Contemporary corporate governance issues - Essay Example

?THE AGENCY THEORY AND ITS RELATIONSHIP TO SHAREHOLDERS AND STAKEHOLDERS Introduction……………………………………….3 Default Position…………………………………...3 Need for TheAgency Theory……………………..4 Governance………………………………………..7 Stakeholders………………………………………8 Conclusion………………………………………...8 References………………………………………...9 Introduction This paper evaluates whether businesses exist solely for the benefit of its owners (shareholders or not). It goes further to look at the agency theory and other related matters as well as the challenges related to it and the need for alternative views and systems in businesses in the present era. Default Position Some decades ago, businesses were basically set up to generate wealth for the owners. This was a capitalist model that ensured that investors got the highest possible returns from their investments. Other concerns were kept to the barest minimum. Parkinson (1994) rightly judged by the events around him, that the “process of supervision and control [management] intended to ensure that the company’s management acts in accordance with the interest of its shareholders [owners]” Twenty years ago, this was a very acceptable standpoint that most people in society would seldom argue against. Wood & Welker (2011) identify a group of shareholders who arose in the 1970s with the view of ‘disciplining’ directors and restoring control of the true ownership of the organization to its owners. This group of people is described by Johnson, Scholes & Whittingon (2008) as pristine capitalists. With this background, there were two major questions: What should a firm do for its connected parties like its workers and suppliers. Are they just a means (in the absence of machinery) for the creation of wealth for these pristine capitalists? Secondly, if all directors were controlled solely by shareholders, what happens to their freewill and what can they do about the needs of other legitimate people connected to the organization in question. So with this, there were a lot of debates and scandals that forced the business community to take the agency theory a step further and incorporate other important and legitimate needs that organizations needed to honor to the larger society and to its connected parties. Need for The Agency Theory The popular Salomon V Salomon case laid the precedence for the separation of ownership and businesses. This has given right to the formation of limited liability companies around the globe that are distinct from their owners. However, to ensure that an entity acts and operates effectively and efficiently, there is the need for organization to employ directors and managers who will manage the supervisory and routine activities of a business respectively. This has led to the need for shareholders and owners to stand aside and transfer the running of their organizations to competent people who can run the organization. These people, often known as directors or managers act as agents of the owners and they need to seek the best for the organization. In doing this, the owners of organizations have to follow the agency theory which ensures: 1. Identification of legal provisions of the contract between the owning companies and joint ventures in line with the rules of the agency theory (which will be discussed later). 2. Accountability to owners (Hutzschenreuther, 2009). Thus national laws as well as articles of associations for the incorporation of the business guards the conduct of managers and directors. This is because these directors, known in Latin as fiduca (which means ‘trust’) and carries connotations of trust, good faith and honesty (Rahaim, 2005). This means that directors and managers need to avoid “self dealing” or “conflict of interest”. The idea of self-dealing refers to a situation where directors use their influence or knowledge in an organization to further their needs. In this case, the director or people managing an organization will lose focus from their primary objectives and use the firm as a vehicle to meet their own personal ends. This will obviously affect the owners and shareholders first. Secondly, a director whose work as a trustee of an organization has direct divergence with the primary objective of the organization, is likely to act amorally and against the interest of first the shareholders and other people connected to the organization. A practical example is a case where the CEO is the same as the Board of Directors. It is likely he would not be independent and this can hamper the operation of the business. On another hand, a manager who has access to privileged information and uses it for his own benefit can be said to have been involved in self-dealing. So to prevent these situations most nations and governments have come up with laws that bolster the agency theory and the agency theory seeks to ensure three things: 1. Information assymetery between both parties in favor of the agent. This seeks to put in place a system where directors and agents of shareholders stay in constant touch with the owners through reporting and meetings to ensure that shareholders are reasonably abreast with activities going on in the firm. 2. Curb conflict of interest between principal and agent: In this case, there are laws that makes it illegal for directors to indulge in certain practices that are detrimental to the interest of the business and also specifically, to the interest of the shareholders. 