Chapter 4: Agency and Stakeholders

Corporate governance – the system by which business corporations are

directed and controlled. The corporate governance structure specifies the
distribution of rights and responsibilities among different participants in the
corporation … and spells out the rules and procedures for making decisions
on corporate affairs.
Many of the issues in corporate governance relate to the agency problem;
the fact that one group of people (the directors) manage and control the
organisation on behalf of another, the owners:
 Historically, the same individual owned, controlled and managed an
individual company. As that company expanded and sought increasing
finance through share issues to the general public, the role of the
owners (shareholders) and managers became separated.
 The development of the market system (stock exchanges) in the UK
and US eventually resulted in shareholders delegating the running of
the business to the company's management. The separation of
ownership and control became evident.
 As the number of shareholders grew, the incentive and ability of
individual shareholders to gather information and monitor managers
decreased. This gave managers greater potential to run the business
as they wanted with little interference and accountability.
Agency theory – duties and conflicts that occur between parties who have
a relationship in which one or more persons (the principals) delegate some
decision-making authority to another person (the agent) in order for the
agent to perform some service on behalf of the principals.

 Agents and principals: An agent is an individual hired or employed

by another, the principal, to carry out a task on the principal's behalf.
 Agency: The relationship between the principal and the agent.
 Agency costs: The costs incurred in establishing and monitoring the
agent by the principal (i.e. how the shareholder controls and verifies
management's activities).
 Residual loss: The reduction in shareholder value that results from
excessive agency costs. For example, directors awarding themselves
other benefits beyond basic salaries and incentive schemes such as
company cars, houses, planes, club memberships, etc.
 Accountability: Under the agency relationship, the agent is
accountable to the principal for the outcome of the work the agent
carries out and the resources used. In theory, the directors (the
 agents) are answerable to, and held responsible by, the shareholders
(the principals) for their actions.
 Fiduciary duty: The duty imposed upon certain persons because of
the position of trust and confidence in which they stand in relation to
another.

The "agency problem" concerns how the shareholders (principals) control the
directors (agents) to ensure that the agents act in the principals' best
interests and not their own.

Examples of potential conflicts between principal and agent include:

 High salaries, benefits and easy-to-obtain bonuses (regardless of
performance).
 Excessive retirement benefits.
 Long-term contracts (making it difficult and/or costly to dismiss
directors).
 "Golden-parachutes" providing directors with significant
compensation in the event of a takeover.
 "Poison-pills" making a takeover difficult when it would be in the
shareholders' interests, but not in the interests of the directors.
 Non-business use of corporate assets.
 Related party transactions which are not at arm's length.

A certain malaise set in with individual shareholders; realising that they

could not influence the directors, they settled for annual dividends and
capital growth. If dissatisfied, they could always sell their shares and, if the
worst happened, they would only lose their initial investment (and not their
entire wealth). In short, there was no effort made to manage the directors'
behaviour.

The gradual emergence of institutional investors (e.g. pension

funds) made the agency problem worse. Such investors were
primarily interested in maximising short-term gains (in share value
and income).
As long as the directors were able to meet the basic needs of shareholders or
offer sufficient "sweeteners" (e.g. special dividends, increased shareholder
benefits), they were more or less able to do as they pleased to run the
company.
1.4 Agency Costs
The total agency cost arising from the agency problem may be summarized
as the sum of (Jill Solomon, 2007):
 Monitoring expenses – these include the costs of having a board
which acts on behalf of shareholders and restricts the activities of
management (e.g. performance-based contracts) and the costs
associated with issuing financial statements (e.g. audit fees). This
includes the cost of non-executive directors.
 Bonding (contracting) costs – the costs of the agents to show
the principals that they have acted in good faith (e.g. financial
statements and interim statements, listing reports, voluntary
statements, meetings with institutional shareholders, websites).
This also includes costs of stock options and other structures which
incentivize agents to act in the principal's best interests.
 Residual costs – the costs of the agents providing themselves with
additional benefits beyond basic remuneration such as bonus and
incentive schemes.

