Updated for the 2026-2027 CFA® Level I curriculum.
A company runs on delegated decisions. Owners hire managers to run daily operations because they cannot do it themselves. This creates a principal-agent relationship, and it also creates room for conflict when the manager's interests do not match the owner's. CFA Level I expects you to identify who the principal is, who the agent is, and what conflict their differing incentives create.
Quick Answer
The principal-agent problem occurs when one party (the principal) delegates decision-making authority to another party (the agent), and the agent's incentives diverge from the principal's interests. In corporations, shareholders are principals and managers are agents. Conflicts arise when managers pursue personal benefits, such as higher pay or job security, at the expense of shareholder value.
Key Takeaways
A principal delegates authority. An agent makes decisions on the principal's behalf.
The principal-agent problem exists when the agent's incentives differ from the principal's, creating potential for self-interested decisions.
Shareholders and managers form the classic corporate example, but lenders, employees, and customers can also face agency conflicts with the firm.
Not every disagreement is an agency conflict. The conflict must trace back to delegated authority and mismatched incentives.
Agency costs are the losses shareholders bear from monitoring agents or from agents acting against shareholder interests.
Governance mechanisms exist specifically to reduce these conflicts, but the mechanisms themselves are covered in a separate note.
What You Need to Know for CFA Level I
Define a principal-agent relationship in a corporate governance context.
Identify the principal and the agent in a given scenario.
Explain why delegated authority creates the potential for conflict.
Recognize stakeholder groups beyond shareholders and managers that can face agency conflicts with the firm.
Distinguish an agency conflict from a general business disagreement or a legal violation.
What Is the Principal-Agent Problem?
A principal is the party that owns an asset or holds a claim on the firm and delegates decision-making authority to someone else.
A shareholder is a principal.
An agent is the party given that authority and expected to act on the principal's behalf.
A manager is an agent.
Delegated authority is the transfer of decision-making power from the principal to the agent. Shareholders cannot run day-to-day operations for a large public company, so they delegate that responsibility to executives and the board.
A conflict of interest appears when the agent's personal incentives point in a different direction than the principal's interests. The agent might prefer higher compensation, more perks, or lower personal risk. The principal wants higher returns and long-term value. When these goals diverge, the agent may act in ways that reduce value for the principal.
This is the principal-agent problem: delegated authority combined with misaligned incentives.
How Principal-Agent Conflicts Arise
Use a simple four-part framework to identify any agency conflict on the exam:
Element | Question to Ask | Corporate Example |
|---|---|---|
Parties | Who is the principal and who is the agent? | Shareholders (principal), CEO (agent) |
Delegated decision | What authority did the principal hand over? | Authority to run operations and allocate capital |
Incentive mismatch | Where do their goals diverge? | CEO wants job security and higher pay; shareholders want higher returns |
Potential cost | What does the mismatch cost the principal? | Excessive executive pay, empire building, reduced dividends |
If a scenario does not include a clear incentive mismatch tied to delegated authority, it is not a principal-agent problem, even if two parties disagree.
Worked Example
A CEO is deciding whether to acquire a smaller competitor. The acquisition would expand the company's size and the CEO's visibility in the industry, but internal analysis shows the deal will likely destroy shareholder value because the price is too high.
Applying the framework: the principal is the shareholder base. The agent is the CEO. The delegated decision is the authority to approve acquisitions. The incentive mismatch is that the CEO gains prestige and career benefits from a larger company, while shareholders bear the financial cost of an overpriced deal. The potential cost is the value destroyed if the acquisition proceeds.
Plain-English interpretation: this is a textbook agency conflict because the CEO's personal incentive (visibility, empire building) works against the principal's financial interest.
Common Stakeholder Conflicts in Corporate Governance
Shareholders and managers are the most tested pair, but Level I also expects you to recognize agency conflicts between the firm and other stakeholder groups.
