Module-3: Corporate Governance Theories

 

1. Agency Theory

Agency theories arise from the distinction between the owners (shareholders) of a company or an organization designated as "the principals" and the executives hired to manage the organization called "the agent." Agency theory argues that the goal of the agent is different from that of the principals, and they are conflicting (Johnson, Daily, & Ellstrand, 1996)

 

The assumption is that the principals suffer an agency loss, which is a lesser return on investment because they do not directly manage the company. Part of the return that they could have had if they were managing the company directly goes to the agent. Consequently, agency theories suggest financial rewards that can help incentivize executives to maximize the profit of owners (Eisenhardt, 1989).

Further, a board developed from the perspective of the agency theory tends to exercise strict control, supervision, and monitoring of the performance of the agent in order to protect the interests of the principals (Hillman & Dalziel, 2003).

In other words, the board is actively involved in most of the managerial decisionmaking processes, and is accountable to the shareholders. A nonprofit board that operates through the lens of agency theories will show a hands-on management approach on behalf of the stakeholders.

Issues regarding the agency Theory

In simple terms, Governance means “the process of decision-making and the process by which decisions are implemented”. Thus governance related to large businesses is called Corporate Governance. Firms are social entities and have certain social obligations.

A firm needs coordination between many groups of people known as stakeholders. The stakeholders are the owners, the managers, the workers, the suppliers, the creditors, the customers, the competitors, the government, and even the society at large.

The Agency Problem

We have seen that in corporate form of business, there is separation of ownership and business. This creates a unique type of problem known as Agency Problem. The problem of Principal-Agent is universal.

Agents (Managers) are expected to work for the benefit of principal (owners) and take decisions that are beneficial for the principal. However often agents take decisions that are beneficial for themselves.

When ownership and business is separated, the managers are expected to act for the benefits of the owners. However, there is chance that managers may pursue certain alternative objectives that are beneficial to themselves rather than owners. The conflict is called Agency Problem.

Mitigating Agency Problems

            One solution to mitigate the agency problem is to appoint the honest and ethical managers. But question is how to determine whether a manager is honest/ethical or not. Thus there is need to do something beyond appointment of managers.

Traditionally auditing was instituted to resolve the agency conflict. Auditors are expected to work on behalf of owners and examine the conduct of business run by managers and submit the report to owners. However the auditing is restricted to financial auditing which can unearth the financial frauds. But it cannot question the managerial efficiency.

In addition to auditing, the corporate governance is used to resolve the agency conflict. Under the corporate governance, the emphasis is on the board including the appointment of directors for the board, who are expected to be independent and expert in their fields. In addition, the board forms sub-committees to have more close interaction with management.

 

 

 

 

2. Stewardship Theory

Stewardship theories argue that the managers or executives of a company are stewards of the owners, and both groups share common goals (Davis, Schoorman, & Donaldson, 1997).

Therefore, the board should not be too controlling, as agency theories would suggest.

The board should play a supportive role by empowering executives and, in turn, increase the potential for higher performance (Hendry, 2002; Shen, 2003).

Stewardship theories argue for relationships between board and executives that involve training, mentoring, and shared decision making (Shen, 2003; Sundaramurthy & Lewis, 2003).

 

3. Resource Dependency Theory

The Resource Dependency Theory focuses on the role of board directors in providing access to resources needed by the firm. It states that directors play an important role in providing or securing essential resources to an organization through their linkages to the external environment.

Resource-dependence theories argue that a board exists as a provider of resources to executives in order to help them achieve organizational goals (Hillman, Cannella, & Paetzold, 2000; Hillman & Daziel, 2003).

The provision of resources enhances organizational functioning, firm’s performance and its survival. The directors bring resources to the firm, such as information, skills, access to key constituents such as suppliers, buyers, public policy makers, social groups as well as legitimacy. Directors can be classified into four categories of insiders, business experts, support specialists and community influentials. Eg:  board members who are professionals can use their expertise to train and mentor executives in a way that improves organizational performance. Board members can also tap into their networks of support to attract resources to the organization.

 

Resource-dependence theories recommend interventions by the board while advocating for strong financial, human, and intangible supports to the executives.

Resource-dependence theories recommend that most of the decisions be made by executives with some approval of the board.

 

4. Stakeholder Theory

Stakeholder theories are based on the assumption that shareholders are not the only group with a stake in a company or a corporation. Stakeholder theories argue that clients or customers, suppliers, and the surrounding communities also have a stake in a corporation. They can be affected by the success or failure of a company.

 Therefore, managers have special obligations to ensure that all stakeholders (not just the shareholders) receive a fair return from their stake in the company (Donaldson & Preston, 1995).

Stakeholder theories advocate for some form of corporate social responsibility, which is a duty to operate in ethical ways, even if that means a reduction of long-term profit for a company (Jones, Freeman, & Wicks, 2002).

In that context, the board has a responsibility to be the guardian of the interests of all stakeholders by ensuring that corporate or organizational practices take into account the principles of sustainability for surrounding communities.

Differences between Agency Theory & Stakeholder Theory

Agency theory paradigm arises from the fields of finance and economics, whereas stakeholder theory arises from a more social-orientated perspective on corporate governance.

 

 Agency theory views the organization from the shareholder perspective whereas stakeholder theory views the organization from a more general and broad public or society perspective.

 

The moral discourse of agency theory is based on self-interest whereas stakeholder theory is based duty and social responsibility.

 

 Agency theory definition is simplistic whereas stakeholder theory definition is infinite as is difficult to identify who are stakeholders.

