Agency Theory and Corporate Governance - Essay Example

Dissertation proposal Agency Theory Table of contents Sl no Particulars Page no 2 Chapter Introduction 3 Chapter 2 Literature Review 7 Chapter 3 Research Metholdogy 12 Chapter 4 Conclusion 19 Bibliography 21 Abstract In this brief dissertation proposal, agency theory has been discussed within the context of corporate governance. The de-facto owners of a corporation are the shareholders who cannot however participate in the day to day management. They have to necessarily entrust the management of the corporation with the Board of Directors who agrees to act as the agents of the shareholders. This is where the agency theory gains significance. However, in actual management, the agents come across conflicting situations where they have to balance the interests of all concerned called stakeholders. At this stage, agency theory is superseded by what is called stakeholder theory. The same not having been clearly defined, modern scholars advocate the theory called “enlightened stakeholder theory” which seeks to remove the shortcomings in the traditional stakeholder theory so that managers who could take shelter under the traditional stakeholder theory and avoid accountability, are now compelled to show performance for value maximisation in the long run. This is sought to be achieved by active participation of agents/managers through proper motivation and communication with a scorecard on hand. Thus the enlightened theory would go a long way in plugging the loopholes in the corporate governance occurring in spite legislations like Cadbury report, Greenbury report in the U.K. and SOX Act in the U.S.A. Chapter 1.1 Introduction Corporate Governance is a much-discussed issue of public importance, of late. One aspect of the issue is the corporate ownership and control which this proposal deals with. In the discussion here, the word ‘corporate’ is loosely described as firm, company, corporation etc, which all refer to public-owned companies listed in stock exchanges. Share-holder activism all over the global corporate environment has given rise to the study of corporate ownership and control and their impact on the performance of the corporates. By 1990 Corporate Governance had become a household name in the United States of America when a California based pension fund company “California Public Employees Retirement System’’ (CalPERS) that had invested members’ funds in the shares of leading companies, pioneered by questioning those listed companies’ practice of buying back shares from the share holders at higher prices which meant draining of companies’ capital and in turn reduction in value of shares held by them. This was soon followed suit by many contemporary companies representing widely dispersed shareholders around the world including U.K. What started as means of funds mobilization for an entrepreneur to engage in large scale activities and to achieve large scale economies soon became a modus operandi to exploit the small and widely dispersed investors by the entrepreneur. In the nineteenth century, even largest companies were owned and controlled by founding fathers who accumulated wealth overtime which they reinvested in their businesses. In spite of this, they could not cope with the developmental requirements and the answer to their problem was to raise additional capital through share markets. As they died or retired, their own shares got parceled out among their descendants. By twentieth century such largest shareholdings were becoming fragmented and dispersed. This was reduction in ownership concentration. Yet such fragmented concentration has been perhaps still large enough warranting the present study. Basically this state of affairs underlies the need to understand how corporations are governed and how the system can be improved. In critically examining the nature of ownership and purpose of corporations, it is worthwhile to discuss the principal-agent theory and stake-holder theory. Though Adolf A Berle and Gardiner C Means 1 first discussed the development of agency theory, we can still go backwards to Adam Smith who in his book “The wealth of Nations” 2 had already identified the agency problem by postulating that company directors would not take much care of other people’s money as their own, as observed by Letza, Sun and Kirkbride. 3 The present state of affairs only reconfirms to reflect that it is truism to say that the share holders own the company. The shareholders are the principals while directors are the agents. Principal-agency relationship is a problem because the agents may not always act in the best interest of the principals. Therefore decisions taken by the agents are not always consistent with principals’ welfare. The stake-holder theory is in stark contrast to the principal-agent theory which mainly focuses on the interests of shareholders. The stake-holders theory suggests that if managers (agents) are over concerned with share holders, the tendency is to concentrate on short-term profits rather than long term interests. If the share holding is on long-term basis this problem will not arise. Corporate Governance is a broader concept in that ‘what is optimal for shareholder often is not optimal for the rest of the society’4 The principal-agency theory assumes that profit maximization is the main motivation for a company’s strategy and tactics whereas stake-holder theory underlies the importance of all concerned affected directly or indirectly by the firm’s operations. Besides the shareholders, the stake-holders are employees, Government, customers, suppliers, bankers and even the general public if environmental aspects are taken into consideration. A balanced approach can be taken between the two theories though the latter theory even by default will not miss the former’s interests. Yet another view is that stakeholders are voluntary partners implying their willingness to take risks as in a contract.5 By virtue of being voluntary stakeholders, they are deemed to have assumed some risks associated with investment of financial or human capital. On the other hand, shareholders are involuntary stakeholders facing risk as a result of firm’s activist as defined by Clarkson. 