Stakeholder Group | Principal-Agent Setup | Typical Conflict |
|---|---|---|
Shareholders and managers | Shareholders delegate operating authority to managers | Managers may prioritize personal pay, perks, or job security over shareholder returns |
Shareholders and the board | Shareholders elect directors to oversee management on their behalf | Directors with weak independence may favor management over shareholders |
Controlling and minority shareholders | Minority shareholders rely on controlling shareholders to act fairly | Controlling shareholders may direct company resources to benefit themselves |
Shareholders and creditors | Creditors rely on management not to increase risk after lending | Management may take on riskier projects that benefit shareholders but increase creditor risk |
Each row follows the same logic: one party depends on another party's decisions, and their incentives do not fully align. This is also the structure behind a principal agent relationship in partnership, where partners delegate authority to a managing partner and face similar incentive risks if that partner's interests diverge from the group's.
How Governance Helps Reduce Agency Conflicts
Firms cannot eliminate agency conflicts, but governance structures reduce their frequency and cost. Independent boards, performance-based pay tied to long-term results, and shareholder voting rights all work to align agent behavior with principal interests. These mechanisms are the focus of the next note, Corporate Governance and Stakeholder Management Mechanisms. This note focuses on identifying the conflict itself before moving to how firms manage it.
Common Exam Traps
Reversing the principal and agent. Candidates sometimes label the manager as the principal because the manager appears to hold power. The principal is the party that delegates authority, not the party that exercises it.
Assuming every disagreement is an agency conflict. A dispute between two departments over budget priorities is not automatically a principal-agent problem unless it traces back to delegated authority and misaligned incentives.
Confusing a stakeholder conflict with a legal violation. An agency conflict is a misalignment of incentives, not necessarily fraud or a breach of law. A CEO pursuing a value-destroying acquisition for personal prestige is an agency conflict, not automatically illegal conduct.
Overloading the answer with governance mechanisms. When a question asks you to identify a conflict, do not spend time describing board structure or compensation design. Save that detail for governance-mechanism questions.
Practice Question
A private company's founder-CEO holds 15% of shares and receives an annual bonus tied entirely to revenue growth. The remaining shareholders have no board representation. The CEO approves a large marketing campaign that boosts revenue in the short term but requires heavy discounting that reduces overall profitability.
Which of the following best identifies the principal-agent conflict in this scenario?
The CEO is the principal, and the shareholders are the agents, because the CEO holds decision-making authority over marketing spend.
The shareholders are the principal, and the CEO is the agent, because the CEO's revenue-based bonus creates an incentive to grow revenue even at the expense of profitability.
There is no principal-agent conflict, because the CEO is also a shareholder and therefore shares the same interests as the other shareholders.
Correct Answer: B
The shareholders delegated operating authority to the CEO, making them the principal and the CEO the agent. The CEO's bonus structure rewards revenue growth regardless of profitability, creating an incentive mismatch with shareholders who care about overall returns.
Option A. Reverses the principal and agent. Holding decision-making authority makes the CEO the agent, not the principal.
Option C. Assumes partial ownership eliminates conflict. A 15% stake does not align the CEO's incentives with the other 85% of shareholders, especially when the bonus structure rewards a narrow metric.
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FAQs About Principal-Agent Relationships and Stakeholder Conflicts
What is the difference between a principal and an agent?
A principal delegates decision-making authority. An agent receives that authority and makes decisions on the principal's behalf. In a corporation, shareholders are principals and managers are agents.
Is the principal-agent problem the same as a conflict of interest?
A conflict of interest is the cause of the principal-agent problem. The principal-agent problem describes the broader situation where delegated authority combined with misaligned incentives creates the risk that an agent acts against the principal's interest.
Can a principal-agent relationship exist outside of shareholders and managers?
Yes. It can exist between controlling and minority shareholders, between shareholders and creditors, or between partners in a partnership where one partner manages decisions on behalf of the group.