 

5. Transaction Cost Theory

Transaction cost theory states that a company has number of contracts within the company itself or with market through which it creates value for the company. There is cost associated with each contract with external party; such cost is called transaction cost. If transaction cost of using the market is higher, the company would undertake that transaction itself.

 

6. Political Theory

Political theory brings the approach of developing voting support from shareholders, rather by purchasing voting power. It highlights the allocation of corporate power, profits and privileges are determined via the governments’ favor

Models of Corporate Governance

Corporate form of business is generally managed by the Board of Directors and the board members are elected by shareholders. The board in turn appoints the professional managers to manage the business.

Different countries have different regulations and corporate governance models differ based on these differences

The Corporate governance models are broadly classified into following categories:

1.      Anglo-American Model

The shareholder rights are recognised and given importance. They have the right to elect all the members of the Board and the Board directs the management of the company.

This is shareholder oriented model. It is also called Anglo-Saxon approach to corporate governance being the basis of corporate governance in Britain, Canada, America, Australia and Common Wealth Countries including India

•      Directors are rarely independent of management

•      Companies are run by professional managers who have negligible ownership stake. There is clear separation of ownership and management.

•      Institution investors like banks and mutual funds are portfolio investors. When they are not satisfied with the company’s performance they simple sell their shares in market and quit.

•      The disclosure norms are comprehensive and rules against the insider trading are tight

•      The small investors are protected and large investors are discouraged to take active role in corporate governance.

The Anglo-US model is characterized by share ownership of individual, and increasingly institutional, investors not affiliated with the corporation known as outside shareholders or “outsiders”; a well-developed legal framework defining the rights and responsibilities of three key players, namely: Management, Directors and Shareholders; and a comparatively uncomplicated procedure for interaction between shareholder and corporation as well as among shareholders.

The General shareholder meeting appoints the Board of Directors to represent different category interests who are  Non-Executives, Independent, Affiliated and Constituent as the case may be.

These directors themselves shoulder responsibilities for committees like Audit, Nomination, Remuneration and Risk Management

The board of directors is responsible for selecting the management committee/board for daily conduct of activities in a smooth manner.

Disadvantages of the model

Concentration of power in the hands of one person

Concentration of power in a small group of persons

Management and/or the board of directors’ attempts to retain power over long period of time

The board of directors’ flagrant disregard for the interests of outside shareholders The same person has served as both chairman of the BOD and CEO which led to abuses of power

2.      The German Model

This is also called European Model. It is believed that workers are one of the key stakeholders in the company and they should have the right to participate in the management of the company.

The corporate governance is carried out through two boards, therefore it is also known as two-tier board model. These two boards are:

Supervisory Board: The shareholders elect the members of Supervisory Board (“Aufsichtsrat”). Employees also elect their representative for Supervisory Board which are generally one-third or half of the Board.

Board of Management or Management Board: The Supervisory Board appoints and monitors the Management Board (“Vorstand”).. The Supervisory Board has the right to dismiss the Management Board and re-constitute the same.

 

3.      The Japanese Model

Japanese companies raise significant part of capital through banking and other financial institutions. Since the banks and other institutions stakes are very high in businesses, they also work closely with the management of the company.

The shareholders and main banks together appoint the Board of Directors and the President. In this model, along with the shareholders, the interest of lenders is recognised.

The Japanese model is characterized by a high level of stock ownership by affiliated banks and companies;

A banking system characterized by strong, long-term links between banks and corporation

A legal, public policy and industrial policy framework designed to support and promote "keiretsu"

BOD composed of solely insiders and comparatively low(in some corp., non- existent)level of input of outside shareholders

Equity Financing is important for Japanese Corporations

Insiders and their affiliates are the major shareholders in most Japanese corporations.

The Japanese system of Corporate Governance is many-sided, centering around a main bank and a financial/industrial network or keiretsu

The bank provides its corporate clients with loans as well as services related to bond issues, equity issues, settlement accounts and related consulting services.

The main bank is generally a major shareholder in the corporation.

In the US, Anti-monopoly prohibits one bank from providing this multiplicity of services

Many Japanese corporation also have a strong financial relationships with a network of affiliated companies. These networks, characterized by crossholding of a debt and equity, trading of goods and services, and informal business contacts, are known as Keiretsu

Government-directed industrial policy plays a key role in Japanese Governance, this includes official and unofficial representation on corporate boards, when a corporation faces financial difficulty

In the Japanese model, the four key players are:

1. Main Bank(a major inside shareholder)

2. Affiliated company or keiretsu(a major inside shareholder)

3. Management and the

4. Government

Interaction among these players serves to link relationship rather balance power, as in the case of Anglo-US Model - non-affiliated shareholders have little or no voice in japanese Governance -As a result, there are few truly independent directors(representing outside shareholders)

If a company’s profit fall over an extended period, the main bank and member of the keiretsu may remove directors and appoint their own candidates to the company’s board.

Appointment of retiring government bureaucrats to corporate boards

The average japanese board contains 50 members

 

 

 

4.      Social Control Model

Social Control Model of corporate governance argues for full-fledged stakeholder representation in the board. According to this model, creation of Stakeholders Board over and above the shareholders determined Board of Directors would improve the internal control systems of the corporate governance. The Stakeholders Board consists of representation from shareholders, employees, major consumers, major suppliers, lenders etc.

5.      Indian Model

In India there are mainly three types of companies’ viz. private companies, public companies and public sector undertakings. Each of these companies has distinct kind of shareholding pattern. Thus the corporate governance model in India is a mix of Anglo-American and German Models.