6 Moreover real stakeholders are those who have legitimate claim and the ability to influence their firm.7 As such it becomes clear there are primary and secondary partners in a firm with proprietary interests as shareholders and others interests in less tangible assets as contractors, suppliers etc. It is very clear that stakeholders other than shareholders in a firm are protected by much legislation to safeguard their interests and hence firms are not necessarily expected to go farther in the name of corporate governance. There are however limitations in pure shareholders theory as the only stakeholders since the company board have to act in some other way if the shareholders behave in a manner against the interest of the company. However, there have been further refinements of this theory as “enlightened stakeholder theory”. With these newer theories, corporate governance has acquired further dimensions. This proposal intends to compare all the theories and advocate the best suited theory in the present day world of corporate governance wrought with never ending corporate failures and scandals. This proposal has a brief literature review in Chapter 2 and Research methodology in Chapter 3 followed by conclusion in Chapter 4 justifying the hypothesis below for the ultimate dissertation. 1.2 Problem statement Corporate governance is the much bandied concept in the corporate world in the wake of corporate scandals. Pursuant to SOX legislation in the U.S. and Cadbury report in the U.K. loopholes in the corporate governance have been plugged. Yet corporate failures and sandals have not ceased. The agency theory and stakeholders theory have been some what helpful in tackling the problem of corporate ownership and control. Yet they have not resulted in completely preventing avoidable corporate failures. Executive compensation has been the hottest subject of discussion these days in the wake of successive corporate failures which could have been avoided had there been better policy decisions. It is felt that the agency theory and stakeholder theory have not adequately helped shaping of corporate governance policies towards tackling the menace of corporate failures. As a refinement to the stakeholder theory, an ‘enlightened stakeholder theory’ has emerged of late, purporting to make up the inadequacies in the former. This state of affairs leads to the following research questions in the proposed study. 1.3 Research questions 1) What is Agency theory and how far it has shaped corporate governance? 2) What are stakeholder theory and its contribution to the understanding of corporate governance? 3) and What is enlightened theory and how it can help future corporate governance? The hypothesis of this proposed dissertation is enlightened theory is best suited theory for effective corporate governance. In meeting with the proposal, structure of the main dissertation will consist separate chapters devoted to an exhaustive literature review, a detailed discussion of research methodology adopted, a critical review of the findings from the literature review, discussion, conclusion and recommendations and reflections. The aim and objectives of the proposed dissertation are 1) to critically analyse the agency theory, the stakeholder theory and the enlightened stakeholder theory within the context of corporate governance and 2) to compare and contrast the three above stated theories and justify which one of these best fits with the present status of corporate governance. Chapter 2 Literature Review 2.1 Theory of firm in corporate governance context According to Jensen and Meckling, a firm is formed out of an agency relationship whereby the shareholders as the principals engage managers to act as their agents on their behalf for running of the company.8 In the process, the principals delegate some decision making authority to the agent. In this relationship, problems crop up because there can be no perfect contractual understanding for day to day actions taken by the agents on behalf of the principals. Thus the decisions of the agents affect both their own welfare and that of the principal.9 Hence, the need arises to make the mangers to act in the best interests of the shareholders. 