Lecture 8: Corporate

Governance Theories
Recap

 CSR is a prominent contemporary phenomenon

 Whilst debate exists as to the role of business, most

businesses embrace a range of CSR practices

 CSR in marketplace, workplace, community &

ecological environment

2
 Overview

 The birth of modern corporate governance

 Corporate Governance Theories

o Agency Theory

o Stewardship Theory

o Stakeholder Theory

3
Corporate Governance

4
 Some Corporate Failures
 In the last several decades, there have been a series of corporate meltdown, frauds, and other
catastrophes, leading to the destruction of billions of dollars of shareholders, the loss of
thousands of jobs, criminal charges, and bankruptcy.

 Prominent corporate failures include, for example,

 Barings Bank – 1995 – England

o One of oldest established banks in England.

o In 1993, trader Nick Leeson who was based in Singapore made more than £ 10 million (10%
of the bank’s profit that year)
o His run of good luck was not to last, when the stock market was adversely affected by a
severe earthquake in Japan, he incurred huge losses.
o He requested more money – surprisingly, he got it – but suffered further losses
o The losses were so great (£ 850 milion), the bank collapsed and was bought for only £ 1.
o Reason of failure: Lack of effective internal controls - trusting one employee without
supervision and understanding of his activities.

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 Some Corporate Failures
 Enron – America – 2001

o The seventh largest American company – US $ 997 million profit in the 2000 financial
year.
o For many years, Enron’s leaders (e.g., the president of the Boards of directors, CEO,
CFO) involved in massive fraudulent accounting practices.
o Particularly, they created about 3000 ‘Special Purpose Entities’ to borrow money and
hide the losses.
o When the prices of Enron’s shares went down, the company encountered serious
problems (they had to take the debts from their SPEs back).
o Enron’s massive fraudulent accounting practices were possible because, among others,
its independent auditor Arthur Andersen appeared to be compromised.
o Enron filed for bankruptcy in 2001.
o Reasons of failure:
 Directors were not questioned closely enough about the use of SPEs and their accounting treatment;
 Directors are not people of integrity and not acting honestly
 Failure of the independent auditor.

6
 Some Corporate Failures
 Parmalat – Italy – 2008

o Founded by Calisto Tanzi,

o Specialized in long-life milk - A great success for many years.

o In 2003, Parmalat have difficulties in paying debts (its debts were £ 10 million). It decided to utilize its
large cash reserves.

o However, it turned out that the large cash reserves were non-existent. The company went into
administration.

o In 2008, the court found that Calisto Tanzi was guilty on a number of charges, including falsifying accounts,
and misleading investors and regulators.

o Reasons of failure:

 Parmalat was a family-owned firm and its board of director were dominated by family members –
Lack of independent directors & committees.

 Lack of timely disclosure of information 7

 Some Corporate Failures
 Satyam – India - 2009

o India’s fourth largest IT group by revenue.

o In 2009, its chairman Raju wrote to the Board and confessed that he has manipulated
many figures in the annual financial statements over a number of years, resulting in
overstated profits and non-existent assets.

o The company was then bought by another company in 2009.

o Reasons of failure

 No effective mechanisms to supervise a powerful chairman who was able to

falsify accounts over a period of time

 Ineffective auditors

 Lack of disclosure requirements

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 Some Corporate Failures
 Securency – Australia – 2012

 Securency was a subsidiary of the Reserve Bank of Australia (RBA) –

produces and supplies of polymer banknotes.

 Alleged of bribery and corruption: Securency paid commission to

foreign middle man, who bribed central banking officials in countries in
Asia, Latin America and Africa to replace their paper notes with
Securency’s polymer notes.

 In 2012, the RBA fired two top executives of Securency.

 Reason of failure: Lack of ethical behaviour by some of the key

directors.

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 Some Corporate Failures
 Many other examples of high profile corporate failures such as
China Forestry (2008); Olympus Corporation (Japan); Royal Bank
of Scotland (2008); and Tyco, Adelphia, WorldCom, Global
Crossing (2002, America).

