Agency theory and corporate governance - Assignment Example

?Introduction Involving a series of intentional fraud and corruption, the Enron, Worldcom, Northern Rock and Bank of Credit and Commerce International scandals were just a few of the biggest financial scandals ever recorded for the last two decades. Intervention of regulatory authorities and shareholders for corporate governance increased (Burton, 2000) in a way that provoked the initiation of several conventions -- particularly notable are the Cadbury (1992), Greenbury (1995) reports and the Combined Code (1998). These codes have always served as the groundwork for corporate governance among UK listed companies. The Combined Code adopts the best practices stipulated in both the Cadbury and Greenbury conventions. Despite the financial scandals, the Combined Code was able to guide, though less significantly, listed companies in improving corporate governance. In this light, this paper determines whether the actual and strict compliance to the code, while may not be legally binding, had in a way assisted in improving corporate governance among listed companies. The Combined Code for UK Listed Companies It was following the bankruptcy of a large UK company, Polly Peck, the defunct of the Bank of Credit and Commerce International, and the fraud committed by Robert Maxwell when the Cadbury Commission was founded in 1992 and provoked the issuance of the code of best practice for corporate governance, the Cadbury Code (Davidson, 2008). The Cadbury Code clearly laid out the framework for corporate governance in the guise of accountability, integrity, or honesty (Applied Corporate Governance, 2009). The Greenbury Code, on the other hand, centered on the director’s remuneration and its lack of transparency (Davidson, 2008). The Combined Code, a result of both the Cadbury (1992) and Greenbury (1995) codes (hence the name), includes the best practices for corporate governance specifically with regard to the quality of the board, division of offices of the chairman and the managing director, balance of the executives and the non-executives, remuneration of directors, and the nomination committee (Sealy & Worthington, 2007). As opposed to the previous codes, the combined code employs principles (Davidson, 2008). In the Cadbury convention, the most notable aspect which the Combined Code adopted was its approach on ‘compliance and explanation’ in a way that the listed firms should report the extent to which they have complied with the code and/or explain any form of non-compliance (Sealy & Worthington, 2007). This approach does not only produce external impacts but also importantly internal impacts for it allows a firm to identify which parts or principles of the code worked best for the company and what did not. As a head start, regulatory authorities may now be able to determine which parts of the code are faulty or that do not yield positive results. Added to strict rules and requirements for capital and liquidity, the said approach will define the most effective method for corporate governance (Walker, n.d. as cited in Haddrill, n.d.). Although the Cadbury report and the succeeding ones do not bind companies into a legal obligation, it has become habitual among listed companies in that the Stock Exchange deems it necessary (Sealy & Worthington, 2007). The Combined Code ensures that all constituents in the corporation incur optimal gains and minimal losses in the course of maximizing profit and reducing costs. In essence, the concept of corporate governance seems easy to apply. In practice, however, the connectedness between the shareholders and the managers for the most part creates conflicts of interests -- the agency problem. The abstraction arising from contracts allows agents (e.g. managers) to act in effort to benefit from an endeavor that may, in turn, work against the favor or interests of the principal (e.g. shareholders). Effectiveness of the Combined Code in Relation to Agency Problems In order to determine the effectiveness of the Combined Code in practice, that is, in identifying the effects it created on the corporate governance among listed companies, the impact may be measured in the degree of efficiency of the board and qualities of the board members who are leveraged by the attractiveness of the approved director’s remuneration report; in the positive impacts of the division of the roles of the chairman and the managing director, and balance of the membership among executives and non-executives. The ‘comply and explain’ approach is a powerful tool to understand such ramifications in the political structure of a firm. Although the 1998 Combined Code had undergone slight amendments in 2003, its original focus was retained. Regulatory bodies are requiring listed companies to follow suit in order to stabilize the economic conditions. According to the Financial Regulatory Council (FRC) 2009 report on the impact of the code upon the standards for corporate governance, a significant number of respondents which comprised of accounting firms, service providers, academics, and other significant professional bodies have confirmed the positive influence it imposed upon the corporate system (FRC, 2009b). Few respondents have argued the necessity to increase the regulation in amplifying on the penalty clauses while a few others proposed an overhaul that borders on outcomes and not merely on principles alone (FRC, 2009b). At one point, principles are indeed indefinite concepts thus subject to a number of interpretations depending on variables characteristic in a firm (i.e. size, structure, ownership). Haddrill (n.d.) supports this proposed approach. This could account for the conflicting and diverging definitions of corporate governance. Espenlaub et al. (2006) concluded that there has been a significant improvement in the disclosure of the details of the directors’ remuneration since the issuance of the Cadbury, Greenbury and the Combined codes which all recommend that firms impose attractive remuneration reports without unreasonably spending too much. More importantly, the publication of the Combined Code had allowed shareholders to participate in the approval of the directors’ remuneration in the hope of effectively readjusting the interests of shareholder and managers. Espenlaub et al. (2006) replicated