Case Study - Concept of Risk Management

QUESTION

Ms. Sania, a fund manager at institutional investor - Investo House, was reviewing the annual report of one of the major companies in her portfolio. The company, Sunway Ltd, had recently undergone a number of board changes as a result of a lack of confidence in its management from its major institutional investors of which Investo House was one. The problems started two years ago when a new chairman at Sunway Ltd started to pursue what the institutional investors regarded as very risky strategies whilst at the same time failing to comply with a stock market requirement on the number of non-executive directors on the board.

Sania rang Sunway Ltd's investor relations department to ask why it still was not in compliance with the requirements relating to non-executive directors. Also when she asked how its board committees could be made up with an insufficient number of non-executive directors, the investor relations manager said he didn't know and that Sania should contact the chairman directly.

She was also told that there was no longer a risk committee because the chairman saw no need for one. Sania telephoned the chairman of Sunway Ltd. She began by reminding him that Investo House was one of Sunway Ltd's main shareholders and currently owned 17% of the company. She went on to explain that she had concerns over the governance of Sunway Ltd's and that she would like him to explain his noncompliance with some of the requirements of SEBI LODR Regulations, 2015 and also why he was pursuing strategies viewed by many investors as very risky.

The chairman reminded Sania that Sunway Ltd had outperformed its sector in terms of earnings per share in both years since he had become chairman and that rather than questioning him, she should trust him to run the company as he saw fit. He thanked Investo House for its support and hung up the phone.

PLEASE ANSWER BELOW MENTIONED QUESTIONS

(a) Explain what an ‘agency cost' is and discuss the problems that might increase agency costs for Investo House in the case of Sunway Ltd.
(b) Describe, with reference to the case, the conditions under which it might be appropriate for an institutional investor to intervene in a company whose shares it holds.
(c) Evaluate the contribution that a risk committee made up of non-executive directors could make to Sania's confidence in the management of Sunway Ltd.

ANSWERS (a)

Definition of agency costs: Agency costs arise from the need of principals (here shareholders) to monitor the activities of agents (here the board, particularly the chairman). This means that principals need to find out what the agent is doing, which may be difficult because they may not have as much information about what is going on as the agent does.

Principals also need to introduce mechanisms to control the agent over and above normal analysis. Both finding out and introducing mechanisms will incur costs that can be viewed in terms of money spent, resources consumed or time taken.

Problems with agency costs in Sunway Ltd.

• Attitudes to risk: The first reason for increased agency costs is that the company's attitude to risk is a major area of concern on which Investo House requires more information, since the risk appetite appears significantly greater than what would normally be expected in this sector.
• Unwillingness of chairman to be monitored: Agency costs will certainly increase because he is unwilling to supply any information about the reasons for his policies, certainly indicating arrogance and also a lack of willingness to accept accountability. This means that Investo will have to find out from other sources, for example any nonexecutive directors who are on the board. Alternatively they may contact other investors and take steps to put more pressure on Chairman, for example by threatening to requisition an extraordinary general meeting.
• Inadequacy of existing mechanisms: Agency costs will also increase because existing mechanisms for communicating concerns appear to be inadequate. There are insufficient nonexecutive directors on the board to exert pressure on the Chairman. There is no risk management committee to monitor risks. The investor relations department is insufficiently informed and unhelpful. The Chairman has abruptly dismissed the one-off phone call. Because of the seriousness of the concerns, ideally there should be regular meetings between Chairman and the major shareholders, requiring preparation from both parties and increasing agency costs.

ANSWER (b)

The conditions under which it might be appropriate for an institutional investor to intervene in a company whose shares it holds are-

• Institutional shareholders may intervene if they perceive that management's policies could lead to a fall in the value of the company and hence the value of their shares.
• There could be concerns over strategic decisions over products, markets or investments or over operational performance. Although they can in theory sell their shares, in practice it may be difficult to offload a significant shareholding without its value falling.
• Institutional investors may intervene because they feel management cannot be trusted like in the case Chairman has done away a key component of the control system (the risk committee) without good reason.
• Institutional investors may take steps if they feel that there is insufficient influence being exercised by nonexecutive directors over executive management.
• Intervention would be justified if there were serious concerns about control systems.
• Even if there is no question of dishonesty, there may be intervention if institutional investors feel that management is failing to address their legitimate viewpoints.

ANSWER (c)

Importance of Risk Management Committee: Risk committees are considered to be good practice in most worldwide governance regimes; particularly in situations like this where there are doubts about the attitudes of executive management. A risk committee staffed by non-executive directors can provide an independent viewpoint on Sunway Ltd.'s overall response to risk; a significant presence of non-executive directors, as required by governance guidelines, would be able to challenge Chairman's attitudes.

• The committee can pressurize the board to determine what constitutes acceptable levels of risk to reduce the incidence and impact on the business.
• Once the board has defined acceptable risk levels, the committee should monitor whether Sunway Ltd. is remaining within those levels, and whether earnings are sufficient given the levels of risks that are being borne.
• There should be a regular system of reports to the risk management committee covering areas known to be of high risk, also one-off reports covering conditions and events likely to arise in the near future. This should facilitate the monitoring of risk.
• The committee should monitor the effectiveness of the risk management systems, focusing particularly on executive management attitudes towards risk and the overall control environment and culture.
• A risk management committee can judge whether there is an emphasis on effective management or whether insufficient attention is being given to risk management due to the pursuit of high returns.

CONCLUSION

As we are aware that trade is taking of risks. Risk is the most important factor in life of an business entity. Risks are of many types some are controllable, some are uncontrollable. But prevention of the risk is better than cure. A risk will be properly controlled through risk identification, risk analysis, risk management, risk retention and risk transfer. Every entity wants to some extent risk management activities. In large organisation Risk Management Committee is must and directly report to the Board of Directors. An event in a non-risk controllable environment will wiped out whole profit and reputation of an entity earned in preceding years. We can define a “Risk” as possibility of loss or injury.

DISCLAIMER: The case study presented here is only for sharing knowledge with the readers. The views are personal, shall not be taken as professional advice. In case of necessity do consult with professionals for more understanding and clarity on the subject matter.