Theories of Corporate Governance - Literature review Example

Theories of Corporate Governance Student’s Name: Name of Institution: Instructor’s Name: Course Code: Date of Submission: Introduction Much debate has surrounded the definition and conceptualization of corporate governance. Regarding the set scope of this paper, this essay will not delve into the variations alluded to, except merely to note that despite them, many scholars agree on the theories meant to explain it. Although some papers have showed more than three theories, this paper will focus on the three main ones. Agency Theory This theory has its roots in the economic theory is basically concerned with the relationship between the company principals (i.e. shareholders) and agents (i.e. managers and executives). The premise here is that shareholders (who are actually company owners or principals) hire gents to perform company work, and delegate the daily running of business to the managers and executives (the agents) (Clark, 2004). Figure 1 below illustrates the Agency theory. Figure 1: Agency Theory Source: Abdullah & Valentine (2009) According to Daily et al (2003), the prominence of the agency theory is attributed to two key factors. One, it is conceptually simple and reduces the whole corporation to two parties, i.e. the shareholders and managers/executives, i.e. ownership and control. Two, the theory suggests the idea of self-interest among managers/executives or employees. Although the shareholders expect and hope the agents will act/behave and make decisions in a way to serve the principal’s interest, this may not necessarily be the case (Padilla, 2002). In other words, the agents may succumb to self interest and opportunistic behavior, and thereby fail to meet the congruence between the expectations and aspirations of the principals and the pursuits of the agent. Davis et al (1997) also confirm the problems that arise from such a separation. In line with this, Holmstrom and Milgrom (1994) argue that the agents, rather than providing incentive payments that fluctuate, may focus only on the projects that promise high returns and therefore have fixed earnings/wages without any component providing incentive. Although this may promise fair judgment, it however does not kill or minimize corporate misconduct. Ultimately, since this theory emphasizes the maximization of shareholders’ value, it rather entertains individualistic interests. This is the main criticism directed against this theory. Stewardship Theory Stewardship theory refers to the role of top management, i.e. stewards, in integrating their goals and objectives with those of the organization. The stewards here include company managers and executives who work selflessly for the shareholders, protecting and making profits for them. As Davis et al (1997) put it: “a steward protects and maximizes shareholders wealth through firm performance, because by so doing, the steward’s utility functions are maximized”. This is to say that stewards become satisfied and motivated when their organization(s) attains success. But to facilitate and even enhance this, it is important for there to be structures that not only empower the stewards, but also grants them maximum autonomy based on trust (Davis et al, 1997; Bhimani, 2008). Figure 2 below summarizes Stewardship theory. Figure 2: Stewardship Theory Source: Abdullah & Valentine 2009 But many writers, especially the proponents of agency and stewardship theory see the two as contradictory. Davis et al (1997), for instance, accept the possibility that the methodologies they used in the studies aimed at providing support for the theories may have been lacking in some ways. One such deficiency is that the studies did not exactly distinguish between the impacts of industry regulation on a firm and those of having a dominant shareholder playing the supervisory board, i.e. the so-called relationship investor. Also, Turnbull (1997) suspects that stewardship could be self-fulfilling. This can especially be seen in the firms around Mondragon area, which do not have independent directors. All the firms’ board members are either some kind of stakeholders or managers (Turnbull 1995d, cited in Turnbull, 1999). Although these boards are controlled by other councils or boards, the question of self-fulfilment is not exempted. In this respect therefore, stewardship theory can be viewed as a sub-set of other broader corporate governance theories, e.g. the theory. Ultimately, the validity of this theory is context-dependent. As Turnbull (1997) concludes, the need and inclination for one to act as a selfless steward is largely culturally contingent. Stakeholder Theory Stakeholder theory, which has its roots in both organizational and sociological disciplines, is more of a broad tradition of research rather than a formal unified theory, incorporating aspects of ethics, philosophy, political theory, law, economics and organizational science (Wheeler et al 2003). Figure 3 summarizes the Stakeholder Theory. Figure 3: Stakeholder Theory Source: Abdullah & Valentine 2009. Essentially, Stakeholder theory is concerned with an individual who or a group that can both affect and/or be affected by an organization’s activities in the process of pursuing its objectives. Rather than serving shareholders, as is the case of Agency theory, here the management serves a network of relationships, including employees, suppliers, business partners, other interest groups, e.g. environmentalists, media, etc. The premise is that a firm should aim to create value or wealth for its stakeholders in the form of goods and services (Bhimani, 2008). In favor of this theory, Porter (1992, cited in Turnbull 1997) advised the US government to encourage not only long-term ownership of employees, but also board representation by significant suppliers, customers, employees, financial advisers and community representatives. This representation would be aimed at giving stakeholders ownership and direct voice in governance. However, Turnbull (1997) fears that Porter’s recommendation to allow various stakeholder groups to appoint representatives to a common unitary board may be counter-productive. If such membership were to occur, although doubtful, Turnbull (1997) argues, it should strictly be based on informational participation, as is achieved through Keiretsu Council in Japan or supervisory boards and works council in continental Europe. Hill and Jones (1992, cited in Turnbull, 1997), on the other hand, used both explicit and implicit contractual relationships within a firm to develop a theory that borrows from both the Stakeholder and Agency theories. Regardless of a still-ongoing debate, the significance of Stakeholder management is seen in the way that it has increasingly become a major tool for corporate management in the contemporary world. Conclusion Because of the recommended size of this paper, it has only taken an at-a-glance examination of the three theories of corporate governance. Still, it provides a crucial basic framework for the discussion on the theoretical study of corporate governance. Bibliography Abdullah, H & Valentine, B 2009. Fundamental and ethics theories of corporate governance. Middle Eastern Finance and Economics, Eurojournals Publishing, Inc. Issue 4. http://www.eurojournals.com/mefe_4_07.pdf (accessed 15 July 2012) Bhimani, A 2008. ‘Making corporate governance count: the fusion of ethics and economic rationality’, Journal of Management and Governance, vol. 12, no. 2, pp. 135-147. Clark, T 2004. Theories of corporate governance: the philosophical foundations of corporate governance, London and New York: Routledge. Daily, CM, Dalton, DR & Canella, AA 2003. ‘Corporate governance: decades of dialogue and data’, Academy of Management Review, vol. 28, no. 3, pp. 371-382 Davis, JH, Schoorman, FD & Donaldson, L 1997. ‘Toward a stewardship theory of management’, Academy of Management Review, vol. 22, no. 1, pp. 20-47 Holmstrom, B & Milgrom, P 1994. ‘The Firm as an incentive system’, The American Economic Review, vol. 84, no. 4, pp. 972-991 Padilla, A 2002. ‘Can agency theory justify the regulation of insider trading’, The Quarterly Journal of Austrian Economics, vol. 5, no. 1, pp. 3-38 Turnbull, S 1997. ‘Corporate Governance: Its scope, concerns & theories’, Corporate Governance: An International Review, vol. 5, no. 4, pp. 180-205, http://cog.kent.edu/lib/turnbull4.html (accessed 15 July 2012) Wheeler, D, Colbert, B & Freeman, RE 2003. ‘Focusing on value: reconciling corporate social responsibility, sustainability and a stakeholder approach in a network world’, Journal of General Management, vol. 28, no. 3, pp. 1-28 Read More