T1Q3 Sentosa House

6 Sentosa House
1. Sonia Tan, a fund manager at institutional investor Sentosa House, was reviewing the annual
report of Eastern Products (Eastern), one of the major companies in her portfolio. Sentosa House,
like Eastern’s other major institutional investors, has become increasingly concerned about the
company’s management team.
2. The problems which have prompted the institutional investors’ lack of confidence in Eastern’s
management started two years ago when a new Chair, Thomas Hoo, started to pursue what the
investors regarded as very risky strategies, whilst at the same time failing to comply with a stock
market requirement on the required number of the non-executive directors on the board.
3. After reviewing Eastern’s annual report, Sonia rang the company’s investor relations department
to ask why it still was not in compliance with the requirements relating to non-executive
directors. She was told that, because Eastern was listed in a principles-based jurisdiction, the
requirement was not compulsory. It was simply that Eastern chose not to comply with that
particular requirement. When Sonia 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 Sonia should contact the Chair directly. She was also told that there was no longer
a risk committee because the Chair saw no need for one.
4. Sonia then telephoned Thomas Hoo, the Chair of Eastern Products. She began by reminding him
that Sentosa House was one of Eastern’s main shareholders and currently owned 13% of the
company. She went on to explain that she had concerns over the governance of Eastern Products
and that she would like Thomas to explain his non-compliance with some of the stock market’s
requirements and also why he was continuing to pursue strategies viewed by many investors as
very risky. Thomas reminded Sonia that Eastern had outperformed its sector in terms of earnings
per share in both years since he had become Chair and that rather than question him, she should
trust him to run the company as he saw fit. He thanked Sentosa House for its support and hung
up the phone.
Top tips. Part (a): Although the requirement asks for an explanation of agency cost, simply
knowing the definition will not be enough to pass part (a). The majority of the marks are
available for relating agency costs to the scenario and for discussing the issues that might
increase those costs. (The key elements that incur agency costs are the means of obtaining
information and controls established over the agent.)
In (b) you need to think about threats to value and the various problems associated with a
cavalier attitude towards control - including, potentially, risks to the investor’s own reputation
for being associated with it.
Marking Scheme
Marks
(a)Up to 2 marks for the definition of agency costs 2

1 mark for each problem identified and briefly discussed 5
Up to a maximum (for part (a)) of 7 marks 7
(b)1 mark for each relevant point identified, and briefly

described, on conditions for intervention, up to 7 marks Max 7
1 mark for each relevant point made in relation to the Eastern
Products case, up to a maximum of 4 marks Max 4
Up to a maximum (for part (b)) of 10 marks 10
17
Study Guide
B1 Agency
a) Discuss the nature of the principal-agent relationship in the context of governance
b) Analyse the issues connected with the separation of ownership and control over the
organisation's activity
Answer
(a) Explain what an ‘agency cost’ is and discuss the problems that might increase agency
costs for Sentosa House in the case of Eastern Products. (7 marks)
Agency Costs
Agency cost is the internal cost associated with the agency relationship between the principal and
the agent. The agent has the authority to make decisions on behalf of the principal. The principal
does not know what the agent is doing and cannot ensure the agent acts in the interest of the
principal. Hence, this potential divergence in interest is what gives rise to agency costs.
Problems with Agency Costs in Eastern Products
Attitudes to risk
The Chair, Thomas Hoo pursues what the investors regarded as very risky strategies and makes
the investors lose confidence (P2L2-3). Sentosa and other investors may incur losses if Thomas’s
strategies turn out to be a failure due to their riskiness. Therefore, Sentosa will need to know
more about the successfulness of Thomas’s strategy and the risk appetite which incurs more
agency costs.
Unwillingness to Disclose Policies
Thomas Hoo is unwilling to disclose any information regarding the question asked by Sentosa
and acting unwilling to accept accountability (P4L6-8). Sentosa will have to find out the
information from stakeholders such as the board of directors to take further action towards
Thomas.
Inadequacy of Existing Mechanism
The agency costs will increase as there are inadequate existing mechanisms for communicating
concerns between the Chair and its investor relation manager. The investor relation manager is
unhelpful in answering Sentosa’s inquiries regarding the insufficiency of non-executive directors
to give appropriate advice and the pressure on Thomas and there is no risk management
committee to monitor the risk (P3L5-7).
Lack of competence of the management team
When the investor relation manager doesn’t have any information from the Chair about the
insufficient number of non-executive directors and instead tells Sonia to ask the Chair about the
information herself, this implies that there is lack of communication between the managers and
the Chair. (P3L6-9) This may also be due to the investor relation manager’s lack of competence
to enquire necessary information from the Chair during departmental meetings. Hence, the
principals may need to hire external parties such as consultants to analyse and solve the
problems, which further increases the agency costs.
Insufficient numbers of independent committees.
Without independent committees such as risk committees, Eastern is currently being exposed to
high risks of failure if the Chair’s risky strategy were to commence. Sentosa and other investors
might solve conflict issues through proper communication via regular meetings with Thomas.
However, this will also increase the agency costs when regular meetings are being conducted.
(b) Describe, with reference to the case, the condition under which it might be appropriate
for an institutional investor to intervene in a company whose shares it holds. (10 marks)
B3a
Failure to meet investors’ wants
Institutional investors may intervene in a company when the company does not meet investors’
wants. In this case, Thomas has pursued what the investors regarded as very risky strategies
(P2L2-3). It indicates that Thomas does not know well about the risk appetite of its investors. It
may destroy the confidence level of investors in Eastern by pursuing a high-risk strategy that the
investors do not wish to pursue.
Failing to comply with the stock market requirements

