Agency Theory and Rise of Corporate Governance Globally - Essay Example

The relevance of agency theory in explaining the rise of corporate governance globally Contents Introduction Corporate governance refers to the practice of relationship between different stakeholders of an organisation. It can also be defined as a way in which managers attempt to represent the interests of shareholders in a responsible manner. Through corporate governance, shareholders hold the management board of an organisation to account (Johnson, 2006). Corporate governance can be understood through various frameworks of the firm. Agency theory is one of those frameworks, and entails the separation of ownership and control of an organisation. In this case, the shareholders act as owners of the company while the management board acts as the agents of control for the company. This paper attempts to find the relevance of agency theory in explaining the rise of corporate governance worldwide. In order to achieve this, it will include two other frameworks of the firm as benchmarks: stewardship theory and stakeholder theory. The starting point for this paper is to give the different accounts of the rise of corporate governance using various reliable sources. The next step is to highlight the other two frameworks of the firm and explain how they can be used in protecting the shareholders’ investments. The chosen frameworks will then be compared with the agency theory in order to establish which of the three frameworks best describes the rise of corporate governance. The rise of corporate governance There are various factors that can be used to explain the rise of corporate governance. Such factors include: Separation of ownership from control; the rise of prominence of institutional shareholders; insufficient checks on powerful executives which led to scandals; the treatment of companies as separate legal entities; corporate failures caused by insufficient controls; remuneration of executives; economic globalisation; and financial crisis These factors have been considered in UK by different reports that provide specific measures on corporate governance. Such reports include: Cadbury report, Hampel report, Higgs report, the combined report, and UK stewardship report. The rise of corporate governance can be illustrated in depth by looking at the contents of these reports because they address the above factors of the rise of corporate governance. Cadbury Report This report was provided by Cadbury committee on December 1992 to address the financial aspects of corporate governance. The code principles are based on integrity, openness and accountability. Cadbury report requires that boards of directors should be accountable to their shareholders and both should play their roles in making that accountability effective. In the Cadbury report, the role of the board of directors of a company is to lead and control the company (The Committee on the Financial Aspects of Corporate Governance 1992). The recommendation also recommended the establishment of nomination and remuneration committee as part of corporate governance functions. It also supported the establishment of audit committee composed of non-executive directors. Hampel Report The Hampel report on corporate governance was initiated in 1998. The report builds on the importance of corporate governance on business prosperity and accountability. The report focuses on business prosperity and suggests that business prosperity cannot be commanded; instead, it is produced by people, leadership, skills, experience, teamwork and enterprise (Hampel 1997, p. 17). Hampel report requires that the interests of company stakeholders be taken into account. Corporate governance also prevents malpractice and fraud. The Hampel report improves on the Cadbury report and requires that every company should be headed by a board of directors which should lead and control the company as suggested by the Cadbury report. The report agrees with the Cadbury report and makes a few improvements. The report is tasked with the role of relooking at the roles of directors, shareholders and auditors in corporate governance. Higgs Report Higgs report of 2003 reviews the role and effectiveness of non-executive directors of UK companies. The report suggests that the board has a general responsibility of leading and directing the affairs of the company (Higgs 2003, p. 5). The number of meetings of the board and the number of attendance by directors should be indicated in the annual report of the company. The board should be sizeable, and at least half of it should be made up of independent non-executive directors. The report suggests that the roles of the chairman and the CEO should be separated and that the chairman’s role is to create conditions for each director and enhance board effectiveness. The report also recommends that there should be a nomination committee to appoint members of the board and make recommendations regarding to the board. The Combined Report The combined report on corporate governance is based on the argument that corporate governance enhances better performance of a company and helps the board to perform its duties in the best interest of shareholders (Financial Reporting Council 2008, p. 13). The report requires that the board’s role should be to provide entrepreneurial leadership of the company through prudent and effective control mechanisms that enhance risk assessment and