07/10/2019

Corporate Governance

Lecture 2 – Theoretical
Perspectives
th
10 October 2019

Bill Lee

Why are theories important?

 Explain why people in organizations might act
in particular ways;

 Such knowledge of why people act, can then

inform policies in markets, government and
organizations to help ensure effective corporate
governance.

Learning Objectives
By the end of this lecture you should be able to:

Identify relationships affecting corporations and

tensions between them

Understand and explain major theoretical

approaches to corporate governance

Critique the different major theoretical approaches

to corporate governance

Consider the reasons why different theories of

corporate governance may exist

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Relationships necessitating
Corporate Governance
Corporations have relationships with a number of bodies

Institutional
Executive investors Other
managers investors

Debt
Employees Corporation providers

Local
community Suppliers

State

Relationships necessitating
Corporate Governance
• List above is not exhaustive.

• While the different group’s interests often coincide,

there are also conflicts in relationships.

• Corporate governance regulates the relationship

between the different parties.

• Different theories about corporate governance

tends to be about the nature of the relationship
between at least some of those parties.

Theoretical approaches to corporate

governance

Stakeholder
Agency theory theory

Corporate
governance

Stewardship Transaction cost

theory theory

Not exhaustive – there are other perspectives

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Theoretical approaches to corporate

governance
Agency theory
Theoretical origins of agency theory is economics
and finance and their ideas about development of
economy.
Jensen and Meckling (1976) and Fama and Jensen
(1983)’s work helped develop agency theory.

Theoretical approaches to corporate

governance
Agency theory
Organizations have grown to a large size because
their capital requirements are greater than can be
serviced by individuals;
Managerial capitalism involved separation of
ownership and control mean that agents – in the
form of executive managers – are contracted to
pursue the interests of principals, or owners/
shareholders;

Theoretical approaches to corporate

governance
Agency theory
Both owners of organizations and their agents are
individualistic and self-serving in terms of seeking to
maximise the utility to themselves of any decisions;
 So managers and shareholders have different
interests;

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Theoretical approaches to corporate

governance
Agency theory
Principal’s objectives Agent’s objectives
• Safe investment; • Salary and benefits;
• Regular dividends; • Maximum bonus;
• Long-term capital • Share options;
growth; • Personal success.
• Maintenance of value.

Adapted from Simpson and Taylor (2013, p. 26).

Theoretical approaches to corporate

governance
Agency theory
Owners are reliant on agents to use their superior
knowledge of the organization to manage the
organization;
Agents could, potentially, act through opportunism
or self-interest to the detriment of the principal. This
is what is known as the principal-agent problem.

Theoretical approaches to corporate

governance
The principal-agent problem Principal’s
objectives
Information to
principal

Principal

Contract line Contract line

Information Diverging interests
asymmetry
Delegation

Agent
Agent’s
objectives
Agent’s
knowledge

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Theoretical approaches to corporate

governance
Agency theory
If markets were perfectly competitive so that
information reached all parties simultaneously, there
would not be any need for corporate governance.
However, this is not the case;

Governance seeks to reconcile the interests of

principals and agents for the benefit of the company;

Internal governance mechanisms of control are used

in attempts to control the agent’s self-serving
behaviour;

Theoretical approaches to corporate

governance
Agency theory – internal measures
Incentives Monitoring
• Level and structure of • Internal
remuneration – NEDs
• Managerial ownership – Board sub-
committees
– Institutional
Both expensive “Agency ownership
Costs”

Theoretical approaches to corporate

governance
Agency theory – Management Bonus Hypothesis
Managers are often rewarded in terms of accounting-
based bonus plans to align their interests with those of
shareholders;
The efficiency perspective of management bonus
hypothesis relates to the initial establishment of the
bonus scheme;
The opportunistic perspective relates to the
subsequent efforts to manipulate profits, and hence,
the bonus.

