Corporate Governance and Agency Theory - Essay Example

Corporate Governance and Agency Theory Corporate Governance and Agency theory Introduction The three types of business ventures are: the sole proprietorship, business partnership, and the limited companies. The sole proprietorship is business venture that is managed and owned by individual. The profits realized are taxed in the form of an individual’s income and the life of the company is dependent on the life of the owner (Core, Guay &Larcker, 2003). The amount of investments injected in the venture is limited to the owner’s wealth. On the other hand, the partnership ventures are characterized by the requirements for the agreements between the involved partners. Its other feature is that if one of the partners dies or leaves the company, then the partnership maybe terminated. In addition, the partnership may limit the number of partners and the challenge these firms encounter is raising capital or cash. Just like the sole proprietorship, the profits are taxed based on personal income. The control of the company is in the hands of the general partners. As for the limited corporation, some of the requirements are the memorandum and articles of Association. In this particular venture, the liabilities are limited and the profits realized by the corporations are taxed according to the rates of the corporate tax. The life of the company is usually not limited and it consists of the board of directors (Daily, Dalton & Cannella, 2003). For the limited corporation, the board of directors can either be single tier system or the two tier system depending on the country. At the top echelon of management are the chair and the Chief Executive Office (CEO) after which they are followed by the executive directors and the non-executive directors. The two tier system consists of the supervisory board at the helm of the affairs followed by the chair and the CEO who are above the executive directors (Dalton, Daily, Ellstrand & Johnson, 1998). Japan and Germany are the example of countries that employ the two tier system while the UK and the US incorporate the one tier system. In the US, the owners of the companies were distinct from those who manage or control the companies. There are several issues that that usually emerge in reference to corporate governance. Some of these issues are associated with corporate are the irregularities of finance; the issue of compensation packages for the executives; the management of the financial risks; and acquisition and merger of corporate. The Organisation for Economic Co-operation and Development (2004) illuminates the ideal principles that should be incorporated in the governance of the corporate. One of the principles is aimed at providing the platform for an effective framework of the governance of the corporation. The second principle tends to focus and lay emphasis on the rights the companies’ shareholders and the vital functions of ownership. The third principle advocates for the equity or liberty of the treatment of the shareholders. It also provides clear guidelines on the roles and the responsibilities of the stakeholders in the governance of the corporate (Denis & McConnell, 2003). The principle of transparency and disclosure is also adamantly advocated for by the principles. Furthermore, the responsibilities of the board of directors are vividly defined. The board of directors consists of both the executives and the non-executives. Therefore, corporate governance according to Shleifer & Vishn (1997) can be described as situations where the financial suppliers to companies aim at getting the returns of their investments. It can also be referred to as mechanisms which can be market based and institutional that ignites the interest of the managers with the aim of increasing the value of the shareholders. However, the best description is that of Farquhar (2011) who describes corporate governance as mechanisms that ascertain that those with stakes in companies get the returns of their economic investments from the firm. Agency theory and corporate governance problem The directors of companies have the responsibility of managing finances of the shareholders. However, they can’t be expected to exercise a lot of vigilance as the owners would have. The majority of the corporations have control that is separate from ownership. This leaves more questions than answers as to how corporations progressively flourish and the agency theory attempts to address this phenomenon. The theory consists of two main parts namely the principal and the agents. The agents are appointed by the principles in order to cater for the interest of the principle (Ingley & Van der Walt, 2004). One of the assumptions of the theory is that individuals are perceived as the optimizers of utilities and they are rationally bounded. The other assumption is that individuals who are the principle and the agent are driven by their self-interest. The utility functions highlighted above encompass arguments that emanate from either wealth or leisure. Moreover, people preferences differ in terms of the optimization of wealth and leisure (Johnson, Ellstrand, Dalton & Dalton, 2004). The final assumption is that agents tend to dislike risks while the principles are usually neutral when it comes to risks. The agency theory presents challenges such as: the firm being treated by contracts between agents and principles in the running of the operations of that firm; and the modalities to ensure that the agents incorporate the interest of the shareholders since both the agent and the principles usually attempt to satisfy their self-interest. The costs related to the agency concept are the summation or structuring costs, monitoring the agent’s contract, and bonding. The expenditure costs are solely monitored by the shareholders while the expenditure that emanate from bonding are monitored by the agents. These costs are vital in the reduction of costs that are bound to surface due to the divergence of the interests of the shareholders and the agents (Solomon, 2007). The reduction of these costs, however, may results in the divergence of attitudes towards risks and the asymmetries of information. The other problems surface due to hazards that are considered moral, as well as in the contracting process which is characterized by adverse selection. According to Dalton et al (2003), the research on agency theory in the corporate governance is faceted into two