Business Ethics and Corporate Governance, Second Edition

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THEORETICAL BASIS OF CORPORATE GOVERNANCE

There are four broad theories to explain and elucidate corporate governance. These
are: (i) Agency Theory; (ii) Stewardship Theory; (iii) Stakeholder Theory; and (iv)
Sociological Theory.

AGENCY THEORY
Recent thinking about strategic management and business policy has been
influenced by agency cost theory, though the roots of the theory can be traced back
to Adam Smith who identified an agency problem (managerial negligence and
profusion) in the joint stock company. The fundamental theoretical basis of
corporate governance is agency costs. Shareholders are the owners of any joint
stock, limited liability company, and are the principals of the same. By virtue of
their ownership, the principals define the objectives of a company. The
management, directly or indirectly selected by shareholders to pursue such
objectives, are the agents. While the principals generally assume that the agents
would invariably carry out their objectives, it is often not so. In many instances, the
objectives of managers are at variance from those of the shareholders. For instance,
a chief executive may want to increase his managerial empire and personal stature
by using the company’s funds to finance an unrelated diversification, which could
reduce long term shareholder value. The shareholders and other stakeholders of the
company, may not be able to counteract this because of inadequate disclosure
about such a decision and because the principals may be too scattered or even not
motivated enough to effectively block such a move. Such mismatch of objectives is
called the agency problem; the cost inflicted by such dissonance is the agency cost.
The core of corporate governance is designing and putting in place disclosures,
monitoring, ‘oversight’ and corrective systems that can align the objectives of the
two sets of players as closely as possible and, hence, minimize agency costs.

The main thrust of the agency theory runs like this. In the modern corporation, in
which share ownership is widely held, managerial actions depart from those
required to maximise shareholder returns. In agency theory terms, the owners are
principals and the managers are agents and there is an agency loss which is the
extent to which returns to the residual claimants, the owners, fall below what they
would be if the principals, the owners themselves, exercised direct control of the
corporation. Agency theory specifies mechanisms which reduces agency loss.
These include incentive schemes for managers which reward them financially for
maximizing shareholder’s interests. Such schemes typically include plans whereby
senior executives obtain shares, perhaps at a reduced price, thus aligning financial
interests of executives with those of shareholders. Other similar schemes tie
executive compensation and levels of benefits to shareholders, returns and have
part of executive compensation deferred to the future to reward long-run value
maximization of the corporation and deter short-run executive action which harms
corporate value.

Problems with the Agency Theory    Total control of management is neither

feasible nor required under this theory. The underlying assumption in the trade-off
that shareholders make on employing agents is that they must accept a certain level
of self-interested behaviour in delegating responsibility to others. The objective of
agency theory is to check the abuse in this trade-off, but its limited success raises
the question of its utility as a theoretical model to promote corporate governance.
Besides, in agency theory the assumption is with the complexities of investor-
board relationship in large organizations, shareholders should have correct and
adequate information to wield effective control. Equity investors rarely get these
and besides they rarely make clear their exact target returns, and yet delegate
authority to meet the target. It is also to be understood that in terms of controls,
equity investors hardly have sanctions over boards. Instead, they have to rely on
self-regulation to ensure that an orderly house is maintained.

There are two broad mechanisms that help reduce agency costs and hence,
improve corporate performance through better governance. These are:

1. Fair and accurate financial disclosures: Financial and non-financial disclosures,

which relate to the role of the independent, statutory auditors appointed by
shareholders to audit a company’s accounts and present a ‘true and fair’ view of the
financial health of the corporation. Indeed, the quality and independence of statutory
 auditors are fundamental to achieve the purpose. While it is the job of the management
to prepare the accounts, it is the responsibility of the statutory auditors to scrutinise
such accounts, raise queries and objections (if the need arises), arrive at a true and fair
view of the financial position of the company, and report their independent findings to
the board of directors and, through them, to the shareholders and investors of the
company.
A company that discloses nothing can do anything. Improving the quality
of financial and non-financial disclosures not only ensures corporate
transparency among a wide group of investors, analysts and the informed
intelligentsia, but also persuades companies to minimise value-destroying
deviant behaviour. This is precisely why law insists that companies
prepare their audited annual accounts, and that these be provided to all
shareholders and is deposited with the Registrar of companies. This is also
why a good deal of effort in global corporate governance reform has been
directed to improving the quality and frequency of disclosures.
2. Efficient and independent board of directors: A joint-stock company is owned by the
shareholders, who appoint directors to supervise management and ensure that it does
all that is necessary by legal and ethical means to make the business grow and
maximise long-term corporate value. Directors are fiduciaries of the shareholders, not
of the management. They are accountable only to the shareholders. ‘Independence’ has
of late become a critical issue in determining the composition of any board.

STEWARDSHIP THEORY
The stewardship theory of corproate governance discounts the possible conflicts
between corporate management and owners and shows a preference for a board of
directors made up primarily of corporate insiders. This theory assumes that
managers are basically trustworthy and attach significant value to their own
personal reputations. The market for managers with strong personal reputations
serves as the primary mechanism to control behaviour, with more reputable
managers being offered higher compensation packages. Financial reporting,
disclosure and auditing are still important mechanisms, but there is a fundamental
presumption that these mechanisms are needed to confim managements’ inherent
trustworthiness.