1.5 Aligning Director and Shareholder Interests

Solutions to aligning director (agent) and shareholder (principal) interests are
often a balancing act between incentivising and active monitoring.
Incentive Schemes
 It is important to consider what remuneration levels will satisfy
directors so as not to pursue their own interests?
 If directors do not have a financial interest in the shares of the
companies they manage, they may only take a short-term view on
notionally maximising shareholder wealth. The actions they take may
create future problems which will crystallise when they have moved on
from the company.
Active participation in Annual General Meetings (AGMs)
 While the vote is considered to be an essential aspect of controlling
the directors, it will only have an effect if a sufficiently large number
of votes are cast in a particular way (e.g. against a directors'
resolution or the reappointment of a particular director).
1.5.3 Board Composition
 The activism of institutional shareholders has, in recent years, resulted
in directors being voted off boards.
 shareholders can request the formation of committees or changes to
the composition of the board, such as the appointment of more non-
 executive directors. Shareholders can also vote against new
appointments or reappointments to the board.
1.5.4 Shareholder Resolutions
In most jurisdictions, shareholders may propose resolutions to be discussed and
voted upon at general meetings. Shareholder resolutions will usually fail if they do
not have the support of the directors or the institutional investors. They are
generally disliked by directors because of the publicity they may generate.

1.5.5 Selling Shareholdings

Concern will be great, however, if the shareholder is an institutional investor as the
action could easily lead to a domino effect, causing other institutional investors to
divest.
1.5.6 One-to-One Meetings

2.0 The Power of Stakeholders

Stakeholder – "Any group or individual who can affect or be affected by the
achievement of an organisation's objectives."
Stakeholders want different things from an organisation and may attempt to
influence the behaviour of the organisation to suit their own aims.
groups that can affect the organisation and/or be affected by the
organisation
Agency theory only considers the relationship between directors and
shareholders with the need to maximise shareholders' wealth.
companies which follow a strong stakeholder approach (including CSR and
corporate governance) to maximising their wealth are outperforming those
which do not.
Donaldson and Preston (1995) suggested that there were two basic
motivations for companies to respond to stakeholder concerns:
 an instrumental approach; and
 a normative approach.
2.2.1 Instrumental Approach
Stakeholder management is "a means to an end", something the company
has to do in order to maximise wealth. A company's interest in stakeholders
is therefore instrumental.
2.2.2 Normative (Intrinsic) Approach
In the normative view, a company establishes fundamental moral principles
(not just based on what is best for the company) on how it will take account
of the concerns and opinions of others.
Stakeholder interests have intrinsic worth in that stakeholder claims also are
often based on fundamental moral principles. They are unrelated to the
instrumental value of stakeholders for a company.
 Business risk is "the risk that the business will not achieve its
objectives".
 Stakeholder risk (as a subset of business risk) can be considered
as the risk that the business will not maximise its wealth because of
the lack of understanding of the impact of stakeholders on the
business by the directors – a failure by the directors to make the
appropriate business case.

Mendelow
 It is important to identify when interest/power of a stakeholder
changes and the effect on the entity that this may have.

2.4.1 High Interest, High Power = Key Players

Greatest attention needs to be paid to the key players. The
organisation cannot manage without them. They have the ability (interest
and power) to prevent the organisation from achieving its strategy (e.g.
upsetting customers will drive them to competitors). A specific difficulty may
be that there are a number of conflicts between stakeholders in this category
which have to be managed.
Alternatively, an interested stakeholder may be in a position of power to
actively lobby for the benefit of the organisation.
2.4.2 Low Interest, Low Power = Minimal Effort
Diametrically opposite to the key players are the stakeholders with low
interest and low power (L/L). Mendelow indicates that these stakeholders can
be largely ignored when considering strategic objectives.
However, from an ethical/moral view, L/L stakeholders should still be
considered because to ignore them could result in negative consequences in
the future if their power and interest increase.
2.4.3 High Interest, Low Power = Keep Informed
High-interest, low-power stakeholders need to be kept informed and not
underestimated. Because of their high interest, they care a lot and can be
useful in forming positive lobby groups. Alternatively, they may join forces to
form a stronger grouping and so move toward the high-power sector and
become lobbyists against the organisation.

2.4.4 Low Interest, High Power = Keep Satisfied

Lastly, the low-interest, high-power stakeholders (often referred to as
"sleeping giants") need to be kept satisfied and stay dormant. If, for
whatever reason, they become more interested (woken up), they can easily
become key players and, for example, frustrate the adoption of a new
strategy.
Alternatively, their interest could be deliberately enhanced by the
organisation so that their power can be effectively used.
2.4.5 Uses of the Mendelow Matrix
Using the power-interest matrix, organisations can:
 understand whether their current strategy is still in line with
stakeholders' interests and power;
 identify who will support a strategic project and who can, and aim,
to stop it;
 try to reposition stakeholders to increase support/reduce threats to
a strategic objective;
 encourage stakeholders to stay in a category or prevent them
moving to another; and
  identify change within stakeholders that may imply that the current
strategy needs to be re-thought with the possibility of a new
strategy being developed.
2.4.6 Issues with the Mendelow Matrix
Although it is a useful basic framework for understanding which stakeholders
are likely to be the most influential, there are issues with the matrix
 Effective measurement of each stakeholder’s power and interest is
difficult to do.
 The power and interest of stakeholders is mapped onto a grid which
may give the perception of finality in the analysis. In reality, this is
not static. Changing events can mean that stakeholders can move
around the grid.

