CAMPUS KÖLN

CAMPUS MAINZ
CAMPUS POTSDAM

Corporate Governance
Module 2 Theoretical Aspects of CG
Tricker Chapter 3
Prof. Dr. Laxmi Remer
Cologne Business School

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Purpose of this Module

• To understand the various main theories that underline the development of

corporate governance
• To be aware of the impact of the form of legal system, capital market, and
ownership structure on the development of corporate governance

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Overview on the Theories

1. Agency Theory
2. Transaction Cost Economics
3. Stewardship Theory
4. Stakeholder Theory
5. Class and Managerial Hegemony
6. Psychological Perspectives

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1. Agency Theory

• One party, the principal, delegates work to another party, the agent.
• In the context of the modern corporation, the owners are the principal
and the directors are the agent.
• “The directors of companies, being managers of other people’s money,
cannot be expected to watch over it with the same vigilance with which
they watch over their own” (Adam Smith, 1776).

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1. Agency Theory

• Problems primarily arise with regard to the self‐ interest of the agent:
– misuse of power for pecuniary or other advantages
– inappropriate risk taking
– information asymmetry

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1. Agency Theory
• Purpose of CG: Minimize the problems that result from the
principal‐agent relationship.
• Principal‐Agent Problem as Core to the Modern Corporation:
– separation of ownership (many diverse shareholders) and control => “ownership
without power”
improving transparency and accountability as parts of CG to reduce information
asymmetry
• Empirical evidence shows that firms with good governance show
better financial performance (Selvaggi and Upton, 2008).

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1. Agency Theory
• Criticisms:
– focus on purely quantitative metrics
– despite the theory, studies which showed that companies with executive directors
perform better
– agency theory assumes that the investor will have a long‐ term perspective; however,
we often find a rather short‐ term orientation
– assumption that man is driven exclusively by self‐interest
– exclusive focus on shareholders

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2. Transaction Cost Economics

• Coarse (1937): The rationale for a company’s existence lies in its possibility to
conduct transactions on the basis of internal instead of external contracts.
• Companies grow to the point where it is cheaper or more efficient to conduct
transactions externally.
• Function of CG: to help the design and control of the internal contracts that
have been made.
– independent outside directors
– risk analysis
– auditing
– nomination and remuneration committees

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2. Transaction Cost Economics

• costs of control and enforcement should be incurred to the point where the
increase in costs equals the reduction of the potential loss of
non‐compliance
• criticism:
– same as that of agency theory

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3. Stewardship Theory

• counter‐position to agency theory

• directors/managers are not inherently opportunistic
• directors usually act in the interest of the shareholders, which is their legal
obligation
• stakeholder interests are also of concern to the directors, but only with legal obligations
• criticism:
– outdated: shareholders do not effectively choose directors anymore
– there is an exclusive focus on the legal dimension
– corporate scandals have shown that directors often do not act in the shareholder ’s interest.

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4. Stakeholder Theory

• Unlike agency theory and TCE, stakeholder theory does not only consider
shareholders as relevant.
• no overriding focus on shareholder‐value
• companies need to recognize their responsibility to all groups in society
which are affected or can affect a company’s decisions.
• This responsibility is seen by many as the price a company has to
pay for incorporation.

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4. Stakeholder Theory

• Traditional Stakeholder Model

Government Competitors

Shareholders
Customers

Firm

Suppliers Employees
Civil
society
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4. Stakeholder Theory

• Modern Stakeholder Network‐Model

Customer
stakeholder
1
Government Competitors

Customer
stakeholder
Shareholders Customers
3
Firm

Employee
Suppliers stakeholder
Employees 1
Civil society
Supplier Employee
stakeholder stakeholder
Civil society
1 2
Civil society stakeholder
stakeholder 1
2
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4. Stakeholder Theory

• Criticism:
– conflicts between the interests of stakeholders are inevitable, whereas
shareholder value is a clear and measurable standard
– difficult for the management which stakeholder interests to consider
– infinite number of potential stakeholders

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4. Stakeholder Theory

• Solutions:
– Maximization of
shareholder value while
taking into account
stakeholder interests
– Models to determine the
importance of
stakeholders (e.g. by
Mitchell et al., 1997).

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5. Class and Managerial Hegemony

• directors perceive themselves as an elite group

• this self‐perception encourages them to behave in an elitist way and to dominate
the company
• they will nominate directors and choose managers who fit into their
self‐perception and sustain their dominance
• governance as an inter‐personal process, group behavior is relevant
• criticism:
– insufficient empirical evidence
– no clear suggestions with regard to implications

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6. Psychological Perspectives

• all other theories focus on the firm level

• personalities of the actors and interpersonal relations are not considered
• individual behavior and psychology have to be studied in order to
understand the decision‐making process of directors
• criticism:
– insufficient empirical evidence
– no clear suggestions with regard to implications

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Conclusions

• A general theory of CG would have to consider:

– the relationship between individual, company and state
– the expectations, interests, requirements and demands of each participant
– the duties and responsibilities of each participant
– the powers and sanction capabilities of each participant

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Consequence

• Three levels of CG are the consequence:

– First level: the regulatory level with laws
• here, compliance is mandatory; violations are sanctioned
• variation across countries with different cultures and legal systems
– Second level: advisory level with voluntary codes of conduct
• responsibility becomes a matter of generally accepted responsible behavior
– Third level: personal level, containing beliefs and values
• personal belief systems are involved, including concern for others, courtesy, social awareness,
etc.
• So far, CG has focused strongly on level 1, somewhat on level 2, and
hardly at all on level 3.

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Discussion Questions

Name and discuss any three theories that underline the development of CG
with their criticisms.

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