parts, alignment and control. In the alignment, compensation packages are employed to commensurate with the interest of the principle and the agents (Khan, Dharwadkar & Brandes, 2005). This is based on the hypothesis that stipulates that the equity in terms of compensation directed towards the executives is vital in ensuring the performance of the firm’s finances (Nelson, 2006). On the other hand, the control is employed to aid in the monitoring processes of the firm’s management. The hypothesis on the control mechanism validates that when ownership is concentrated, the monitoring process is facilitated and this consequently results into the firm’s financial performance (Johnson, Daily & Ellstrand, 1996). In the agency theory, the independent board of directors is mandated with the responsibility of controlling and monitoring the managers. The theory advocates for the separation of the CEO and the chairperson (Hermalin & Weisbach, 2003). The insinuation here is that corporations or companies with clear separation between the CEO and the chair are likely to perform better than those that embraced the duality of the two. Furthermore, most of the directors are from outside the organisations. The directors from outside the organisations are known as non-executives. It is argued that companies with greater proportions of the non-executives tend to perform better than those with lower proportions of the non-executives. It is prudent to know that the market plays a crucial role in the control of the corporate. Walsh & Seward (1990) argue that takeovers as the devices for governance are used in cases where mechanisms for internal controls have failed or proved unsuccessful. The proponents for the theory illuminate that free markets are ideal for either acquisition or merging (Roberts, McNulty & Stiles, 2005). The theory has, however, received several criticisms from different quarters. Hendry (2005) vindicates that managers of corporations are usually driven by self interest while the agents are always opportunistic. It is a reflection of the human behavior as a model. Dalton et al (2003) on the other hand, argues that the theory does not consider the wider role of the board of directors such as services, resources and strategy. In other words, the boards are insufficiently modeled with their functions. Besides, there are no mechanisms that can be used to examine the behavioural processes and mechanisms that correlate the performance of the board and its structure. There is little support for the predictions of the theory. Hendry (2005) extrapolates that since there is the logic of self driven interests from both the agents and the principles, the board of directors should constitute of the non-executives only. In the international corporate governance, the vital components entail the protection of the investors, the system of finance, the system of corporate governance of the firm, and the control mechanisms (Jensen & Meckling, 1976). Different countries have different legal systems in form of common law that provide the investors with protection. These laws emanate from the need for the protection of the shareholders, as well as the enforcement of the laws. The majority of nations have regulation that are strong but the enforcement of the laws at times leave more questions than answers (Jensen & Meckling, 1976). However, in most cases, the efficiency of the judicial systems, as well as, the enforcement of order and the rule of laws are key determinants in the protection rights (Tadesse, 2004). In addition, there are countries such as Japan and Germany that embrace bank based systems while others such as the US and the UK embrace market based system. In the bank based system, banks play a crucial role in the movement of funds from and to the demands and supply in terms of capital (Eisenhardt, 1989). The system is also characterized with monitoring process that is more active. On the other hand, the market based system characterized by securities markets and the discipline in the external market (Wu, 2004). The control mechanisms depend on the structure of ownership the firm has incorporated. The two most common structures are firms that are widely held and those that are closely held. For the firms that are widely held, they usually have control that is separate from ownership. The managers have the responsibility of tackling agent issues. Moreover, there are strategies for exiting the investments (Dalton, Daily, Certo, & Roengpitya, 2003). However, for those firms that are closely held, the managers’ incentives, as well as, the shareholders’ incentives are made to align. Shen (2003) explains that the agent issues are between the non-controlling and the controlling shareholders. In addition, in the corporate control of the market, if the managers are not performing, takeovers form external market may infiltrate into the system and the underperforming companies may be acquired by those that are performing. Countries with corporate controls that are strong in the market attract and boost investors’ confidence (Seifert, Gonenc & Wright, 2005). According to Jensen (1986), the agency cost emanate when the interest of the managers of the company and the shareholder do not coincide. The agency model or theory as illuminated earlier, identifies the mechanisms for governance aimed at minimizing the agency costs in the alignment of the interest of the owners and the managers (Faccio & Lasfer, 2000). In Britain, companies have to incorporate board structures that are consistent with the best practices of the Combined Code. Most companies employ governance mechanisms that are aimed at maximizing the value of the company. However, it is argued that such firms should do away with the concept of maximizing their value and instead move towards structures that are non-optimal (Ross, 1973). Conclusion The limited corporations ought to be operated using principles labeled in the OECD (2004). The mechanisms for corporate governance can either be internal or external. The agency theory is one of the theories that have been developed to address problems that surface in the corporate governance. Since there are assumptions in the theory, critics have always highlighted the limitations of the theory. Reference List: Solomon, J (2007). Corporate Governance and Accountability. Cheltenham: Edward Elgar Publishing Core, J.E., Guay, W.R &Larcker, D.F. (2003). 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