management. The report also recommends that the board should meet regularly to perform its duties formally and in an effective manner. It also holds that there should be a clear separation of duties between the chairman and the chief executive. The combined report also recommends a balance of executive and non-executive directors. The process of selecting board members should also be done formally, rigorously and transparently. The UK Stewardship Code The purpose of the UK stewardship code is to promote the success of companies so that the providers of capital also prosper. Stewardship ensures that it is not only the company that benefits from corporate governance, but also investors and the economy. In the stewardship code, the investors (shareholders) not only vote, but also participate in various business issues of the company including strategy, risk, performance, culture, remuneration, and capital structure (Financial Reporting Council 2012, p. 1). The code requires shareholders to participate in decision making and monitor their investee companies. The shareholders should also vote and report regularly on their voting and stewardship activities. The Walker Review (2009) provides recommendations to the UK banks. It suggests that shareholder engagement is a key element of the stewardship. Recommendation 16 of the Walker Review provides that “the remit of the FRC should cover the development and adherence to principles of best practice in stewardship by fund managers and institutional investors” p. 17. The recommendation also provides that the content combined code should be separated from the contents of the Stewardship code in order to clarify the stewardship roles of institutional investors and fund managers. The Stewardship code generally has seven principles as listed in the appendices section Alternative frameworks of corporate governance In order to determine the effectiveness of agency theory, it is important to compare it with other alternative frameworks. This report has chosen stewardship and stakeholder theories as alternative frameworks. Stewardship theory This theoretical framework of corporate governance views people as collectivists and trustworthy (Solomon, 2013). As stewards of the organisation, shareholders are expected not to depart from the interests of the organisation. This theory assumes that the steward exhibits a rational behaviour such that she/he derives greater utility from cooperative behaviour. In this theory, the board of directors should act in the best interest of shareholders. It should develop governance structures to enable executives to maximise the organisation’s benefits. Stewardship also entails giving CEOs the authority and discretion to enjoy unambiguous responsibility. Unlike agency theory which allows the executives to control and direct activities in the organisation, stewardship suggests that exerting control over stewards lowers their motivations. Stakeholder theory Stakeholder theory considers a wider range constituents rather than only shareholders, and proposes a social contract between the society and organisations (Mallin 2013, p. 20). This framework requires companies to observe moral principles such as respecting others, taking care of the environment, avoiding harm to members of the community, being honest, and honouring contractual agreements with various stakeholders. According to stakeholder theory, it is the purpose of corporate governance to recognise responsibilities to various interest groups such as the environment, employees, the government, creditors and the community in general. Financial obligations to shareholders should also be recognised through corporate governance. Stewardship theory accords corporate responsibility to not only shareholders but also a broad range of other stakeholders. Evaluation of the two theories Stewardship theory The stewardship theory can be evaluated by relating it to the reports described above in order to determine how they have contributed to corporate governance. The Steward code is a key reference point of stewardship theory. The UK stewardship code defines the rise of corporate governance in terms of the role of shareholders to hold the board to account for the fulfillment of its responsibilities (Financial Reporting Council 2012, p. 5). The stewardship theory is applied in the code and has become an important element in defining the responsibilities of shareholders in corporate governance. Stewardship theory suggests that stewards derive utility from cooperative behaviour. This is applicable in the stewardship code which requires shareholders (the stewards) to participate in decision making of the company (cooperative behaviour). In comparison with agency theory, the objective of corporate governance in stewardship theory is to give executives the right amount of authority. The purpose of corporate governance in agency theory is to restrain self-interested agents. In agency theory the shareholders are not involved in decision making except through voting; but stewardship allows participation of shareholders in business level decision making. Stakeholder theory This theory is relevant in explaining the rise of corporate governance because it has been a key concern in modern businesses. Stakeholder theory highlights the aspect of financial obligation towards shareholders. This is reflected in the Cadbury and Hampel reports which argue that companies should provide financial reports with