Theoretical Perspectives of Corporate Governance PDF

1 FIN-3229 Business Ethics and Corporate Governance Theoretical Perspectives of Corporate Governance  2 Session objective To provide a broad understanding, comparison and implications of different corporate governance theories ...

1 FIN-3229 Business Ethics and Corporate Governance Theoretical Perspectives of Corporate Governance  2 Session objective To provide a broad understanding, comparison and implications of different corporate governance theories  3 Corporate governance theories The following theories elucidate the basis of corporate governance (a) Shareholder theory (b) Agency theory (c) Stewardship theory (d) Stakeholder theory (e) Resource dependency theory (f) Transaction Cost Theory  4 Stockholder/shareholder theory, Milton Friedman (1970) Proposed by Milton Friedman only duty of a corporation is to maximize the profits accruing to its shareholders. believes that businesses do not have any moral obligations or social responsibilities at all, other than to maximize their own profit. shareholder would either remove the board of directors or would sell his shares ,If the company does not earn enough profits Later realized that ,there are disadvantages to concentrating solely on the interests of shareholders.  5 The agency dilemma “The directors of the companies, being manager of other peoples money, can not be expected to watch over it with the same vigilance with which they watch over their own” (Adam Smith, The Wealth of Nations,1776)  6 Agency theory , Jensen and Meckling (1976) Agency theory is defined as “the relationship between the principals, such as shareholders and agents such as the company executives and managers”. Shareholders are the owners or principals of the company and hires the agents to perform work. Principals delegate the running of business to the directors or managers, who are the shareholder’s agents The agency theory shareholders expect the agents to act and make decisions in the principal’s interest. The agent may not necessarily make decisions in the best interests of the principals.  7 Agency theory , Jensen and Meckling (1976) Source: Abdullah and Valentine (2009)  8 Agency theory , Jensen and Meckling (1976) This suggests that ownership and managerial interest may not be aligned, leading to agency costs and internal inefficiencies. Due to the existence of agency costs and internal inefficiencies, agency theory argues that the purpose of corporate governance mechanisms is to provide shareholders with some assurance that managers will try to achieve outcomes that are in the shareholders’ interests.  9 Stewardship theory, Donaldson and Davis (1994) Stewardship theory looks at governance through a different lens from agency theory, reflecting original legal view of the corporation. Shareholders nominate and appoint the directors, who then act as stewards for their interest. Stewards are company executives and managers working for the shareholders, protects and make profits for the shareholders. Directors/managers have a fiduciary duty to act as stewards of the shareholders interest. Inherent belief that directors can be trusted. Directors’ legal duty is to their shareholders not to themselves nor to other interest groups  10 Stewardship theory, Donaldson and Davis (1994) Role of top management being as stewards, integrating their goals as part of the organization The theory believes that directors do not act in a way that maximizes their own personal interests Stewardship recognize that directors need to identify the interest of other stakeholders, but under the law their first responsibility is to the shareholders How stewardship theory resolves the conflict of interest between stakeholder groups?  11 Stewardship theory, Donaldson and Davis (1994) Source: Abdullah and Valentine (2009)  12 Stewardship theory, Donaldson and Davis (1994) Hence, stewardship theory differs from agency theory with respect to the motive of managers. Therefore, stewardship theory purports there is no conflict between managers and owners, The underlying argument for this assertion is that the managers are naturally trustworthy and there will be no major agency costs associated with managers. However, Turnbull (1997) claims that the inclination of individuals to act as stewards or self-serving agents may be dependent upon the institutional and cultural context.  13 Comparison of agency theory and stewardship theory Agency theory stewardship theory Definition Agency theory is Stewardship an economic theory is a human model which model which describes the describes the relationship relationship between principal between principal and agent and Steward Relationship Owners/sharehold Owners/sharehold ers and agent ers and steward  14 Comparison of agency theory and stewardship theory Agency theory Stewardship theory Approach Control Collaboration Governance Monitoring and Empowering mechanism incentives structures  15 Stakeholder theory Stakeholder theorists suggest that managers in organizations have a network of relationships to serve – this include the suppliers, employees and business partners. And it was argued that this group of network is important other than owner-manager-employee relationship as in agency theory Stakeholder theory incorporated the accountability of management to a broad range of stakeholders.  