 There is a common reason in these failures:

POOR CORPORATE GOVERNANCE

 These companies have not structured and operated in a way

that properly protects the interests of their shareholders and
other stakeholders.

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 What is a corporation ?

 Corporation is

o an artificial legal person created by the law

o having its own rights and responsibilities distinct from those of its owners.

 Corporations enjoy most of the rights and responsibilities that an individual has,
e.g., a corporation can

o enter into contracts,

o sue and be sued,

o loan and borrow money,

o hire employees, own assets and pay taxes.

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 What is a corporation ?
 Company is the dominant type of corporation.

 Over 1.92 million companies in Australia.

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 Types of Company: Proprietary
(Private) & Public Company

It is possible for the director and the shareholder to be the same person,
although in larger companies there is a separation of ownership and control.

13
 What is a corporation ?

An important feature of a corporation is limited liability.

If a corporation fails, shareholders normally stand to

lose their investment only.

Shareholders are, therefore, able to keep their personal

wealth and assets safe from the corporation's creditors.

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 Separation of Ownership & Control

 Prior to the creation of limited liability corporations (1856), most

business ventures were owned and managed by the owners - No
separation between ownership and control.

 Thus, the owners could conduct the business in whatever manner they
see fit.

 However, in modern corporations, it is common that

 The assets of the corporation are owned by the shareholders, but

 Controlled and managed by the board of directors and the

management team.
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Separation of Ownership & Control

Shareholders

Own

Company

Control

Directors &
Managers

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 Separation of Ownership & Control

 This separation gives rise to the need of corporate

governance.

 Why ?

 To ensure that a corporations is directed and controlled in

the best interest of its shareholders and other stakeholders.

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 What is Corporate Governance?

 Corporate governance is the internal means by which

corporations are operated and controlled (Cadbury,
1992)

 A set of relationships between a company ’ s

management, its board, its shareholders and other
stakeholders (OECD, 2004)

 It is the relationship among various participants in

determining the direction and performance of
corporations (Monks and Minow, 2001)
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Key Corporate Governance Actors

Shareholders
(Own the
company)

Serve Elect

CEO & Board of

Management Directors
(Run the (Control the
company) company)

Hire

Source: John L. Colley, Jacqueline L. Doyle, Wallace Stettinius, George Logan (2005) What is Corporate
Governance?, McGraw-Hill Professional

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Governance & Management
Governance – the work of the board
of directors or other governing bodies

Management – the work of the

executive and management team,
consisting of, e.g.,

 Chief Executive Officer (CEO), Chief

Financial Officer (CFO),
 Chief Information Office,
 Chief Lawyer,
 Chief Operations Officer (COO), and
 Other managers.
Source: Tricker (2009, p.36)

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The board and management

Outside (non-executive)
directors
Executive directors
Other managers not on
the board

Source: Tricker (2009, p.36)

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Governance & Management

 Management runs the business.

 The board (governance) ensures that the business is

being well run and run in the right direction.

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 SUMMARY – Corporate Governance Internal means:
• Board of directors
Key players: Board • Ownership structure
(governance)
• Remuneration
• Institutional investors
Serve Elect
Management team
These means are formed on the
basis of hard law, soft law,
and/or hybrid law.
≠ Management
Hire

Corporate governance is the internal means by

which corporations are operated and controlled. Why corporations need to be
effectively operated and
controlled ?
• Is it because of the separation
of ownership & control ? Why ?
• What is a corporation ? • What would be the result of
poor governance ?
• How many types of company are there in Australia ?
• Corporate collapse ?
• What is the most important feature of a corporation ?
• Who can be affected ?
• What is the separation of ownership & control ?
 “Hard Law”
• Strict legal rules – corporations have to follow
Internal means to govern a • For examples, Corporations Act 2001 (Cth)
(corporate/company law), judge-made law (common law);
corporation accounting standards, and auditing standards.
• Board of directors

