TRANSACTION COST THEORY

Transaction cost theory originated from the 1930s,

when the economist Ronald Coase was
investigating the reasons companies exist and why
they were growing so large.

Transaction costs are incurred in spending time

researching, negotiating and agreeing a
transaction. Transaction cost theory examines the
theory that directors would rather enter into
agreements for their sources of goods and services
as this reduces uncertainty as they have
everything they need for the foreseeable future. By
doing this the time and expense of sourcing
materials is avoided.

Coase believed that, on average, directors would

prefer to lose the flexibility of searching for inputs
in order to have the certainty of predicting what
would happen with their business in the future.
Whilst committing to long-term agreements and
contracts avoids uncertainty and is easier to
control, it could mean that better opportunities
may be missed.

Coase’s concern was that directors were making

their own life easier at the expense of
opportunities that would improve shareholder
wealth. However, if directors are not concerning
themselves with constantly sourcing and
renegotiating resources, they have more time to
spend on longer-term strategy issues.

Transaction cost theory explains why companies

are getting bigger. Transaction cost theory says
that in order to reduce uncertainty and to increase
control, a company should tie itself up in more
agreements and this therefore means more staff,
more assets, more contracts and a larger
company.

Alternatively, a board of directors who are worried

about the security of their supplies may choose to
buy the company that supplies them. This is called
vertical integration. The downside to vertical
integration is that supplies will always come from
that one company and there may be better quality
or prices to be had elsewhere.

This helps to explain why the agency problem is

getting worse. A larger company means the gap
between shareholders and directors gets bigger.

In Summary:

1. Directors are likely to prefer to own things, or

at least have long-term contracts in place, because
it makes their lives easier through increased
control and certainty over the future.
2. As such, they are likely to create larger and
larger organizations/companies. This may be good
for them, but may not result in the best decisions
for shareholders or other stakeholders as:
 the organisation may grow larger than is
efficient;
 by agreeing long term contracts, the ability to
take advantage of good deals in the future may be
lost;
 because directors will get to know company
staff, assets etc. very well (because they are
internal), they may simply renew contracts without
looking at outside options.

Mechanism of Corporate Governance

Internal Mechanism
The foremost sets of controls for a corporation come from
its internal mechanisms. These controls monitor the
progress and activities of the organization and take
corrective actions when the business goes off track.
Maintaining the corporation's larger internal control
fabric, they serve the internal objectives of the
corporation and its internal stakeholders, including
employees, managers and owners. These objectives
include smooth operations, clearly defined reporting lines
and performance measurement systems. Internal
mechanisms include oversight of management,
independent internal audits, structure of the board of
directors into levels of responsibility, segregation of
control and policy development.

External Mechanism
External control mechanisms are controlled by those
outside an organization and serve the objectives of entities
such as regulators, governments, trade unions and
financial institutions. These objectives include adequate
debt management and legal compliance. External
mechanisms are often imposed on organizations by
external stakeholders in the forms of union contracts or
regulatory guidelines. External organizations, such as
industry associations, may suggest guidelines for best
practices, and businesses can choose to follow these
guidelines or ignore them. Typically, companies report
the status and compliance of external corporate
governance mechanisms to external stakeholders.
 Regulatory Mechanisms of corporate governance
in India
A natural question to ask, given the theory behind
corporate governance, is why do we need to
impose particular governance regulations through
stock exchanges, legislatures, courts or supervisory
authorities? If it is in the interest of firms to provide
adequate protection to shareholders, why mandate
rules, which may be counterproductive? Even with
the best intentions regulators may not have all the
information available to design efficient rules.
Worse still, there is a danger that regulators can be
captured by a given constituency and impose rules
favoring one group over another.
In our country, there are some major mechanisms
to ensure corporate governance:
A) Companies Act : Companies in our country are
regulated by the companies Act, 1956, as amended
up to date and replaced by companies act 2013. The
companies Act is one of the biggest legislations with
470 sections and 7 schedules. The arms of the Act
are quite long and touch every aspect of a
company's insistence. But to ensure corporate
governance, the Act confers legal rights to
shareholders to
 Vote on every resolution placed before an
annual general meeting;
 To elect directors who are responsible for
specifying objectives and laying down policies;
 Determine remuneration of directors and the
CEO;
 Removal of directors and
 Take active part in the annual general meetings.
B) Securities law
The primary securities law in our country is the SEBI
Act. Since its setting up in 1992, the board has taken
a number of initiatives towards investor protection.
One such initiative is to mandate information
disclosure both in prospectus and in annual
accounts. While the companies Act itself mandates
certain standards of information disclosure, SEBI Act
has added' substantially to these requirements in an
attempt to make these documents more
meaningful. The main objective of SEBI regulation is
shareholder value maximization by putting
corporate governance structures in place and
through the reduction of information asymmetry
between the managers and the investors of the
company.

C) Reserve Bank of India (RBI)

The RBI, established in 1935, is the central bank of
India and is entrusted with monetary stability,
currency management and supervision of the
financial and payments systems. Its functions and
focus have evolved in response to India's changing
economic environment. It acts as the banker to the
state and national governments, the lender of last
resort and the controller of the country's money
supply and foreign exchange. The RBI supervises the
operations of all banks and NBFCs in the country. It
is responsible for monetary policy, setting
benchmark interest rates, managing the treasury
operations (both borrowings and redemption) for
the government and acts as custodian and
controller of the foreign exchange reserves.
D) Nominees on company boards
Development banks hold large blocks of shares in
companies. These are equally big debt holders too.
Being equity holders, these investors have their
nominees in the boards of companies. These
nominees can effectively block resolutions, which
may be detrimental to their interests.
Unfortunately, the role of nominee directors has
been passive, as has been pointed out by several
committees including the Bhagwati Committee on
takeovers and the Omkar Goswami committee on
corporate governance.
E) Statutory Audit
Statutory audit is yet another mechanism directed
to ensure good corporate governance. Auditors are
the conscience-keepers of shareholders, lenders
and others who have financial stakes in companies;
Auditing enhances the credibility of financial reports
prepared by any enterprise. The auditing process
ensures that financial statements are accurate and
complete, thereby enhancing their reliability and
usefulness for making investment decisions.
F) Codes of Conduct
The mechanisms discussed till now are regulatory
in approach. They are mandated by law and
violations of any provision invite penal action. But
legal rules alone cannot ensure good corporate
governance. What is needed is self-regulation on
the part of directors, besides of course, the
mandatory provisions.
H) Global best practices
 A number of supranational organizations have
drawn codes principles of corporate governance.
The most well known is perhaps the OECD
principles of corporate governance of 1999. It is
instructive to summaries the five basic pillars of
OECD code, viz.,
i, Protecting the rights of shareholders;
ii. Ensuring equitable treatment of all shareholders
including having an effective grievance redressal
system ;
iii. Recognizing the rights of stakeholders as
established by law;
iv. Ensuring the timely and accurate disclosure
regarding the corporation including the financial
situation, performance, ownership and governance
of the company; and
v. Ensuring the strategic guidance of the company,
effective monitoring arrangement by the board and
the board's responsibility to the company and the
shareholder.