3.1 Internal Stakeholders

Internal stakeholders – individuals or groups, who are directly and/or financially
involved in the organisation.

Directors
Directors are responsible for the strategic direction of a company, its day-to-day
operations and its moral and corporate social behaviour. Directors' powers are
usually set out in the company's formation documents and moderated by company
law and corporate governance code

Employees
Employees carry out management's instructions to achieve the
organisation's short, medium and long-term objectives and provide
appropriate feedback to their supervisors.
Employees should comply with the risk management and control systems in
the corporate governance framework of the company.

Connected stakeholders – may have an indirect financial stake in the

organisation, and are affected by the organisation's operations.

Customers
Customers are primarily interested in their satisfaction with their purchase.
At its most basic this is the price/quality combination offered by the product
or service and additional factors such as after-sales service and product
warranties.
3.2.3 Suppliers
Suppliers are primarily interested in a fair procurement system, being paid a
fair price and being paid promptly. They may also be interested in
opportunities for growth through feedback, partnerships and access to
networks.
Creditors are interested in the organization’s ability to service its debt, its
credit rating is a key indicator. The relative power of each provider of credit
depends on the specific terms and conditions in the debt contract, such as:
 the power to seize and liquidate assets if the debt is not repaid; or
 restrictive covenants (e.g. forcing limits on dividend payments).

External stakeholders – have no direct financial stake in the organisation, but are
indirectly influenced by the organisation's operations.

3.3.1 Trade Unions

Trade unions protect and develop employee interests. I

3.3.2 External Auditors

External auditors provide assurance to the shareholders regarding the
reliability of the financial statements presented by the directors.

3.3.3 Regulators
Regulators can be governmental and affect all organisations (
Most regulators exist to protect customers from abuse.
The key interests of regulators are to ensure compliance with appropriate
regulations and assess how effective those regulations are.

3.3.4 Government
The government's interest in an organisation potentially takes many forms,
including:
 Tax revenues – sales taxes, profit taxes, capital gains taxes, payroll
taxes, import duties and withholding taxes on dividends.
 Providing grants and subsidies – to encourage new business
ventures.
 Direct investment – in some jurisdictions, governments may
purchase shares in a company to save it from collapse (e.g. a bank
that is considered essential to the financial system). In countries in
which property rights are weak there is even a risk that the state
will nationalise a company against the wishes of its shareholders.
Corporate Social Responsibility – CSR is the continuing commitment by business
to behave ethically and contribute to economic development while improving the
quality of life of the workforce and their families as well as of the local community
and society at large.
It refers to all of the impacts a company may have on society and the need to deal
with those impacts on all stakeholders in a responsible way.
The purpose of CSR is to encourage organisations to conduct business in an ethical
manner and to work towards having a more positive impact on society through
ensuring sustainable growth.

CSR deals with the following areas:

 Treatment of stakeholders – in particular employees, suppliers and
customers;
 Approach to the environment;
 Its interactions with local communities; and
 Transparency and integrity.

4.3 CSR viewpoints

Gray, Owen and Adams’s mapped ‘seven positions on social responsibility’,

which describes a continuum of viewpoints on CSR.
1. Pristine capitalists: This is the extreme stockholder end of the
continuum, where shareholder wealth maximization is held to be
the fundamental principle that should be followed. Directors are
agents of the shareholders and should not act in a way that reduces
the return to the shareholders.

2. Expedients: While sharing the same underlying value of

maximising shareholder wealth, expedients recognise that some
CSR expenditure may be needed in order to maximise profit – for
example to improve customer loyalty or avoid reputationally
damaging revelations.

3. Social contract position: The social contract between businesses

and society demands that the business act in a socially acceptable
way. If the business transgresses these social norms, the ‘license’
to operate can be withdrawn by society.
 4. Social ecologists: While the social contract is externally imposed,
social ecologists believe that organisations should adopt socially
responsible policies because they feel a responsibility to do so, a
responsibility that is internally imposed, regardless of the demands
of society.

