THEORIES OF CORPORATE GOVERNANCE

MICHAEL ADUSEI

INTRODUCTION In the previous lectures the agency

theory has been mentioned manytimes. This is because it is at the heartof corporate governance.

This lecture is devoted to delving intothis agency theory and its counterpartstewardship theory which is central to

corporate governance.

Introduction CONT’D At the end of the discussion, the student should be able to

able to:

Explain agency theory

Identify the factors that contribute to agency problem incompanies

Explain how agency problem manifests in companies

Explain how to manage agency conflict in companies

Appreciate the difference between agency and stewardshiptheories

DEFINITION OF AGENCY THEORY Agency theory is the branch of financial

economics that looks at conflicts of interestbetween people with different interests in thesame assets. Specifically, the theory is concernedwith the conflicts between:

Shareholders and managers of companies

Shareholders and bond holders

Insiders or controlling shareholders and outsidersor non-controlling shareholders. How this agency

manifests is discussed in lectures 8 and 9.

DEFINITION OF AGENCY THEORY CONT’D

Jensen and Meckling (1976) define theagency relationship as...."explicit or implicitcontracts in which one or more persons (theprincipal(s)) engage another person (theagent) to take actions on behalf of theprincipal(s). The contract involves thedelegation of some decision-makingauthority to the agent."

DEFINITION OF AGENCY THEORY CONT’D

When the manager is the sole equity ownerof a firm, there is no separation ofownership and control, and thus no agencyproblem exists between the manager andthe owner. However, when ordinary sharesof a company are diffused among manyoutside investors, the separation ofownership and control leads to potentialdivergence between the interests of ownersand managers

DEFINITION OF AGENCY THEORY CONT’D

Unlike other types of profit-makingorganizations in which ownership andcontrol are combined, in pubic limitedliability companies ownership andcontrol are separated; the owners ofpublic limited companies are usuallynot managers. This creates an agencyrelationship in which the non-owners(managers) act as agents of the owners(principals).

DEFINITION OF AGENCY THEORY CONT’D

The agents are expected to makedecisions that are consistent withprimary objective of the firm:Shareholder wealth maximization.Unfortunately, in practice, the agents donot do this. Instead, they seem to beinterested in decisions that are in linewith their interests; thus, creating theagency problem.

DEFINTION OF AGENCY THEORY CONT’D

In summary, three factors explain theagency problem:

Divergence of ownership and control:Those who own the company are not themanagers.

Conflict of goals between owners andmanagers where the goals of the owners aredifferent from the goals of managers.

DEFINITION OF AGENCY THEORYCONT’D

Possible management goals include: growth ormaximizing the size of the firm; increasingmanagerial power; creating job security; increasingmanagerial pay and rewards and pursuing theirown social objectives or pet projects (Watson andHead, 2007).

Information asymmetry between owners(principals) and managers (agents) where thelatter have better information about the companythan the former.

CLASSIFICATION OF THE AGENCY PROBLEM John and Senbet (1998) identify four

types of agency problem: Managerialagency, debt agency, social agency andpolitical agency. However, in this coursewe are interested in the first two.

Managerial Agency or Managerialism:The conflict between shareholders andmanagers is called managerial agency ormanagerialism which refers to self-serving behavior by managers.

CLASSIFICATION OF THE AGENCYPROBLEM CONT’D

This conflict results in managerial propensity for

expanding their span of control in the form of

“empire building” at the expense of shareholders and

for unduly conservative investments in the form of

seeking safe (but inferior) projects to maintain the

safety of wage compensation and their own tenure

(John and Senbet, 1998).

CLASSIFICATION OF THE AGENCY PROBLEM CONT’D

Debt Agency: This is the conflict betweendebt holders and managers. This ariseswhen managers invest in risky investmentsas part of the shareholder valuemaximization drive. When such riskyinvestments succeed, the debt-holdersreceive only the fixed debt income under thedebt contract whilst equity-holders take therest.

