Comparing Agency Theory and Stakeholder Theory - Essay Example

? Comparison and Contrast Between Agency Theory and Stakeholder Theory of the of the of the or Institution Date of Submission Comparison and Contrast Between Agency Theory and Stakeholder Theory Introduction “Agency theory explores how contracts and incentives can be written to motivate individuals to achieve goal congruence” (Anthony, Dearden and Vancil, 1972, p.530). The theory identifies the main criteria to be taken into consideration in designing incentive contracts or incentive compensation arrangements. An agency relationship is established when one party: the principal hires another party: the agent to carry out a particular service, thereby delegating decision-making authority to the agent. In a corporation the principal are the shareholders, whose agent is the chief executive officer hired by them; thus, the agent is expected to act in the interest of the shareholders. The main challenge is in motivating the agents to increase their productivity to a level they would achieve if they were the owners. Further, one of the key factors of agency theory is that principals and agents have different preferences or goals; and these divergent preferences can be aligned with the help of incentive contracts. Stakeholder theory is to a great extent not a formal, unified theory, but is more of “a broad research tradition, incorporating philosophy, ethics, political theory, economics, law, and organizational social science” (Solomon, 2007, p.23). Stakeholder theory is underscored by the fact that companies are large and have a far-reaching impact on society; hence they are accountable to many more sections of society than their shareholders alone. A common feature among all stakeholders of a company is their participation in an exchange relationship with the company by providing contributions while expecting their own interests to be fulfilled through ‘inducements’. Stakeholders include “shareholders, employees, suppliers, customers, creditors, communities in the vicinity of the company’s operations, and the general public” (Solomon, 2007, p.23). The environment, animal species as well as future generations are also considered to be stakeholders by some authors. The manager has to maintain the support of all of these groups, balancing their interests, while taking measures to ensure that all the stakeholder interests can be maximized over time in the organization. Thesis Statement: The purpose of this paper is to compare and contrast Agency theory and Stakeholder theory; and to determine which theory offers the most useful insights into corporate behaviour. Agency and Stakeholder Theories are Based on Essential Moral Principles: of Honouring Agreements and Respecting the Autonomy of Others Firms with high levels of agency may face threats from other firms in the business environment, through the mechanism of the market for corporate control. These assumptions are based on presuming the presence of a functional, “efficient, competitive environment, in which information asymmetries are minimal, and competitive pressures are high” (Udayasankar, Das and Krishnamurti, 2005, p.1). Agency theory pertains to discussion on moral hazards and agency costs. Agency theory can only be applied effectively if four moral principles were observed: “avoiding harm to others; respecting the autonomy of others; avoiding lying; and honouring agreements” (Solomon, 2007, p.25). That is, the principal-agent model would be applicable only if it was based on the setting of these moral principles. Thus, the principle of agent morality stated that only when agents fulfilled their basic moral duties as human beings, could they involve themselves in maximizing shareholders’ wealth. Further, Agency theory is interwoven with transaction cost theory. Both provide different views of the theory of the firm and of managerial behaviour, while using different terminology to describe the same problems and issues. For example, while agency theory confronts moral hazards and agency costs, transaction cost theory assumes that people are often opportunistic. Further, the unit of analysis in agency theory is the individual agent, while according to transaction cost theory, the unit of analysis is the transaction. However, the ultimate goal of both theories is the same: the pursuasion of company management to work for shareholder’s interests, as well as profit maximization of both company and shareholder, rather than pursue their self-interest. Thus, agency theory and transaction cost theory are “simply different lenses through which the same problems may be observed and analysed” (Solomon, 2007, p.23). A third lens is that of stakeholder theory. Stakeholder theory (Freeman, 1984) has become increasingly popular with the concept of stakeholder management contributing beneficially to the performance of firms. Udayasankar et al (2005) state that focusing on stakeholders depends on the extent of protection provided to different stakeholder groups. In countries where minority shareholders are given better protection, firm value is higher. In countries with greater protection of minority investor rights, there is curbing of overinvestment in declining industries. Therefore, for achieving an effective system of stakeholder management of firms, it is necessary to identify such stakeholders, through appropriate legislation. Stakeholder theory has been advocated and approved in the management literature because of its three main components which are inter-related but distinctly different from each other: its instrumental