Advisability of the Appearance of Agency Theory - Essay Example

Agency theory As per the traditional view, the purpose of the existence of the company is to earn and maximise profits. The company formation was mainly due to personal benefits of the owners and managers of the company. The conventional view deals with the earning of profits and maximizing of shareholders wealth. The traditional view was more of closed system thinking (Alphen, 2010). It lacked a well defined hierarchy system. The authority and powers were vested upon the owner of the company. There was no scope of creativity for the workers. The fault in any error of the production system lay on the workers of the company (Hoffman, 2007). The emergence of the concept shareholders value arose from the concept of separation of ownership and control which is also known as fragmentation of ownership. The concept focussed on how the owners of the company usurp the company’s profits for personal interest. The concept of shareholders emerged to enhance the betterment of the company. The relationships between the banks and the companies in UK prevented concentrated share ownership of certain companies in UK. The prevalent laissez –faire policy in the UK focussed on the non economic interest of the company and wanted to underpin the emerging corporate economy. There were sudden changes in the policies of the company where there was minimum government intervention and the concept of shareholders value evolved. The concept revolved around the fact that individual private owners of the company are the shareholders of the company, and managers have to act in accordance with their decisions. Whenever shareholders were unavailable for decision making in a meeting, the managers of the company would make the decisions on the shareholders behalf (European Investment Bank, 2012c). This ensured that the divergence between the interests of shareholders and managers did not become too extreme. The modern day business practices regard shareholders as the owners of the company. They usually buy the shares of the company (European Investment Bank, 2012a). There is no specific amount of shares that need to be bought in order to become a shareholder of the company. Shareholders can exercise their voting rights in the company. There are some exceptions, like the Kuala Lampur Stock Exchange prohibits the shareholders from exercising their voting rights. Shareholders regard the annual meeting as a serious event as they can question the management regarding issues which are pertaining to the company and are included and excluded in the annual report. They are also involved in frank and vivid discussions with the board of directors regarding legal and procedural requirements. Shareholders can contribute towards the corporate governance of the company if they exercise their rights judiciously (The UK Shareholders Association, 2010). The exclusive rights of the shareholders are to convene general meetings of a company, attend, proxy and make decisions at a meeting, vote at general meetings, and to enforce these rights (Securities commission, 2000). Shareholders are given exclusive rights of voting and making decisions on behalf of the company. Shareholders are given these exclusive rights because they bear with the residual risks of the company. This is one of the primary reasons of their privileges. The shareholders do not have the first claim on the company assets, when it is liquidated. The privilege belongs to the creditors of the company. The shareholders have a claim on the dividends, if declared by the company (Gamble and Kelly, 2001). Maximizing the shareholders wealth is a major purpose of the management of the company (Chandler and Werther, 2010). Corporate Values have to be undertaken by the company to promote goodwill of the company. For example: Companies have to comply with the ISO 26000 standard which provides certain guidelines to the companies for undertaking social responsibility (European Investment Bank, 2012c). These components form an integral part of decision making of the management as they not only provide guidelines to the company but also transparency to the shareholders of the company. The board of directors form an integral part of the company as their primary duties are to maintain financial statements, balance sheet, and director’s report for each financial year. They are also liable to act honestly and diligently by providing the true and fair report. The members of board of directors should not engage in certain practices, such as Insider Trading (European Investment Bank, 2012b). A member of board of directors should enter into a transaction of a company only by taking the resolution of other members of the board. They should not exercise their powers for collateral purposes (Securities commission, 2000). The decision making power in a general annual meeting of the company lies with the shareholders of the company. However, if the company is small then it becomes an easier task for the board of directors to include their voting rights. If the company is big then it becomes impractical and irrational for the shareholders to make various decisions for the company. This makes it necessary for the company to have a separate body to run the activities of the company. This step is necessary for the welfare of the company. The powers between the board of directors and shareholders are divided by four means, such as, a) the common law, b) memorandum and articles of association, c) the companies act of a particular country, and d) the listing rules should comply with the relevant stock exchange in case of listed companies (Securities commission, 2000). The