• Ownership structure
“Hybrids”
• ‘Hybrids’ fall somewhere between the two: neither
• Remuneration
mandatory nor purely voluntary.
• For example, ASX Listing Rules, ASX’s Corporate
• Institutional investors
Governance Principles and Recommendations
Formed (2007) (‘comply or explain’ regime)
mainly on
the basis of
“Soft Law”
• Voluntary sources of governance standards that
companies have the freedom to adopt or not
• For examples, other Corporate Governance
Codes/guidelines, e.g., Cadbury Report (1992),
Combined Code (1998, 2003), Sarbanes-Oxley Act
(2002)); scholarly and trade writings (in the form of
books, reports and articles)…
 Sure, corporations need to be effectively
operated and controlled.

BUT HOW ?
.

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 Corporate Governance Theories
(Theories about how corporations should be governed)

 Agency theory

 Stewardship theory

 Stakeholder theory

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 Agency Theory
 In modern corporations, there is typically a separation of ownership
and control.
o The assets of the corporation are owned by the shareholders, but
controlled and managed by the board of directors and the management
team.
o Such a separation is potentially problematic.
o Smith observed in 1838 that:
» ‘The directors of such companies, however, being the managers rather
of other people’s money than of their own, it cannot well be expected
that they should watch over it with the same anxious vigilance with
which the partners in a private company frequently watch over their
own’.

 The agency theory focuses squarely on the relationship between

shareholders & managers of a corporation. 27
 Agency Theory
 The theory is simple - a firm is reduced to only two participants, namely, the
firm’s owners (shareholders) and managers.

 The agency theory proposes that the firm’s owners (principals) hire managers
(agents) and then delegate the firm’s day-to-day operating decisions to these
managers.

 The theory assumes that both parties – owners and managers - seek to
maximize their own personal interests.

o Owners seek to maximize profit.

o Managers seek self-interests (instead of maximizing shareholders’

returns), including short-term earning, low risk projects, and excessive
remuneration…

(Jensen and Meckling 1976, p. 308)

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 Agency Theory
 The principal-agent relationship also gives rise to the
problem of information asymmetry - the principal and the
agent have access to different levels of information.
 This means that the principal is at disadvantaged because
the agent will have more information.
 Information asymmetry also means that it is costly and
difficult for the owners to verify the extent to which the
managers perform the employment agreement .
 The managers thus have a temptation to avoid working to
the terms of the employment agreement.
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 Agency Theory: Principal-Agent
Divergence of Objectives &
Asymmetry of Information

Self interest Self interest

Principal Agent
(Shareholders) (CEO/Mgmt)

Performs tasks authorized

by the principal

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 The principal-agent problems
 Divergence of objectives & asymmetry of information are called agency problems.

 The agency problems give rise to agency costs, i.e. the costs of addressing the agency
problems, including

 Bonding costs:

o To encourage the managers to work in the best interest of the owners, the owners have to provide
a variety of incentives, such as, generous remuneration, stock option grants or restricted stock
grants.

o Bonding costs also mean it is hard and costly to write and enforce the contract between the
owners and the managers.

 Monitoring costs:

o For example, annual audit of the manager’s financial statements; constructing an effective board
of directors.

 Residual loss: regardless of these mechanisms, managers may still make decisions that are not in
the best interest of the owners. The finical loss resulted from these decisions called ‘residual loss’.
 Agency Theory: Agency Costs
Divergence of Objectives &
Asymmetry of Information

Self interest Self interest

Agency Costs:

Bonding Costs Agent

Principal
Monitoring Costs
(Shareholders) (CEO/Mgmt)
Residual Loss

Performs tasks

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 Agency theory – Governance
mechanisms
 The agency theory considers corporate governance mechanisms,
especially the board of directors, as an essential monitoring
device to ensure that senior managers act in the best interest of
shareholders.

 Blair (1996) wrote:

o Managers are supposed to be the "agents" of the "owners“, …

o … but managers must be monitored and institutional

arrangements must provide some checks and balances to make
sure they do not abuse their power.