power, normative validity, and descriptive accuracy. Donaldson and Preston (1995) found that the three aspects are mutually supportive, and that the “normative base of the theory – which includes the modern theory of property rights – is fundamental” (p.65). Closely related to stakeholder theory is the concept of corporate social responsibility. As a result of increasing environmental, social and political challenges, companies are urged by environmental and social lobby groups to comply with moral and ethical requirements, and satisfy the interests of all the stakeholders of the company. Thus, ethical behaviour has to be adhered to, whether it is profitable or not. Quinn and Jones (1995) reiterate that this approach is termed as non-instrumental ethics, since corporations cannot avoid fulfilling their moral obligations to society, and ethical behaviour has to be followed whether it is profitable or not. On the other hand, companies have “a legal and fiduciary obligation to shareholder wealth maximization” (Solomon, 2007, p.25). Therefore the business cannot be based purely on ethics. However, an illustration of a business case or instrumental ethics approach to social responsibility is found in a recent report by Rio Tinto Company in their Report to Society, 2004, that the company’s commitment to sustainable development has become even more compelling, from a business case perspective. This is based on evidence that companies that maintain high levels of performance in all social, economic and environmental aspects, attract the best people in the business as management and other employees. Adherence to high standards of ethics also increases the motivation and commitment of employees while achieving continued loyalty of their customers, strong relationships with other stakeholders, and stronger corporate reputation. All these factors help to increase shareholder value (Solomon, 2007). Agency Theory: Principals’ and Agents’ Divergent Goals and Information Asymmetry “Agency theory assumes that all individuals act in their own self-interest” (Anthony et al, 1972, p.530). It is assumed that agents are satisfied not only with financial compensation, but also various perquisites and privileges that they can claim, on the basis of an agency relationship. On the other hand, principals or shareholders are believed to be interested only in the financial returns that would result from their investment in the firm. Further, agents and principals also diverge in relation to risk preference. Thus, agency theory assumes that managers opt for more wealth than less, but at the same time, marginal utility or satisfaction decreases as more wealth is obtained. Agents usually have most of their wealth dependent on the fortunes of the firm, this includes both financial wealth and their human capital which depend on the firm’s performance. Therefore, agents are assumed to be risk averse. Company stock is held by many owners who diversify their wealth by owning shares in several companies. Thus, owners are interested in the expected value of their investment, and are consequently risk neutral. Further, information asymmetry is the outcome of the principal having inadequate information about the agent’s performance, and his uncertainty about the extent to which the agent’s efforts contributed to the company’s financial results (Anthony et al, 1972). There are two main control mechanisms for dealing with the problems of divergent objectives and information asymmetry. These are monitoring of the agent’s actions and reducing the agent’s welfare at the cost of the principal’s interest. Other monitoring devices include incentive contracting. An illustration is CBS included a protection clause in CEO Les Moonves’ contract, that would provide him $5 million if CBS was sold to another company. A few months after Moonves arrived at CBS, Westinghouse purchased CBS, and activated the clause again. Other incentive plans include CEO Compensation and Stock Ownership Plans, and Business Unit Managers and Accounting-Based Incentives (Anthony et al, 1972). Significantly, none of the incentive arrangements can ensure the attainment of goals. The reasons are the differences in risk preferences, the asymmetry of information, and the costs of monitoring. These differences result in additional costs. Even an efficient system of incentive alignments would result in divergence of preference, termed as residual loss. Anthony et al (1972) state that agency costs include the incentive compensation costs, the monitoring costs and the residual loss. Corporate scandals involving corruption by companies’ agents, are found to result from divergent goals, information asymmetry, lack of monitoring of agents, and are based on stakeholder theory, public management and agency theory. Agency Theory Results in Failure of Corporate Governance Global concern has been expressed about the limitations of the systems of corporate governance. Besides other countries, all English speaking countries such as Britain, Australia and others have similar system. In Germany, the distance between ownership and control is far less than in the United States. Japan’s system of corporate governance is considered to be mid-way between Germany and the United States, and is different from both in other ways also. The international comparisons indicate varied approaches to the problem of corporate governance, the problem of ensuring that managers act in shareholders’ interest (Crowther and Jatana, 2005). The validity of agency theory is based on the relationship between the principal and the