SBL Notes - Chapter 4 Agency and Stakeholders Pankaj Khandelwal

CA, CFA, CIA

Corporate governance is the system of rules, practices, and processes by which a company is
directed and controlled.

It establishes the structure for how the board of directors, management, and shareholders interact,
ensuring accountability, transparency, and ethical decision-making to balance the interests of all
stakeholders.

The Governance Structure

The power and responsibilities within a company are typically divided among three key groups:

1. Shareholders: The owners of the company who provide capital and vote on major
decisions, such as electing board members.
2. Board of Directors: Elected or appointed individuals who represent the shareholders'
interests. They oversee management, set high-level strategy, and ensure the company
remains accountable.
3. Management (C-suite): Led by the CEO, this group is responsible for the daily operations
and execution of the board's strategic vision.

Agency Theory
Agency Theory explains the relationship between the owners of a business (Principals) and the
people hired to run the business (Agents).

The theory states that a conflict can arise because owners want to maximize shareholder wealth,
while managers may pursue their own personal interests, such as higher salaries, job security,
prestige, or perks.

This difference in objectives creates an agency problem.

Because ownership and control are separated, directors may act in their own interests instead of
shareholders' interests. This is called the agency problem.

Examples of Agency Problems

Directors may:

• Pay themselves high salaries and bonuses regardless of performance.

• Give themselves excessive retirement benefits.
• Sign long-term contracts that make it difficult to remove them.
• Demand large compensation ("golden parachutes") if the company is taken over.
• Use "poison pills" to block takeovers that would benefit shareholders.
• Use company assets for personal purposes.
• Enter into unfair related-party transactions.

How the Problem can be Reduced

After major corporate scandals in the 1980s and 1990s:

• Corporate governance rules became stronger (e.g., the UK Corporate Governance Code
and the Sarbanes–Oxley Act of 2002).
• Greater emphasis was placed on Corporate Social Responsibility (CSR).
• Institutional investors became more active in monitoring directors and protecting
shareholders' interests.
SBL Notes - Chapter 4 Agency and Stakeholders Pankaj Khandelwal
CA, CFA, CIA
Agency Cost
Agency Cost refers to the cost incurred due to the conflict of interest between principals
(shareholders) and agents (managers).

Monitoring Costs

• External audit fees

• Internal audit department
• Independent directors
• Compliance and governance systems
• Performance reviews

Bonding Costs

• Signing performance contracts

• Obtaining professional indemnity insurance
• Implementing governance certifications

Residual Loss

• Residual loss is the reduction in shareholder wealth even after monitoring and bonding
mechanisms are in place.

Aligning Directors' and Shareholders' Interests

1. Incentive schemes: Pay directors through bonuses and share options linked to long-term
performance.
2. AGMs: Shareholders vote on directors, dividends, and key decisions.
3. Board composition: Appoint independent directors and remove poor-performing
directors.
4. Shareholder resolutions: Shareholders propose and vote on important company issues.
5. Sell shares: Dissatisfied shareholders, especially institutional investors, can sell shares
and pressure management.
6. One-to-one Meetings: Institutional investors meet management to discuss concerns and
improve accountability.

Trick to Remember: AB MISS

• A – AGMs
• B – Board composition
• M – Meetings with management
• I – Incentives
• S – Shareholder resolutions
• S – Sell shares

Stakeholders
Stakeholder theory groups stakeholders into:

(1) Capitalist institutions

(2) CSR stakeholders and
(3) Environment & future generations.

1. Capitalist Institutions - Core business stakeholders

• Shareholders
• Managers
• Employees
SBL Notes - Chapter 4 Agency and Stakeholders Pankaj Khandelwal
CA, CFA, CIA
• Customers
• Suppliers

2. CSR Stakeholders
• Society & governance
• Government
• Local communities
• Society

3. Environment & Future Stakeholders

• Long-term sustainability
• Environment (animals, plants, natural resources)
• Future generations

Risk in Corporate Governance

Good corporate governance reduces business and stakeholder risks by ensuring directors understand
and manage the interests of key stakeholders.

• Business Risk: The risk that a company fails to achieve its objectives.
• Stakeholder Risk: The risk that the company loses value because directors ignore or
misunderstand stakeholder interests.
• Directors should:
o Identify all stakeholders.
o Assess each stakeholder's interest and power.
o Consider them while making business strategy.

What is Mendelow's Matrix?

Mendelow's Matrix helps managers identify and prioritise stakeholders based on two factors:

• Power – How much influence a stakeholder has.

• Interest – How much the stakeholder cares about the company's decisions.

Influence = Power + Interest

Stakeholders can change over time, so they should be monitored regularly.

Power Interest Action

Manage closely – most important

High Power + High Interest Key Players
stakeholders.

Keep them happy so they don't become

High Power + Low Interest Keep Satisfied
active.

Share information and maintain good

Low Power + High Interest Keep Informed
communication.

