Agency risk
The risk that a company's management, who control day-to-day decisions, pursue their own interests rather than those of the shareholders who actually own the business.
In plain language
Shareholders own a company, but they do not run it. Management does that instead, and management is not always watching out for the owners.
That gap between who owns and who controls creates agency risk — the chance that management either pursues its own interests at the shareholders' expense, or simply is not capable enough to run the business well.
How it works
The workbook explains the cause plainly: shareholders own the company but hand day-to-day control to management, so they must trust management to act in the company's and the shareholders' interest. That trust is exactly where the risk sits — management may chase "personal interests at the cost of shareholders" instead, or simply may not be capable enough to run the business well.
The workbook does not ask analysts to judge management's honesty directly — it treats that as nearly impossible for an outsider to assess. Instead it points to something checkable: a checklist of governance controls covering board composition, audit committee independence, auditor rotation and independence, and approval of related-party transactions. A company that scores well on this checklist is better placed to stop agency risk before it happens, or at least to catch and fix it quickly.
A worked example
Illustrative. A listed textile company's promoter-CEO routes the company's road transport requirements through a private logistics firm he also owns. The private firm bills the listed company Rs 40 crore a year for freight services that an independent, unrelated logistics provider would charge Rs 25 crore for.
That Rs 15 crore annual gap is value flowing from the listed company's minority shareholders into the promoter's private pocket — agency risk in action, and exactly the kind of related-party arrangement the audit committee and disclosure rules exist to surface.
Why NISM asks about it
Chapter 7.6, right where the workbook explains the separation of ownership and management, introduces agency risk immediately before Chapter 7.6.1–7.6.2's checklist of governance controls. Expect a question defining agency risk, or one asking which governance mechanism specifically addresses it.
Common exam traps
- Agency risk is internal to the company, and belongs under "Weakness" in a SWOT analysis, not "Threat." The workbook draws this line explicitly for a closely related example — high customer concentration — and the same logic applies to management self-dealing.
- Agency risk cannot be eliminated by regulation alone — the workbook's own framing is that governance controls can at best prevent it or catch it early, not remove the underlying conflict of interest.
Check yourself
1.Why does the separation of ownership and management in a company create agency risk?
- a)Because shareholders are legally barred from meeting the management
- b)Because management may pursue personal interests at the cost of shareholders, or may not be capable enough to run the organisation
- c)Because the board of directors is appointed by the management
- d)Because auditors are appointed by the promoter group
Show the answer
Answer: (b) Because management may pursue personal interests at the cost of shareholders, or may not be capable enough to run the organisation
Shareholders own the company but a separate management team runs it day to day. That reliance creates agency risk — the risk that management pursues personal interests at the cost of shareholders, or is not capable enough to run the organisation effectively.
Option C reverses the reporting line: the management team reports to the Board of Directors, who are appointed by the shareholders. Option D is wrong as stated — the audit committee is responsible for nominating the auditors. Option A is simply invented; nothing bars shareholder engagement.
Where this is taught
Free preparation for NISM Series XVRelated terms
- Audit committeeThe board sub-committee responsible for reviewing a company's financial statements and nominating its auditors, which SEBI requires to be at least two-thirds independent directors.
- Auditor independence testThe corporate-governance check that an auditor's total fees from a company or group stay below 10% of the auditor's overall income, so it is not financially dependent on that one client.
- Corporate governanceThe rules, processes and procedures followed in running a company, judged by an analyst against a checklist of board, audit and related-party tests rather than by reputation.
- Related party transactionA deal between a company and a party connected to its controllers — promoters, their relatives, group firms. Watched because it can enrich the promoter group at minority shareholders' cost.
- Independent directorA director who is neither part of management nor otherwise connected to the company — at least half the board where the chairman is executive, and one-third otherwise.
- Auditor rotationThe corporate-governance rule that a company's statutory auditor must be changed at least once every five years, so a long-standing relationship cannot let facts stay hidden.
- Non-executive directorA board director who is not part of day-to-day management, but who is also not classed as independent — a third category sitting between executive and independent directors.
- Remuneration committeeThe board committee that decides the pay of directors and senior management, which SEBI requires to be made up entirely of non-executive directors with an independent director as chairman.
- Pledging of sharesPromoters using their shareholding as collateral to raise a loan instead of selling it — legitimate on its own, but a governance risk analysts must size up when the pledged amount is high.
- Sweat equityShares a company issues to employees, promoters or technocrats under Section 54 of the Companies Act, 2013, to reward their contribution rather than to raise fresh capital.
- ESG frameworkA framework in which investors assess a company on environmental, social and corporate governance criteria, used as a screening filter before the usual financial analysis is done.
- Nomination committeeThe board committee that appoints independent directors, which the workbook says should ideally consist exclusively of independent directors so that company executives have no role in the appointment.
- Keyman riskThe risk that a company depends so heavily on one or a few individuals that a change at the top can derail its decision making.