3. Curb the opportunistic behavior of agents: In this context, we are talking of legal instruments that criminalizes the director who uses loopholes and issues to further his own personal interests and gains (Hutzschenreuther, 2009) On the other hand, using the agency theory comes with several agency transaction costs. Hutzschenreuther (2009) again identify them as: 1. Signaling cost of agency: This refers to the costs associated with the presentation and reporting of matters that occurred in the organization. We can talk about the various functional managers’ reports particularly from the accounting department which comes in the form of costs of hiring and accountant. 2. Control costs of the principal: This includes the arrangements put in place to monitor and certify the operations of the firm. They include auditing costs, which involves the expression of an opinion by an independent body appointed by the shareholders to go through the accounts prepared by the directors and pass an opinion on whether it reflects the true and fair proceedings in the period under question or not. There is also the risk-management cost factor, where shareholders task the board to have internal audit teams and risk management teams to ensure that the business is operating in accordance to relevant legislations and conventions. These costs are high and can increase the costs of production. 3. The remaining residual loss: This refers to situations where the people tasked with the direct monitoring fail to provide optimum results. Thus the difference between what they would have actually saved if effective action was taken and what was actually spent becomes the remaining residual loss. With thee seemingly negative effects, most shareholders might be tempted to ignore spending too much on agency costs but with challenges like the globalization of capital markets and the powerful information technologies being used around the world, it is important for organizations to live according to the requirements of the agency theory (Freeman et al, 2007). The principle of the agency theory does two things for organizations. First of all, it promotes the principle of corporate legitimacy which refers to the fact that a business must be managed for the benefit of its owners and the fiduciary principle, where management have a fiduciary responsibility to stakeholders as well (Evan & Freeman, 1988). Thus, there has been a trend of the development of ethics and standards that ensure that organizations live to check and ensure that their companies are honoring not only obligations to shareholders but to other companies connected to the business as well. Ferell et al identify three main areas that ethics overlaps in the principal-agent relationships as well as the social-agent demands of an organisation. They are stakeholder issues, corporate social responsibility and corporate governance. Governance Fama & Jensen, (1983) explains further that the “…agency theory’s concept of peer monitoring or mutual monitoring, views peer control as a medium to align workers (including managers and employees in this case) with organizational interest. This therefore suggests that the agency theory encourages organizations to use proper monitoring techniques to ensure that every unit of the organization living according to expectations. In the modern world, this is usually done by the creation of a board of directors to supervise and direct operations in organizations (Solomon, 2007). This is popularly known as corporate governance. She identifies five main areas of intervention that corporate governance in the activities of an organization: 1. Entrepreneurial leadership: The Board refers to some kind of intermediary between the shareholders who are the owners and the organization as a whole. Due to the fact that they have connections to both parties, they are expected to further the business development of the business in a way that will ensure that shareholder interests are fulfilled. On the other hand, with their constant touch with the organization, boards of directors have a first-hand understanding of activities that occur in the operation of the organization. This therefore means that they are more abreast with the issues affecting people linked to the organization (stakeholders). 2. Establishment of a system for the prudent and effective controls, assess risks and management. 3. Set strategic aims of the company. 4. Safeguard financial and human resource interests of the organization. 5. Review management performance. In short, Jill Solomon (2007) explains corporate governance as “… the system of checks and balances both internal and external to companies which ensures that companies discharge their accountability to all their stakeholders and act in a socially responsible way.” Stakeholders In nations, governments have identified that from time immemorial, strong people have tried to take advantage of weaker people. Thus, in the most capitalist nations around the world, the government intervenes to do seven main things: 1. They regulate the markets 2. Maintain competitive markets 3. Maintain a balance of power between capital and labor 4. Protect consumers 5. Ensure orderly capital markets 6. Ensure equal opportunities and 7. Protect the environment (Colley et al, 2003) They do this by creating laws and using various monitoring tools like accounting and conventions to ensure that organizations in the nation do not get undue advantage over other citizens who are too weak to rise above the capitalist demands of businesses. This therefore places a limitation on organizations’ desires and interest to operate solely for the interest of their shareholders. “Businesses convert investor, supplier and employee inputs into customer outputs” (Donaldson & Preston, 1995), this suggests although directors and managers are primarily appointed by shareholders and by default, should honor shareholder expectations, organizations form a complex web of interrelated parties who are connected to the business and have the right to make demands and get their demands honored. Hawley, James identifies that “firms have a range of responsibilities and obligations to stakeholders in addition to maximizing financial returns to stockholders.”