Major Theories OF Corporate Govenance PDF

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ASSIGNMENT ON MAJOR THEORIES IN CORPORATE GOVERNANCE

Submitted to,

Adv.Veena venugopal Faculty of company law and corporate governance University of Calicut Submitted by,

Akram usman Department of law University of Calicut

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CONTENT I. II. III.

Definition and meaning Principles of corporate governance Major theories of corporate governance  Agency Theory  Stewardship theory  Stake Holder Theory  Resource dependency theory

IV.

Few other theories

IV.

 Social contract theory  Legitimacy theory  Political theory  Managerial Hegemony Theory Conclusion

3 4 5-6 7-10 11-17 18-20 21-22

23 23 23 24 25

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DEFINITION The definition of corporate governance most widely used is “the system by which companies are directed and controlled” (Cadbury Committee, 1992). The OECD Principles of Corporate Governance states: “Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.”1

Gabrielle O'Donovan defines corporate governance as 'an internal system encompassing policies, processes and people, which serves the needs of shareholders and other stakeholders, by directing and controlling management activities with good business savvy, objectivity, accountability and integrity. Sound corporate governance is reliant on external marketplace commitment and legislation, plus a healthy board culture which safeguards policies and processes'2. Report of SEBI committee (India) on Corporate Governance defines corporate governance as the acceptance by management of the inalienable rights of shareholders as the true owners of the corporation and of their own role as trustees on behalf of the shareholders. It is about commitment to values, about ethical business conduct and about making a distinction between personal & corporate funds in the management of a company.”3 The definition is drawn from the Gandhian principle of trusteeship and the Directive Principles of the Indian Constitution. Corporate Governance is viewed as ethics and a moral duty.

PRINCIPLES OF CORPORATE GOVERNANCE 1 OECD Corporate Governance Portal 2 Homayara Latifa Ahmed, Md. Jahangir Alam, Saeed Alamgir Jafar, Sawlat Hilmi Zaman (2008). A Conceptual Review on Corporate Governance and its Effect on Firm’s Performance: Bangladesh Perspective. AIUB Bus Econ Working Paper Series, No 2008-10, http://orp.aiub.edu/WorkingPaper/WorkingPaper.aspx?year=2008 3 Report of the Committee on Corporate Governance, OCTOBER 5,2017

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Key elements of good corporate governance principles include honesty, trust and integrity, openness, performance orientation, responsibility and accountability, mutual respect, and commitment to the organization. Of importance is how directors and management develop a model of governance that aligns the values of the corporate participants and then evaluate this model periodically for its effectiveness. In particular, senior executives should conduct themselves honestly and ethically, especially concerning actual or apparent conflicts of interest, and disclosure in financial reports. Commonly accepted principles of corporate governance include4:

Rights and equitable treatment of shareholders: Organizations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by effectively communicating information that is understandable and accessible and encouraging shareholders to participate in general meetings.

Interests of other stakeholders: Organizations should recognize that they have legal and other obligations to all legitimate stakeholders.

Role and responsibilities of the board: The board needs a range of skills and understanding to be able to deal with various business issues and have the ability to review and challenge management performance. It needs to be of sufficient size and have an appropriate level of commitment to fulfill its responsibilities and duties. There are issues about the appropriate mix of executive and non-executive directors.

Integrity and ethical behavior5: Ethical and responsible decision making is not only important for public relations, but it is also a necessary element in risk management and avoiding lawsuits. Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making. It is important to understand, though, that reliance by a company on the integrity and ethics of individuals is bound to eventual failure. Because of this, many organizations establish Compliance and Ethics Programs to minimize the risk that the firm steps outside of ethical and legal boundaries.

Disclosure and transparency: Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide shareholders with a level of accountability. They should also implement procedures to independently verify and safeguard the integrity of the company's financial reporting. Disclosure of material matters concerning the organization should be timely and balanced to ensure that all investors have access to clear, factual information.

MAJOR THEORIES IN CORPORATE GOVERNANCE 4http://www.oecd.org/dataoecd/32/18/31557724.pdf 5 Cadbury, Adrian, Report of the Committee on the Financial Aspects of Corporate Governance, Gee, London, December, 1992,

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The following theories elucidate the basis of corporate governance: (a) (b) (c) (d) (e) (f) (g) (h)

Agency Theory Stewardship theory Stake Holder Theory Resource dependency theory Social contract theory Legitimacy theory Political theory Managerial Hegemony Theory

HOW, WHEN AND WHAT IS AGENCY THEORY?