16 Stakeholder theory The Stakeholder Model Source: Donaldson and Preston( 1995)  17 Stakeholder theory In the premise of stakeholder theory, corporate governance can be viewed as control mechanisms designed for the efficient operation of a corporation on behalf of its stakeholders. Thus stakeholder theory could be reconciled with the agency theory by broadening the classical agency relationship between managers and owners to incorporate the relationships between managers and all stakeholders.  18 Stakeholder theory The stakeholder approach is seen as a commercial necessity in a world where competitive advantage stems more and more from the intangible values embodied in human and social capital. (knowledge &skills) (social networks, trust & values) Hence, it has become common for companies to set goals which take account of environmental quality and social equity in addition to the traditional measures of economic performance. The challenge is to balance the potentially conflicting interest of diverse set of stakeholder  19 Bucholtz, A. K. and Carroll, A. B. 2012  20 Conceptual differences between the shareholder and stakeholder perspective of corporate governance  21 Resource dependency theory Provide a foundation for directors resource role Consider the relationship between a company and its external environment Johnson et al, (1996) concurs that resource dependency theorists provide focus on the appointment of representatives of independent organizations as a means for gaining access in resources critical to firm success Boards serve as a ‘co-optative mechanism’ whereby a company links itself with its external environment to secure resources and, on occasion, protect itself against environmental uncertainty” (Pearce and Zahra, 1992,p.415).  22 Resource dependency theory According to Hillman, Canella and Paetzold (2000) that 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. Four categories of directors insiders business experts support specialists community influential  23 Resource dependency theory Director category Areas of Types of label resource needs directors in provided category Insiders Expertise on the Current and firm itself as well former officers of as general the firm strategy and direction Specific knowledge in areas such as finance and law  24 Resource dependency theory Business Expertise on Current and experts competition, former senior decision making and officers of other problem solving large for profit Serve as sounding firms boards for ideas Provide alternative viewpoints on internal and external problems Channels of communication between firms  25 Resource dependency theory Support Provide specialized Lawyers specialists expertise on law, Bankers banking, insurance and (commercial and public relations investment) Provide channels of Insurance communication to large company and powerful suppliers representatives or government Public relations agencies experts Ease access to vital resources, such as financial capital and legal support  26 Resource dependency theory Community Provide non-business Political leaders; influential perspectives on University faculty; issues, problems and Members of clergy ideas Leaders of social Expertise about and or community influence with organizations powerful groups in the community Representation of interests outside competitive product or supply markets  27 Comparison between agency theory and resource dependency theory Agency theory focuses on the directors control role while resource dependency theory focuses on the directors resource role. “agency role has been termed the control role of boards by Johnson, Daily and Ellstrand (1996), the management control model and the corporate control role all of which focus on the important monitoring and governance function of boards”. In contrast, resource dependency theory focuses on the role that directors play in providing or securing essential resources to an organization through their linkages to the external environment.  28 Transaction Cost Theory Transaction Cost Theory (TCT), developed by Ronald Coase (1937) and further expanded by Oliver Williamson (1975, 1985), explains why firms exist and how they structure their governance to minimize transaction costs. It suggests that firms emerge when they can perform transactions more efficiently internally than through market mechanisms.  29 Which theory is the best? “Different theories have different purposes and therefore different validity criteria and different implications’ Donaldson and Preston (1999, p.70) “Many of these theoretical perspectives are intended as complements to, not substitutes for, agency theory” (Daily, et al., 2003, p.372)  30 Theoretical implications to the board Theory Role of the Implications for board board behaviors Agency theory Managerial Independent boards are a control mechanism for shareholder to retain ownership control rights Stewardship Managerial The board controlled by theory empowerment management is empowered and manages corporate assets responsibly Resource Co-optation Board with strong external links dependency serves is a co-optation theory mechanism for firms to access external resources Source: Muth and Donaldson (1998) 31