CLASSIFICATION OF THE AGENCY PROBLEMCONT’D

However, if the investments fail, equityholders are insulated while the value ofcollateralization is reduced with theresultant reduction in the value ofoutstanding debt. Indeed, if the businesscollapses, equity-holders lose only the valueof their shares whilst the rest of the loss isshifted to creditors

CLASSIFICATION OF THE AGENCY PROBLEM CONT’D

Social Agency: The conflict betweenthe private sector (the agent) and thepublic sector (principal)

Political agency: This is the conflictthat occurs between the agents of thepublic sector (e.g. regulators) and therest of the society or taxpayers.

MANIFESTATION OF AGENCY PROBLEM

In companies, agency problem manifests in the following areas:

Investment decisions: Since managerial reward schemes are usually based on short-term performance measures, managers tend to focus their attention on projects that yield short-term returns at the expense of long-term projects which can ensure survival of the company.

MANIFESTATION OF AGENCY PROBLEM CONT’D

Besides, whereas managers areinterested in low-risk projects,shareholders are interested inhigher-risk projects becausehigher-risk projects yield higherreturns.

MANIFESTATION OF AGENCY PROBLEMCONT’D

Financing decisions: Managers usuallyprefer the use of equity finance to the use ofdebt finance since equity finance comeswith no interest payments and lowerbankruptcy risk. However, to shareholdersequity finance is more expensive than debtfinance because increasing equity finance ofa company increases the cost of capital ofthe company.

MANIFESTATION OF AGENCY PROBLEM CONT’D

Divergence of interests of shareholdersand debt holders: The return toshareholders is unlimited whilst their loss islimited to the value of their shares.Therefore, they prefer higher-risk projects.Conversely, the return to debt holders islimited to a fixed interest so they are notlikely to benefit from higher returns fromriskier projects. Therefore, they preferlower-risk projects.

MANAGING THE AGENCY PROBLEM

Both external and internal mechanisms havebeen identified to deal with agency problemsbetween managers and owners. Externalmonitoring mechanisms include the outsidemanagerial labor market, monitoring fromthe capital market by financial analysts,institutional shareholders and blockshareholders, and the takeover market.

MANAGING THE AGENCY PROBLEM CONT’DInternal monitoring mechanisms include anatural process of monitoring from higher tolower levels of management, mutualmonitoring among managers, and the boardof directors (Fama, 1980; Fama and Jensen,1983). Of all monitoring mechanisms, theboard is viewed as the “ultimate internalmonitor” (Fama, 1980) and “the common apexof the decision control systems oforganizations,

MANAGING THE AGENCY PROBLEM CONT’D

large and small, in which decisionagents do not bear a major share of thewealth effects” (Fama and Jensen, 1983)cited in He and Sommer (2010). Howis the agency problem betweenshareholders and managers as well asthe agency problem betweenshareholders and debt holdersaddressed?

MANAGING THE AGENCY PROBLEM BETWEEN SHAREHOLDERS AND MANAGERS

Two main strategies have been suggested:

Shareholders should monitor the actions ofmanagement using monitoring devices such asindependently audited financial statements andthe use of external analysts

Incorporation of clauses into managerial contractswhich encourage goal congruence. Such clausesformalize constraints, incentives and punishments(Watson and Head, 2007).

MANAGING THE AGENCY PROBLEM BETWEEN SHAREHOLDERS AND MANAGERS CONT’D

Two main managerial incentives thatare often used to achieve goalcongruence are performance-relatedpay (PRP) and executive share optionschemes. Shareholders can find anaccurate measure of managerialperformance and align it withremuneration.

MANAGING THE AGENCY PROBLEM BETWEENSHAREHOLDERS AND MANAGERS CONT’D

Performance indicators such as profit,earnings per share and return oncapital employed are usually linked tomanagerial remuneration. Executiveshare option schemes allow managersto acquire shares in the company undera special arrangement aimed atachieving goal congruence.

MANAGING THE AGENCY PROBLEM BETWEEN

DEBT HOLDERS AND SHAREHOLDERS

Debt holders have two main strategies toprotect their interests in the company:

Securing their debt against the assets ofthe company: Debt holders can secure theirdebt against the assets of the companywhich will ensure that in the event of thecompany going into liquidation they willhave a prior claim over assets which they cansell to recoup their debt.

MANAGING THE AGENCY PROBLEM BETWEEN DEBT

HOLDERS AND SHAREHOLDERS CONT’D

Using restrictive covenants: Debt holderscan protect their interests and limit theamount of risk they face in the company byresorting to restrictive covenants into debtagreements which may restrict thecompany’s decision-making process. Suchclauses may, for example, bar the companyfrom paying out excessive levels ofdividends.

