Theories of Corporate

Governance

AC311: CG- Governance and

Management 1
The fundamental problem of
corporate governance
The fundamental problem of corporate governance has
been known for over 200 years.
This problem was first described by Adam Smith in his
famous book:
“Wealth of Nations. ‘the directors of companies, being
managers of other people’s money cannot be expected to
watch over it with the same vigilance with which they watch
over their own’’.

It means whenever the owner (called the Principal)

contracts with someone else (called the agent) to
manage his/her affairs, the agency, the agency problem
arises. The key challenge is how to ensure that the
agent acts in the interest of principal.
The fundamental problem
of corporate governance
This agency problem becomes presents a
major challenge in the context of
companies because companies have many
shareholders and many directors.

This situation is usually considered to

have led to separation of ownership of
companies from management.
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The fundamental problem of
corporate governance
The agency problem in modern times has become
even more complex because of evolutions of
business.
For example, when an individual invests in a fund
(say Umoja Fund), the fund in turn invests in a
Bank say CRDB which invests in a company say
TCC (giving them a long term loan or buying a
limited number of shares). Tracing the agency
chain can be difficult and to assessing the extent of
risk exposure may nearly impossible.
Yet, agency problems exist throughout the chain.
The fundamental problem
of corporate governance
The increasing demand for reporting,
transparency, accountability, audit, independent
directors, requirements in company law, securities
legislations, listing requirements in stock
exchanges, and requirements of the corporate
governance codes are all responses to the agency
problem.

Several theories have evolved overtime and are

used as lenses to examine the agency problem.
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Corporate governance
theories
i. Agency theory
ii. Transaction cost economics
iii. Stewardship theory
iv. Resource dependence theory
v. Managerial hegemony theory
vi. Class hegemony theory
vii.Stakeholder theory
Agency theory
This theory examines the corporate
governance problem as a contractual
relationship between the principal and the
agent where shareholders are the
principal(s) and directors are agents.

In this theory, it is argued that directors

have interests that are different from
those of shareholders.
Agency theory
They seek to maximize their personal benefits, by
taking actions that are advantageous to
themselves by detrimental to interests of
shareholders. For example, they will try to prefer
to pay themselves high salaries, engage in
conspicuous consumption (e.g. buying luxurious
cars) using company.

These actions have the effect of reducing profits

which could be shared among shareholders (as
dividend).
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Agency theory
According to this theory, trust involves
an agreement between parties unequal
(asymmetrical) access to information.

That is, directors know far more about

the enterprise than shareholders do. In
the same way managers know far more
about the company than directors do.

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Agency relationship

Principal (Shareholders)

Who takes
contracts advantage of

Agent (directors)
Agency theory
Apart from having interests that may conflict
with those of shareholders, directors may also
have different views than that of shareholders
regarding corporate risk.

Thus, directors (and management) may take

risks that are too high just because they do not
care as money used is not theirs. That level of
risk may not be acceptable to shareholder.
Agency theory
Agency theory has been used to study the
relationship between certain aspect of
governance and the firm performance and
has shed some light in advancing
understanding of corporate governance.

However, it has also been criticized.

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Agency theory
Criticism:
 The theory is narrow focusing only on some
quantitative measures of corporate
governance while ignoring processes-
interpersonal relationship between directors,
group dynamics, and political intrigue
(maneuvering)
Agency theory
The theory is simplistic in nature and ignores
complex situations such as where chains of
investors exist where the real shareholder is
several steps away from company in which
his/her money is invested.

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Agency theory
Agency theory assumes that people are self-
interested not altruistic (humane, unselfish)-
they cannot be expected to look after the
interest of other people. This is seen as a low
view of human beings, stewardship perspective
takes the opposite view.

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2. Transaction cost
economics (TCE)
This theory is closely related to agency theory
and based on the theory of origin of
organizations/firms developed a Ronald Coarse
in 1937.

