What is the conflict between stockholders and bondholders?

Conflicts between a company's management and its shareholders are usually referred to as agency costs and are borne by shareholders. Activist shareholders and increased corporate governance increasingly deal with agency-related conflicts, but these conflicts can be especially intense for shareholders of smaller, closely-held companies. Smaller companies can be subject to less-rigorous audits – depending on relationships with banks, customers and suppliers – and minority shareholders in closely-held companies are usually resistant to the only source of recourse, litigation, which can be expensive and risky.

Your management team may be more willing to take on higher levels of risk, – operating, financial or investing – while your shareholders desire maximized returns in the form of capital gains and dividends. Shareholders are generally risk-averse, which is viewed as prudent and conservative. If your management team receives a large portion of its compensation in annual salaries and stock options, managers have less to lose because salaries are constant, and stock option values rise in response to increased volatility, a form of risk.

Your shareholders desire minimized taxes, as opposed to maximization of shareholder wealth. Management teams sometimes exploit this by setting salaries in excess of industry norms, presumably because compensation expenses are tax deductible and lower taxable income.

It can be difficult to balance the return requirements of your shareholders with different long-term goals and tax situations. Your business could also form a plan that comes at the expense of shareholder returns. Common examples fueling these decisions include concern about leaving a legacy, engaging in “empire building," which involves acquiring companies at a fast pace, even if it involves taking on too much debt, or sacrificing profitability.

Management teams sometimes alter capital structures – the mix of debt and equity financing employed – in ways that preserve a level of control rather than a mix that maximizes wealth for your shareholders. Another example is poison-pill amendments adopted by boards of directors in support of a management team that purposely causes the company’s shares to lose substantial value in the event of a hostile takeover, offering high returns to shareholders at the expense of your company's leaders.

There may be a constant tug-of-war between your and your investors over the company’s capital. Shareholders often view excess cash on a company’s balance sheet and agitate for its return to shareholders in the form of cash dividends or the repurchase of shares, which boosts stock values. However, you may be very hesitant to do so, sometimes rightly so. You should not repurchase shares simply to appease shareholders, but only when the company’s shares are undervalued.

Also, you may want to raise capital to invest in new projects while shareholders view this as a threat. Issuing new shares can dilute existing shareholders’ stakes, and issuing debt can increase leverage risk and, therefore, the risk associated with the company’s stock. Shareholders should always read management reports on financing closely and examine the statement of cash flows to understand the methods of financing the business is using.

In order to continue enjoying our site, we ask that you confirm your identity as a human. Thank you very much for your cooperation.

As an investor, you have two main choices for investing in a given company. You can either purchase shares of a company's stock (generally via a brokerage), or you can buy its bonds. Shareholders are those who own stock in a company, whereas bondholders are those who own bonds issued by a company. Both investments offer the opportunity to make money, but there are risks inherent in each as well.

Shareholders
When you purchase a company's stock, you're essentially buying a piece, or share, of that company. As an investor, you have the option to choose from common or preferred stock. If you buy preferred stock, you'll get a higher dividend payment, and your dividends will take priority over those paid to holders of common stock. In exchange, however, you'll forego voting rights in the company.

As a shareholder, you can make money two ways: by selling your stock for a price that's higher than what you paid for it, or by holding the stock and collecting dividends. If a company generates enough of a profit and declares dividends, it will make payments to its shareholders, typically on a quarterly basis. Companies have the option to determine whether they will pay dividends at all, and the rate at which shareholders will be paid.

Bondholders
When you purchase a bond, what you're essentially doing is lending money to a company in exchange for a predetermined amount of interest. Once your bond matures, or comes due, the issuing company will return your principal as well.

As a bondholder, you can make money two ways: by selling your bonds for more than what you initially paid for them, or by holding the bonds and collecting interest payments. Bondholders typically receive interest payments twice a year. Whereas companies are not obligated to pay dividends if they fail to generate enough earnings, bondholders receive fixed interest payments regardless of a company's performance provided that it has the cash on hand to make those payments. Bonds generally have a lower rate of return than stock.

Risks
Both shareholders and bondholders face certain risks when they choose to invest in a given company. Those who own stock in a company run the risk of having share prices fall due to poor earnings, negative news related to the issuing company, or general market fluctuations. Furthermore, if a company performs poorly, it may opt not to issue dividends, thus eliminating a source of income for its investors.

Like shareholders, bondholders run the risk of bond values falling due to factors like poor financial performance, negative press, or general market conditions. Additionally, a company might fail to make scheduled payments, including interest payments and the repayment of principal at maturity, if it does not have enough cash on hand to fulfill its obligations as specified in its bond contract. This is known as a default.

Who takes priority?
In the event of a corporate bankruptcy, bondholders take priority in terms of repayment. Once bondholders are paid, preferred shareholders are next in line. Those who own shares of common stock are last to be paid, and for this reason, common stock is generally considered to be the riskiest way to invest in a company, while bonds are considered the least risky. No matter how you choose to invest in a company, however, the potential for monetary loss can't be ruled out.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Stockholders and bondholders both make money by putting money into businesses. Conflict between shareholders and bondholders happens because stockholders benefit from corporate gambles, while bondholders benefit from playing it safe. Because management is the shareholders' agent, corporations often do what the shareholders, not the bondholders, want.

Covenant bond agreements reduce conflicts between shareholders and bondholders. For example, corporations have an incentive to please shareholders by issuing big dividends, even if that risks their ability to pay off debt. A covenant limiting the size of dividends prevents that.

The relationship between stockholders and corporate management is one of principal to agent. The stockholders, as the owners of the company, are the principals. The corporation's management is the agent charged to act in the stockholders' interest.

