Corporate Governance: Agency Theory and Principles

Chapter 1: Corporate Governance

• Corporate governance is explored throughout the chapter

Learning Outcomes

• Understanding agency theory's definition, principal-agent problems, and related costs is a learning outcome
• Finding solutions to agency problems
• Defining corporate governance and understanding its key principles.
• Knowing the roles of the board of directors and stakeholders
• Understanding the role and key principles of the King IV report in promoting good corporate governance in South Africa is a learning outcome

Company Organizational Structure

• Stockholders elect the Board of Directors
• The Board of Directors hires the President (CEO)
• The President (CEO) manages various managers

Agency Relationship

• Management and ownership separation leads to managers of large companies owning a small share proportion
• Shareholders and management have an agency relationship
• Managers, as agents for shareholders, may prioritize their interests
• Management should maximize shareholder wealth, but shareholders may suffer losses from manager decisions

The Agency Problem

• Agency theory explains relationships between principals and their agents
• A principal-agent arrangement involves an agent acting on behalf of a principal
• Shareholders elect management to act on their behalf
• Principals are shareholders, agents are company executives
• Conflicts of interest arise when managers' decisions don't align with shareholder wealth maximization
• Agency problems stem from management-ownership separation
• Agency costs, borne by shareholders, represent a loss of shareholder wealth, either directly or indirectly

Principal - Agent Relationships

• Besides the agency theory concept, several types of relationships feature disagreement.
• In Shareholders and Company Executives, principals relinquish control
• The CEO is hired to run the firm
• Managers are appointed to manage operations and maximize shareholder value by shareholders.
• The board ensures the CEO acts in shareholders' best interests
• In Investor and fund manager the investor is giving a portion of their income to the fund manager (agent) to allocate on their behalf
• Conflicts of interest include when a fund manager invests in high risk stock where the potential for losses are high

Sources of Agency Problems

• Separation of ownership, where the executive team manages the daily operations
• Conflicts of interest when managerial goals don't align with shareholder interests
• Risk aversion: principals and agents have differing risk preferences
• Information asymmetry, where access to information leads to agency problems

Direct Agency Costs

• Include corporate expenditures benefiting management at shareholder expense
• Managers pursue policies improving their image but imposing direct costs
• Managers attempt to maximize firm size or resources they control
• Activities include acquiring other companies and subsidiaries with overpayment
• Monitoring management actions by paying auditors incurs agency problem costs

Indirect Agency Costs

• Lost opportunities when management is unwilling to act
• Managers using resources for their benefit over projects generating shareholder returns
• Indirect cost occurs if takeover bid made
• Takeover bids are made to management, who might reject the offer not because of value
• Rejected because of value but because they fear losing their jobs

Solutions to the Agency Problem

• Shareholders incurring costs to align objectives, improved transparency, and accountability are solutions
• Clear communication and fair decisions, approved by each party
• Accountability is achieved by appointing an independent board without direct ties
• Structure management compensation linked to firm performance, including share options
• Linking management performance to share performance
• Threat of a takeover and increased focus on corporate governance are solutions
• King IV is considered a solution

Corporate Governance

• Corporate governance is receiving attention due to corporate scandals and alleged criminal activity
• Refers to the rules, processes, and laws that companies operate, control, and are regulated by
• Aligns managers' and shareholders' interests
• Management and the board act in shareholders' interests, also including other stakeholders
• Boards should be independent, internal controls should be in place, and good IT governance and risk management policies should exist
• Management adheres to ethical standards, laws, and regulations, accurate financial performance, including performance and risk disclosure
• Government shapes corporate governance, set out in the King IV report in South Africa

Corporate Governance: King IV

• King IV is a corporate governance code from the Institute of Directors in Southern Africa (IoDSA)
• Provides principles/recommendations for good corporate governance practices
• The code is voluntary, but some companies in South Africa have adopted it as a best practice standard
• JSE mandates listed companies to adhere to King IV
• Released in 2016, King IV replaces King III
• Assumes application of all principles, unlike King III, which was an "apply or explain" system
• Contains 17 principles and 214 recommended practices for achieving governance outcomes
• Emphasizes stakeholder roles
• Principle- and outcomes-based: not rules-based
• Applicable to all sectors: SMEs, NPOs, SOEs, municipalities, and retirement funds

Corporate Governance: King IV Purpose

• The purpose of King IV is to promote effective, ethical, and sustainable corporate governance practices
• It provides a framework for companies to create value for all stakeholders
• The framework considers including shareholders, employees, customers, communities, and the environment
• It also aligns with corporate governance developments, new governance structures, emerging risks and opportunities from technologies, and reporting requirements

Paradigm Shifts in the Corporate Environment

• Three shifts include inclusive capitalism, long-term sustainable capital markets, and integrated reporting
• Inclusive capitalism considers triple context with economy, society and the environment as the operations of the company
• Capitals are used to create value: Financial, Intellectual, Human, Natural, Social/Relationship, and Manufactured Capital
• Sustainability involves a time dimension and long-term value creation and encourages organisations to move away from a focus on short-term profits as mentioned in the Long-term sustainable capital markets
• Annual financial statements are critical for shareholders and requires management to report on its use of the six capitals is mentioned in integrated reporting

Corporate Governance: King IV

• King IV defines Corporate governance as the exercise of ethical and effective leadership
• The board will adhere to the principles and explain its implemented practices to achieve governance principles set out in the Code
• Effective control, ethical culture, Good performance, Legitimacy

The Five Parts to Corporate Governance in King IV

• Key components include Leadership, Ethics, Stakeholder Relationships, Performance and Reporting, Governance Functional Areas, Governing Structures & Delegation

King IV Principles

• The Board should lead ethically and effectively.
• The Board should govern the ethics of the organisation in a way that supports the establishment of an ethical culture.
• The Board should ensure that the organisation is, and is seen to be, a responsible corporate citizen.
• The Board should appreciate that the organisation's core purpose, its risks and opportunities, strategy, business model, performance and sustainable development are all inseparable elements of the value creation process.
• Ensure reports issued by the organisation enable stakeholders to make an informed assessment of the organisation's performance including short, medium and long-term prospects
• The Board should serve as the focal point and custodian of governance in the organisation.
• The Board should comprise the appropriate balance of knowledge, skills, experience, diversity and independence for it to discharge its roles and responsibilities objectively and effectively.
• The Board should ensure that its arrangements for delegation within its own structures promote independent judgement and assist with balance of power, including effective discharge of its duties.
• The Board should ensure that the evaluation of its own performance and that of its committees, its chair and individual members supports continued improvement in its performance and effectiveness.
• The Board should ensure that the appointment of and delegation to management contribute to role clarity and the effective exercise of authority and responsibilities.
• The Board should govern technology with strategic objectives
• Enable assurance services and functions for an effective control environment
• Adopt a stakeholder-inclusive approach that balances needs, interests, and expectations of material stakeholders