integrity, transparency and openness. Companies can meet the needs of shareholders by showing accountability in terms of financial reporting. The Cadbury report suggests that shareholders use financial reports to analyse companies. However, the reports do not mention the relationship between the company and other stakeholders, which is strongly supported by the stakeholder theory. When compared to agency theory, stakeholder theory suggests that companies should take a good consideration of shareholder’s interests, and the interests of other stakeholders in the company. Agency theory considers corporate governance as a way of separating ownership from control, which leads managers to be experts in agency (Bloomfield, 2013). Managers in agency theories are rational and self serving, and reward themselves with high salary and other benefits. These awards and benefits are intended to motivate them in their management duties. However, managers in the context of stakeholder theory are more concerned with the interests of other stakeholders rather than self-interests of the managers. Relevance of the agency theory The stakeholder theory and stewardship theory are used to reflect on agency theory because they are almost opposites of the agency theory. While the agency theory focuses on the motivation of managers through high remunerations in order for them to maximise shareholders’ wealth, stewardship suggests that it is necessary for the shareholders to monitor the company and ensure that managers act in the best interest of the investors (Rebérioux, 2002). It is also important to use the stakeholder theory because it brings in other stakeholders in the company, unlike the agency theory which places the role of managers on maximisation of shareholders’ interests only without much concern to other stakeholders. From this analysis, it is clear that agency theory is not appropriate to explain the rise of corporate governance. This is because agency theory is more concerned on the interests of the agents (managers) rather than the shareholders of the company and other stakeholders. If managers including CEOs are to maximise shareholders’ interests, agency theory suggests that they should be motivated through heavy remuneration and benefits (Blanpain et al, 2011). However, this is not appropriate explanation of corporate governance because corporate governance is concerned with stewardship, accountability, stakeholder interests, openness and integrity as suggested by the various reports discussed in this report. Real world examples One of the real world bad examples which can be used to explain corporate governance is the fall of Enron Company in 2001. Enron was an energy company based in Houston. Oppel (2001) suggests that the company collapsed after a shaky accounting and a lot of borrowed money. Most importantly, the company failed due to its unwillingness to provide information for investors who became more doubtful and suspicious of its financial reports. Investors and partners then backed out, leaving the company insolvent. This shows the problem of agency theory whereby managers do not have the responsibility to account for the business transparently and accountably. A good example of corporate governance is Toyota. An important element of the company is that it encourages the participation of employees, shareholders and suppliers in decision making. The company fosters a corporate culture that involves individual creativity, teamwork value and mutual trust. As a result, the company is one of the leading automobile manufacturers in the world. This is a clear indication of the suitability stakeholder theory in explaining stewardship theory because mutual trust and teamwork value are key indicators of the collectivism and trustworthiness suggested by the stewardship theory. The Stewardship code of UK also provides the same opinion that stakeholders should be engaged in decision making of the organisation. Conclusion This report uses shareholder and Stewardship theories to explain corporate governance because the current and most recent UK codes on corporate governance use the stewardship and stakeholder theories. The most recent corporate governance code, the stewardship code acknowledges the importance of stewardship and concern for stakeholders in an organization’s management. This provides a good reason to focus on these two theories. From the good and the bad examples, it is clear that agency theory is indeed not enough theory in explaining corporate governance; stakeholder and stewardship theories are also needed to explain corporate governance. Agency theory does not show any concern of managers for their company’s shareholders. Agency theory considers that managers only pursue their own self interests. Managers under the agency theory do not even consider the interests shareholders who are the key investors of the company. Often, when this takes place the investors withdraw from funding the company, and leave the company bankrupt. That is what happened in Enron Company in 2001. Taking care of investors’ interests is therefore a key element in corporate governance, something that agency theory lacks. References list Blanpain, R., Bromwich, W., & Agut, GC 2011, Rethinking corporate governance: From shareholder value to stakeholder value, Kluwer Law International, Alphen aan den Rijn. Bloomfield, S 2013, Theory and practice of corporate governance: An integrated approach, Cambridge