Chapter 2: Theories of Corporate Governance

- The theories have applications in corporate governance

- Enlightened agency theory

The market model:

Standard assumptions
 Many firms (sellers), who compete prices down
 Many buyers (no buyer power)
 Centralized exchange (market clearing)
 Full information
 Complete markets
 No transaction costs

- The price mechanism lead to market equilibrium (demand = supply)

- Efficient equilibrium, because it is not possible to find a better resource allocation
- Individual agents will not do better by changing their production or consumption plans
- Institutions in corporate governance: legal forms (companies), ownership structure,
boards, incentive systems, information systems (accounting) and government
regulation
- Corporate governance discussion:
- Ownership is irrelevant to resource allocation
- Efficient ownership depends on transaction costs

Agency theory:
 Ownership-management = good corporate governance
 How to make sure that the managers do their best?
 The core problem: the relationship between owners and managers – incentive problems
 Relationship between firms and sales agents
 Relationship between citizens and the government
 All have asymmetric information – and with that comes incentive problems
 Corporate governance codes: guarantees like product labels e.g. “organic”
 Solutions: monitoring and sanctions, bonus systems, laws and even ethical codes

The owner-manager problem:

- The owner-management agency problem: separation of ownership and management
- Owner-mangers have a natural incentive to work hard
- Owners/shareholders wants the manager to deliver results
- Generic agency problem: managers act criminally, type of expenditure like is a
company jet business motivated or private consumption, mergers and acquisitions,
overinvestment, entrenchment (barriers which make it hard to fire managers)
- Business judgement rule: a legal principle according to which managers are
assumed to be in the right, unless proven otherwise

The key elements of the agency problem:

 Separation of ownership (principal) and management (agent)
 Conflicting interests – the owners and managers have different interests
 Asymmetric information – the agent knows more about his own abilities than the owner
 Uncertainty – the existence of other factors like weather, bad luck etc.
 Risk aversion – performance pay will involve risk for the agent

Goal: find an optimal contract that makes the agent maximize his/her utility or value function
Types of agency problems:
1: Between shareholders and managers, because the managers do not always act in
the interest of the shareholders
2: Between majority and minority investors, the founding family might have other wishes for
the company than the smaller investors, who maybe just want dividends
3: Between shareholders and stakeholders, decisions made by shareholders, which affects
the welfare of the stakeholders

Information problems:
Two types of information asymmetry:
o Moral hazard (hidden action) – after the owner has made a decision
 Solution: encourage management to do their best through
incentives and monitoring
 Trade-off between risk and incentives
o Adverse selection (hidden knowledge) – before the owner has to make a decision
 Solution: hire the right and replace the bad managers – find a way to
secure that you take the right decision

Extensions to agency theory:

Agents watching agents: Many shareholders/investors are employees and they
might tend to watch after low performance
Common agency problem: Often many owners with different objectives and
preferences, which leads to confusion
A repeated game: if an agent misbehave is will affect her reputation and it might be
hard to find a new job – therefore good behavior is an incentive to reduce agency
problems

Incomplete contracts:
Pay-for-performance contracts
Allocate ownership by the managers with the most information

Transaction costs:
Explains vertical integration: why two independent firms do business with each
other might save costs
Make-or-buy decision: should the company produce itself or should it
outsource production?
o Insourcing might be beneficial if the relationship between buyer and
seller is characterized by asset specificity, uncertainty and a high
transaction frequency.
Psychology:

Confirmation bias: decision makers look and hold on to information, which

confirms their own ideas and past decisions
Small sample bias: decisions makers will often make decisions based on small samples
Illusory patterns and correlations biases: decision makers see patterns even
where there are none
The fundamental attribution error: people tend to see own failures as a result of
bad luck, while successes is caused by own performance and ability
Anchoring bias: people tend to use reference points when assessing situations
Emotional stress: can lead to even more biased decision making in times of crisis
Hindsight bias: Everybody always knew what would happen, 5 minutes later. Like,
successful decisions tend to be obvious afterwards
Personality: The personality of the CEO etc. always affects the company
Group psychology: Matters to board behavior, groupthink problems
because board members are often very much the same, age, gender,
education etc.

Sociology: The network theory – clusters

Culture varies and the same does the degree of motivated by performance-based pay,
incentives, less control and honesty
Political science: politics shapes the law, influenced by policymakers, voting
Law: reduce agency problems,
Management: There is a connection between leadership style and governance

II. The three main theories in corporate governance

Agency theory
One party maximizes his utility at the expense of the other
Information asymmetry between the two parties
o Quite often the case – ex. insider trading
How can owners (principals) ensure that mangers (agents) work in the best
interest of the owners
o How do we bring these two interest together, so they get one goal?
Agency costs:
o Cost that occur to owners due to conflicts of interest with managers
o Difference in value of a firm with agency conflicts and a hypothetic firm without
o Consist of three elements:
 Monitoring expenditure
 Bonding expenditure (incentives)
 Residual loss (value loss for wrong decisions)
o In a perfect world, the firm does not have all these costs
Size of agency costs
o Depends on multiple aspects
 How much shares are owned? To how many are the stocks split
up? How many owners? How many people influence the firm?
 Size of the firm