agent. However, Crowther and Jatana (2005) argue that the validity of the theory is challenged by the fact that there can be no relationship between the principal and the agent. Particularly, in the modern world, most managers are almost as impermanent as shareholders, therefore there is no loyalty to the business from anyone involved in the firm’s functions. Under the circumstances, the principal-agent contract is one where the shareholder looks towards growth in share value, and the manager towards rewards, and only in the context of the present, with no farsightedness regarding the future of the business. Thus, the managers are not interested in stewardship, but wish to manage the finances of the firm for immediate benefit, sharing the same with the owners with little consideration for other stakeholders. It is argued by Crowther and Jatana (2005) that relying on agency theory for managing business leads to excesses and corruption by agents and senior level management, leading to a breakdown of corporate governance. Enron Energy-Producing Corporation and other Companies: Corporate Scandals Resulting from Breakdown of Governance Relations The source of almost all the corporate scandals that destabilized American businesses between late 2001 through 2002, have been traced to a “break-down of the governance relation between shareholders, the board, and the senior executives” (Heath and Norman, 2004, p.2), although evidence of any other common explanation for the scandals has not been identified. Thus, stakeholder theory, the company’s corporate governance, and public management are the key elements of the corporate crimes. The Enron scandal is known as one of the biggest white collar crimes in American history. After the corporate crime came to light in October 2001, it ultimately resulted in the bankruptcy of the Enron Corporation, an American energy-producing and trading company based in Houston, Texas. It also led to the dissolution of the Arthur Andersen, one of the five largest audit and accountancy partnerships in the world. Thus, in American history of that time, Enron was not only the largest bankruptcy reorganization, but was also the biggest audit failure (Sterling, 2002). The name “Enron” is used symbolically here to represent the wave of corporate scandals that rocked American business from late 2001 to the end of 2002. These included leading firms such as “Arthur Andersen, WorldCom, General Electric, Tyco, Qwest, Adelphia, Halliburton, Global Crossing, AOL, Time-Warner, Merrill Lynch, Health South and, of course, Enron” (Heath and Norman, 2002, p.2). Since shareholders are given extensive status and control under corporate law, and their interests are taken into consideration by the firm’s management, supporters of Stakeholder theory tend to defend shareholder rights to a very minimum. Stakeholder theorists who took into account shareholders’ rights have largely attempted to limit or circumscribe their rights in order to provide for the rights or interests of other stakeholder groups. However, examining the case of Enron should make us reconsider this assumption, since shareholders during that era could not ensure that all their interests were taken into consideration by senior management. Thus, lessons are evident from this case, for those those with a vested interest in the system of shareholder-focused capitalism, that is, “investors, brokerages, auditors, financial regulators, legislators, and so on” (Heath and Norman, 2002, p.2). These stakeholders reacted swiftly to the bankruptcy and audit failure of the company. Authorities hastily attempted to identify flaws in the governance relation that had allowed the occurrence of the most conspicuous wrong-doing, and further proposed to patch up the flaws, frequently in the form of revised regulations or voluntary codes to prevent or discourage the occurrence of similar scandals in the future. Therefore, almost all the post-Enron reforms were undertaken to strengthen the accountability of corporate executives to their boards and their shareholders. The authors argue that stakeholder theorists who opposed the dominant shareholder-focused conception of the firm, stood to gain even more important lessons. First, stakeholder theorists underestimated the importance of shareholder interests and shareholder control for promoting the interests of other stakeholders of the firm. Hence, each of the stakeholders of Enron was negatively impacted when the company’s senior managers “conspired against the interests of the shareholders, and when investors lost confidence in the company” (Heath and Norman, 2002, p.3). Second, issues of governance and corporate law need to receive greater attention among those who promote stakeholder theory, or who advocate a shift from the shareholder-focused conception of the firm. Heath and Norman (2002) believed that there should be an integration of the interests of shareholders and other stakeholders, and studied the relevance of agency problems to governance in general, and to the governance of firms based on stakeholder theory. The corporate scandals which occurred during the Enron era were essentially due to “a failure of these firms and their shareholders to protect themselves against agency problems” (Heath and Norman, 2002, p.3). Senior executives or agents acted against the interests of the principals or shareholders, by exploiting information asymmetries and conflicts of interests on the board. They evidently had a reasonable expectation of evading punishment. The authors investigated whether governance relations in firms that operated on