Governance in Theories

Introduction:

The development of the form and structure of markets since the Industrial Revolution has demanded a special concept to organize the governance between the owners of wealth and the directors of firms. This has motivated scholars to produce a number of theoretical frameworks to clarify this relationship, protect shareholders’ interest, control directors’ personal interests and reveal the conflicts which may occur between these two parties for creating strong governance.

The frameworks theories based on different concepts, although their main concentration is on shareholders’ benefits more than anything else. Agency theory, Transaction Cost Economic, Stewardship, Stakeholder, Class hegemony, Managerial hegemony, and Resource dependency, are the most well-known theories.

However, the most widespread and adopted theories are the Agency, Transaction Cost Economic, Stewardship and Stakeholders theories. The first three of these theories mostly concern shareholders benefit more than other stakeholders, and assume that the main role for directors is to increase shareholders’ wealth. Thus, in the Stakeholder theory, and due to modern market complexity, the appearance of international corporation (corp), and the vital new role for social responsibility, all these factors forced scholars to develop CG to go beyond shareholders, interest and include stakeholders’ interest within directors’ roles.

Consequently, there is a big debate between all these theories in terms of the validity in practice in corp within the new modern market, new legislation, corp complexity, basic human right requirement and power groups in societies, besides exploiting shareholders profits.

However, the financial crises in 2007/2008 triggered CG to track these theories to highlight; what the loyalties of directors in practice are for?, for whom they should work?, how their work can be understood, and how the information could be used to identify how directors ought to work (Tricker, 2009, Mallin, 2007, Nordberg, 2011).

Corporate Governance definition:

"the process of controlling management and of balancing the interest of all internal stakeholders and other parties (external stakeholders, governments and local communities) who can be affected by the corporations conduct in order to ensure responsible behaviour by corporations and to achieve the maximum level of efficiency and profitability for a corporation" (Du Plessis et al, 2005, pp.6-7).

In general, Corporate Governance (CG) considers controlling management processes to meet the entity target by maximizing the efficiency and profitability of all internal stakeholders. CG also considers the interests of other external stakeholders, who may be affected by the entity behaviour, and certifies a responsible conduct by corp.

Theories connected with the development of CG:

There are many theories have influenced CG. The main theories which have affected CG are the Agency, Transaction cost economics, Stakeholder and Stewardship theories. Agency theory; shows the relationship between two parties, where one party is the principal (owners or shareholders) who delegates work to the second party, who is the agent (directors, managers). This relationship is organized in a corporation framework within a nexus contract between those two parties, and, accordingly, the principal contributes capital and accepts the risk of corp, while the agents are usually exclusively responsible for decision management to increase principal wealth (Stiles & Taylor, 2002).

The transaction cost economics: represents corp itself as a governance structure, and that structure can arrange in a line the interests of directors and shareholders. Whilst the Stakeholder Theory; focuses on stakeholders rather than on shareholders. Accordingly, the governance structure of corp could have a direct representation of the key stakeholder representatives. One more is the Stewardship Theory; in which directors are considered as the stewards of corps assets, and will be expected to manage, so that in the shareholders can ultimately benefit (Mallin, 2010, p. 14).

The contribution of Agency theory in CG:

During and after the Industrial Revolution, business has faced massive developments with wide opportunities. Those people who have wanted to capture these opportunities have started to build a general partnership and a joint venture to undertake a long-term business and establish big enterprise. The partnership and joint venture have created new relationships between active and passive partners -the unicorporate stock company-. This relationship has responsible for managing companies’ assets, as well as determining a share responsibility between partners for the liability of the business. Within this type of partnership, the law has separated the asset of firms from the personal asset of the partners. Consequently, that base has grown and boomed to form the contemporary corporate concepts, producing new partners, who are shareholders and directors. As a result, these developments in markets and firms have led to special techniques to manage the new relationships between partners (Blair, 2006, p. 48).

However, passive partners delegated Agency theory to organize the relationships between the agents and the principals, in which the principals delegate work to the agents through a contract regulated by this relationship, and the agent has to achieve that work. However, within this relationship, a conflict has arisen between the agents and the principals, when the agents meet a partial interest of the principal’s interest. Consequently, that mismatching in interest between those two parties initiated a misused delegation by the agent, and leading to the agent taking risks that were not approved by the principal.