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Agency theory was elaborated by Alchian and Demtez 1972 and further developed by, Johnsen and Mackling 1976.It is defined as the relationship between the principal, such as shareholders and agents such as the company executives and managers. According to this theory shareholders who are the owners or the principals appoints the managers or the agents to manage the business on their behalf. There are two factors that can, influence the prominence of this theory6 First this theory is conceptually very simple theory that reduces the corporation into two participants that is managers and shareholders. Second agency theory suggests employees or, managers in an organization can be self-interested. The agency theory shareholders expect the agents to act and make decision in the principals' interest7. On the contrary, the agent may not necessarily make decision in the best interests of the principals and may be succumbed to self-interested opportunities behavior and falling short of congruence between the aspirations of the principal and the agents. In brief the agency model of corporate governance presupposes that the principal-agent relationship is at heart a dyadic (one to one) relationship. In addition, the model assumes that individuals have access to complete information, that investors possess significant knowledge of whether or not governance activities conform to their preferences, and that the board has complete knowledge of investor’s preferences. Furthermore, the model presupposes that boards believe that proposed methods of governance regulation constitute a threat to their managerial authority, and that governance naturally gravitates towards equilibrium

SIGNIFICANCE OF AGENCY THEORY

6 Abid, Ghulam and Khan, Binish and Rafiq, Zeeshan and Ahmed, Alia, Theoretical Perspectives of Corporate Governance (January 13, 2015). Bulletin for Business and Economics, 3(4), 166-175.. 7 ibid

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Agency theory act as a cardinal parameter as far as executives and members are concerned for making crucial decisions such as strategic policies. It comes in handy if decision makers have a tendency to be greedy and profit at the expense of the company. It is also an invaluable guideline when a company's long-term interests conflict with actions that may provide lesser but more immediate benefits to stakeholders.8 

Decision-making protocols. In theory, buying a share of company stock gives you a vote in major company decisions. This right is diluted by the fact that some stockholders may own a single share, giving them a single vote, while others own thousands of shares, giving them thousands of votes. Executives and board members should represent all shareholders, but they might over represent those who own the most equity. Agency theory is a step toward navigating these complex and sometimes conflicting obligations.



Greedy executives. The people with the power to make high-level corporate decisions are often directly in line to benefit from some of these decisions, especially with regard to issues of corporate pay. In a perfect world, high pay and large bonuses for executives would motivate and reward them for quality work that brings in extra income for all shareholders. In the real world, high corporate pay can come at the expense of the bottom line that is divided among the broader pool of shareholders.



Long-term vs. short-term interests. It may be in the best interests of a company to invest in the future, but these outlays often come at the expense of short-term rewards such as shareholder dividends. Executives’ conscientiously practicing corporate agency theory will use the knowledge and skills that landed them in management positions to make the best calls possible for the organization as a whole.9’10

THE HURDLES OF AGENCY THEORY

8 https://efinancemanagement.com/financial-management/agency-theory 9 https://www.igi-global.com/dictionary/agency-theory/834 10 https://bizfluent.com/about-6729036-agency-theory-corporate-governance.html

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Most business concern is focused on profit maximization. However, profit maximization fails for a number of well-known reasons; it ignores: the timing of returns; the cash flows available to shareholders; and risk. Without explicitly considering these factors, higher earnings alone do not necessarily translate into higher share prices.11 In the real world, managers perform the decision-making function with four factors or linkages in mind: shareholders, bondholders, society and financial markets. Competitive market conditions place significant pressure on agents and managers who will be tempted to resort to unethical means to portray a positive picture. It is acknowledged that the wealth maximization objective is not always compatible with a firm’s social obligations, and it usually involves an agency problem which arises when the managers fail to act in the best interests of the shareholders, preferring instead to benefit themselves. Differences in the objectives of ownership and management lead to agency costs; if these are to be controlled, the shareholders must maintain a strict watch over the functioning of the company. The managers should be rewarded for acting in the interests of the shareholders and the managers should maintain a balance between the interests of the shareholders and other stakeholders. In this context, the GFC (GLOBAL FINANCIAL CRISIS) highlighted the important influence that incentive structures within financial institutions and other businesses can have on risk-taking and financial performance. In particular, it highlighted the dangers of badly designed remuneration incentive arrangements leading to excessive risk-taking, poor financial performance and a bias towards short-term results at the expense of longer-term financial soundness (Mortlock, 2009)12.

It is well documented that executive compensation packages should be designed to align the interests of senior management with those of the shareholders and thereby reduce the dysfunctional behavior of managers; this is typically done by rewarding executives for taking decisions and actions that increase shareholder wealth . Unfortunately, the shareholders (and directors) may have neither complete information about the actions of executives or the expertise to evaluate those actions, making it difficult to base compensation on actions alone. Instead, compensation in practice is often linked to measures that are positively correlated with managerial performance, for instance market share, share price or accounting profit.13

Typically, there are different goals and interests among individuals involved in an agency relationship. Agency theory presupposes that individuals are opportunistic, that is, they constantly aim to maximize their own interests. Thus, there is no guarantee that agents will always act in the best interests of principals. Rather, there is a constant temptation for agents to maximize their own interests, even at the expense of principals.

