Contemporary Corporate Governance Issues - Literature review Example

Institution : xxxxxxxxxxx Title : xxxxxxxxxxx Tutor : xxxxxxxxxxx Course : xxxxxxxxxxx @2013 Introduction The conception that the existence of a firm is only to benefit its shareholders, is one of the dominant and debatable corporate governance issues. The existence of such debates has therefore resulted to the emergence of the stakeholder theory which argues that a business does not operate in a vacuum. Consequently, there is need for the management to maximize the interests of other stakeholders such as the customer, employees, institutional investors, creditors, the community at large and the government. Nevertheless, Solomon, (2011) acknowledges the fact that companies that are accountable to their shareholders tend to be more prosperous and successful. A big question that arises is that: to what extent does a company exist only for the benefit of its shareholders. This particular paper therefore seeks to evaluate the extent to which a company exists only for the benefit of its shareholders. In addition, the scope of the analysis will also be grounded on evaluating agency theory, its alterative and problems that arise from such theories. To a great extent, it can be argued that a company should only exist to maximize the interests of the shareholders. This is because if the interests of the shareholders are not maximized the company is bound to fail or collapse in the long run. As propagated by the agency theory, the shareholders, who are also referred to as the principles bestow the duty of management to the principles or the managers with the objective of maximizing their wealth (Forbes-Pitt, 2011). Nevertheless, if the interests of the shareholders are not effectively managed the company is bound to fail. A case in point is the collapse of many dominant firms such as Enron which gave a clear indication that if the management does not effectively manage the wealth of the shareholders, then it is destined for failure. Solomon, (2011) further highlights that the notorious collapse of Enron in the 2001 directed the attention companies to the failure and the role played by the adoption of strong corporate governance in the prevention of loss by shareholders. Munzig (2003) also highlights that the collapse of Enron was due to failed corporate governance that was a result of lack of accountability to the stakeholder. In the context of Enron, the shareholders of the company lost approximately $11 billion due to the mismanagement by the executives of the organization (Bryce, 2008). A crucial lesson that can be derived from the collapse of dominant firms such as Enron is that without maximizing the needs of the shareholders, a company is bound to fail. Consequently, it can be stated that to large extent, a company should only exist to maximize the interests of the shareholders. According to Cooper, (2004) an important consideration is based on the fact that the present business environment and society is capitalist in nature. Within the context of a capitalist society competition is a key attribute within the market. This makes company’s to fight ensure that their self interests are attained. Consequently, the agents (management) of the company have to work tirelessly to ascertain that they maximize the interests of the shareholders. Cooper, (2004) highlights that due to the competitive nature of the market, sometimes managers may use unethical means in order to ensure that company continues to make more profits. A case in point is the disclosure by BBC panorama whereby Barclays mislead shareholders and also the public concerning one the biggest investment that has ever taken place in the history of the bank. The bank had made an announcement concerning an investment in which Sheikh Mansour the Manchester City had agreed to make an investment of more than £3bn. Nevertheless, the BBC discovered that the money which assisted the Bank to prevent a bailout by taxpayers actually come from the Abu Dhabi government (BBC, 2013).What is evident in this particular scandal is that the management of Barclays bank had misled the shareholder. As a result, it is vital for firms to focus more on benefiting interests of the shareholders within the capitalist system. The benefits of the shareholder should also be a reason for the existence of a company based on the fact that shareholders are the main source of capital for an organization (Pearson, 2012). A company usually has three major sources of capital, which include debt, earnings and equity. Dependence on earnings usually has certain limits essentially when it comes to long term investments. This is because long-term investments tend to take a long time before the earnings are obtained. In addition, earnings can be disrupted by factors from external environment such as the recent financial crisis which resulted to a decline in terms of earning for many companies. Reliance on debt on the other hand, has implications of making the company to be overleveraged which can rather be catastrophic for the business (Elson, 2010). Consequently, Elson (2010) argues that equity is the best source of capital for a company at any point