PA Core 3 – Good Governance and Social Responsibility

LESSON II
THOERIES OF GOOD GOVERNANCE

Learning objectives:
At the end of the discussion the students:
1. Discuss the different theories of governance.

2. Relate the significance of these theories to high ethical standards.

3. Develop the independence of decision making.

4. Value the importance of open communication in organization and its work

Governance Theories

Good Governance is the heart of any successful institution. It is essential for an organization to
achieve its objectives and drive improvement, as well as maintain legal and ethical standing in the eyes
of shareholders, regulators and the wider community. However, it is important to understand the
foundation of governance and discuss the different theories and models of good governance and its
conceptual framework in the light of both developed and developing nations through interpreting the
contemporary management and public policy. In this chapter we will discover the analytical definitional
and theoretical framework of the concept of governance, discuss the dimensions of theories related to
governance and present conclusions from findings and observation in recent Philippine governance.

This entry intends to discuss the different theories and models of governance and its conceptual
framework in the light of both developed and developing nations through interpreting and reinterpreting
the contemporary management and public policy literature. This entry has three sections. First, we take
an analytical look into the definitional image and theoretical framework of the concept of governance.
Secondly, we discuss the dimensions of theories related to governance. Thirdly, we present our
conclusions and discuss our findings. This entry intends to discuss the different theories and models of
governance and its conceptual framework in the light of both developed and developing nations through
interpreting and reinterpreting the contemporary management and public policy literature. This entry
has three sections. First, we take an analytical look into the definitional image and theoretical framework

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of the concept of governance. Secondly, we discuss the dimensions of theories related to governance.
Thirdly, we present our conclusions and discuss our findings.

Stewardship theory

This is a theory that managers, left on their own, will act as responsible stewards of the assets
they control. Stewardship theorists assume that given a choice between self-serving behavior and pro-
organizational behavior, a steward will place higher value on cooperation than defection. Stewards are
assumed to be collectivists, pro-organizational, and trustworthy.

Stewardship theories argue that the managers or executives of a company are stewards of the
owners, and both groups share common goals (Davis, Schoorman, & Donaldson, 1997). Therefore, the
board should not be too controlling, as agency theories would suggest. The board should play a supportive
role by empowering executives and, in turn, increase the potential for higher performance (Hendry,
2002; Shen, 2003). Stewardship theories argue for relationships between board and executives that
involve training, mentoring, and shared decision making (Shen, 2003; Sundaramurthy & Lewis, 2003).

In Philippine politics, an example of the stewardship theory is where a president practices a

governing style based on belief, they have the duty to do whatever is necessary in national interest,
unless prohibited by the Constitution.

The Goal of Stewardship Governance

A steward is defined as someone who protects and takes care of the needs of others. Under the
stewardship theory, company executives protect the interests of the owners or shareholders and make
decisions on their behalf. Their sole objective is to create and maintain a successful organization so the
shareholders prosper. Firms that embrace stewardship place the CEO and Chairman responsibilities
under one executive, with a board comprised mostly of in-house members. This allows for intimate
knowledge of organizational operation and a deep commitment to success.

Agency Theories

Agency theories arise from the distinction between the owners (shareholders) of a company or an
organization designated as "the principals" and the executives hired to manage the organization called
"the agent." Agency theory argues that the goal of the agent is different

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from that of the principals, and they are conflicting (Johnson, Daily, & Ellstrand, 1996). The
assumption is that the principals suffer an agency loss, which is a lesser return on investment because
they do not directly manage the company. Part of the return that they could have had if they were
managing the company directly goes to the agent. Consequently, agency theories suggest financial
rewards that can help incentivize executives to maximize the profit of owners (Eisenhardt, 1989).
Further, a board developed from the perspective of the agency theory tends to exercise strict control,
supervision, and monitoring of the performance of the agent in order to protect the interests of the
principals (Hillman & Dalziel, 2003). In other words, the board is actively involved in most of the
managerial decision making processes, and is accountable to the shareholders. A nonprofit board that
operates through the lens of agency theories will show a hands-on management approach on behalf of
the stakeholders.