 The agency theory is the most prominent and important theory about
corporate governance.

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 Agency Theory & Its implications
for Governance
 Strong, independent boards of directors

 CEO and board chairman to be different persons

 Outside/Non-executive directors advocated

 Important role for Audit and Remuneration Committees

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 Limitations of Agency Theory
 Perrow (1986) noted that the theory’s view of individuals as
opportunistic and self-seeking may be too simplified.
 Eisenhardt (1989) thus recommended that
 the agency theory should be used with other theories …
 … because the agency perspective “presents a partial view of
the world that, although it is valid, also ignores a good bit of
the complexity of organizations. Additional perspectives can
help to capture the greater complexity” (p. 71).
 Additional perspectives include the stewardship and
stakeholder theories.
35
 Stewardship theory
 Based in the works of Maslow and Argyris - Psychology & Sociology.

 It rejected the fundamental premise of the agency theory, i.e. managers are
driven exclusively by self-interests.

 Instead, it suggests that individuals are motivated by a range of non-economic

factors, including the need to

o achieve,

o gain intrinsic satisfaction through successfully performing challenging tasks,

o exercise responsibilities and authority, and

o gain recognition from peers and bosses (Donaldson,1990)

 As a result, managers are good stewards/servants of the corporations, and

possess sufficient self-motivation to act in the best interest of the owners.
36
 Stewardship theory

 The theory is a different perception of human

behaviour.
 Thus, it represents a different approach to corporate
governance.
 Particularly, empowering/entrusting managers to
exercise authority and responsibility will facilitate the
maximisation of the organisational financial
performance and shareholder value.

37
 Stewardship theory and its
implications for Governance
 Governance structures should effectively facilitate,
empower, and entrust managers/stewards rather than
monitor and control them.

o CEO and chairman to be same person – role duality

o Inside directors advocated

o Board members act as advisors to Management

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 Limitations of Stewardship Theory
 The assumption that individuals are motivated by a
range of non-economic factors/noble purposes is over-
simplified and unrealistic.

 Executive behaviour has often proved to be

opportunistic.

 Human behaviours are not fixed or unchangeable – from

good servants to bad masters.

 Lack of empirical evidence.

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Stakeholder theory
 It is a perspective on CSR as well as CG.

 In contrast to the agency theory, the stakeholder theory

rejects the assumption that the sole important relationship
in a corporation is the relationship between the principals
(shareholders) and agents (managers).

 Instead, stakeholder theory considers a corporation from

a much broader perspective: shareholders are only one of
many stakeholders (e.g., employees, customers,
government authorities, and local communities).

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Stakeholder theory
 Thus, the stakeholder theory suggests that

o It is important to maintain & enhance shareholder value.

o However, at the same time, the interests/value of other

stakeholders, e.g., employees, creditors, customers and
suppliers, should also be taken into account.

(Donaldson and Preston, 1995).

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Stakeholder Theory and its
Implications for Governance

 CEO and chairman to be different persons

 Outside directors advocated

 Stakeholder-oriented board: large board size with

representatives of stakeholders such as significant
customers, suppliers, financial advisers, employees and
community representatives (Porter, 1992)

 Important role for Nomination Committee

 Should encourage long-term employee ownership 42

Limitations of Stakeholder
Theory
 Hard to identify legitimate stakeholders

 Balancing stakeholder interests is an ill-defined

notion

 If management is made to be accountable to

multiple stakeholders, it may effectively end up
accountable to no one

 Maximising shareholders’ interests is the sole

legal purpose of a firm.
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 Conclusions
 Corporate governance is a relatively new area.

 Agency theory - the most influential.

 Stakeholder theory takes account of a wider group of stakeholders rather

than shareholders.

 Stewardship theory is relatively new with little empirical results/support.

 These theories are not exhaustive but provide useful guidance as to how
corporation should be governed.

 The development of corporate governance has proven that board of

directors, ownership structure, and remuneration are among the most
important corporate governance tools.

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