stakeholder theory, could be safeguarded from comparable agency problems. The reason for a cautionary approach to agency theory and public management will be that any restructuring of corporate law and corporate governance to encourage stakeholder management, could lead to firms that can potentially be vulnerable to both the internal fraud of Enron and the extensive inefficiencies of companies such as Ontario Hydro or British Steel. Because of these potential problems, the basic concepts of stakeholder theory may best be met by strategies ensuring a shareholder-focused governance structure in the firm. Therefore, the significance of using the stakeholder theory is emphasized, for improved organizational behaviour. The Failure of Corporate Governance in the Case of Parmalat Dairy Foods Co. In the Parmalat group, a global frontrunner in the dairy food business, a standard accounting fraud was initially revealed. However, the company eventually collapsed and had to acknowledge extensive holes in its financial statements, and seek bankruptcy protection in December 2003. Several billion euros were found missing from the firm’s accounts. This sensational collapse resulted in doubts regarding the quality of accounting and financial reporting standards, “as well as the Italian corporate governance system” (Melis, 2005, p.478). Research evidence indicates that information supply agents in Parmalat were not held accountable in carrying out their work. The agents include the board of directors, board of statutory auditors, internal control committee, senior management and external auditing firm. It was confirmed that there was “lack of a monitoring structure making corporate insiders accountable in the presence of a corporate governance system characterised by a controlling shareholder” (Melis, 2005, p.487). Based on the Italian traits of the roles of the ownership and control structure, with respect to the controlling shareholder’s role, and of the board of statutory auditors, it may appear that Parmalat is a specifically Italian corporate governance case. Additionally, the controlling shareholder held his positions of Chairman and CEO of Parmalat Finanzaria which resulted in an extensive accumulation of powers. Although this state of multiple positions is uncommon among large Italian listed companies, the separation of the two positions is not recommended by the Italian code of best practice. Hence, Parmalat formally complied with it. On an international level, Italian corporate governance is not of the highest standard; however the standards in themselves were not entirely at fault in the Parmalat case. It was found that Parmalat’s corporate governance structure failed to comply with some of the key existing Italian corporate governance standards of best practice such as the presence of independent directors and, particularly of the internal control committee as non-effective monitors appear to suggest that the Parmalat case is suitable for the global corporate governance argument. It is not entirely different from Enron or other Anglo-American or continental European corporate scandals. While the Parmalat case pertains more to the Italian context, its corporate governance problems cannot be disregarded on grounds of being country-specific, since the same conditions can appear in other firms around the world (Melis, 2005, p.487). The Utility of Agency Theory and Stakeholder Theory Although agency theory is considered to result in failure of corporate governance, on the other hand, numerous studies validate agency theory predictions in different contexts. Some contexts that apply agency theoretic framework include firms’ public offer of new capital, franchisee set up, technology strategy in new product development, and labour union transactions. The reason why a firm’s diversification strategy is likely to reduce firm value is because diversified firms trade at a discount. This is in contrast to their single-segment peers. Earlier studies found a significant link between greater shareholder wealth and focused strategy for many leading United States firms, state Bowrin, Sridharan, Navissi and Braendle (2006). When diversification can lead to reduction in value, managers resorted to corporate diversifications since their private benefits including incentives and non-financial such as perquisites, privileges and power, were related to diversified portfolio. Moreover, franchisee set up is regarded as efficient to minimize agency problems of shirking. Since franchisees are compensated from the residual claims of their individual units, they normally bear the costs of shirking either entirely or to a great extent. While agency theory is supported empirically, new research studies investigate the theory’s utility for newer variants of organizational structures. Additionally, new studies also analyse agency theory’s applicability as compared to other theories. For example, corporate diversifications are examined with strategic management-led stewardship theory as, against agency theory which is organizational economics-led (Bowrin et al, 2006). For optimising corporate behaviour, the theory of ownership structure for the firm integrates aspects of the theory of agency, property rights, and finance based on the reasoning that ownership and managerial interest may not be the same, thereby resulting in corporate inefficiencies and subsequent costs to the firm. The scholars’ analysis reveals new implications in relation to the definition of the firm, the differences between ownership and control, coporate social responsibility, corporate objective