The agency theory revolves on the basic proposition about humans, which deals with principals
and agents as self-oriented focusing on exploiting their personal advantage. Agency theory described
managers as opportunistic by seizing its optimum advantage for his appointment and role as the mover
in the firm for its own benefit, at the expense of the principal. Both parties’ goal is to gain that personal
advantage in every way possible with the least outlay and expenditure. These expenditures are defined
as agency costs. This is the total of cash outflows made by the principal for its organization be it in
budget proportions, auditing, or employee honorariums; the expenses incurred by the agent for income
generating projects and the marginal loss due to the decline in the expected income of the principal as
caused by the resulted deviation of motives between the agent’s resolution and the main goal of the
principal to obtain maximum returns from its investments.

Thus, high conflicting of interests between the principals and agents that resulted from
information asymmetry is the main statement in an agency theory. Asymmetry of information between
the two parties is displayed when the manager align his capabilities with the expected outcome, result
and rationality of the principal (not knowing his own abilities) leads to satisfying decision-making on
the part of the principal while this is an example of “adverse selection” for the agent. More often than
not, this leads to a number of non-satisfactory overall performances of the manager which will in due
time lead to the destruction of the firm and the reputation of the agent. As well as for the principals,
their incapability of selecting candidates that acts appropriately in all circumstances are proofs of adverse
selection. The outcome always entails an ambiguous job description on both parties. Nevertheless, there
are still some factors

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that the agency theory fails to point out, other than motivational or self-gratitude. These maybe are the
intrinsic inability or low ability, poor knowledge on business and misinformation of agents that resulted
in their failure to deliver high performance for their principals.

Moral hazard is another agency problem confronted by the corporate governance. It’s another
kind of opportunism which includes utilizing, seizing and assuming all extra benefits from a delegated
authority to rule in behalf of the principal. Since it is difficult for the principal to monitor agents, this
authority is undeniably has a chance of being abused or misused by the managers. This problem’s
solution is to adapt a good monitoring system and internal self- governance by the principal which entails
agency cost. A company does not behave based with the conventional model in which the agents must
act in the best interest of the owners of the firm. Most likely as a consequence, the principal then would
guarantee that the managers would act in their best interest. The idea of formulating a contract is relied
upon by the agency theory to align the motives of both parties concerned. The goal is to balance the
intention by allocating maximized values for shareholders and added incentives and benefits for the
managers. Committee audits and performance evaluations by the board may act as effective authority
tool for monitoring and scrutinizing potentially opportunistic agents. This internal governance system
as a solution to ensure the compliance of the agents bounded by the contract will simultaneously be given
to a non-executive sect who will be composed of auditors, supervisors and other structural
arrangements. This non-executive part of the ownership structure serves as the middle man
interconnecting the principal and the agent having a role in monitoring, thereby extending an enormous
effect in the change or variation in control. In relation to corporate governance, legitimate actions
against deceits and other modes of fraudulence may provide some fortification on the part of the
principal. Economic analysis suggests that incorporating these solutions to the firm may considerably
eliminate opportunism. But there are still factors that need to be considered in this special structure of
the firm that is created for internal governance of which other forms of opportunism may arose in those
entrusted with responsibility to check on the managers of the firm. All these efforts executed by
principals to avoid agency problems, minding the fact that there are still managers that won’t deliver
exactly what they’re expected to, entails agency costs as discussed. Often, the goal of the principal is to
minimize agency costs and focus on profit even if not in growth. Here comes the conflict of organizing
the principal-agent relationship wherein the idea is exemplified but the measures are often inadequate,
thus the alignment of the interests of the principal and manager is hardly ever absolute. A control-
oriented firm is then considered necessary under

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agency theory which suggests that agents will not act to take full advantage of the returns to the principal
if and only if systematic self-governance mechanisms are implemented in the firm to protect the
shareholder’s interest.

Difference between Agency Theory and Stewardship Theory

Agency theory concentrates primarily on the association between the principal and the agents
in corporations, having a formal and contractual nature of relationship however with the presumed goal
indifference and incongruence of interest. Meanwhile, Stewardship theory is involved mainly in
analyzing the importance of the co-existence of trust-based relationships along with agency relations in
firms. The stewardship approach, which encompasses commitment and trust to shared goals and desires
exhibited by the principal and the manager alike, aligns the interest of the two parties.