2.2 Agency costs These are cost to be borne by the shareholders due to divergence of interests between the shareholders acting as principals and managers acting as agents. Thus agency cost is the sum total of monitoring cost, bonding cost and residual cost.10 Monitoring costs are incurred by the shareholders as principals to monitors the actions of the managers as their agents in order to control their behaviour. These costs will include auditing costs, managerial remuneration, and cost of dismissing the managers also. According to Fama and Jensen, though these costs are initially borne by the principals, they are in fact borne by the agents themselves as part of their executive compensation.11 The monitoring processes are also supplemented by the legislative actions such as Cadbury report 12 and Greenbury report 13 for compliance or non-compliance of requirements as part of their corporate governance. While Denis, Denis and Sarin 14 insist that monitoring restricted to some groups or individuals should be done by experts who should be given incentives for effectively controlling the managers’ performance, Burkart, Gromb and Panunzi 15 assert that too much control will be counter-productive. This is also a part of criticism of Cadbury report since it is apt to run counter to the spirit of managerial enterprise. Next comes the bonding costs which are incurred for setting up systems that will ensure that managers act in the interest of shareholders failing which they are duly compensated by the same systems. This cost also will be ultimately borne by the managers as agents though originally incurred by the principals. These systems will provide additional disclosures to the shareholders which the managers as agents have the convenience of preparing themselves. In U.K., the bonding systems stipulate that closely held companies must fully part with the income after meeting the business expenses. Part of the agency cost is the residual loss that arises as a result of conflict of interests since interests of shareholders and managers will not be fully in alignment even after the costs of monitoring and bonding.16 Enormity of Corporate Governance According to the Institute for Policy Studies report 2001-2002, there are some 40,000 corporations in the world out of which just 200 corporation alone have one fourth control over the world’s entire economic activity. And that the U.S. based Philip Morris Corporation that operates in over 171 countries have annual revenues equal or exceeding that of the economy of New Zealand. The fact is further confounded because it turns out that out of the 100 largest economies of the world, 51 are corporations. Thus there more economies are in the hands of corporations than the countries.17 The corporations act almost as forms of Governments. The true owners of the corporations are the shareholders who were originally considered as the only stakeholder to whom management is responsible as mentioned in the memorandum of Stanford Research Institute in 1963 when the term “stakeholder” first appeared in the management literature. The stakeholder was originally defined as the one without whose support, the corporation could not exist.18 Stakeholder theory Carroll and Buchholtz state that there are strategic stakeholders as groups vital as both threats and opportunities to the company. The strategic stakeholders are mainly concerned with economic efficiency and growth of the company. The strategic stakeholder approach (SSA) citing moral strategic approach (MSA) underlies the importance of strategic stakeholders as essential for the very existence of the company. These SSA approach includes shareholders, suppliers and employees as contributors of inputs for being converted into benefits to its customers. The Moral Stakeholder Approach on the other hand, proposes Moral Stakeholder theory encompassing families of the employees, local community and society at large in addition to the actors of SSA. This MSA is regarded as capable of increasing the long term shareholder value. Thus MSA posits that who ever affects or is affected by the company is a stakeholder.19 Problem with stakeholder theory Jensen states that the traditional stakeholder theory like in the MSA above, expects that mangers should take into account of all concerned i.e. not only shareholders, suppliers but also employees, buyers, local communities, communities at large, government agencies, environments and also terrorists and blackmailers!. This assumption is because of the fact the stakeholder theory fails to guide managers how they can make the tradeoffs to enable them take valid decisions. This in turn makes managers indecisive and complacent without being accountable for their acts. This stakeholders theory will be quite handy for those who are self-serving managers and directors.20 Enlightened stakeholder theory In the same breath, Jensen offers Enlightened stakeholder theory to be the guiding spirit of corporate governance. Creation of long term value is broader than value maximisation of the organisation. Value maximisation as a corporate vision will not involve workers and managers to work for value creation. He states that value maximisation objective should be accompanied by a uniting corporate vision and strategy binding the stakeholders in their endeavour to achieve a dominant position in the competitive world. Although maximisation of value cannot be achieved without the participation of the stakeholders, the theory must enable the managers to make the tradeoffs among the stakeholders in order to arrive at value maximisation in the long term. He calls it the ‘enlightened stakeholder theory’. Whereas the traditional stakeholder theory simply informs value maximisation in the long term without spelling out how to achieve it, the enlightened stakeholder theory aims at enlightened value maximisation by proper motivation and communication with managers, employers and other participants. Instead