Institutional investors may also intervene in a company when the company fails to comply with
the stock market requirements. Even though the requirement was not compulsory under
principles-based jurisdiction (P3L3-4), it must be explained the reason for not complying with
the requirements. Non-compliance of the requirements may lead to stocks being delisted from
the stock market which will then affect the investors’ benefit.
Dismissal of risk committee without a good reason

Institutional investors may intervene in a company when the risk committee is dismissed without
a good reason (P3L8). Risk committee helps to identify risk and implement a risk management
programme. If the risk committee was removed, then the risk management in the company may
become questionable. Risks not properly managed may lead to huge losses to the company
which may then affect the gain on dividend of shareholders.
Weakness of the internal control system

Due to the absence of the independent committees, the Chair seems to found loopholes in
Eastern’s policies where there was no person that has the same authority to control the Chair’s
actions without any further discussion with the institutional shareholders. Therefore, the
institutional shareholders may need to intervene in Eastern by forcing the company to recruit
audit committees in order to protect the future sustainability of Eastern.
Future sustainability of Eastern

As institutional investors, Sentosa may preferably have stable growth earnings rather than
sudden growth earnings. Moreover, Thomas mentioned that the shareholders should trust him to
run the company as he saw fit, not to mention his unethical attitude towards its main shareholder
by hanging up the phone (P4L8) The advisors may encourage Sentosa or other investors to pull
out from investing in Eastern due to its unethical reputation and the riskiness of his strategy,
despite being successful for only 2 years.
Lack of non-executive directors
Institutional investors must take steps when they feel that there is insufficient influence being
exercised by non-executive directors over executive management. Non-executive directors
provide independent views and they oversee the implementation of the company’s strategy.
Without non-executive directors, no one will challenge the management and act in the best
interest of shareholders.
Failure to comply with laws and regulations

Non-complying with the laws and regulations such as failure to follow the standards set by the
specific authorities and failure to report to relevant authorities. The consequences are fines or
penalties, licence revocations, business disruptions, erosion of trust, and a damaged reputation.
The company’s going concern could be questioned and investors will intervene as this may affect
the investors of the company negatively.

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6 Sentosa House

(a)Up to 2 marks for the definition of agency costs 2

(b)1 mark for each relevant point identified, and briefly

Problems with Agency Costs in Eastern Products

Unwillingness to Disclose Policies

Inadequacy of Existing Mechanism

Lack of competence of the management team

Failure to meet investors’ wants

Failing to comply with the stock market requirements

Dismissal of risk committee without a good reason

Weakness of the internal control system

Future sustainability of Eastern

Failure to comply with laws and regulations

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