Agency Theory and Corporate Governance - Research Paper Example

Agency Theory and Corporate Governance Abstract The objective of this paper is to evaluate the definition of corporation as a ‘nexus of contracts’ for interpreting its compatibility in the present modern business and thus to examine the importance of corporate governance. For the purpose of fulfilling the objective of this paper, the definition of firm as a nexus of contracts has been presented and its relation to the agency theory has been evaluated. It was found that the assumption of agency theory with respect to this definition states that self-interest of the individuals is the main basis of their wealth maximization. For verifying the assumption of the agency theory, the insights of the definition towards the theorists have been researched. It was discovered that there are various critics to this notion of the agency theorists in the modern world. The critics determined that the factor of morality has been ignored by the definition of the agency theorists. Moreover, for measuring the characterization of the definition towards importance of corporate governance, research was done and its was found that the definition has been termed as ‘misleading’ by various critics because of the fact that it incurs legal enforcement of the shareholders while at the same time shareholders hold the least power of legality among all the stakeholders. Introduction The agency theory in relation to the corporate governance represents a two-stage mode of controlling the firm. The two levels are those of the managers and the owners. This research paper is aimed towards discussing the various significant issues related to the existence of agency theory in a corporation. The paper will focus on the interpretation of ‘nexus of contracts’ in relation to the agency theory and corporate governance. The paper found its basis from the fact that the interest groups or the stakeholders in a corporation have their own contracts and since they operate within a corporation, there prevails ‘nexus of contract’ (White, 2011). Corporation as a ‘Nexus of Contracts’ Agency theory assumes that conflicts prevail among the stakeholders pertaining to the fulfillment of individual objectives. In general terms, corporation is an entity that enhances growth through expanding of the firm’s financial resources. The use of the phrase, ‘nexus of contracts’ provides a new dimension to the corporation definition. Under this term, the problem of conflicts within a firm is observed as a unit of the contract enforcement. Agency costs are determined as the contract enforcement costs on the basis of the assumption that corporation often acts as ‘nexus of contracts’. Under this definition, the structure of the corporation is defined to be adapting to an attempt aimed towards profit maximization by way of trading among the different parties of contract that meets within the corporation (Maloney, 2003). Relationship between Nexus of Contracts and Agency Theory The definition of the firm ‘nexus of contracts’ has been provided by the agency theory. The nexus of contracts has been defined among various suppliers of a firm’s resource. The nexus of contracts presume two central parties to the agency theory. These are the principals and the agents. Principals are those who supply the capital to the firm and agents are those who manage the operational functions of a firm. Agency costs are encountered by the organization because of the reason that the interests of the two parties do not coincide. The costs of contract enforcement under this presumption consists of the cost of observing the agents’ behavior inclusive of the practices of compensation, restrictions of budget allocation and also the profit and loss because of the rules of operations and that of management restrictions (Proffitt, 2000). Insights of ‘Nexus of Contracts’ for Agency Theorists Under the assumption of the agency theory that defines a firm as a nexus of contracts, it is taken for granted that it is the self-interest of the parties which acts as a motivator and this is true in case of both the principals as well as the agents. Self-interest is explained as the mode of maximizing the benefits of wealth of the stakeholders individually. But the agency theorists, during this assumption had made no allegation of the term and concept of morality. Rather, the theorists claimed that self-interest is the best explainer of the motivation of human beings. However, this presumption of the agency theorists had generated an enormous number of criticisms in the financial ethics prose. Furthermore, in the definition of firm as a nexus of contract, several ethical implications also exist. The agency theorists stated that the definition does not take into account the factor of “personalization” of the firm. At the same time, the entire responsibility for the actions of the firms is placed on to the agents who take the decisions. The critics of the definition of the firm as a nexus of contracts are of the view that there is de-emphasize of the ethics’ role in the improvement and endorsement of corporate policies. They also mentioned that the definition bears an implied promotion of the “value-free” practice of decision making under the financial regime (Rhee, 2008). Nexus of Contracts Characterization towards Emphasizing Importance of Corporate Governance within Corporations Agency theory, determining the concept of firm as a nexus of contracts, depicts the dominant view of corporate governance. This theory disregards task of the corporate governance as generation, accumulation, transfer and safeguard the specific knowledge of the firm. The characterization of this definition puts emphasis on the importance of corporate governance within a firm. It represents that a knowledge worker is not in a position, in any way, to make a contract with his future knowledge. It is only the insiders who can interpret the specific knowledge of the firm and monitor its creation and alteration. Thus, the corporation should have a greater reliance on the insiders than any other stakeholders. It has also been implied from the definition of nexus of contracts that the insiders should be selected only by those employees of the firm who are concerned of taking the knowledge-specific decisions of the firm. The firm’s outlook as a nexus of contracts provides a dominant view to the theory and practice of the corporate governance. It holds the shareholder’s supremacy. However, this approach of the agency theory becomes inadequate in the consequences of the firms in modern world which focuses on gaining competitive advantage by utilizing knowledge and not actual investments by outsiders. The agency theory or firm’s outlook as a nexus of contracts is somehow misleading and depicts the firm as legalistic picture. The critics have even argued that the supremacy of shareholders cannot be justified as fewer contractual safeguards are held by the shareholders than any other stakeholders of the firm. Thus, the characterization of the nexus of contracts itself emphasizes the significance of corporate governance within firms (Osterloh & Frey, 2006). Conclusion From the discussion made over the evaluation of the definition of corporation as a nexus of contracts, it has been sorted out that this definition has evolved as a dominant definition over the corporate governance of a firm. The definition, although, holds contractual enforcement, it fails to consider several other important aspects of the firms’ operations. Morality and knowledge are among those aspects. It has been, however, derived from the discussion that the definition does not hold well in the operational norms of the present world’s firms. As a concluding statement to the above discussion, it can be mentioned that the firm’s definition of the nexus of contracts is misleading for modern firms which works on knowledge specific views. This presumption of the definition puts specific emphasis on the importance of corporate governance for a firm. References Maloney. (2003). A study in property rights, inter-firm contracting. Retrieved May 18, 2011, from http://myweb.clemson.edu/~maloney/827/3.pdf Osterloh, M. & Frey, B. S. (2006). Corporate governance for knowledge production: theoretical foundations and practical implications. Corporate Ownership & Control / Volume 3, Issue 4, Summer. Rhee, R. J. (2008). Corporate ethics, agency, and the theory of the firm. Journal of Business & Technology Law. White, R. F. (2011). Corporations: descriptive and prescriptive dimensions. Retrieved May 18, 2011, from http://inside.msj.edu/academics/faculty/whiter/NEXUSOFCONTRACTS.htm Read More