. This rightly points out the fact that the people running and governing and organization needs to render some other responsibilities to other people who are connected to the organization, as identified supra, like employees, suppliers and customers. The classical definition of a stakeholder is “any group or individual, who can affect or is affected by the achievement of the organization’s objectives.” (Freeman, 1984). Donaldson & Preston (1995) states that every legitimate person or group involved in the activities of a business does so to obtain benefits. So this gives them legitimate rights to make demands to the organization to honor some obligations. Thus organizations need to ensure that all those stakeholders are satisfied with their activities and this ensures that the organization gets a legitimate face in the wider society. Stakeholder satisfaction entails a lot of money that will either make sure that the internal activities of an organization is suitable for employees, suppliers, consumers and other connected parties. This means that organizations need to spend a lot of money to put in place the right structures of the organization. Businesses are therefore forced to use parts of their profits to satisfy these stakeholders. This obviously affects the amount of money to be declared to shareholders as dividends. This therefore means that organizations do not solely exist to provide wealth to its shareholders but also to benefit the wider society as well. Corporate Social Responsibility “Corporate social responsibility is a commitment to improve community wellbeing through discretionary business practices and contributions of corporate resources” (Kotler & Lee, 2005) In spite of the legal responsibility of organizations to follow certain legal principles to satisfy stakeholders and other related parties, a business might opt or would be required to give something back to the society. With Donaldson & Preston’s idea of input-output relationship between an organization and its external environment, there is a pressing need for organizations to optionally give back to the society they operate in. This form of giving is often recognized in the accounts of these companies and it ends up reducing the profits and provide happiness and a better quality of life for the wider society. Conclusion It is therefore clear that businesses do not only exist to generate wealth to the detriment of the wider society. Organizations are required by law to honor the agency theory which separates ownership from directorship, which effectively constitutes a principal-agent relationship. Such a relationship tasks agents to seek the interest of the owners of their businesses. However, there are also some legal provisions in modern nations that forces directors not only to seek the pure interest of shareholders but to improve the lives of members of the society, including stakeholders. However, in order to ensure that a balance is drawn between the interest of owners and the activities of managers and directors, there is the need for the use of corporate governance principles which encourages the formation of a supervisory board of directors that seeks the interest of the shareholders as well as the managers and by extension, regulate their relationship with other stakeholders. This brings about responsible behavior on the part of businesses and encourages optional contributions to improve the society the business operates in. References Colley, John, L., Doyle, Jacqueline, L., Logan George, W., Stettinius, Wallace (2003) Corporate Governance New York: McGraw Hill Donaldson, T & Preston, L (1995) “The Stakeholder Theory of the Modern Corporation: Concepts, Evidence & Complications” Academy of Management Review 20, 65 – 91 Evan, W, M. & Freeman, R. E (1988) “A stakeholder Theory of Modern Corporation: Katian Capitalisation” Eds. T. Beauchamp & N. Bowie Ethical Theory of Business 75 – 93 Englewood Cliffs, NJ: Prentice Hall. Fama, Eugene, F. & Jensen, Michael, C (1983) “Separation of Ownership & Control” Journal of Law & Economics Vol 26 No. 2, June 1983. Ferrell, O. C, Fredrich, John, Ferrell, Linda (2005) Business Ethics: Ethical Decision Makgin & Cases Mason, OH: Cengage Freeman, R. Edward, Harrison, Jeffrey, S. & Wicks, Andrew, C. (2007) Managing For Stakeholders: Survival, Reputation & Success NY: Caravan Books. Freeman, R. Edward (1984) Strategic Management: A Stakeholder Approach Boston: Pitman Hawley, James, P. & Williams, Andrew, T. (2000) The Rise of Fiduciary Capitalism: How Institutional Investors can Make Corporate Governance More Democratic Philadelphia: University of Pennsylvania Press Hutzschenreuther, Jens (2009) Management Control in Small & Medium-Sized Enterprises: Indirect Control, Combinations & The Effect on Company Performance Berlin: Gabler. Johnson, G. Scholes K. Whittington, R (2008) Exploring Corporate Strategy Financial Times: Prentice Hill Kotler, Philip & Lee Nancy (2005) Corporate Social Responsibility: Doing The Most Good for your Company & Your Course Hoboken, New Jersey: John Wiley & Sons Rahaim, Christian Deeb (2005) The Fiduciary: An In-Depth Guide to Fiduciary Duties from Studebaker to Enron Lincoln, NE: iUniverse Parkinson, J. (1994) Corporate Power & Responsibility Oxford University Press Solomon, Jill (2007) Corporate Governance and Accountability Hoboken, NJ: John Wiley & Sons. Wood, David & Welker, Marina (2011) “Shareholder Activism & Alienation” Current Anthropology, April, 2011 pp 557 – 569 University of Chicago Press. Yan, Yanni (2000) International Joint Ventures in China: Ownership, Control & Performance NY: Palgrave Macmillan. Read More