CORPORATE GOVERNANCE

ETHICAL THEORIES

1/28

Corporate GovernanceEthical Theories

o Agency Theory (1900s)
o Stewardship Theory o Shareholder vs. Stakeholder Approaches o Stakeholder Theory (1930s) o Sociological Theory

Agency Theory
Adam Smith identified an agency problem Terms :- Principal, Agent, Agency cost and agency problem Principal:- Shareholders (the owners) Agents:- Management Agency problem:- the mismatch in the objectives of shareholders and managers Agency cost :- The extent to which the returns to the owners fall. The core corporate governance is designing and putting in

place disclosures, monitoring, oversight and corrective systems that canalize the objectives of the two sets of players as closely as possible and, hence, minimize agency cost.
3

Agency Theory
Agency theory is traced back to the early period

of the 20th century,

when ownership of capital and ownership of firm were

first distinguished. Separation of decision making and risk bearing was not clearly defined.

An Agency agreement between financers and managers (the Agent) did specify utilization of funds and the division of profits; but freedom in decision making process. The Agent appointed its own internal Board (of Directors)

Thrust areas for better Agency System

Two broad mechanism that help reduce agency

cost and improve performance through better governance are: Fair and accurate financial disclosure Efficient and independent board of directors

Problems with the Agency Theory

The total control of management is neither feasible nor

required under this theory. The utility of theoretical model to promote corporate governance is questionable. Assumption that the agents must accept a certain level of self-interested behavior in delegating responsibility to others. Assumption that the shareholders must get correct and adequate information to make effective control. Equity investors neither get these nor make known their targeted returns, and yet delegate authority to meet the target.

Stewardship Theory
This theory assumes that managers are basically trust-

worthy and attach significant value to their own personal reputation. The managers are stewards whose motives are aligned with the objectives of their principles. Given a choice between self-serving behaviour and proorganisational behaviour, a stewards behaviour will not depart from the interests of his/her organisation. Control is considered potentially counterproductive as it undermines the professional behaviour of a steward by lowering his/her motivation.
7

Stewardship Theory
A Steward is
Motivated to act in the best interest of the governance

principles
Pro-organisational decision making based on

collectivism; and less individualistic

The Steward appointed its Board (of Directors) made up of

primarily inside directors

The Directors are trust worthy and attach importance to

their own reputation

Strong personal reputation controls their behaviour Such directors are offered higher compensation packages
8

Differentiation: Agency versus Stewardship Theory

The fundamental difference between Agency Theory and Stewardship Theory can be broadly classified into: 1. Behavioral factors 2. Psychological factors 3. Situational factors

Behavioral Factors
BEHAVIORAL RESPONSE Managers act as AGENCY THEORY STEWARDSHIP THEORY

Agents
o Individualistic o Opportunistic o Self-serving o o o

Stewards
Collectivistic Pro-organisational Trustworthy

Behavioral Pattern

Motivation by Identification

Own objectives Managers and Principals Interests Differ

Principals objectives Managers and Principals Interests Converge

Management Structures
Owners behavior Relationship bet owner manager

Monitor and control

Risk Avoidance Attitude Control-based

Facilitator and empowerment

Risk taking Attitude Trust-based
10

Psychological Factors
PSYCHOLOGICAL RESPONSES AGENCY THEORY
o Lower order

STEWARDSHP THEORY
o Higher order needs

Motivation

economic needs psychological, economic) Social comparison Attachment with company Other manager/ Competitor Little attachment

growth, self actualisation Principal Great attachment

Power

Institutional Personal (expert / (legitimate/ consultant / coercive / reward) referent)

11

Situational Factors
SITUATIONAL RESPONSES Management Philosophy While dealing with increasing Uncertainty and risk AGENCY THEORY STEWAREDSHIP THEORY

Control oriented Greater control More supervision

Involvement oriented Training and empowering people Making jobs to be more challenging and motivating Through trust Long term based Improving performance Collectivism Small power distance
12/28

Risk orientation Time frame Objective Cultural differences

Through a system of control Short term based Cost control Individualism Large power distance

Shareholders vs. Stakeholders Approaches

Shareholder approach focuses on satisfying the owners of a business Stakeholder approach attempted to satisfy the stakeholder of a business The separation of society and business is supported by the shareholders view This view is challenged by the stakeholder theorists and it includes responsibility as another measure of business success

13

Stakeholders Theory
The stakeholder theory is a theory of organizational

management and business ethics that addresses morals and values in managing an organization. It was originally detailed by R. Edward Freeman in the book Strategic Management: A Stakeholder Approach. It identified the stakeholder groups of a corporation, and Recommended methods by which management can give due regard to the interests of those groups.
14

Stakeholders Theory
o The Stakeholders theory (1930)
o considers a firm as a system of stakeholders o operating within in an environment for the firms

activities
o providing legal and market infrastructure
o for converting their stakes into goods and services.

o Managers can be seen as the agents for all the

stakeholders under this theory.

15

Sociological Theory
Sociological Theory focuses on the Board

composition and wealth distribution. To promote equity and fairness in society the theory assumes board composition, financial reporting, disclosure and auditing as essential mechanisms to achieve socio-economic objectives.

16

CLASS TEST: MBA IV

DATE: 27-1-2012 Time allowed: 45 min.

a) Discuss salient differentiation features of

Agency Theory and Stewardship Theory.

b) OR c) Shareholders and Stakeholders Theory

discuss its merits and demerits.