There are two streams developed in this theory; the Principal-Agent relationship and corporate control. The Principal- Agents relationship is concerned with building a formal theory, and that is largely applied to many agency relationships, such as employer-employee, lawyer-client, and buyer-supplier. The corporate control -meanwhile- is concerned only in the relationship between shareholders and agents in large companies (Eisenhardt, 1989).

However, the main argument in Agency theory is the conflict between principals and agents. Lambert (2001) disclosed four causes for conflicts arising between principals and agents: the first point is that agents could not have a desire to give the optimal effort when completing their work and this happens when there is an expectation for effort aversion by agents. Secondly, agents may use their delegations to exploit an opportunity to divert resources to their personal advantages. Thirdly, is the time differential between agents and principal this happens when the principals evaluate their involvement in the agency relationship for a long period -more than 10 years-, while agents expect a short term relationship with the agency. Finally, it is concerned the different attitudes to risk detained by both two parties.

Moreover, because of the information asymmetry, both agents and principals have access to different level of information. Accordingly, principals cannot know the actual situations and recognize agents’ performance well (Mallin, 2010, p. 14).

Furthermore, Eisenhard (1989) added that conflict may arise when both principals and agents have different attitudes to manage risks, and this happens when each one has different risk appetites and different risk actions.

Consequently, the conflicts between agents and principals have produced an agency cost. this cost has appeared due to the importance of monitoring agents’ behaviour, which has required adopting some arrangements to give reasonable assurances and control agents attitudes. The costs of monitoring agents’ attitudes to prevent misusing their delegation, and the cost to check their actual performance, are determined as the agency cost. Lambert (2001) added that costs which may arise are either to limit agent’s capability to misreport or to limit the ability of agents to reliably disclose their information. If any of those two limits are available, there is a possibility to have misreporting as a symmetry attitude.

 Practically, Berger & Patti (2006) confirmed that capital structure, which is recommended by Agency theory, mitigates agency cost to give a positive relation with cost reduction. They proved empirically that the high leverage or a low equity/asset ratio cuts the agency costs of outside equity, and raises firm value by encouraging or reassuring managers to perform more in the shareholders’ benefit.

However, what happened in Enron, WorldCom and other failures, has given an impression that earnings management is exploited by agents for their personal benefits, rather than principal benefits. Nevertheless, empirically, Jiraporn et al (2008) concluded in their study that “…firms with more (less) earnings management have higher (lower) value. Earnings management appears to be beneficial.

Furthermore, Guay et al (1996) positively confirmed that management cost could be valued because it may enhance the information value of earning, and agents may give decisions over earnings to provide private information to stockholders and the public. 

Eisenhardt (1989) stated that, theoretically, researchers should focus on information systems, outcome uncertainty, and risk in Agency theory to show all the pros and cons for this theory. Also, she added that positive researchers have solved agency problems with governance mechanism, so have an outcome-based contract, information-valid agent behaviour, a good information system, and outcome uncertainty. So, these points have a positive impact on agents’ attitude, and they will be more likely to conduct themselves in the benefit of principals.

However, Agency theory is widely spread due to the importance and popularity of the relationship between the agent and the principal in much cooperative behaviour. (Tricker, 2009; Eisenhardt, 1989 ). Thus, Agency theory is difficult to apply in cases where contracting problems could not be managed, when there are a big goal conflicts between two parties, when risks associated with the theory are undoubtedly caught, , and when there are difficulties to evaluate agents’ behaviour (Eisenhardt, 1989) .

Transaction Cost Economics (TCE):

This theory is close to Agency theory, but it assumes firms as a governance structure while the Agency theory assumes firms as a nexus of contract.

Particularly, in TCE, the main point is the operation of market cost, which is represented by the cost of making or buying. Accordingly, TCE aims to give the optimal profit for corp by making the best decisions and answering when it will be cheaper to produce transaction internally or to buy it from the market. As a result, managing resources without any agents bias, and maximizing profits with avoiding agents and principal interest conflicts, TCE has taken CG as a mechanism to take this decision (Stiles & Taylor, 2002).