STEWARDSHIP THEORYStewardship theory argues that managers

are inherently trustworthy and thus are not

susceptible to misappropriate the

resources of the firm (Davis, Schoorman

and Donaldson 1997; Donaldson and

Davis, 1991).

STEWARDSHIP THEORY CONT’D It posits that there are non-financial motivators

and that corporate managers are seen as

drawing motivation from the need to achieve,

to gain intrinsic satisfaction via successful

execution of intrinsically challenging work, to

exercise responsibility and authority and by it

draw recognition from peers and bosses

(McClelland, 1961).

STEWARDSHIP THEORY CONT’D When corporate managers identify with

the firm (more likely if they have been

with the firm for a long time and have

shaped its form and directions), this

facilitates the merging of individual ego

and the corporation, thus melding

individual self-esteem with corporate

prestige.

STEWARDSHIP THEORY CONT’DThe theory argues that it is possible for a

corporate manager to find a course of action

personally unrewarding, nonetheless, they are

likely to pursue it from a sense of duty.

This compliance with a duty when there is no

personal reward is referred to as normally

induced compliance (Etzioni, 1975).

STEWARDSHIP THEORY CONT’DWhen corporate managers perceive that

their fortunes are inextricably tied to their

current employers through an expectation

of future employment or pension rights,

they may view their interest as aligned

with that of the firm and its owners even

if they do not own shares in the firm.

STEWARDSHIP THEORY CONT’D

In essence, the stewardship theory submits that there

is no inner motivational problem among corporate

managers; corporate managers aspire to achieve good

corporate performance.

Performance variations, in the view of the theory,

emanates from the structural situation in which

corporate managers find themselves.

If the structural situation is convenient one should

expect good corporate performance from corporate

managers.

STEWARDSHIP THEORY CONT’D The question arises as to whether or not the

organizational structure supports corporate managers to

formulate and implement plans for high corporate

performance.

Structures support goals to the extent that they

“provide clear, consistent expectations and authorize

and empower senior management” (Donaldson and

Davis, 1991).

STEWARDSHIP THEORYIn terms of the role of the CEO, structures

will support the CEO to achieve superior

performance for the corporation to the

extent that complete authority over the

corporation is vested in the CEO and that

the role of the CEO is unambiguous and

unchallenged.

STEWARDSHIP THEORY CONT’D To ensure this, CEO duality (a governance practice in which

the CEO is also the chair of the board of directors) is

recommended by stewardship theory.

CEO duality places power and authority in one person which

leaves no room for doubt as to who has authority or responsibility

over a particular matter.

According to the theory, CEO duality has benefits such as

unity of direction as well as strong command and control.

STEWARDSHIP THEORY CONT’D

In a nutshell “stewardship theory focuses not on

motivation of the CEO but rather facilitative,

empowering structures, and holds that fusion of the

incumbency of the roles of chair and CEO will enhance

effectiveness and produce superior returns to

shareholders” (Donaldson and Davis, 1991, p.52)

AGENCY THEORY VRS STEWARDSHIP OVER CEO GOVERNANCE

According to the agency theory, CEO

duality can only be beneficial to

shareholders if the interest of the CEO is

aligned with that of shareholders by a

suitable incentive scheme for the CEO.

That is if the firm implements a system of

long-term compensation additional to

basic salary.

AGENCY AND STEWARDSHIP THEORIES ON CEO GOVERNANCE CONT’D

Where a CEO holds the dual role of chair, the

presence of long-term compensation will align their

interests with shareholders’.

According to agency theory, any superiority in

shareholder returns observed in CEO duality is

attributable to spurious effects of financial incentives.

AGENCY AND STEWARDSHIP THEORIES ON CEO GOVERNANCE CONT’D

By contrast, stewardship theory posits that any

observed superiority in shareholder returns from CEO

duality is not a spurious effect of greater financial

incentives among CEO.

Indeed, stewardship theory argues that CEO duality

promotes shareholder-value-maximization agenda.