articles and memorandum of association clearly defines the powers of management of the shareholders and board of directors. There are certain rights and powers exclusively preserved for the board of directors like the alteration of memorandum and articles of association. Few shareholders attend the annual general meeting of the company which naturally makes the board of director the most powerful body in the annual general meeting (Securities commission, 2000). Corporate Governance involves the regulatory and market mechanisms and the relationships between the shareholders, stakeholders and the management of the company. The corporate governance of the company promises the welfare of the shareholders of the company. It reduces the perceived risk of companies (Expert Corporance Governance Service, 2013). The UK corporate governance implemented in the year 2010 focussed on the behaviour of the chairman, importance of the behaviour of the board of directors and long term success of the companies. The financial crisis in the year 2008 demanded the implementation of a new set of corporate governance codes. The implementation of this corporate governance was successful as there was no systematic failure under this corporate governance method (Copnell, 2010). It was one of the best mechanisms that dealt with the financial crisis of 2008. Good corporance governance method is instilling moral and ethical practices in the company (Kaushik and Pande, 2009). The implementation of these codes was necessary amidst the financial crisis as the management should be clear about the strategies and risk appetite of the company (Kaushik and Pande, 2009). There have been certain flaws in the risk management and incentive system (Copnell, 2010). Firstly, the nature of the business model should be explained to the shareholders and the board of directors of the company. Secondly, the Board of directors should decide the risk appetite of the company and clearly state it to the shareholders. Thirdly, performance related payment to the employees should adhere to the long term interests and policies of the company. Lastly, members of the board of directors should be re-elected annually (Copnell, 2010). The concept of stakeholder’s theory was introduced by Stanford Research Institute in the year 1963. He defined that stakeholders are a group of members of the company without whom the company would cease to exist. Later, the concept was developed by theorist Edward Freeman. Stakeholders include creditors, suppliers, government and the employees. The debate “Stakeholders versus Shareholders” in the early part of nineteenth century between theorists A.A Berle and M.Dodd sparked controversies across UK. The debate occurred during the great economic depression of United States of America (USA). The debate began with A.A Berle stating that shareholders are the sole beneficiaries of the company and stakeholders are the mere trustees of the company (European network and Information Security Agency, 2010). Later, the theorist M.Dodd retaliated by stating that shareholders need to be protected and given more powers of the company so that the company is not usurped by the managers for personal benefits. The crux of this debate was that the stakeholders were ignored and benefits were given only to the shareholders. The background of the debate was mainly influenced by the fact that the American and UK companies were being out beaten by the Japanese and German companies (Friedman and Miles, 2006). Agency theory defines the relationship between the principal and agent. There are major conflicts between the two parties because both the parties may not cooperate with each other (Mallin, 2007). For example the principal may not act in accordance with the best interest of the company and vice versa. As per the corporate governance principle, principal and agents are played by shareholders and managers respectively (Amah, 2009). The theory states that managers tend to use the company for their own personal benefits and so their regular actions should be checked and monitored (Pitt, 2011). The costs arising from the misuse of their power is determined as “Agency costs” (Mallin, 2007). The theory usually cites the relationship between the managers and shareholders but the theory can also be applied to show the relationship between creditors and managers. There is a separation between ownership and control and this was cited by the theorist Adam Smith in 1838. He explained that managers run the company with the shareholders money and so they cannot be the owners of the company and there must be a difference between the two. The relationship between the ownership and control as outlined and defined by the theorist A.A Berle is applicable to the USA and UK countries (Shalhoub, 2002). In the last few years the pressure on the shareholders has increased significantly and this is due to the issues like overpayment to the director for poor performance, shareholders losing their investment money etc. Decisions taken by the shareholders have made a positive impact in the company. This is because the shareholders have adhered to the corporate governance codes and there has been transparency between the management of the company and the shareholders. Investors are better informed about the current financial position of the company and this has resulted in curbing down of the malpractices performed by the management of the company. Shareholders ensure that the resources of the company are utilized to the optimum level, which in turn should benefit the shareholders and society as a whole. Both the parties, agents and principal favour different corporate governance structures (Mallin, 2007). The agency theory is a very primitive concept and has influenced concepts like corporate governance. Corporate governance theory has been greatly influenced by the Agency theory. Figure 1: Influence of Agency Theory (Source: Mallin, 2007) Corporate governance emphasizes that the shareholders should be treated fairly and given the authority to exercise their rights. The managers of the company should realize that stakeholders are also an important part of the company. The stakeholders should be given due importance. The difference in the ideas and beliefs of the shareholders and management of the company leads to potential conflicts. This can be sorted out if there is clear communication between the principal and agent. Agency theory reflects that much of the company culture is based on self interests. Agency theory has made two important contributions to the company culture. The first would be the treatment of information; information is treated as a purchasable commodity. This gives importance to information systems like Management by Objectives and budgeting concepts. The company can invest in information systems to control agent opportunism. From an agency perspective, boards can also use monitoring devices for shareholders benefits. The second contribution would be the risk implications. A company witnesses uncertain futures which may result in prosperity or bankruptcy. Agency theory helps in ascertaining outcomes under different situations. However, it was found that demand and technological uncertainty did not affect the make or buy decision of the company (Clarke, 2004). As per the theory the total control of management is not feasible. In agency theory the shareholders have the right to get correct and adequate information. In reality the equity share holders are not provided with true and correct information. Equity shareholders do not even get to make decisions on behalf of the company. The equity shareholders rely on self regulation mechanisms. The theory is actually a limited success in reality and very few companies practice this theory. Stewardship theory is an alternative approach to Agency theory and Transaction cost of economics. It is based on the assumptions of the underlying concepts of Agency theory and Transaction Cost of Economics (Clarke, 2004). The Stewardship theory emphasizes on the beneficial consequences on shareholders returns. The theory emphasizes the fact that the managers are not motivated by individual goals. They are stewards whose motives should adhere with the objectives of the company. A steward’s goal will always align with the interest of the company (Fernando, 2009). Control can be potentially counterproductive because it undermines the pro-organisational behaviour of the firm (Fernando, 2009). The basic goal of stewardship theory is to minimize the conflict between the corporate management and the board of directors of the company. The theory assumes that managers are basically trustworthy and give high priority to the interest of the company. Correct financial reporting and auditing are important mechanisms that can be possible only with the managers trustworthiness (Fernando, 2009). Transaction cost of economics views the company as a governance structure. The theory emphasizes on the fact that the company needs to undertake certain transactions seriously like reduction of strategic cost and operational costs. The theory emphasizes that as the company grows bigger, the less efficient it becomes. The management of the company need to focus on lowering the operational costs of the company rather than looking for opportunism (Mallin, 2007). Therefore, we can say that in the agency theory power rests with the institution and there is little attachment towards the company. The agency theory philosophy is control oriented and emphasizes on the fact that a company should focus on cost control (Gibbons, 2003). The Theory deals with greater amount of uncertainty and risk. Stewardship theory on the other hand emphasizes on the fact that power of the company should be vested upon the managers of the company. There is too much attachment towards the company and the theory is philosophy oriented (Fernando, 2009). The theory advocates the empowering and training of managers. The objective of Stewardship theory is to improve the performance of the managers of the company (Fernando, 2009).Corporate Governance is basically a very new concept and the concept has been affected by many theories. Agency theory provides a theoretical framework and has been the most controversial theory. Stakeholder theory is the most applied theory (Alexander and Akehurst, 1999). Stakeholder theory makes the managers aware that they cannot operate the company in isolation and should be equally dependant on the shareholders and stakeholders of the company (Clarke, 2004). It is concluded that shareholders make decisions for the betterment of the company. The managers, board of directors and the shareholders should have equal amount of say in the decision making of the company. The management should follow the basic principles of stewardship theory to clear conflicts with the shareholders and board of directors. This facilitates communication between management and the shareholders of the company. Shareholders should take the initiative of taking quality decision making. References Alexander, N. and Akehurst, G., 1999. The emergence of modern retailing 1750-1950. London: Routledge. Alphen, V.E., 2010. Modern and traditional business management: An overview of two ideal types of management, their differences and influences on performance. 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