University Press, Cambridge. Du Plessis, Jacques, Jean, McConvill, James, & Bagaric, Mirko 2005, Principles of contemporary corporate governance, Cambridge University Press, Cambridge. Fernando, AC 2010, Business ethics and corporate governance, Dorling Kindersley (India), licensees of Pearson Education in South Asia, New Delhi. Fernando, AC 2009, Corporate governance: Principles, policies and practices, Pearson Education, New Delhi. Financial Reporting Council 2012, The UK Stewardship Code, Financial Reporting Council Ltd, London. Financial Reporting Council 2008, The combined Code on Corporate Governance, Financial Reporting Council Ltd, London. Fort, T. L., & Schipani, CA 2000, “Corporate governance in a global environment: The search for the best of all worlds”, Vanderbilt Journal of Transnational Law, vol. 33, vol. 4, pp. 829-876. Freeman, RE 2010, Stakeholder theory, Cambridge University Press, Cambridge. Gunay, SG 2008, Corporate governance theory: A comparative anaylsis of stockholder & stakeholder governance, Iuniverse, S.I. Hampel, Ronnie 1997, Committee on Corporate Governance: Final Report, Gee Publishing Ltd, London. Healy, Paul M and Krishna, GP 2003, “The Fall of Enron”, Journal of Economic Perspectives, vol. 17, no. 2, p. 14. Higgs, Derek 2003, Review of the role and effectiveness of non-executive directors, The Department of Trade and Industry, London. Johnson, LP 2006, “Faith and faithfulness in corporate theory”, Catholic University Law Review, vol. 56, no. 1. Mallin, CA 2013, Corporate governance, Oxford University Press, Oxford. Nicolodi, R 2007, Pension fund engagement as substainability driver: A shakeholder-theory- based legitimation as sustainable pension fund engagement in a Swiss context, Haupt, Bern. Nix, P., & Chen, JJ 2013, The role of institutional investors in corporate governance: An empirical study, Palgrave Macmillan, New York. Ong, DM 2001, “The impact of environmental law on corporate governance: International and comparative perspectives”, European Journal of International Law, vol. 12, no. 4, pp. 685-726. Oppel, Richard A 2001, Enrons collapse: the overview; Enron collapses as suitor cancels plans for merger. The New York Times. Accessed March 12, 2014 from http://www.nytimes.com/2001/11/29/business/enron-s-collapse-the-overview-enron- collapses-as-suitor-cancels-plans-for-merger.html. Rashid, K., & Islam, SMN, 2008, Corporate governance and firm value: Econometric modeling and analysis of emerging and developed financial markets, Emerald, Bingley, UK. Rebérioux, A 2002, “European style of corporate governance at the crossroads: The role of worker involvement”, Journal of Common Market Studies, vol. 40, no. 1, pp. 111-134. Shleifer, Andrei 1997, “A survey of corporate governance”, The Journal of Finance, vol. 52, no. 2, pp. 737-783. Solomon, Jill 2013, Corporate Governance and Accountability, Wiley, Hoboken. The Committee on the Financial Aspects of Corporate Governance 1992, The financial aspects of corporate governance, Gee Publishing Ltd, London, UK. The Walker Review Secretariat (2009). A review of corporate governance in UK banks and other financial industry entities: final recommendations. Accessed March 20, 2014 from http://webarchive.nationalarchives.gov.uk/+/http:/www.hmtreasury.gov.uk/d/walker_revi ew_ 261109.pdf Appendix Principles of the Stewardship code Principle Requirement Principle 1 Institutional investors are required to disclose how they are going to discharge their stewardship responsibilities Principle 2 Institutional investors should develop a robust policy on conflict management Principle 3 Institutional investors are mandated to monitor their investee companies Principle 4 Institutional investors are required to provide clear guidelines on how they will enhance their activities in order to promote shareholder value Principle 5 Institutional investors should act collectively alongside other investors where necessary Principle 6 Institutional investors should develop clear guidelines on voting its disclosure Principle 7 Institutional investors should report on their stewardship voting activities on regular basis Propositions and relation of the three theories to corporate governance Agency theory Stakeholder theory Stewardship theory Control and ownership of corporations should be separated Agents are managers and owners are shareholders Relies on agents’ expertise Agents reward themselves with huge amounts of salaries Imperfect markets; hence owners have limited access to information Agency costs are incurred by principals Relation with corporate governance: internal corporate governance mechanism used external corporate governance/regulation There is a social contract between the organization and the society Companies observe moral principles by avoiding causing harm to others Relation with corporate governance Corporate governance involves responsibilities towards the environment, employees, etc The theory requires organizations to demonstrate accountability, which is a key role of corporate governance Human beings are considered as collectivists and trustworthy The behaviour of a steward is related to interests of his/her organization Stewards show rational behaviour Relation with corporate governance Directors act in the best interest of shareholders Encourages corporate governance structures that allow executives to maximize benefits of the organization. Elements of control will lower the motivations of stewards Read More