11 https://www.oecd.org/sti/ind/2090569.pdf 12 ibid 13 ibid

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Under conditions of incomplete information and uncertainty prevalent in business settings two kinds of problems arise: adverse selection and moral hazard. Adverse selection refers to the possibility of agents misrepresenting their ability to do the work agreed; in other words, agents may adopt decisions inconsistent with the contractual goals that embody their principals’ preferences. Moral hazard, on the other hand, refers to the danger of agents not putting forth their best efforts or shirking from their tasks. This divergence between the interests of the principal and the agent unavoidably generates costs. Agency costs are residual costs that result in a failure to maximize the principals’ wealth. These may be incurred by the principal – through measures to control the agent’s behavior – or by the agent – through efforts to demonstrate his commitment to the principals’ goals. , agency theory conforms follows a ‘logic of consequences’, which means that governance is used as a means to achieve objectives that may be self-interested. However: “Ambiguity or conflict in rules is typically resolved not by shifting to a logic of consequentiality and rational calculation, but by trying to clarify the rules, make distinctions, determine what the situation is, and what definition ‘fits’”. This is a ‘logic of appropriateness’, which suggests that the assumption of the board as pure compensation maximizers is difficult to support, since such behaviors are irrational, given that negative consequences usually follow.

Furthermore, the ability of agents to function in an institution is reflected in their willingness to conform and ‘swimming against the tide’ is an activity rarely encouraged in corporate boardrooms. There is evidence that managers are not necessarily self-serving, and one longitudinal evaluation of 29 large US firms found that on average managers’ annual gain and losses from stock returns far exceeded their remuneration. In addition, where firm market returns decreased, the probability of managerial turnover increased. Consequently, managers’ interests were best served by the performance of the firm. Also, institutions do not simply offer compensation and other benefits to their members; culture, ideology and other corporate values become slowly ingrained in new board members and the business environment too plays a role; whither these factors in principal-agent theory? In terms of controls, equity investors currently have few sanctions over boards, relying instead on self-regulation to ensure that an orderly house is maintained14.

CONCLUSION

14 https://www.oecd.org/sti/ind/2090569.pdf

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The whole point behind agency theory is to come up with mechanisms that ensure an efficient alignment of interests between agent and principal, thereby reducing agency costs. Outside of this, agents do not subscribe to any moral imperative; they willingly engage in immoral conduct whenever convenient. Acting morally would be reasonable only if it presented a greater economic incentive in terms of utility and pleasure than the contrary

DERIVATION OF THE STEWARDSHIP THEORY

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A “steward” means a “person employed to manage another's property, especially a large house or estate” or a “person whose responsibility it is to take care of something”. In its original historical context, a “steward” was an “officer of the royal household, especially an administrator of Crown estates” in Britain. Without delving much into the British history, it would not be wrong to think of stewards in those days as being responsible to and required to demonstrate loyalty to the British royal household, whose estate is entrusted to the stewards. In the context of modern investment, institutional investors, such as mutual funds, pension funds, insurance companies, and investment advisors, are considered to be “stewards”, as they are entrusted with their clients’ money for investment purposes. The use of the term “stewardship” suggests that stewardship codes are based on the following logic produced by an analogy with the historical “steward”: Institutional investors must be loyal to their clients, who have entrusted their money to the institutions for investment purposes, and should exercise their rights as shareholders of investee companies in order to fulfill their responsibility as “stewards” of their clients15.

Stewardship theory was introduced by Donaldson and Davis (1989) as a normative alternative to the agency theory. The executive manager, under stewardship theory, far from being an opportunistic shirker, essentially wants to do a good job, to be a good steward of the corporate assets.16 As it is rooted in psychology, sociology and leadership theories, stewardship theory argues for the possible alignment between the principals and agents which is reflective of a psychological contractor a close relationship with agent behaving in a community-focused manner, directing trustworthy moral behavior towards the firms and its shareholders, Davis, Frankforter, Vollrath, & Hill, 2007 Stewardship theory holds that there would be no inherent, general problem of executive motivation (Donaldson& Davis, 1991). Managers who identify with their organizations and are highly committed to organizational values are more likely to serve organizational ends. (Davis, Schoorman and Donaldson (1997)17 The steward’s behavior is pro organizational and collectivist and has the higher utility than individualistic self-serving behavior and steward’s behavior will not depart from he interest of the organization because the steward seeks to attain the objective of the organization

15 Davis, James H., et al. “Toward a Stewardship Theory of Management.” The Academy of Management Review, vol. 22, no. 1, 1997, pp. 20–47. JSTOR, www.jstor.org/stable/259223. 16 Davis, J., Schoorman, F., & Donaldson, L. (1997). Toward a Stewardship Theory of Management. The Academy of Management Review, 22(1), 20-47. Retrieved from http://www.jstor.org/stable/259223 17 Davis, James H., F. David Schoorman, and Lex Donaldson. "Toward a Stewardship Theory of Management." The Academy of Management Review 22, no. 1 (1997): 20-47. http://www.jstor.org/stable/259223.

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Stewardship place the CEO and Chairman Responsibilities under one executive, with a board comprised mostly of in-house members. This allows for intimate knowledge of organizational operation and a deep commitment to success18.

18 Davis, James H., F. David Schoorman, and Lex Donaldson. "Toward a Stewardship Theory of Management." The Academy of Management Review 22, no. 1 (1997): 20-47. http://www.jstor.org/stable/259223.

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ALIGNMENT OF VALUES In a corporat...