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Theoretical approaches to corporate

governance
Agency theory – the Debt Hypothesis
Firms enter into debt contracts with external lenders
and these external lenders will scrutinise managers;
These debt contracts will reduce agency costs for
owners (the efficiency perspective);
Management will choose “favourable”, cheaper
methods of financing to represent their performance
as better or an opportunistic perspective;
Debt finance could prove detrimental to owners as
leverage in the capital structure increases risk.

Theoretical approaches to corporate

governance
Agency theory

Other external monitoring may also take place:

- Auditing
- Regulation
- Markets
- Takeovers

Theoretical approaches to corporate

governance
Agency Theory: Strategies for resolving principal-
agent problem
“Voice” “Exit”
• Increasing shareholder • Sell shares -
activism e.g. ultimate sanction
 Use Voting Rights • Companies need to
 Engagement/Dialogue retain shareholders
 Shareholder • Takeover market
resolutions

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Theoretical approaches to corporate

governance
Resolution of Agency Problem
Information to
principal
Principal’s
Principal objectives

Monitoring Incentives
Transparency? Aligned interests?

Agent’s
Agent objectives

Agent’s External
knowledge Regulation

Theoretical approaches to corporate

governance
Weaknesses in agency theory
Model of human ontology and a universal
rationality of agents being self-serving is
questionable;

Roberts (2001, p 1549) says that “contrasting

ontological assumptions are better understood
as effects generated by the operation of systems
of accountability”;

Assumes model of human agent developed in

private sector is also applicable to public sector;

Theoretical approaches to corporate

governance
Weaknesses in agency theory

Focus is on opportunistic agents, but what about

opportunistic principals who might offer contracts
that are impossible to meet;

Agency theory tends to present the conflict that

exists as being between shareholders or
principals – but reality is more complex than that.

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Theoretical approaches to corporate

governance
Stakeholder theory
Theoretical origin of stakeholder theory is law, politics
and economics.

Definition of stakeholders:
Any identifiable group or individuals who can affect the
achievement of an organisation’s objectives, or is
affected by the achievement of an organisation’s
objectives (Freeman and Reed 1983).

Theoretical approaches to corporate

governance
Stakeholder theory
Definition of stakeholders:
• Primary stakeholders - one without whose continuing
participation the corporation cannot survive as a going
concern;

• Secondary stakeholders - those who influence or

affect, or are influenced or affected by, the
corporation, but they are not engaged in transactions
with the corporation and are not essential for its
survival.

Theoretical approaches to corporate

governance
Stakeholder Theory

Shareholders

Government Employees

Interest groups The company Providers of credit

Local communities Suppliers

Customers

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Theoretical approaches to corporate

governance
Stakeholder theory
Contextualises the organisation as part of a broader
social system

Corporate governance exists to support board’s

capability to address different interests in that social
system

Different variants of stakeholder theory

- Moral/ ethical (e.g., Gray et al., 1996)
- Managerial (e.g., Elkington, 1997)

Theoretical approaches to corporate

governance
Stakeholder theory – managerial
Managers’ role remains to “maximise
shareholder value”;
Does so by satisfying different groups’
demands within a context of pursuit of
profitability;
Managers should also legitimise organization’s
own objectives in the eyes of stakeholders;
Different types of reporting are ways in which
the organization gains legitimacy.

Theoretical approaches to corporate

governance
Stakeholder theory – moral/ ethical
Organizations exist because broader society permit
them to do so – social contract;

Organizations have the capacity to cause harm;

Organizations have a moral obligation to society;

Rather than managing expectations of stakeholders

and seeking to legitimise corporate goals, the role of
managers is to respect other stakeholders’ interests
even if that does not result in maximising shareholder
wealth.

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Theoretical approaches to corporate

governance
Weaknesses of stakeholder theory
Assumes different stakeholders’ interests are
legitimate and reconcilable – are they?
Stakeholder theory may be partly derivative of broader
political economy theory (Gray et al., 1996), but some
variants do not give sufficient weight to different levels
of political strength of stakeholders.
Jensen (2010) Stakeholder theory is not a complete
theory as it does not provide explicit statement of
corporation’s goals – i.e., who are the stakeholders
and what do they want?