an already established theory about the non-linear relationship between managerial incentives and firm risks. Furthermore, they have indicated that managerial incentives and firm risks can significantly change depending on the size of the firm. Small firms where there are less-to-zero division of ownership and management, increased risk-taking behavior does not necessarily affect the incentive appropriation (Espanlaub et al., 2006). Since the publication of the Combined Code, there had been evidence to the effect shareholder influence generates on board behavior that in turn increases the propensity of the shareholders to approve remuneration reports (Gordon, 2009). The Combined Code aims to provide more room for flexibility among board members and the board itself in structuring the governance framework that should likewise enable shareholders to employ appropriate discretion (FRC, 2009a). However, Ferri and Maber (2009) have found no evidence for any change in compensation and in the growth rate since the stipulation that increases shareholder intervention on the directors’ remuneration. Forces prevailing in the market were still significant factors to that end, although there was an increase of pay-poor performance sensitivity (Ferri & Maber, 2009). The code had not significantly affected the agent’s terms but it had affected shareholder (or owners’) accountability and provided more opportunity for them to handle potential risks effectively because of this increased participation thereby decreasing information asymmetry. In that case, shareholders should be more reassured of their influence on the board behavior despite the fact that it may be largely influenced by incentive alignment (Burton, 2000). Another aspect to consider in relation to the agency problem is the separation of the roles of the chair and the CEO. Although the separation may potentially reduce agency costs arising from CEO duality, it may still be written-off since there runs the risks of incurring costs attributed to regulating the Chair especially the person who has no significant form ownership (Brickley et al., 1997 as cited in Burton, 2000). As a matter of fact, there had also been overwhelming evidence in the lack of sufficient relationship between board composition and financial failures in the past (Burton, 2000). The need to identify and weigh the potential costs still matters a lot. Firms tend to end CEO duality when they incur higher agency costs of debt and equity (Kwok & Shuk, 1998). Additionally, such separation of roles has produced less significant change in the accounting performance of a firm (Kwok & Shuk, 1998). However, there are still a chunk of considerable evidences that split positions have yielded significant impacts on firm performance (Kwok & Shuk, 1998). Discretion is advised in the using of this scheme for the characteristics of a firm vary from industry to industry (Brockman et al., 2004). Conclusion Even though the Combined Code had produced ‘amiable’ results according to a few professional and academic perspectives, there appears to be a lack of adequate empirical evidence thus far as to the agency cost- reducing mechanisms that the Combined Code adopts. That is why, the principles in the code may not (for the time being) be able to transcend ultimate efficacy without the leverage of foolproof theories. The Combined code have only aided in the way through ‘comply and explain’ approach where regulating bodies and shareholders are given more access to information, reducing information asymmetry as well as regulation. However as to the direct and universally acceptable relationship that the code should be able to establish is still a matter for academic and professional pursuits. References Applied Corporate Governance, 2009. Definition of corporate governance. [online]. Available at: http://www.applied-corporate-governance.com/definition-of-corporate-governance.html [Accessed 3 Jan. 2011]. Brockman, E., Hoffman, J., Dawley, D., Fornaciari, C., 2004. The impact of CEO duality and prestige on a bankrupt organization. Journal of Managerial Issues, 16 (2), pp.178+. Burton, P., 2000. Antecedents and consequences of corporate governance structures. [online]. Available at: http://www.statec.co.uk/pdf/corporate-governance.pdf [Accessed 4 Jan. 2011]. Davidson, A., 2008. How the city really works: the definitive guide to money and investing in London's Square Mile. UK: Kogan Page Publishers. Espenlaub, S., Stathopoulos, K., & Walker, M., 2006. Agency theory versus managerial ownership theories: understanding the non-linear relationship between managerial incentives and firm risk. [online]. Available at: http://69.175.2.130/~finman/Barcelona/Papers/Incentives-Risk.pdf [Accessed 4 Jan. 2011]. Ferri, F. & Maber, D., 2009. Say on pay vote and CEO compensation: evidence from the UK. [online]. Available at: http://efmaefm.org/0EFMSYMPOSIUM/CGC%202009/papers/Ferri.pdf [Accessed 4 Jan. 2011]. Financial Reporting Council, 2009a. Review of the effectiveness of the Combined Code: call for evidence. [online]. Available at: http://www.frc.org.uk/documents/pagemanager/frc/Combined_Code_2009/Combined%20Code%20Review%20consultation%20document%20March%202009.pdf [Accessed 4 Jan. 2011]. Financial Reporting Council, 2009b. Review of the effectiveness of the Combined Code: summary of the main points raised in responses to the March 2009 call for evidence. [online]. Available at: http://www.frc.org.uk/documents/pagemanager/frc/Combined_Code_2009/Web_changes_to_2009_REview_of_the_Combined_Code_July_2009/FRC%20Summary%20of%20responses%20to%20March%202009%20consultation.pdf [Accessed 4 Jan. 2011]. Gordon, J., 2009. “Say on pay”: cautionary notes on the UK experience and the case for shareholder opt-in. [online]. Available at: http://www.georgeson.com/usa/sayonpay/GordonSayonPayForum.pdf [Accessed 4 Jan. 2011]. Haddrill, S., n.d. Lessons from a crisis. [online]. Available at: http://www.icsa.org.uk/assets/files/pdfs/Conferences/lessonsfromacrisis.pdf [Accessed 4 Jan. 2011]. Kwok, J. & Shuk Y., 1998. Does CEO duality matter?: an integrative approach. [online]. Available at: http://scholar.lib.vt.edu/theses/available/etd-23098-6757/unrestricted/p1-142-3.pdf [Accessed 4 Jan. 2011]. Sealy, L. & Worthington, S., (2007). Cases and materials in company law. New York: Oxford University Press. Read More