Monitor occasionally; they need the least

Low Power + Low Interest Minimal Effort
attention.
SBL Notes - Chapter 4 Agency and Stakeholders Pankaj Khandelwal
CA, CFA, CIA
Uses of Mendelow's Matrix

• Identify the most important stakeholders.

• Predict who will support or oppose a strategy.
• Develop strategies to manage different stakeholders.
• Monitor changes in stakeholder power and interest over time.

Limitations

• Power and interest are difficult to measure accurately.

• Stakeholders move between categories as situations change.
• The model may encourage managers to ignore low-power stakeholders, raising ethical
concerns

Stakeholders Type

1. Internal - People inside the company.

o Shareholders (owners)
o Board of Directors
o Managers
o Employees
2. Connected - People who do business with the company.
o Customers
o Suppliers
o Lenders/Banks
o Distributors
o Strategic partners
3. External - People outside the company who can influence or are affected by it.
o Government and regulators
o Local communities
o Society
o Media
o Pressure groups/NGOs
o Environment
o Future generations

Corporate Social Responsibility (CSR) is a company's commitment to operate ethically,

protect the environment, support society, and create long-term value for all stakeholders, not just
shareholders.

Meaning of CSR

• CSR means a company is responsible not only to shareholders but also to employees,
customers, society, and the environment.
• It encourages businesses to act ethically and contribute positively to society.
• The goal is to achieve sustainable (long-term) growth while creating value for all
stakeholders.

Key Areas of CSR

• Employees – Fair treatment and good working conditions.

• Customers & Suppliers – Honest and ethical business practices.
• Environment – Protect natural resources and reduce pollution.
• Local Communities – Support community development.
• Transparency & Integrity – Be honest, accountable, and ethical.
SBL Notes - Chapter 4 Agency and Stakeholders Pankaj Khandelwal
CA, CFA, CIA
Gray, Owen and Adams’s – ‘seven positions on social responsibility’,
Viewpoint Simple Meaning

Profit Only - Business should only maximise shareholder wealth. CSR is not a
Pristine Capitalists
priority. – Berkshire Hathway

CSR for Profit - CSR is acceptable only if it increases profits (e.g., better
Expedients
reputation, customer loyalty). – Mcdonald’s

Follow Society's Rules - Businesses must meet society's expectations to keep

Social Contract
their "license to operate." – Tata Steel

Do the Right Thing - Companies should act responsibly because it is the right
Social Ecologists
thing to do, even without pressure. – Tata Group

Reduce Inequality - Businesses should help reduce inequality and benefit

Socialists
society, not just owners. - Amul

People Before Power - Businesses should promote values like fairness,

Radical Feminists compassion, equality, and cooperation instead of power and competition. –
The Body Shop

Deep Ecologists Planet First - Businesses should protect the environment and all living beings,
(Deep Greens) even if profits are reduced. – Jaipur Rugs

Concept Evolution:

Moving from "Profit Only" to "Planet First."

• Profit First → Pristine Capitalists, Expedients

• Balance Profit & Society → Social Contract, Social Ecologists
• Society & Environment First → Socialists, Radical Feminists, Deep Ecologists

Trick to remember: PE SSS RD

• P – Pristine Capitalist
• E – Expedient
• S – Social Contract
• S – Social Ecologist
• S – Socialist
• R – Radical Feminist
• D – Deep Ecologist

CSR Pyramid
1. Philanthropic
2. Ethical
3. Legal
4. Economic
SBL Notes - Chapter 4 Agency and Stakeholders Pankaj Khandelwal
CA, CFA, CIA
Ethical Stance
How much a company goes beyond its minimum legal responsibility towards stakeholders and
society.

Ethical Stance Principle Simple Meaning

Focus only on short-term profits and meet minimum

Laissez-faire Profit First
legal requirements.

Do Good = More Invest in CSR only if it improves long-term profits and

Enlightened Self-Interest
Profit reputation.

Forum for Stakeholder Balance Balance the needs of shareholders, society, and the
Interaction Everyone environment (Triple Bottom Line).

Change the Business aims to improve society and the environment,

Shapers of Society
World even if profits are lower.

Corporate Citizen
A good corporate citizen avoids causing harm, creates benefits for society, is transparent and
accountable to stakeholders, and earns sustainable profits for shareholders.

Principle Meaning Example

Avoid harming people, society, A factory installs pollution control

1. Minimise Harm and the environment through equipment to reduce air and water
business activities. pollution.

A company invests in employee training,

2. Maximise Create positive value for society,
education programs, or community
Benefit not just for shareholders.
healthcare while also earning profits.

Listen to stakeholders, be honest, A company publishes a sustainability report

3. Be Accountable
and take responsibility for your and openly explains both its achievements
and Responsive
actions. and challenges.

Earn profits so the business A company increases sales and profits while
4. Support Strong
remains sustainable and rewards continuing to invest in responsible business
Financial Results
its shareholders. practices.

Trick to remember: MMBS