CFA Level I Exam · Organizational Forms, Corporate Issuer Features, and Ownership

Agency Problems and Conflicts of Interest in Corporate Issuers

Updated 7 October 2026 · Fact-checked

An agency problem arises when managers (agents) act for owners (principals) but pursue their own interests instead. Costs of monitoring, bonding and lost value are agency costs. To solve questions, identify the principal and the agent, name the conflict, then match a control such as governance, pay design or covenants.

Understand Ownership, Agency Problems and Conflicts of Interest

A company is owned by shareholders but usually run by managers. This split between ownership and control creates an agency relationship. The principal (the owner) hires the agent (the manager) to act on the principal's behalf. Because the agent has different goals and more information, the agent may not always act in the principal's best interest. This is the agency problem, also called the principal-agent problem.

The cost of this problem is called agency cost. Three kinds matter for the exam: monitoring costs (paid by the principal to watch the agent, such as audits and board oversight), bonding costs (paid by the agent to assure the principal, such as agreeing to restrictions or reporting), and residual loss (the value still lost even after monitoring and bonding, because the interests never align perfectly).

The best-known conflict is shareholders versus managers. Managers may take perks, build empires through value-destroying acquisitions, avoid risk to protect their jobs, or focus on short-term results. Remedies include an independent board, performance-based pay linked to long-term results, share ownership by managers, and the threat of takeover or removal by shareholders.

Other conflicts exist. Shareholders versus creditors: shareholders gain from upside, while creditors have a fixed claim. Shareholders may favour riskier projects, extra borrowing or large dividends, which move value from creditors to owners. Creditors respond with covenants, security and higher yields. Controlling versus minority shareholders: a controlling owner (a founder family, a parent company or the state) may use control for private benefit, for example related-party deals on favourable terms. Remedies include independent directors, minority protection rules, disclosure and board seats for minority holders.

Think of it as a simple chain. Identify who has the claim, who has the control, and whose interests differ. Then pick the mechanism that reduces the gap: oversight, incentives, contracts or disclosure.

Key formulas to remember

Agency costs: Agency costs = monitoring costs + bonding costs + residual loss; Monitoring is borne by the principal; bonding by the agent; residual loss is value lost despite both.
Agency relationship: Principal (owner) → hires → Agent (manager) who acts on the principal's behalf; Conflict arises from differing goals and information asymmetry.
Shareholder-creditor conflict: Shareholders: residual claim with upside; creditors: fixed claim with downside; Risk-shifting, extra debt and large dividends benefit shareholders at creditors' expense.
Controlling vs minority conflict: Control rights ≠ cash-flow rights can allow private benefits of control; Minority holders bear the cost when controllers extract private benefits.

How to solve Ownership, Agency Problems and Conflicts of Interest questions

Use this method for any question on ownership structure, agency problems or conflicts among stakeholders.

1Read the stem and identify the two parties in conflict (shareholders and managers, shareholders and creditors, or controlling and minority owners).
2Decide who is the principal and who is the agent, or who holds the fixed claim and who holds the residual claim.
3Name the behaviour that creates the conflict, such as perks, empire building, risk shifting, excess dividends or related-party deals.
4Classify any cost described: monitoring (principal pays), bonding (agent pays) or residual loss (value still lost).
5Match the remedy to the conflict: independent board and pay design for managers; covenants for creditors; minority protections and disclosure for controlling owners.
6Test each of the three options against your answer and eliminate the two that mix up the parties or the cost type.
7Check direction: confirm who benefits and who bears the cost before choosing.

Quickest way: Who pays, who gains: 20-second check

When to use it: Use when a question gives a short scenario and asks you to name the conflict, the cost type or the fix.

Ask who pays the cost: principal means monitoring; agent means bonding; nobody directly means residual loss.
Ask whose claim is fixed: if creditors, think covenants and risk shifting.
Ask who controls the votes: if one owner dominates, think minority shareholder protection.
Pick the option whose remedy directly targets that conflict and drop the other two.

Common mistakes in Ownership, Agency Problems and Conflicts of Interest

Mixing up monitoring costs and bonding costs.
Both aim to reduce the conflict, so they look alike.
Fix: Remember who pays: the principal pays monitoring costs; the agent pays bonding costs.
Treating residual loss as a cost that can be fully removed.
Students assume enough monitoring removes all conflict.
Fix: Residual loss is what remains after monitoring and bonding. It is the leftover divergence in interests.
Saying creditors gain when shareholders take more risk.
Higher risk is linked with higher return in general.
Fix: Creditors have fixed claims and limited upside, so extra risk mostly raises their downside. Shareholders capture the upside.
Assuming the only agency conflict is between shareholders and managers.
It is the textbook example.
Fix: Also check for creditor conflicts and controlling versus minority shareholder conflicts.
Choosing pay linked to short-term profit as a good fix.
Performance pay sounds like alignment.
Fix: Short-term pay can encourage short-term behaviour or earnings manipulation. Alignment works best with long-term, share-based measures.

Worked examples

Example 1

A company's shareholders pay an external firm to audit management's expense claims and the board reviews the results. Which type of agency cost is this? A. Bonding cost B. Monitoring cost C. Residual loss

Show the solution

Identify who pays: the shareholders (principals).
Identify the purpose: watching the agent's behaviour through an audit and board review.
Costs paid by the principal to oversee the agent are monitoring costs.
Bonding costs are paid by the agent, and residual loss is the value lost after such measures, so A and C are eliminated.

Answer: B. Monitoring cost

Example 2

A leveraged company borrows to pay a large special dividend to shareholders, and the market value of its existing bonds falls. Which conflict does this best illustrate? A. Controlling versus minority shareholders B. Shareholders versus managers C. Shareholders versus creditors

Show the solution

Note the action: extra debt and a large payout to owners.
The payout reduces assets available to repay lenders and raises the firm's leverage, so creditors' bonds lose value.
Value moves from the holders of the fixed claim (creditors) to the holders of the residual claim (shareholders).
No party in the stem is a controlling owner or a manager acting against owners, so A and B are eliminated.
Creditors would respond with covenants limiting dividends and new debt.

Answer: C. Shareholders versus creditors

Exam tips

Questions often give a short scenario and ask you to label the cost type. Decide who pays first.
In creditor conflict items, look for words like riskier projects, additional debt or dividends. These point to value moving from creditors to shareholders.
When a stem mentions a founder family, parent company or state holding a majority, think controlling versus minority conflict.
Eliminate options that propose a remedy for a different conflict, such as covenants for a manager problem.

Practice questions from Organizational Forms, Corporate Issuer Features, and Ownership

Ownership, Agency Problems and Conflicts of Interest in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Ownership, Agency Problems and Conflicts of Interest: frequently asked questions

What is the agency problem in corporate finance?

It is the conflict that arises when managers, acting as agents, make decisions that serve themselves rather than the owners who hired them. It exists because ownership and control are separated and because managers have more information than owners.

What are the types of agency costs for CFA Level I?

They are monitoring costs paid by the principal, bonding costs paid by the agent, and residual loss. Residual loss is the value that is still lost after monitoring and bonding because interests never fully align.

How can conflicts between shareholders and managers be reduced?

Common tools are an independent board, share-based and long-term incentive pay, manager share ownership, audits and disclosure, and the threat of takeover or removal. None removes the conflict fully, so some residual loss remains.

Why do shareholders and creditors have conflicts of interest?

Shareholders hold the residual claim and gain from upside, while creditors hold a fixed claim. Shareholders may therefore prefer risky projects, more debt or higher dividends, which can reduce the value of creditors' claims. Creditors use covenants, security and higher required yields to protect themselves.