of being taken as a vision or mission, value maximisation should be used as a scorecard for the firm as posited by Jensen.21 Chapter 3 Research methodology Research Methodology is the framework within the confines of which a study is conducted. It lays down approach to a problem to be applied in a research programme. This chapter will choose a method by highlighting different research methods in practice. There is no single best method for research. Rather an approach most effective for the solving of the problem under study will be selected. And “Research methodology is always a compromise between options in the light of tacit philosophical assumptions, and choices are frequently influenced by availability of resources”22 The end result of this study should go a long way in explaining conflict between ownership and control through the enlightened theory for which purpose it has become necessary to apply appropriate research methods. This section includes research design and justification of the methods selected and also narrates how the research has been conducted to achieve the object of this study. 3.1 Data requirement Studies are conducted by either the quantitative or qualitative research approaches. Mark Saunders et al 23 quotes Carl Gustav Jung as saying that science which relies on the concept of averages is not suitable for subjective studies. This study being subjective, statistical science which works on averages is considered unsuitable for achieving the aim of this study. The present study was found to be feasible only by way of adopting qualitative research methods. The conflict between corporate ownership and control could be better studied as a hands-on experience rather than as a perspective study as in quantitative approach which calls for validity and reliability and requires a lot of theoretical persuasiveness especially because this study is meant for the benefit of all the stakeholders. To achieve the objectives of this study, many ways of (methods) gathering information were available through literature reviews. 3.2 Research design and justification In research terminology, the research objectives are theories to be developed. Saunders et al 24 endorse the proposition of Engelen and Zwaan 25 that theory development trajectory involves using of existing theory and practices and construction of a new theory reflecting reality with a high predictability. Testing of the same is done to determine its confirmation or rejection in other words answering the research questions as correct or not. In theory application, a problem is diagnosed, defined and theories (suggestions) to improve the unwanted situation (deficiency) are determined (arrived at) see figure 3.1 below. Figure 3.1 Figure 3.1 (Mark Saunders et al 2003) The literature review above has thrown open different theories of ownership and control, citing several sources of research giving rise to new theories. Figure 11 confirms this. Saunders et al 26 state that Engleen and Zwaan differentiate two main research cycles for management studies. They are 1) Empirical cycle with five steps of Research goal, Research design, Data Collection, Data Analysis and Reporting. And 2) Design cycle also has the five steps of Design Goal, Design specifications, generation of different designs, selection from different designs and Reporting. As the author is decisive about only qualitative approach for this study, empirical analysis is considered unnecessary. The statistical analysis even if done can not give any answer to problem addressed or research questions since it does not warrant study of causal relationship between variables. 3.2.1 Research philosophy Saunders et al 27 agree with the suggestion of Dan Remenyi & others 28 that research philosophy is of three kinds. They are positivistic philosophy, realistic philosophy and interpretivistic philosophy. This study falls largely under the interpretivistic philosophy as study of corporate ownership and control and conflict between the two involve facts that are real. In an attempt to understand the theories of ownership, the author has collected following secondary information through foregoing literature review which discusses Agency theory Stakeholder theory Enlightened theory. Primary data collection, though desirable, is not considered necessary in view of the scholarly studies already available on the study and it has been ensured that whatever secondary data relied upon for this proposed study have undergone primary research. 3.2.2. Research strategy The secondary data collected are subject to the above qualitative assumptions. Secondary information and data are the support bases for this study. In the literature review, a near-exhaustive discovery has been made as to different types of theories on corporate governance. What this study aims to achieve is to think out of the box and to arrive at a justifiable theory for corporate ownership and control. The secondary data through literature review would only serve as a beacon for seemingly never ending search. 3.3.1 VALIDITY AND RELIABILITY The validity of research depends up on the internal and external validity of the research. Whereas the internal validity is “the extent to which its design and the data that it yields allow the researcher to draw accurate conclusions about cause and effect and other relationship within data”29, the external validity is “the extent to which its results apply to situations beyond the study itself”30 Internal validity The internal validity will be ensured by ensuring that secondary data have already been subjected to validity and reliability studies Being a post-mortem research as described by Saunders et al, this researcher has taken care to by sending a copy of this research for. peer review to double check validity of the findings. 