Stewardship theory can be reduced to the following basics:

 The theory defines situations in which managers are not motivated by individual goals,
but rather they are stewards whose motives are aligned with the objectives of their
principles.
  Given a choice between self-serving behaviour and pro-organizational behaviour, a
steward’s behaviour will not depart from the interests of his/her organization.
 Control can be potentially counterproductive, because it undermines the pro-
organizational behaviour of the steward, by lowering his/her motivation.

This emphasis on the responsibility of the board to shareholders in the Anglo-

Saxon model of corporate governance in terms of stewardship and trusteeship is
nowhere better articulated than in the Canadian guidelines. It is stated therein:
‘Stewardship refers to the responsibility of the board to oversee the conduct of the
business and to supervise management which is responsible for the day-to-day
conduct of the business. In addition, as stewards of the business, the directors
function as the catch-all to ensure no issue affecting the business and affairs of the
company falls between cracks.’ Similar views, though differently told,
predominate in corporate governance guidelines of many countries of the world.

The greatest barrier, however, to the adoption of stewardship mechanisms of

governance lies in the risk propensity of principals. Risk taking owners will
assume that executives are pro-organization and favour stewardship governance
mechanisms. Where executives, investors cannot afford to extend board power,
agency costs are effective insurance against the self-interest behaviours of agents.

Of course, these concepts of stewardship and trusteeship are not new. The sacred
scriptures, both in India and Christendom, emphasize the almost filial relationships
between the rulers and the ruled. Gandhiji too elaborated the concept of trusteeship
to make Indian industrialists better understand and appreciate their roles and
responsibilities towards their employees. It is said in many oriental societies
including Japan, that an employer has been ordained by God to act as His trustee to
own and administer assets for the benefit of his employees.

Though the Agency and Stewardship Theories have something in common, there
are certain basic differences. The tables set out below summarize the main
differences between the two theories.4

Davis, Schoorman and Donaldson (1997) state that the owners-managers

relationship depends on the behaviour adopted respectively by them. Managers
choose to act as agents or as stewards according to certain personal characteristics
and their own perceptions of particular situational factors. Principals choose to
create a relationship of one type or the other depending on their perceptions of the
same situational factors and of their managers’ psychological mechanisms. The
following tables set out these variables and the differences between the two
theories.
Shareholder Versus Stakeholder Approaches    While studying theories of
corporate governance, it is common to distinguish between shareholder and
stakeholder approaches. Shareholder approaches argue that corporations have a
limited set of responsibilities, which primarily consist of obeying the law and
maximizing shareholder wealth. The basic argument is that corporations, by
focussing on shareholder interests maximize societal utility. The logic of this
position goes back to the ability of the shareholder model to maximize utility,
however, is tenuous in that it is based on the assumption of perfect competition. To
the extent that the conditions of perfect competition are not in place, the argument
falters. More specifically, as deviations from the conditions of perfect competition
increase (e.g. imperfect markets, incomplete contracts, information asymmetries),
after a certain point, corporations will not be maximizing societal utility by merely
pursuing shareholder interests. The shareholder approach is logically most
compatible with the Anglo-American model of corporate governance.

Table 14.1 Behavioural Differences

Agency Theory Stewardship Theory

Managers act as agents. Managers act as stewards.

Governance approach is materialistic, Governance approach is sociological and

psychological.

Behaviour pattern is Behaviour pattern is

  • individualistic   • collectivistic
  • opportunistic   • pro-organizational
  • self-serving   • trustworthy

Managers are motivated by their own Managers are motivated by the principal’s
objectives. objectives.

Interests of the Managers and principals Interests of the managers and principals
differ. converge.

The role of the management is to monitor The role of the management is to facilitate and
and control. empower.

Owners’ attitude is to avoid risks. Owners’ attitude is to take risks.

 Principal-manager relationship is based on Principal-manager relationship is based on
control. trust.

Adapted from “Development of Corporate Governance System: Agency Theory

Versus Stewardship Theory in Welsh Agrarian Cooperative Societies”, by Alfonso
Vargas Sanchez.

Table 14.2 Psychological Mechanisms

Agency Theory Stewardship Theory

Motivation revolves around Motivation revolves around

  • lower order needs   • higher order needs
  • extrinsic needs   • intrinsic needs

Social comparison is between compatriots. Social comparison is between principals.

There is little attachment to the company. There is great attachment to the company.

Power rests with the institution. Power rests with the personnel.

Adapted from “Development of Corporate Governance System: Agency Theory

Versus Stewardship Theory in Welsh Agrarian Coorperative Societies”, by
Alfonso Vargas Sanchez.