In the Agency theory, principals cannot obtain a complete contract to cover all that may eventually happen during the contract period, and due to the cost of writing contracts in an apt way and the cost of negotiations with others, TCE has seen the governance structure as a good device to cover and make decisions for all these specific issues (Mallin, 2010, pp14-15).

Nevertheless, Fama & Jensen, (1983) argued that Agency theory also gives a strategic role to the board. One of the key board roles is to evaluate agents and corp performance as a whole, while the board should also monitor agents’ activities besides minimizing the agency cost. As a result, the board will protect principals’ interest and reduce the agents’ risks in agency. Thus, Zahra & Pearce (1989) claimed that there is little empirical support of the nature of the strategic role of the board in Agency theory. Moreover, TCE provides little detail on how boards should be organized and structured behind the role of providing strong control.

 However, there are big scholars’ debates regarding the real role of the board, and its actual efficiency. Also, studies have exposed the passive role of boards, and these support the research of the executive domination of the board. So, there is a potential that may change the balance of power between executives and non-executives in the role of the board (McNulty & Pettigrew, 1999).

Nonetheless, the similarity between Agency and TCE is that both are pursuing management to pursue shareholders interest and maximize shareholder/ corp profit. On the other hand, the main difference between them is that each has different terminology to describe the same issues. To exemplify this, TCE assumes people are always opportunistic, but in agency they always concentrate on moral risk issues and agency costs. Also, in TCE managers are opportunistic in managing their transactions, whereas in Agency, managers follow incentives and own interest. Furthermore, in TCE theory, the unit of analysis is transactions, but in agency theory it’s agents (Solomon, 2007, pp.22-23).

Stakeholder Theory (ST):

The main concept of ST is to rely on checking corp reactions to external influences by examining “…How does the structure of an organization's stakeholder relationships affect its response to stakeholder pressures?...” (Rowley, 1997). It defines stakeholders, categorizing them into useful groups, and provides an understanding of how individual stakeholders influence corp. The notion that ST assumes stakeholder management contributes to effective economic performance (Donaldson & Preston, 1995).

Solomon, (2007, p.23) added that ST exceeds shareholders to cover employees, providers, customers, governments, local communities, and the environment. Accordingly, it considers social and environmental lobby groups who investigate corp that have treated their stakeholders immorally. As a result, the shareholders’ importance becomes less evident in ST.

However, several corp make every effort to maximize shareholders’ profit and stakeholders’ group interest in the same time. In ST stakeholders have the privilege in the cash flow distribution, whilst shareholders are recipient of the residual free cash flow (Mallin, 2010, p. 16).

There are many scholars who argue that ST is a descriptive theory. Donaldson & Preston (1995) stated that ST is unarguably descriptive because it defines corp as a group of cooperative and competitive interests possessing fundamental value, but it is also instrumental because it introduces a framework for examining any relationship between stakeholders’ practice and corp performance. Moreover, ST’s fundamental concept is normative: It assumes that stakeholders have a reasonable interest in corp even if corp don’t have any equivalent interest with them, and the interest of stakeholders is inherent in corp value. Finally, ST not only describes present situations or forecasts cause-effect relationships, it mentions “…attitudes, structures, and practices that, taken together, constitute stakeholder”.

One of the most arguable points in ST, and discussed by many scholars such as Jensen (2001), claims that the advocates of ST refuse to determine how managers can compromise the interest of each stakeholder group, and therefore managers become unable to make purposeful decisions. As a result, the indistinct measurable objective makes managers uncountable. Furthermore, Jensen concludes that a comprehensive theory does not need only to clarify stakeholders influence, but it should clarify how to respond to stakeholders, and describes how corp responds with each stakeholder. Finally, the mutual interdependence and interaction between all stakeholders in unison must be taken in to consideration.

Nonetheless, the study which was conducted by Hillman & Keim (2001) empirically confirmed that stakeholder theory has a positive and negative relationship with shareholders’ wealth. So building fruitful relationships with primary stakeholders such as employees, suppliers, and customers has a positive impact on increasing shareholders’ wealth by improving intangible assets of corp. Thus, using corp resources for social issues which are not related to primary stakeholders has shown a negative relationship with shareholders’ value.