function, “the determination of an optimal capital structure, the specification of the content of credit agreements, the theory of organizations, and the supply side of the completeness of markets problems” (Jensen and Meckling, 1976, p.305). On the other hand, the adverse implication of Agency theory is that managers in nonprofit and governmental organizations who are not provided with incentive compensation, basically lack the motivation for aligning their goal with that of the owner or principal. Further, the components of the theory cannot be quantified, for example estimating the cost of information asymmetry would not be possible. Additionally, the theory oversimplifies to a great extent the relationship between superiors and subordinates. Anthony et al (1972) reiterates that the model uses only a few elements while not taking other essential factors into consideration such as: the personalities of the participants, motives unrelated to finance, agents not risk averse, the principal’s trust in the agent, the agent’s level of capability, and other reasons. It is increasingly likely that the creation of value for stakeholders by companies that focus on maximizing value for communities, employees, environmental impacts, and other factors, may actually create more financial value for shareholders. Therefore, neglecting the requirements of stakeholders can lead to decline in financial profits and ultimately result in corporate failure. A contrasting aspect to this concept is that satisfying the needs of a diverse group of stakeholders may not necessarily lead to achieving the ultimate goal of shareholder wealth maximization. In the long-term, it is found that both agency theory and stakeholder theory have the same objectives. Thus, only by taking into consideration both stakeholders’ and shareholders’ interests, can “companies achieve long-term profit maximization and ultimately, shareholder wealth maximization” (Solomon, 2007, p.29). Requirement for a Combined Agency-Stakeholder Theory and Conclusion This paper has highlighted agency and stakeholder theories of the firm. Both theories offer useful insights into corporate behaviour, but also have their limitations. The interests of principals and agents diverge mainly because of their different utility functions. This can result in direct conflict regarding the use of resources. Agency theory focuses on the divergence of interests between managers and stakeholders. On the other hand, Hill and Jones’ (1992) stakeholder-agency theory takes into consideration the causes of conflict between managers and stakeholders as a result of disequilibrium conditions. Further, stakeholder-agency theory also indicates a theory of the adjustment mechanisms that integrate management and stakeholder interests. The core issue in the debate between agency and stakeholder theories of the firm consists of two competing views of the firm. Due to the sharply contrasting assumptions and processes of the approaches, agency and stakeholder theories are frequently considered to be polar opposites. According to Shankman (1999), agency theory can be incorporated within a general stakeholder theory of the firm. By analysing the assumptions of agency theory, the author argues that the theory must include a recognition of stakeholders; uphold a moral minimum placing four moral principles as essential and unaffected by the interests of any stakeholders including shareholders; and infuse trust, honesty and loyalty into the agency relationship as an offshoot of agency theory’s inherent contradictory assumptions about human nature. The author uses empirical hypotheses to substantiate his argument that stakeholder theory is the logical conclusion of agency theory. Laplume, Sonpar and Litz (2008) reported an extensive increase in the prominence of stakeholder theory in the last fifteen years. Shareholders’ theory being another term for agency theory, it is important to integrate this theory with stakeholder theory, for obtaining best practice in corporate governance. This was seen in the examples of Enron and Parmalat companies, as well as other corporate scandals, where further monitoring of the company’s agents was crucially required. The authors recommend further empirical research across a wider range of organizations, more qualitative research to investigate the cognitive aspects of managers’ response to stakeholders’ expectations, and greater focus on the theory’s emphasis on the positive outcomes related to stakeholder management, through with a broader perspective on firm performance, and focus on the roles of various agents, with extensive monitoring and regular evaluation of their work. Therefore, it is concluded that for obtaining the most useful insights into corporate behaviour, it is necessary to use a combination of agency and stakeholder theories, incorporating the former concept into the latter, as suggested by Shankman (1999). Word Count: 3998 words Bibliography Anthony, R., Dearden, J. and Vancil, R. (1972). Management control systems: Text, cases and readings, New York: Tata McGraw-Hill Education. Bowrin, A., Sridharan, V., Navissi, F. and Braendle, U. (2006). The theoretical foundations of corporate governance. Retrieved on 28th March, 2011 from: http://www.virtusinterpress.org/additional_files/book_corp_govern/sample_chapter02.pdf Crowther, D. (2004). Managing finance: A socially responsible approach. Oxford, England: Butterworth-Heinemann. Crowther, D. and Jatana, R. (2005). Agency theory: A cause of failure in corporate governance. 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