There are two key points that differentiated the Agency Theory and Stewardship Theory. These
are the motivation and power comparison. In an agency type, the manager is motivated by personal
interests and extrinsic rewards. In the stewardship, the manager is motivated by the human need for
intellectual growth, achievement, and self-actualization, and by intrinsic rewards. In an agency theory,
the power is institutionally directed while in the stewardship, it is based on personal ability and power
to run the particular organization.

Agency Theory and Stewardship Theory are not mutually exclusive but create a link between
agency and stewardship relationships. Clearly, the stewardship theory provided a room for the failures
and gaps in the agency theory. A manager of a firm may choose what type of inclination he is up to
particularly in decision making as long as these three assumptions are supplemented. First the decision
must be mutually agreed upon by both the principal and the agent. Secondly, it will always depend on
the situation, and third objective is the expectations of the parties involved.

Resource-Dependence Theories

Resource-dependence theories argue that a board exists as a provider of resources to executives

in order to help them achieve organizational goals (Hillman, Cannella, & Paetzold, 2000; Hillman &
Daziel, 2003). Resource-dependence theories recommend interventions by the board while advocating
for strong financial, human, and intangible supports to the executives. For example, board members
who are professionals can use their expertise to train and mentor executives in a way that improves
organizational performance. Board members can

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also tap into their networks of support to attract resources to the organization. Resource- dependence
theories recommend that most of the decisions be made by executives with some approval of the board.

Stakeholders Theory

Stakeholder theories are based on the assumption that shareholders are not the only group with
a stake in a company or a corporation. Stakeholder theories argue that clients or customers, suppliers,
and the surrounding communities also have a stake in a corporation. They can be affected by the success
or failure of a company. Therefore, managers have special obligations to ensure that all stakeholders
(not just the shareholders) receive a fair return from their stake in the company (Donaldson & Preston,
1995). Stakeholder theories advocate for some form of corporate social responsibility, which is a duty
to operate in ethical ways, even if that means a reduction of long-term profit for a company (Jones,
Freeman, & Wicks, 2002). In that context, the board has a responsibility to be the guardian of the
interests of all stakeholders by ensuring that corporate or organizational practices take into account the
principles of sustainability for surrounding communities.

Corporate Social Performance Model

This model was developed to help determine if a company was being responsible to their legal
and economic stakeholders, while also being socially responsible. This model is called a corporate
social performance model and consists of three elements (social responsibility categories, mode of
social responsiveness, and social issues of stakeholders), which are drawn into a three dimensional
model for easy interpretation by managers.

In order to fully understand the model, you first need to brush up on some basic terminology.
In this lesson, we will first review the definition of social performance, corporate social responsibility,
and corporate citizenship. In addition, we will explain the responsibilities of corporate social
performance.

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Corporate Social Responsibility

Corporate social responsibility (CSR) is the use of a business's resources to respond to help solve social
problems and achieve social goals. An example of a company practicing good CSR is Prime Five Homes
that builds sustainable homes which use less energy. Their stakeholders are satisfied that the homes are
better for the environment. In addition, Prime Five Homes also takes a portion of all home sales to use
for charitable activities.

Corporate Citizenship

Corporate citizenship is when a company shows commitment to ethical behavior by balancing

stakeholders' needs and protecting the environment. The difference between CSR and corporate
citizenship is that there is more concern for employee rights, environment, and education with corporate
citizenship. For instance, Microsoft recently won Corporate Citizenship Company of the Year for their
work with Making Cents International, where they help with education and training a global youth
workforce.

Corporate Social Performance

Now that you have an understanding of the terms, let's discuss the idea of corporate social performance,
which is the stakeholders' assessment of the CSR and corporate citizenship over time in comparison to
competition. How will stakeholders assess a company through the model? They will evaluate and
analyze a company through the three variables. We will use Microsoft as an example since they
epitomize a socially responsible company.

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Activity II.
Answer the following questions:
1. What are the advantages in applying any of these theories in organization?

2. Any challenges may encountered in the organization?

3. What do you think the significance of these theories in achieving good

governance?