Remarkably, Shankman (1999) underlined four points to prove that AT may be considered inside a general stakeholder model. First, ST is the rational conclusion for AT, and is therefore a more appropriate way to abstract theories of the firm. Second, the right AT modified is, at best, a basic form of ST. Third, the assumption about human behaviour and motivation implicit in AT are contradictory. Finally, all firms’ theories must maintain a minimum implicit moral, which considers basic rights and principles. As a result, the hypothesis of human behaviour on other traditional theories mostly needs to be revised or even reconceived.

Stewardship Theory:

Stewardship theory was successfully developed in the mid-nineteenth century. Its model was built on the joint stock company with limited liability for its shareholders. It reflects the conventional idea of CG, so managers have a legal duty to shareholders and not to themselves or to other interest groups. But, it has a contrary belief with Agency theory because it assumes that directors do not always aim to maximize their personal interest, but also they can act responsibly with independence and integrity. Moreover, Stewardship advocates that directors should concentrate on customers, employees, and other legitimate stakeholders’ interest, but under the law, their first priorities should be shareholders (Tricker, 2009, pp. 223-224).

However, strange concerns in Stewardship theory arise when roles of CEO and chair are held by the same person, and the benefit consequences on shareholder returns because of facilitative authority structures. Also, the safe protection of returns to shareholders is delegated to managers to take independent executive achievements, and not of placing management under greater control by owners (Mallin, p. 19).

Nevertheless, Tricker ( 2009, p.225) stated that stewardship critics are the limited company whose model is built on its base and is quite different from the modern corp concept (listed companies). In contemporary corp, shareholders become remote from corp and do not nominate directors. Also, in sophisticated corp, transparency is lackadaisical, so their directors are not really accountable to shareholders. Likewise, because the theory reflects the legal view of companies, it is normative; it is not predictive, and unable to show the normal relationship between specific behaviour and performance.

Thus, according to stewardship theory, the contributions of the principal are expected to be accountable in the same level as the steward would be. Though, both contributions - the principal and the steward - may be qualitatively diverse and not easily measureable, the comparison and mutual accountability are expected (Davis et al, 1997).

Conclusion:

In general, the fundamental corp concern is increasing shareholders’ wealth, and Agency theory theoretically and empirically is built on this basis and may justify why it’s wide spread. Thus Stakeholder theory has become to play more roles than before, because corp recognizes that they cannot run their business in isolated environments considering only their shareholders.

Consequently, in the U.K section 3.3 in the Modernising Company Law 2002; indicated clearly the significant roles of directors is not only in shareholders’ interest, but it should include the corp stakeholders too:

 “...The Review considered to whom directors should owe duties ... the basic goal for directors should be the success of the company in the collective best interest of shareholders, but that the directors should also recognise, as the circumstances require, the companys need to foster relationships with its employees, customers and suppliers, its need to maintain its business reputation, and its need to consider the company’s impact on the community and the working environment.” the Modernising Company law ( 2002, section 3.3 cited from Solomon, 2007, p. 232 ).

Moreover, Boatrigh (1999) stated that the free market mechanism invisibly rewarded corp ethical behaviour and punished unethical behaviour. Accordingly, social responsibility plays a dominant role in distribution corp wealth, which finally reflects in shareholders’ wealth, demonstrating ST. Moreover, both TCE and Stewardship have had their assumptions proved empirically and certainly.

However, the development of CG in connection with legal requirements, capital market system and ownership structure, led corp to deliberate to attract preserve equity investments, and be more responsible to their shareholders, giving actual concern to the interest of their stakeholder constituencies. Nonetheless, because CG is still needed by theoretical foundations to reflect the reality of CG, it does not have widely-accepted speculative base or commonly accepted theory (Tricker, 2009, PP. 219-231).

However, McGrath et al (1981) alluded that “… much of the methodological literature seems to say: Your method, X, is flawed. Therefore, my method ,Y, must be good … It is relatively easy to detect and denote the flaws of the lab (or the field study, or the survey, and so forth). Doing so does not thereby make some other method flawless …

 

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Raida Mashal

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