Number of management layers (Nordics: relative flat hierarchy
structure, Germany: more layers, more hierarchy)
 More layers, more costs
o Agency costs can be controlled by special mechanisms
CG control mechanisms
o Executive compensation (fixed pay, stock options, bonuses etc.)
o Board of directors (control with the setup of the board)
o Large investors (usually a part of the board, want low agency costs)
o Takeovers
o Auditors, rating etc. (external factors)
Demsetz, 1983
o Agency costs should be related to economies of scale: when we have
international companies, they use to have more agency costs than smaller
local companies
o Some stages are only able to reach with agency costs: especially start-ups in
order to grow
o What is the difference?
 Both are interrelated with each other
 We try to decrease the agency costs, but we cannot avoid them totally,
when we have large companies or want a company to grow
o References: Go to google scholar, take the name and the year and put it in to
google scholar and then you get some sources
Acceptance of agency costs
Benefits Costs
- Capital raising - Agency costs
- Professionalism - Poor incentives
- Specialization - Bureaucracy
- Routine of tasks - Free riders
- Liquidity
Why large firms at all?
o Benefits
 Often large companies are more professional, because they can hire
people with a good education, because they can pay well
 Large companies are often more specialized, Porsche = sport cars,
Facebook = social network, a focus on an industry, product lines
 Routine of tasks, set up in a professional way, in bigger companies
there are more tasks, roles and
 Interrelated to professionalisms, cash management, less risk
to get bankrupted
o Costs
 Poor incentives: people just relax and do nothing
 Bureaucracy: in really large companies they have problems with this
o Why large firms?
 Large firms are relatively new
 Did not exist until the mid 19th century
 Dominating after WW1
 Reasons:
 Greater productivity
  Lower costs and higher profits (pressure on the suppliers,
market power)
 More cash flow (in that way they have more cash flow)
 Rapid payments (because they have more cash flow)
Invisible / visible hand
o Market model
o Firm is a black box (technology and profit maximization)
o Economy works by itself under price mechanism (invisible hand – Adam Smith)
 Based on pre industrial society
 Buyers and sellers compete price down
 Central exchange (trading both goods and capital is more efficient
now, easy to trade with countries all around the world)
 Full information
 Complete markets
 No transaction costs (financial markets, quite less transactions costs)
Why large firms?
o Why organize so much production within a single unit despite the agency problem?
o Why not coordinated by price mechanism?
o Why not just let one large firm produce everything?
o Answer Coase (1937)
 Tradeoff between making and buying things: outsourcing argument,
making and buying decision, the costs for outsourcing gets lower and
lower, communication is almost the same
 Costs that are attached to buying from the market can be
substituted by production costs
Cost of trade Cost of production
- Find beneficial prices - Production costs
(search on the web, make (material staff, servers,
analysis) computers etc.)
- Evaluate products (what - Internal coordination costs
do we need, compare)
- Negotiation (about price)
- Transaction costs (new
infrastructure, fly to
India)
- Forecasting problems
 Only outsourcing less important things. You do not outsource your IT,
when it is your core competences
New arising firms
o When economic planning is cheaper when relying on price mechanism
o Not really different from a large firm; firms grow based on the same logic:
 Firms become larger as additional transaction costs are organized
by the entrepreneur (the entrepreneur is efficient in doing
business)
 Firms become smaller as the entrepreneur abandons such costs
Describing points
o Costs of an extra transaction within the firm reaches the cost of a transaction
in the outside market
o When internal transactions increase it will be harder to place factors there
where the production is highest
 High transaction cost if we do everything on our own
  Point where loss through waste of resources equals market costs
Other relationships, when the firm becomes larger:
o The less the costs of organizing are and the less transaction costs rise
(when our company is setup in a quite efficient way, transaction costs are
quite low)
o The less likely the entrepreneur is to make mistakes and the smaller the
mistakes weighted with an increase in transactions (first outsource, then
afterwards we decide to get it back in-house, result in more transaction costs)
o The greater the lowering of supply prices of factors is with a larger firm
size (put pressure on suppliers to get cheaper prices)
Which problem is better?
o When avoiding transaction costs, we face another problem:
o Large firms are more depend on managers Agency problem
o During market trade we are more vulnerable to appropriation
o It is possible to choose?
Intro into agency theory
o Jensen & Mackling 1976 & Eisenhardt (1989)
o Different parties have different interests
 Potential risk of people acting in their own interest on the other party’s
expense
o Agents and principals: principals = owners, or anyone who hire someone else
to do a certain job at their expense
 Agents = managers, a person hired to do a certain job in
exchange for an agreed compensation
o Whenever in a contract, one party therefore needs to:
 Monitor the other party
 Find ways to ensure that interests are aligned
The owner-manager problem
o Separation of ownership and control give rise to the need for professional managers
o Owners employ managers to run the firm in the best interest of the investors
– and most managers do
o However, some managers act criminal and embezzle shareholder funds
o Another classical agency problem is excess expenditure: what expenses are business
motivated and what is the manager’s private consumption
The agency problem consists of these five factors