3.3.2 EXTERNAL VALIDITY. Saunders et al 31 say external validity is the endorsement that findings in a study could be applied in a wider context beyond the realms of the study itself as an answer to the question raised by Remenyi et al.32 There can be no doubt about the external validity of this study on corporate ownership and control, already covered by survey reports and individual case studies from the secondary data of the proposed study. 3.3.3Reliability of the study .This deals with the trustworthiness of the data collected for the qualitative research. Saunders et al 33 adopts the view of Scale that “the trustworthiness of a research report lies at the heart of issues conventionally discussed as validity and reliability” 34 It has been ensured that questionnaires for case studies in the secondary data have undergone peer review before commencement of the actual case studies as suggested by Saunders et al 35 The author will also follow the advice on the writing up of this thesis given by Wolcott’s 36 As per the advice, the researcher will start writing this at the earliest possible opportunity instead of collecting every thing upfront required for the thesis. For example, Wolcott points out that “many qualitative researchers make the mistake of leaving the writing up until the end i.e. until they have got “the story” figured out. However, Wolcott makes the point that ‘writing is thinking’. Writing actually helps a researcher to think straight and to figure out what the story should be. The motto of every qualitative researcher should be to start writing as soon as possible.” 37 3.4 Conclusion This chapter dealing with the variety of research methodologies has justified the adoption of qualitative approach to achieve the objective of this study. The quantitative approach short of statistical methods has all also been liberally adopted. The hypothetical approach is needed only when there are unclear phenomenons not visible to naked eyes. The problem statement of corporate ownership and control is clearly within the qualitative approach as the study is within the context of corporate governance. However the author found the research more problematic than presented in the text books as described by Andrew M Pettigrew 38 that research process is “best characterised in the language of muddling through incrementalism and political process than as rational, foresightful, goal-directed activity” The author also found the observation of Becker 39 very realistic as he says that “every researcher knows that there is more to doing research than is dreamt of in philosophies of science, and texts in methodology offers answers only to a fraction of the problem one encounters. The best laid research plans runs up against unforeseen contingencies in the collection and analysis of data; the data one collects may prove to have little to do with the hypothesis one sets out to test; unexpected findings inspires new ideas; Now however carefully one plans in advance, the research is designed in the course of its execution, the finished monograph is the result of hundreds of decisions, large and small, made while the research is under way and our standard texts do not give us procedures and techniques for making those decisions…. It is possible, after all, to reflect on one’s difficulties and inspirations and see how they could be handled more rationally the next time around. In short one can be methodological about matters that earlier had been left to chance and improvisation and thus cut down the area of guesswork”40 Chapter 4 Conclusion In this concluding chapter of the proposal, the researcher is confronted with the need to justify the best possible theory of corporate governance. In the forgoing literature review and the introduction, it has been said that the shareholders can be best taken care of by proper policy objectives. In the process, agency theory, stakeholder theory and the enlightened theory have been briefly discussed. In the ultimate analysis, the enlightened stakeholder theory is seen as the best alternative for proper corporate governance in order to minimise or even to remove the conflict between the ownership and control. The main dissertation will proceed along these lines to interpret enlightened stakeholder theory as the best possible bench mark for corporate governance. As a limitation to this study, the concept of corporate governance has become ever evolving and hence new concepts in the wake of globalisation will give rise to newer theories. In fact an “enlightened shareholders theory” has been mooted by a scholar which will be touched up on in the main dissertation. As this is still in embryonic stage, it is premature now to adopt this one. Bibliography Books Adolf A Berle and Gardiner C Means, The Modern Corporation and Private Property. ( Macmillan, New York 1932) 76 Archie B Carroll and Ann K Buchholtz, Business and Society Ethics and Stakeholder Management, (5 th edn South-Western, Mason, OH 2003)73 Engelen J Van and Zwaan Der Van, Theory Development and Theory Application (1994)28. 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