The Nature of Conflicts of Interest within the Firm

Article excerpt


There are many ways to evaluate the quality of a jurisdiction's business law rules. From a practical point of view, however, there is no better method of evaluating the efficacy of a particular system of rules than by measuring how conflicts of interest are handled.

Conflicts of interest are ubiquitous and inevitable. From decisions about executive compensation to decisions about corporate control transactions, corporate governance systems regulate conflict within the firm. In fact, viewed broadly, a strong argument can be made that corporate law does very little of much value other than regulating conflicts within the firm. Indeed, moving beyond the confines of corporate law to the issue of conflicts of interest more broadly, traditional ethical theory presumes that conflicts of interest are fundamental to the human condition and that the study of ethics contains the solutions to these dilemmas. Put simply, ethical norms are what inform the decisions about whose interests should be sacrificed in order to resolve the conflicts.

Conflicts of interest are a perennial problem precisely because they cannot be prohibited.1 They must be regulated, simply because often it is simply not possible, much less desirable, to avoid conflicts within the firm. Executives have to be paid. Firms need capital, and sometimes, particularly when the firm is in distress, that capital can come only from insiders. More generally, firms must make decisions in the ordinary course of business, and these decisions inevitably generate conflict. While these conflicts may or may not rise to the level of legally cognizable conflicts, they are conflicts nonetheless. Decisions to raise prices, raise workers' wages, change suppliers, relocate, or pay dividends instead of reinvesting the free cash flow, all make some of the corporation's constituents better off while making other constituents worse off. In this and many other ways, they create conflicts within the firm. Thus, ethical theory only guides us to the extent that we can avoid conflicts, which is to say, hardly ever as a practical matter. Some way of managing conflicts is necessary in the real world, and that is through the contracting process.

For this reason, theories that suggest that the way to deal with conflicts of interest is simply to avoid them are not of much practical value, since in the real world it simply is not possible to avoid conflicts entirely. An additional practical problem associated with the standard ethical perspective on conflicts is that it fails to distinguish between what economists would characterize as ex ante conflicts and what they would describe as ex post conflicts. An ex ante conflict is one that emerges, or can be reasonably foreseen, before a party has made any sort of investment or commitment in a particular endeavor. An ex post conflict is one that emerges after investments or commitments have been made, and could not reasonably have been foreseen by the parties prior to making their investments.

Conflicts that were anticipated ex ante, or that should have been anticipated ex ante, should be treated differently than conflicts that are unforeseeable. Putting together these two categories, there is one large set of conflicts that are unavoidable but foreseeable, and a smaller set of conflicts that are both unavoidable and unforeseeable. It is the latter, smaller set of conflicts that we need worry about, because this is the set of conflicts that cannot be solved adequately through either explicit or default contractual arrangements.

A puzzle emerges from the above analysis. Many of the conflicts that appear to undermine modern corporate governance are quite foreseeable. In particular, conflicts such as executive compensation and the proper role of management in dealing with mergers and acquisitions are ubiquitous, widely discussed in the literature, and easily dealt with, at least in theory if not not in practice. …