STAKEHOLDER THEORY/BEYOND

THE BALANCE SHEET THEORY

This theory focuses on the issues

concerning the stakeholders of a firm.

It stipulates that a firm invariably seeks to

provide a balance between the interests of

its diverse stakeholders in order to ensure

that each interest constituency receives

some degree of satisfaction.

STAKEHOLDER THEORY CONT’DIn short, the theory argues that in the

governance of the firm the interests of the

various stakeholders must be accounted

for.

For example, in constituting board of

directors representation should be given

to the key stakeholders of the firm.

STAKEHOLDER THEORY CONT’DThe theory submits that the parties involved

should include governmental bodies, political

groups, trade associations, trade unions,

communities, associated corporations,

prospective employees and the general public.

The theory recognizes competitors and

prospective clients as stakeholders to help

improve business efficiency in the market

place.

STAKEHODER THEORY CONT’D The theory identifies three types of stakeholders

Consubstantial stakeholders: stakeholders that are

essential for the business’s existence (shareholders

and investors, strategic partners, employees).

Contractual stakeholders: These stakeholders have

some kind of a formal contract with the business.

Examples are financial institutions, suppliers and

subcontractors, customers

STAKEHOLDER THEORY CONT’D

Contextual stakeholders: These are representatives

of the social and natural

systems in which the business operates and play a

fundamental role in obtaining business credibility and,

ultimately, the acceptance of their activities.

Examples are public administration, local

communities, countries and societies, knowledge and

opinion makers.

RESOURCE DEPENDENCE THEORY

The main idea of resource dependence

theory is the need for environmental

linkages

between the firm and outside resources.

In this perspective, directors serve to

connect the firm with external factors by

co-opting the resources needed to survive.

RESOURCE DEPENDENCE THEORY

CONT’D

The theory posits that environmental linkages

or network governance could reduce

transaction costs associated with environmental

interdependency.

The organization needs to require resources

and this leads to the development of exchange

relationships or network governance between

organizations.

RESOURCE DEPENDENCE THEORY

CONT’D

Several factors would appear to intensify the

character of this dependence, e.g. the importance

of the resource(s), the relative shortage of the

resource(s) and the extent to which the

resource(s) is concentrated in the environment.

LEGITIMACY THEORY Legitimacy is defined as “a generalized

perception or assumption that the actions of an

entity are desirable, proper, or appropriate with

some socially constructed systems of norms,

values, beliefs and definitions”.

Legitimacy theory is based upon the notion that

there is a social contract between the society

and the firm.

LEGITIMACY THEORY CONT’D

The firm gets permission to operate from the

society and is ultimately accountable to the

latter for how it operates and what it does,

because the latter provides corporations the

authority to own and use natural resources and

to hire employees.

The theory submits that the firm must be

governed in such a way that it can gain

legitimacy with its stakeholders.

LEGITIMACY THEORY CONT’D

It emphasizes that an organization must consider the

rights of the public at large, not merely the rights of the

investors.

Failure to comply with societal expectations may

result in sanctions being imposed in the form of

restrictions on the firm's operations, resources and

demand for its products.

THE RESOURCE-BASED VIEW The resource dependence theory argues that a

board’s effectiveness is measured by the

external resources that the individual board

members wield that could inure to the benefit

of the firm.

Its proponents argue that the board is a critical

resource for providing advice, counsel,

legitimacy, social capital and network

resources to the firm.

THE RESOURCE-BASED VIEW CONT’DStudies aligned with this theory either point

towards board composition (size,

insider/outsider ratio, demographics/diversity,

functional specialists) or board leadership

structure (i.e. CEO duality or split), or board

compensation and incentives as factors that

determine board effectiveness usually

measured in terms of firm performance.

THE RESOURCE-BASED VIEW CONT’D In terms of composition, it has been predicted that a

more gender diverse board would furnish the firm with

unique and valuable resources and access to various

important stakeholders in the external environment, due

to the networks of diverse directors.

GROUP ASSIGNMENT“Since the board of directors is made up of

human beings with selfish tendencies,formation of board of directors irrespectiveof its configuration, cannot eliminate theagency conflict.” Fully evaluate thisassertion. Submit by 8th November, 2017 forFull-time and 10th November for part-time. 3pages; double line spacing; Times NewRoman, Font Size=12