Coarse recognize that a firm could save costs

by undertaking activities within the
organization rather than externally. But, as
firms grow, they may reach a level where
external markets become cheaper.
2. Transaction cost
economics (TCE)
TCE developed by Williamson, argues that
large corporate companies/groups could
overcome the disadvantages of scale by
the choice of governance structures.

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2. Transaction cost
economics (TCE)
TCE focuses on the cost of enforcement
or checks and balance mechanisms
such as internal and external audit
controls, information disclosure,
independent directors, and other
reforms in corporate governance meant
to control the agency problem.

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2. Transaction cost
economics (TCE)
According to TCE costs should be
incurred to control the agency problem
to the point at which increase in costs
equals reduction of the potential loss
from aberrant behavior.

The theory makes similar assumptions

as Agency theory.
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3. Stewardship theory
Stewardship theory looks at governance
from the opposite lens from agency theory
and reflecting the legal view of the
corporation.

The theory reflects the classical duty of

directors to shareholders not to themselves
as viewed in agency theory.
3. Stewardship theory
It is assumed that directors do not
always act to maximize their interest;
they can and do act responsibly with
integrity.

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Stewardship relationship
Shareholders

To protect their Who accept the

interests, fiduciary duty to
nominate and be stewards of
elect those interests

Directors
Stewardship theory
Criticism
 Modern corporations have become
complex and shareholders have become
more remote from the company and do
not nominate directors. Financial reports
have become complex and complex
corporations are lack transparency and
directors are not really accountable to
shareholders.
Stewardship theory
This theory is normative – emphasizing what
should be done. But it is not predictive and is
unable to show the causal relationship
between specific behaviors and corporate
performance

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4. Resource Dependence
Theory
This theory takes a strategic view of
corporate governance and focuses on the
board of directors.

It sees the board of directors as link

between a company and the resources it
needs to achieve its objectives.
4. Resource Dependence
Theory
These resources could include links to the
relevant markets including potential
customers, and competitors, access to
capital, know how and technology, political
and society support etc.

Directors are therefore seen as boundary-

spanning nodes of networks able to
connect the business to its strategic
environment.
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5. Managerial Hegemony
theory
This theory states that managers of large
corporations are in charge of corporations.

Given the nature of modern large

corporations, it the managers who provide a
slate of directors to be voted by
shareholders. Directors therefore beholden
to management (i.e. the CEO)
5. Managerial Hegemony
theory
Use of this approach is usually
hampered by lack of access to
individual directors

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6. Class Hegemony theory
This theory was developed in the US and it
argued that boards of directors were
dominated by a particular class or social
group which has similar interests,
aspirations and views of the world.
6. Class Hegemony theory
They also used boards of directors to
perpetuate itself. Interlocking directorships
was a key mechanism by which this social
group perpetuated itself.

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7. Stakeholder theory
This theory is concerned with the values
and beliefs about the appropriate
relationship between individuals, the
enterprise, and the state.
7. Stakeholder theory
According to this theory, companies
should recognize a responsibility to all
those affected by companies including-
customer, employees, managers,
suppliers, financiers, shareholders, the
local community and the broader
societal interests such as the
environment.
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7. Stakeholder theory
Under this theory, it is sometimes
claimed that the responsible behavior to
all stakeholders is the price that society
demands from companies for the
privilege of incorporation – granting
shareholders limited liability for the
company debts.

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Stakeholder theory
Criticism
 The theory ignores the ownership rights of
shareholders. A company is the property of
shareholders and that being the case, their
ownership rights must be respected. Companies
should be accountable to shareholders alone. By
being accountable to many stakeholders
companies will be accountable to no body.
Corporate governance
theories [An Overview]
The theories provide different ways of
looking at the phenomenon of corporate
governance.

Each theory highlights particular aspects of

corporate governance but no theory has
been able to shed light on all aspects of
corporate governance.
Corporate governance
theories [An Overview]
Thus, the debate on corporate
governance and the search for a
paradigm continues.

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 The End!!

Questions/Comments

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