of its lifecycle. Shareholders are the main source of equity for the company. In most cases shareholders take huge risks in order to invest their capital on a company. Thus, it can be argued that a company should exist only for the benefit of its shareholders, because shareholders are the main source capital. Stout, (2011) highlights that to a great extent a company should exist only for the benefit of its shareholders based on the fact that the company or the firm belongs to the shareholders. Consequently, the main purpose of the existence of the company should be to increase the wealth of the shareholders. Despite of the fact that shareholders do not take part in the day to day running of the business, they do posses the biggest stake in the business. Horrigan, (2010) also highlights that shareholder primacy is founded on the notion that those who invest in firm are actually its true ‘owners’. As a result, it is on their interests alone and their behalf that the corporation or company should be managed. Based on the arguments raised by Stout, (2011) and Horrigan, (2010) on the basis of ownership, it can be stated that to a great extent, a company exist only for the benefit of its shareholders. Also, a company should exist only for the benefit of its shareholders based on the fact that a system that is shareholder oriented is effective in promoting and supporting the financial market and thus improving sectorial development. Maher and Andersson, (2004) highlights that; sectors that depend on external funding are usually favored in scenarios whereby minority shareholders are effectively protected and transparency upheld. Furthermore, the focus on the shareholders encourages entrepreneurship, creation of dynamism and innovation in sectors such as Medium-sized Enterprise (SME). For example business venture capital and angels are significant in the promotion of innovation and entrepreneurship, and these activities are closely linked to the stocks market, based on the fact that they give investors an exit mechanism and liquidity. Maher and Andersson, (2004) further reveals that capital markets that focus on an environment that is shareholder oriented has the ability to influence the actions of key parties. A case in point is where the ability of the management to monitor the business is greatly reliant on the discipline applied by the capital markets. For instance, it is possible for the prices of shares to drop whenever the management of the company experiences difficulty in minimizing the value of shareholders, thus making the company to be predisposed to change of management and takeovers. Malekian, (2012) highlights that; a firm cannot focus on maximizing the interest of other stakeholder without first of all working towards benefiting the shareholders. Consequently, based on this analogy a company should exist only for the benefit of its shareholders, which will finally lead to meeting the needs of other stakeholders within the organization. This is because, if the interests of the shareholders are met, then is becomes possible for the firm to also meet the needs of other stakeholders. Keown, (2003) argues that maximizing the wealth of the shareholders is the most appropriate goal for any particular firm. As proven by the study of micro economics, profit maximization is basically the main goal of a company. The concept of profit maximization stresses on ensuring that the resources of the company are used effectively in order to increase profits and thus maximizing the wealth of the owners. Nevertheless, sometimes managers display a tendency towards ‘egoism’ which leads them to maximizing their own interests as opposed to the interests of the shareholders (Solomon, 2011). However, to a great extent, the key objective of the existence of a firm should only be to benefit of its shareholders. On the other hand, it can be argued that a company’s existence should not only be for the benefit of its shareholders. Stout, (2012) highlights that; the view of placing the interests of the shareholders first is one of the biggest mistakes companies have done. This is based on the fact that aiming only at the benefits of the shareholders causes the managers (agents )of the organization to focus myopically on reports that depict short term earnings at the expense of long term performance . In the long –run instead of the managers making long term profits for the company, the business ends up collapsing on giving minimal returns to its shareholders. A case in point is the collapse of Wall Street in the Madoff scandal. Bernard Madoff used the Ponzi scheme as a way to demonstrate to shareholders of the company that they can actually earn more in a short period of time (Kara, 2009). In Madoff’s Scandal “Ponzi Scheme,” shareholders did not have information about how their money was being invested or how the high returns were obtained. Nevertheless, they received increased earnings in the short run, yet in the long run the performance of the company declined and the shareholders lost everything (Suzanne, 2008). Marin, (2012) also highlights that the extent to which a company exists to benefit its shareholders should be minimal. According to