Table 14.3 Situational Mechanisms

Agency Theory Stewardship Theory

Management philosophy is control oriented To deal To deal with increasing uncertainty

with increasing uncertainty and risk, the theory and risk, the theory advocates
advocates exercise of exercise of
  • greater controls   • training and empowering people
  • more supervisions   • making jobs more challenging
and motivating

Risk orientation is done through a system of control. Risk orientation is done through
 trust.

Time frame is short term. Time frame is long term.

The objective is cost control. The objective is improving

performance.

Cultural differences revolve around Cultural differences revolve around

  • individualism   • collectivism
  • large power distance   • small power distance

Adapted from “Development of Corporate Governance System: Agency Theory

Versus Stewardship Theory in Welsh Agrarian Coorperative Societies”, by
Alfonso Vargas Sanchez.

In contrast to shareholder approaches, stakeholder models of corporate

governance argue that those responsible for the governance of the corporation have
responsibilities to parties other than shareholders and that, any fiduciary
obligations owed to shareholders to maximize profits might be subject to the
constraint of respecting obligations owed to such stakeholders.

STAKEHOLDER THEORY
The stakeholder theory of corporate governance has a lengthy history that dates
back to 1930s. The theory represents a synthesis of economics, behavioural
science, business ethics and the stakeholder concept. The history and the range of
disciplines that the theory draws upon has led to large and diverse literature on
stakeholders. In essence, the theory considers the firm as an input-output model by
explicitly adding all interest groups—employees, customers, dealers, government
and the society at large—to the corporate mix.

The theory is grounded in many normative theoretical perspectives including the

ethics of care, the ethics of fiduciary relationships, social contract theory, theory of
property rights, theory of the stakeholders as investors, communitarian ethics,
critical theory, etc. While it is possible to develop stakeholder analysis from a
variety of theoretical perspectives, in practice much of stakeholder analysis does
not firmly or explicitly root itself in a given theoretical tradition, but rather
operates at the level of individual principles and norms for which it provides little
formal justification. Insofar as stakeholder approaches uphold responsibilities to
non-shareholder groups, they tend to be in some tension with the Anglo-American
model of corporate governance, which generally emphasises the primacy of
‘fiduciary obligations’ owed to shareholders over any stakeholder claims.

The stakeholder theory is often criticized, more often than not as ‘woolly minded
liberalism’, mainly because it is not applicable in practice by corporations. Another
cause for criticism is that there is comparatively little empirical evidence to suggest
a linkage between stakeholder concept and corporate performance. But there are
considerable theoretical arguments favouring promotion of stakeholders’ interests.
Managers accomplish their organizational tasks as efficiently as possible by
drawing on stakeholders as a resource. This is in effect a ‘contract’ between the
two, and one that must be equitable in order for both parties to benefit.

Criticisms of the Stakeholder Theory   The major problem with the Stakeholder
Theory stems from the difficulty of defining the concept. Who really constitutes a
genuine stakeholder? There is an expansive list suggested by authors of the theory,
ranging from the most bizarre to include terrorists, dogs and trees, to the least
questionable such as employees and customers. Some writers have suggested that
any one negatively affected by corporate actions might reasonably be included as
stakeholder, and across the world this might include political prisoners, abused
children, minorities and the homeless. However, a more seriously conceived and
yet contested list of stakeholders would generally include employees, customers,
suppliers, the government, the community, assorted activist or pressure groups, and
of course, shareholders. Some writers on the theory opine that where there are too
many stakeholders, ‘in order to clarify and ease the burden it places upon directors’
it is better to categorize them as primary and secondary stakeholders. Clive
Smallman, in his article ‘Exploring Theoretical Paradigms in Corporate
Governance’ says: ‘The case for including both the serious claimants and the more
flippant are rooted in business ethics, in managerial morality and in best practice in
business strategy. However, whilst the inclusion of a wide range of interested
parties may be well-intentioned, in practice if directors (as agents) attempt to serve
too many principals they will fail to satisfy those who have a genuine claim on an
organization.’

Further, Clive Smallman points out to another problem that stems from the
Stakeholder Theory. ‘Relating to the range and diversity of stakeholders, some
critics also accuse stakeholder theory of being “superfluous”, by which they mean
that the intent of the theory is better achieved by relying on the hand of
management to deliver social benefit where it is required.’
 In the assessment of Clive Smallman, ‘the stakeholder model also stands accused
of opening up a path to corruption and chaos; since it offers agents the opportunity
to divert wealth away from shareholders to others, and so goes against the
fiduciary obligations owed to shareholders (a misappropriation of
resources)’.5 Thus, the stakeholder model of corporate governance leads to corrupt
practices in the hands of managements with a wide option and also to chaos, as it
does not differ much from the agency model, while increasing exponentially the
number of principals the agents have to tackle.

SOCIOLOGICAL THEORY
The sociological approach to the study of corporate governance has focussed
mostly on board composition and the implications for power and wealth
distribution in society. Problems of interlocking directorships and the
concentration of directorships in the hands of a privileged class are viewed as
major challenges to equity and social progress. Under this theory, board
composition, financial reporting, disclosure and auditing are necessary
mechanisms to promote equity and fairness in society.

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