10
o Rule of man:
 Homo Economicus is rational, individualistic and opportunistic
(person)
 Always seek to maximize own benefits and personal utility
 Moral responsibilities to act in someone else’s interest are second
priority
o Interest divergence
 Arise when two Homo Economicus meet, for example
owners and managers, which both have their own
interests
 In firms, the conflict of interest becomes especially
important since only one party bears the cost for
running the firm
o Types of agency problems
 Agency conflicts type 1 (owners vs. managers)
 Most common in firms with dispersed ownership
 Collective action problems and free rider
problems (no one has incentive to
monitor)
 Agency conflicts type 2 (majority vs. minority owners)
 Most common in firms with concentrated ownership
 Private benefits of owners
 Agency conflicts type 3 (shareholders vs. rest of stakeholders)
 Common for both, dispersed and concentrated ownership
o Information problems
 Information problems concern primarily two types of
asymmetric information between owners and managers
 Adverse selection occurs before the manager makes
a decision, while moral hazard occurs after a decision
has been taken
 Moral hazard
o “Hidden action”
o Occurs when the action of the manager
cannot be observed b the owner
o Illustrates the trade-off between risk and
incentives: if you do not carry any risk you
lose your incentives to protect yourself
against it
o Managers can be given incentives
to share some of the shareholders’
risk, e.g. by being remunerated with
stock options or bonuses for
excellent firm performance
 Adverse selection
 o “Hidden knowledge”
o Owners know less about the state of the
firm than managers, and they know less
about the capabilities of a new managers
than the manager himself
o Adverse selection can partly be solved through
monitoring or
by looking at the mangers’ past performance
Agency problems: Incomplete contracts theory
o Whoever has asset ownership possesses the residual right of control
o Residual right of control means the right to control in all
situations not already covered by contracts
o Explains why large firms cannot replicate the incentives of
small entrepreneurial firms as employees do not have the
residual right of control they lack incentives to
make an effort as the employer can act in his own interest whenever he’s
not
covered by a complete contract
o We cannot do this for every employee
Transaction costs
o Transaction cost lead to many deviations from the market model
o The existence (and size) of transaction costs affect firm decisions to trade
or produce
o Thus, transaction costs can explain vertical integration and
why firms grow large, thus causing the need for external
finance which makes ownership separate from control

Stewardship theory
Basic idea: agent’s behavior based on different behavioral premises Steward’s
goals are
aligned with the objectives of the principal (managers and owners are best
buddy’s)
Steward’s characteristics:
o By working towards organizational, collective ends, personal needs are
met
o Interest are aligned with that of the corporation and its owners
o Motivated to maximize organizational performance, thereby
satisfying the interests of shareholders (like the owners)
 Comparison

o Motivation: stewardship is motivated by doing the best of the company,

according to
agency theory the employee wants a raise every year
o Identification: Agency theory, I only care about
earning money. According to stewardship I care about
everything in the firm
o Employee: the firm want stewards
There is a lot of critics of this theory

Stakeholder theory
Basic idea: organizations are multilateral agreements between the
firm and its stakeholders: government, employees, customers,
suppliers, communities

A stake can
be:

Who are stakeholders?

o Any individual or group who can affect or is affected by
the actions, decisions, policies, practices or goals of the
firm
Three views of the firm:

Who are business stakeholders

o Primary stakeholders: have a direct stake in the organization and its
success
o Secondary stakeholders: have a public or special interest
stake in the firm that is more indirect
 Further distinction into social/nonsocial primary and secondary
stakeholders
 o

o
Typology of stakeholder attributes
o Classify and prioritize the stakeholders according to the
presence or absence of the three key attributes:
 Legitimacy (lovmæssig inflydelse): the legitimacy
of the claim laid upon the organization by the
stakeholder group
 the extent to which the stakeholder’s actions
are correct or desirable based on his position
within the organization
 Legitimacy – of the relationship & actions in
terms of desirability, properness or
appropriateness
 Is the authority, level of involvement project
stakeholders has on a project.
 Power: the power of the stakeholder group upon an organization
 How powerful is the stakeholder?
 Power – to influence the organization or
project deliverables (coercive, financial
or material, brand or image)
 Is the ability project stakeholders having to
influence the outcome of an organization,
deliverables or a project?
 Urgency: the degree of which stakeholder claims call for
immediate cation
 the extent to which the outcome is interesting for
the stakeholder and the time pressure involved
 Urgency – of the requirements in terms of
criticality & time sensitivity for the stakeholder
 Is the time expected by project stakeholders
for responses to their expectations?
 Proximity: The spatial distance between
the organization and its stakeholders
Agency vs. Stakeholder theory
Agency theory
- Narrow focus on shareholders
- Shareholders residual claimants
who need special protection
- All other stakeholders are protected
by contracts
- Manager should focus on increasing
residual claim shareholder
value
Stakeholder theory
- Broader
- Many stakeholders make firm
specific investments not protected
by contracts
- Manager should focus on
maximization total welfare
- But: Dilution of managerial tasks,
whom
to focus on?