Marin,( 2012 ) the long exiting notion that a company only exists for the purpose of benefiting the shareholder is one of the major contributory factors the recent financial crisis, essentially within financial institutions. Marin, (2012) reveals that financial institutions usually make profits out of a spread between long term and short term interest rates. This implies the financial institutions make money through lending at higher rates, as opposed to the rates of borrowing. As a result, the best technique in which a bank can raise its profits is through increasing its leverage, which is undertaken by making loan opportunities as many as possible. Nevertheless, although an increase in leverage is beneficial for financial institutions, it results to greater risks, which ultimately influenced the recent crisis. According to Marin, (2012) the concept of shareholder primacy was an influential factor for the recent financial crisis. Based on the fact that shareholders are mainly concerned with maximizing their profits or benefits, they were bound to influence financial institutions, through the use of managers, to raise leverage. On grounds of the financial incentives and the legal obligations that managers are faced with today, they were bound to oblige. If they did not do so, the capital markets may have perceived the company as unlevered and thus making it a take over target. Marin, (2012) highlights that based on the fact that financial institutions had the desire raise profits through leverage, they had to lend to various companies. Nevertheless, the lending resulted to the bubble burst which was characterized by many firms being incapable of paying back what they owed the banks. Consequently, the banks were plugged into unpaid debts and losses. The place of the agency theory The agency theory is categorized as one of the theoretical frameworks within corporate governance. The main objective of theory is to offer necessary monitoring in order to ease or lessen what is known as the agency problem which usually arises in the exiting relationship between the agent (management) and the principle (shareholders). In many scenario’s the objective of the principle and the agent usually conflicts which may further bring about the agency problem. The agency problem occurs when the agents maximize their own interests as opposed to the interests of the principles. This mostly takes place when it is expensive or difficult for the principle to know what the agent is doing. The role of the agency theory is therefore significant in the sense that it propagates the implementation of mechanisms that will align the interests of the principle and those of the agents which will reduce the scope of opportunistic behaviour and information asymmetric. The agency theory also reestablishes the significance of self interest and incentives in organizational thinking. Clarke, (2004) highlights that; much of the life cycle of any organization is governed by self interest. Both the principles and the agents do have interests and there interests have to be effectively met. The agency theory therefore propagates the use of mechanisms such increasing compensation incentives for the managers (agents) so that they may not get involved in actions that result to the agency problem for instance maximizing their own interests as opposed to the interests of the shareholders. Another mechanism is through the use of dialogue and engagement, for instance through one on one meetings between the managers and representatives from investment institutions (Clarke, 2004). The role of the agency theory is also predominantly relevant within in the information system of the company. The information system in this case is where the behaviour of the executives are monitored by the board of directors. On the basis of an agency view point, boards are utilized as devices of monitoring the interests of the shareholders. Boards act as a device in which richer information can be provided to shareholders and thus the top executives will develop the behaviour of acting according to the interests of the shareholders as opposed to their won interests. For instance, from the agency perspective, behaviours such as the use of golden parachutes and greenmail which tend to give more benefits to the managers more than the shareholders are not likely to occur when boards can effectively monitor the interests of the shareholders. Operationally, the effectiveness of the information provided by the board of directors can be evaluated in terms of aspects such as the number of board members with industrial and management experience, the number of times the board meetings are held and the number of subcommittee’s in the board. The agency theory therefore promotes the existence of an information system within the company through the significant role played by the board of directors (Clarke, 2004). The agency theory also plays a significant role the creation of risk awareness. In most cases, many companies are usually not certain about their going concern or their future. The future of a business may either be that of bankruptcy or prosperity. More often, the future of a business is in the control of the