
Worked Example 1.2
The board of Company X installs strict financial covenants on management. What agency problem are they addressing?
Answer:
By imposing financial covenants—such as limits on debt or asset sales—the board (on behalf of debtholders or shareholders) restricts management’s ability to take excessive risk, addressing the potential misalignment of management with capital providers.
Structures to Mitigate Agency Issues
1. Compensation Design:
Variable pay, equity-based awards, and deferred vesting link agent income to long-term performance and value creation.
2. Monitoring Mechanisms:
Major shareholders, independent boards, external auditors, and creditors provide ongoing oversight.
3. Contractual Restrictions:
Debt covenants, shareholder agreements, and non-compete clauses align behavior with principal objectives.
4. Market Discipline:
External pressures, such as the threat of takeovers, keep management focused on shareholder value.
Exam Warning
Not all compensation aligns interests. Overweighting short-term or share price metrics can lead to excessive risk, short-termism, or earnings manipulation. For the CFA exam, be able to argue both sides: when option-based compensation aligns or misaligns stakeholder interests.
Risks and Benefits of Agency Arrangements
Benefits:
Effective agency structures encourage value creation, efficient capital allocation, and innovation by giving agents discretion to act on complex information.
Risks:
Without checks, agency problems can cause value destruction—through empire building, resource misallocation, fraud, or stakeholder exploitation.
Revision Tip
CFA exam questions often focus on contrasting agency problems under different governance mechanisms or compensation designs, especially their impact on shareholders and debtholders. Practice identifying which group is most at risk in a scenario.
Summary
Agency issues and incentive alignment are foundational for understanding governance and stakeholder risk. In corporate issuers, well-designed compensation and governance mechanisms can limit agency costs, while ineffective structures increase risk for all stakeholders. For the exam, be ready to analyze principal-agent relationships, identify compensation pitfalls, and recommend efficient structures for stakeholder alignment.
Key Point Checklist
This article has covered the following key knowledge points:
- Principal-agent relationships in governance and stakeholder management
- Common agency conflicts: manager-shareholder, shareholder-debtholder, majority-minority shareholders
- Design of compensation and other mechanisms to align interests and reduce agency costs
- The importance of monitoring and external controls (boards, auditors, creditors)
- Risks and potential failures when incentive design is poor or monitoring is weak
- Real-world exam application: identify agency issues and appropriate remedies
Key Terms and Concepts
- principal-agent relationship
- agency cost
- agency problem
- incentive alignment
- performance-based compensation