5. Socialists: Socialists view businesses as the tools of a capitalist

class subjugating other classes of people. Business is seen as a
concentrator of wealth not a redistributor. Businesses should
operate in such a way as to redress the imbalances in society.

6. Radical feminists: Radical feminists also argue that a significant

readjustment of societal structures is needed, and that the values
on which business is based are those considered masculine in
nature, such as aggression, power, domination and hierarchy. They
argue that businesses based on values traditionally perceived as
feminine (such as connectedness, compassion, fairness and
equality) would result in better outcomes for society.

7. Deep ecologists/deep greens: These are at the other end of the

continuum from the pristine capitalists, and believe that all living
beings have an equal right to existence. Human beings, therefore,
have no right to damage other living beings or their ecosystems,
and certainly no right to do so for financial gain.

4.4 CSR Models

Approaches to CSR have changed significantly over the past few years, and
there are still different conceptual approaches to CSR between organisations.
There are three main CSR models which represent different approaches to
CSR.

4.4.1 CSR Pyramid

Carroll’s CSR pyramid categorises the four social responsibilities of a
business in a hierarchy, where the 1.economic responsibility to make a
profit is the fundamental responsibility, since without that the business
cannot fulfil any other responsibilities. Next in the hierarchy is the
responsibility to obey the
2 law, then the ethical responsibility to act in a way that is expected by
society even if it is not a legal requirement.
At the top of the pyramid, and so the least important, is the discretionary
responsibility to be philanthropic. Since the responsibilities are separated,
this leads to narrow definitions of each of the responsibilities, with the legal
responsibility, for example, being the follow the letter of the law, while the
responsibility to follow the spirit of the law falls within the ethical domain.
In this model businesses undertake CSR due to external pressures – the
expectations of society, so CSR should be undertaken to the minimum level
needed to satisfy these expectations.

Ethical stance – the extent to which an organisation will exceed its minimum
obligation to stakeholders.

Four levels of ethical stance have been described by Johnson and Scholes:
1. Laissez-faire (short-term): The focus is on meeting short-term
profits with regard to only the minimum legal social and ethical
obligations.
o This maximises profits in the short run, but may
harm the organisation in the longer run.
o For example, consumers may boycott organisations
that behave unethically towards a particular group of
stakeholders.
2. Enlightened self-interest (long-term): Recognises that in order
to increase shareholder wealth over the longer term, short-term
profits may have to be sacrificed.
o CSR activity is undertaken to the extent that it will
increase the wealth of shareholders (e.g. developing ultra-
 low emission vehicles (ULEV) to improve brand reputation
and increase sales).
o A proactive approach to ethical issues may also
reduce the risk of more onerous government legislation
being introduced.
3. Forum for stakeholder interaction (multiple obligations): The
organisation's purpose explicitly recognises the needs of a wider
group of stakeholders, not just shareholders, and its strategies
adopt the principle of sustainability.
o To ensure a better quality of life, the three
dimensions of environmental protection, social
responsibility and economic welfare are deemed equally
important.
o Performance is measured in terms of the triple
bottom line – social and environmental benefits as well as
profits (covered in Chapter 6).
o Sustainability will typically have board-level
champions.
This approach may conflict with the needs of the shareholders, but
this is accepted as shareholders are not the only stakeholders.
4. Shapers of society: Here the organisation tries to change society
for the better. The interests of shareholders are of secondary
importance.

The Boston College Center for Corporate Citizenship (www.ccc.bc.edu)

identifies four core principles that define the essence of corporate
citizenship:
 Minimise harm: Work to minimise the negative consequences of
business activities and decisions on stakeholders.
 Maximise benefit: Contribute to society and economic well-being
by investing resources in activities benefiting shareholders as well
as broader stakeholders.
 Be accountable and responsive to key stakeholders: Build
relationships of trust and be transparent about progress and
setbacks.
 Support strong financial results: Return a profit to shareholders.

The objective of the SDGs is ‘to achieve a better and more sustainable future
for all. They address the global challenges we face, including poverty,
inequality, climate change, environmental degradation, peace and justice.’
The 17 goals, with a total of 169 targets, provide a universal framework for
governments, civil society and businesses to work collectively towards
sustainable development. The areas covered include poverty, inequality,
climate change and universal healthcare.
The UN SDGs can be used as a blueprint for businesses to drive positive
social, economic and environmental impact. Businesses integrate the goals
that are relevant for their activities into their strategies, and apply their
creativity and innovation to solve development challenges while achieving
their commercial goals.