Any principal/agent relationship has the potential for conflict. Is the agent making decisions to benefit themselves rather than the principal? Is the agent doing a bad job because they're incompetent?

In corporate governance, shareholders want good money management from their agent. They want to know where their money went, and they want a return on their investment either from dividends or from rising stock prices. If it doesn't happen, they want to know why their agent didn't deliver.

The appeal of bonds is that they're a safe, stable investment compared to stocks. On many bonds, the investor knows exactly what rate of return they're getting and when they'll be paid off. Other bonds offer fluctuating rates or higher risk for higher returns.

If a company takes a gamble and succeeds, shareholders may get larger dividends. Bondholders don't see more money. When a bond issuer takes on added risk, this has no upside to the bondholders' investment and may end up hurting them.

The hurt comes when a bond issuer goes bankrupt. The bondholders then have to compete with other creditors for a share of what they're owed. That gives them a different view of risk than shareholders have.

As the stockholders' agent, corporate management has a fiduciary duty to look out for the investors. The board and the CEO don't have the same obligation to put their creditors' interests first. That's the basic conflict between shareholders and bondholders.

A corporation could, for example, respond to shareholder demands by issuing huge dividends, even if this is bad for the company's long-term health. Taken to the extreme, this behavior puts bondholders and other creditors at financial risk. The company could wind up an empty shell that can't pay back its debts.

Some companies even issue added debt so that they can keep paying dividends. This avoids the wrath of shareholders who might be able to force a change in management. Taking on added debt doesn't benefit bondholders, but they don't have the same influence.

The conflict between shareholders and bondholders typically comes in one of four forms.

1. Excessive dividend payments that reduce the company's financial health.
2. Claim dilution, where the company takes on added debt to pay dividends. The more debt the company carries, the tougher it is for any one creditor to collect if the company collapses.
3. Asset substitution. Suppose someone buys corporate bonds because they see the company's underlying assets are solid. Down the road, shareholders push the company to buy riskier assets with the promise of high return. That's potentially good for the investors, but if it puts the company at greater risk for bankruptcy, it's bad for bondholders.
4. Underinvestment is the flip side of asset substitution. Companies put less money in safe investments because shareholders aren't satisfied with the rate of return. 

Other conflicts arise when a company sells off its assets or merges with another company and uses the added funds for shareholders' benefit rather than creditors.

The full impact of conflict between shareholders and bondholders is hard to estimate. Corporate finance is complicated, and decisions often have multiple motives. It's difficult to identify which decisions can be seen as taking shareholders' side over the bondholders.

One research approach is to look at cases where stockholders are also major bondholders. When shareholders are also heavily invested in bonds, there's no conflict between the two parties. One 2016 research paper found that in those situations, payments decrease in size because the stockholders are keen on getting the bonds paid off as well.

The paper concluded that when bondholders and stockholders aren't the same people, corporations favor payouts to shareholders over paying their debts.

One way corporations can reduce agency conflicts is with bond covenants. These are agreements that obligate the corporation to follow policies that protect the bondholders. They can include both positive and negative covenants.

Negative covenants forbid the corporation from taking certain actions, even if the stockholders demand it:

• Restrictions on issuing further debt.
• Restrictions on securing new debts with corporate assets. Secured debt goes to the head of the line in bankruptcy, ahead of bondholders.
• Setting a limit on the amount of dividends the company pays out.
• Limiting other kinds of payments such as share repurchases.
• Restricting asset sales and mergers. 

Positive covenants require the corporation to act, rather than refrain from doing something:

• Filing regular financial statements.
• Maintaining their property.
• Insuring their assets.
• Hedging against volatility in interest rates.
• Committing the corporation to use the bond money for a specific purpose.
• The company has to maintain certain financial ratios, such as net worth or debt to earnings.
• The company has to check its financial ratios if it takes certain steps, such as issuing added debt.
• The company will increase coupon payments on the bonds if its credit rating drops. This covenant is used primarily on high-yield, high-risk bonds.
• The bondholders can sell their bonds back to the company at a premium if ownership changes, the credit rating is downgraded, or other trigger events come to pass.
• The corporation will pay off the bond within 30 to 90 days if certain conditions happen. These could include bankruptcy or a large legal judgment against the company.  

Covenants are a common solution to conflicts between shareholders and bondholders, but they aren't a perfect one. For example, the bond issuer may find the covenant terms restrict them so tightly they can't make necessary investment and financial decisions. Restrictions on issuing further debt may block the company from raising money when it needs to.

Financial ratio covenants are often a sub-optimal choice for minimizing conflicts with shareholders. It takes regular monitoring to confirm that companies are maintaining the required financial ratio. Banks are well equipped for that work, but most other bondholders aren't.

By the time a bondholder discovers the issuer has exceeded the financial ratios, the corporation may already be insolvent. Setting specific terms on the policies that the business should or should not follow is usually more effective for a company that doesn't want to monitor the ratios constantly.

One proposal for reducing conflicts in the future is to give bondholders a say in corporate governance. The need to keep shareholders happy may lead corporate heads to make decisions that don't benefit the business. Giving bondholders more influence could counteract that.

Shareholders benefit if corporations take risky gambles that pay off. Bondholders benefit if corporations play it safe. Bonds are widely traded after the initial issue. Bond buyers who want to sell need corporations to make decisions that keep the bonds' highly rated, promising a safe return on investment.

The bondholders' need for security could counterbalance the stockholders' interest in risk. If bondholders exercised more direct control, that might increase the health and productivity of the corporate sector for the long haul.