Theoretical approaches to corporate

governance
Weaknesses of stakeholder theory
Different corporate governance interventions
emphasise the primacy of shareholder interests over
other stakeholders. For example, the Hampel Report
(1998) states: “Directors as a board are responsible
for relations with stakeholders; but they are
accountable to shareholders.”

Theoretical approaches to corporate

governance
Stewardship theory
Theoretical origins are sociology, human relations
school of management and organizational theory;

Associated with the work of Donaldson & Davis

(1991) and Davis, Schoorman & Donaldson (1997);

The view of humankind is people are collectivists,

pro-organizational and trustworthy;

They are not motivated simply by economic gain,

but by a range of other needs such as achievement
and service;

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Theoretical approaches to corporate

governance
Stewardship theory
When given a choice between self-serving
behaviour and pro-organizational behaviour, a
steward’s behaviour will not depart from the
interests of his or her organization;

Steward’s behaviour is rational because s/he

perceives greater utility in co-operative behaviour;

Directors in heterogeneous organizations with

competing interests amongst shareholders, will be
predisposed/ motivated to act in the best interest of
shareholders as a group;

Theoretical approaches to corporate

governance
Stewardship theory
Consequently, governance structures should be
designed to empower the executives to enable them
to maximise benefits for the organization;

Donaldson & Davis (1991) argue that CEOs’ pro-

organizational actions are best facilitated when
corporate governance structures give them great
authority and discretion;
Davis, Schoorman and Donaldson (1997) argue that
corporate governance mechanisms that focus on
controlling executives’ behaviour are counter-
productive as they lower stewards’ motivations.

Theoretical approaches to corporate

governance
Weaknesses of stewardship theory
Stewardship theory over-generalises the nature of
human ontology and understandings of rationality.
Roberts (2001, p 1549) – is it the system of
accountability that produces the mode of behaviour,
rather than vice-versa?
The multifarious forms of conflict identified by
Goergen (2012) indicates that the different interests
are more complex than stewardship theory
suggests, so aligning them into a collective interest
for a board to protect, is not possible.

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Theoretical approaches to corporate

governance
Transaction cost theory
 Theoretical origins are organizational theory and
economics;
The work of Coase (1937), Williamson (1975,1984)
and Hart (1995) contributed to the development of this
theory;
Corporations are not an impersonal economic unit in a
world of perfect markets, but an organization that
contains people with different views and objectives;
Those people have come together to substitute for the
market in allocating resources;

Theoretical approaches to corporate

governance
Transaction cost theory
A company’s management internalizes transactions as
much as possible, to remove risks and uncertainties
about supply of materials, etc., that resides in markets
and this has led to organizations getting larger;
Firms will thus expand in size up to the point where it
becomes cheaper or more efficient for the transactions
to be undertaken externally;
As they grow larger, they can also create their own
internal capital market;

Theoretical approaches to corporate

governance
Transaction cost theory
The corporation constitutes a governance structure
per se to manage the objectives of organizational
members;
Shareholders can not stipulate all terms in contracts of
executive managers that oversee the corporation;
Corporate governance, thus, provides a framework for
making decisions that have not been specified in the
initial contract;
Appropriate choice of governance structure can help
align the interests of directors and shareholders – e.g.,
internalizing the transactions to reduce risks.

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Theoretical approaches to corporate

governance
Weaknesses of transaction cost theory
Tends to present organizations in a unitary way so
conflicts of interests resolved by shared economic
interests.
Insufficient weight given to outside regulation by stock
market rules, legislation, etc., rather than as a
consequence of pursuit of transactions to achieve
economic benefits within the organization.

Theoretical approaches to corporate

governance
Why are there different theories of corporate
governance?
Are the authors defining corporate governance in the
same way?
Are they focusing on the same dimensions of
corporate governance to explain why it is?
Do the authors have the same or different values/
morals?
Do they originate from different academic disciplines
and do those academic disciplines share the same
definition of human ontology?

Theoretical perspectives on
corporate governance

Thank you for listening!

Any Questions?

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