management of the organization. Furthermore, environmental implication such as entrance of new competitors, government regulations and change in technology are some of the risks that may affect a business. The agency theory has been significant in extending the thinking of organizations to consequences of creating risk. The implication of this is that the contracts between the agents and the principle will always be grounded on eliminating risks at all costs (Clarke, 2004). The existing alternative for the agency theory is the transaction cost theory. The transaction cost theory mainly argues that it is the manner in which a company is organized that determines its control over transactions. The theory further propagates that the transactions should be handled in a manner to minimize costs in carrying them out. The transaction cost theory can act as an alternative for the agency theory based on the fact that it also addresses the core issue of maximizing the interests of the shareholders. Another theory that can act as an alternative for the agency theory is the shareholder primacy theory. The shareholder primacy theory also propagates that the interests of the shareholders should be the first priority of a company (Keay, 2011). This particular view point is also held by the proponents of the agency theory. There are numerous problems that may emerge by putting the three theories in practice. One of the major problems is that by focusing on the shareholder, the agents may get involved in risky financial decision in order to maximize the interests of the shareholders in the short –run, yet in the long run the performance of the company may decline as a witnessed in the recent financial crisis. Another challenge is that by focusing on the shareholders more, a key element of the company which is the stakeholder is neglected (Boatright, 2010). This may afterwards negatively affect the performance of the company for instance if employees go on strike. Conclusion The above discussion discloses the fact that the notion concerning the extent to which a company should exist only for the benefit of its shareholders, is quite controversial. The essay presents various view points to support the fact that to a great extent, the existence of a company should only be for the benefit of the shareholders. One of the aspects is that if shareholders benefits are not given much focus the company is bound to fail or collapse in the long run. The capitalist nature of society also requires that the interests of the shareholders are not maximized. Another factor is that focusing on the shareholder enhances sectorial development and supports financial markets. The paper also highlights that maximizing the wealth of the shareholders is the most appropriate goal for any particular firm. The paper also discloses the fact that a company’s existence should not only be for the benefit of its shareholders. A significant aspect that was highlighted by the discussion above is that the agency theory does have a great role to play in the management of company’s. Nevertheless, the agency theory and its existing alternatives do bring about negative implications to organizations. References Bryce, R, 2008, Pipe Dreams: Greed, Ego, and the Death of Enron. BBC, 2013, Barclays misled shareholders about source of £3bn, BBC News. Boatright, R, 2010, Finance Ethics: Critical Issues in Theory and Practice, John Wiley & Sons. Cooper, S, 2004, Corporate Social Performance: A Stakeholder Approach Corporate Social Responsibility Series, Ashgate Publishing. Clarke, T, 2004, Theories Of Corporate Governance: The Philosophical Foundations Of Corporate Governance, Routledge. Elson, C, 2010, Five Reasons to Support Shareholder Primacy, Failure to put shareholders’ interests first would drive away investors and capital, argues this director and academic. Forbes-Pitt, K, 2011, The Assumption of Agency Theory, Taylor & Francis. Horrigan, B, 2010, Corporate Social Responsibility in the 21st Century: Debates and Models , Edward Elgar Publishing. Keown, J, 2003, The Logic and Practice of Financial Management, Sage. Keay, A, 2011, The Corporate Objective, Corporations, Globalisation and the Law Series Kara,S, 2009, "Madoff Chasers Dug for Years, to No Avail". The Wall Street Journal. Malekian, R, 2012, Free Cash Flow: The Key to Shareholder Value Creation, Richard Malekian. Munzig, G, 2003, Enron and the Economics of Corporate Governance, Stanford University. Maher, M and Andersson, T, 2004, Corporate Governance: Effects on Firm Performance and Economic Growth. London: Organisation for Economic Co-operation and Development, p.17-19 Marin, M, 2012, The crisis of shareholder primacy, University of Cambridge http://www.cam.ac.uk/research/discussion/the-crisis-of-shareholder-primacy Pearson, G, 2012, The truth about shareholder primacy, The Gurdian. Stout , L , 2011, New Thinking on ‘Shareholder Primacy’, Business Law Institute. Stout, L, 2012, The Shareholder Value Myth: How Putting Shareholders First Harms Investors , Suzanne, B. (2008). "Madoff Case Raises Compliance Questions". The Wall Street Journal . Solomon, J, 2011, Corporate governance accountability, John Wiley & Sons Read More