Bob Tricker

Chapter 1.2
Theories and Philosophies of
Corporate Governance

© Bob Tricker, 2015. All rights reserved.

 Theories and Philosophies of Corporate
Governance
In which we consider:
- the agency dilemma
- agency theory
- transaction cost economics theory
- stewardship theory
- resource dependency theory
- managerial and class hegemony
- psychological and organizational perspectives
- the societal perspective - stakeholder philosophies
- on differing boundaries and levels - systems theory
- a subject in search of its paradigm

Tricker: Corporate Governance, 3rd edition

 Theories and Philosophies of Corporate
Governance
The agency dilemma

As Adam Smith wrote in 1776:

“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.”
The Wealth of Nations (abridged)

This is the agency problem.

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 Theories and Philosophies of Corporate
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• Whenever the owner of wealth (the principal) contracts
with someone else (the agent) to manage his affairs the
agency dilemma arises

• An individual owner might invest his funds through a

financial adviser:
- who invests in a mutual fund or investment trust
- which gears its portfolio by investing in a hedge fund
- which invests in a range of equities, property,
commodities and other hedge funds

• In simple contracts there may be just one principal and

one agent
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 Theories and Philosophies of Corporate
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• In a limited-liability company there may be many principals
(shareholders) and their agents (directors)

• As the number and diversity of shareholders increases

their interests are seldom homogeneous

• As listed companies grew and their shareholders became

more diverse, the separation between owners and
directors magnified and power shifted towards the
directors, which some of them abused. In public
companies today agency relationships can involve strings
of agency relations

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 Theories and Philosophies of Corporate
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• Tracing the agency chain in such cases can be difficult,
and establishing the exposure to agency risk well high
impossible.

• Responses to the agency dilemma include:

– Demands for reporting and transparency
– Requirements for accountability and audit
– Independent directors
– Separation of chairman and CEO
– Other regulations and legal requirements
– Corporate governance codes and principles

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 Theories and Philosophies of Corporate
Governance
• The agency problem is not limited to relations between
shareholders in listed companies and their directors

• The agency dilemma can occur in private companies, joint

ventures, not-for-profit charities, health and education
bodies, professional institutions, and governmental
bodies.

• Wherever there is a separation between the members and

the governing body, the agency dilemma can arise

• The governing body might be called the board of directors,

the council, the committee, the governing body, or the
holding company.

• But the agency dilemma can arise whenever responsibility

for a corporate entity is delegated by members to its
governing
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 Theories and Philosophies of Corporate
Governance
Agency theory

A contract under which one or more persons (shareholders)

engage another person/s (directors) to act on their behalf,
delegating decision making authority

If both parties are utility maximizers… agents will

tend to act in their own interests and not always
in the best interest of their principal.

Jensen and Meckling 1976

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 Theories and Philosophies of Corporate
Governance
• Agency theory statistically powerful, theoretical approach
to corporate governance

• Original work by Coarse (1936)

• Concepts developed by:

– Jensen and Meckling (1976)
– Demsetz (1988)
– Fama and Jensen (1983)
– Jensen (1986)
– Williamson (1987 and 1988)

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 Theories and Philosophies of Corporate
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• A further agency problem is asymmetrical access to
information

• Directors know far more about the corporate situation than

the shareholders

• Indeed, shareholders have to rely on the directors to

decide what information they should have, over and above
the minimum required by regulation and company law.

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 Theories and Philosophies of Corporate
Governance
• Agency theory takes a view on the nature of man:
– that people are self-interested not altruistic
– that directors will act in their own interests not the best
interests of their shareholders
– essentially that people cannot be trusted

• The legal concept of the corporation, and the basis of

stewardship theory takes the opposite view

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 Theories and Philosophies of Corporate
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Transaction cost economics theory

• Coarse (1937) recognised that a firm could provide itself with

goods and services at a lower price than in the market place

• However, as a firm grows, there comes a point at which the

external market becomes cheaper

• Transaction cost economics focuses on the cost of

enforcement or check and balance mechanisms, such as
audit, information disclosure, independent outside directors,
and board committees

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 Theories and Philosophies of Corporate
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• Alternative modes of organizing transactions (governance

structures – such as markets, hybrids, firms, and bureaus)
that minimize transaction costs (Williamson 1979).

• Transaction cost theory (Williamson 1979, 1986) posits

that the optimum organizational structure is one that
achieves economic efficiency by minimizing the costs of
exchange

• The theory suggests that each type of transaction

produces coordination costs of monitoring, controlling, and
managing transactions

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 Theories and Philosophies of Corporate
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• The costs of running the economic system of firms

• He has argued that such costs are to be distinguished

from production costs and that a decision-maker can
make a choice to use a firm structure or source from the
market by comparing transaction costs with internal
production costs

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 Theories and Philosophies of Corporate
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Stewardship theory

• Managers, left on their own, will act as responsible stewards

of the assets they control, and describes the existence of a
strong relationship between satisfaction and organizational
success

• This theory was introduced by Donaldson and Davis (1989)

as an extension to the agency theory, so that managers can
act in the interest of the company

• Argues that a steward recognizes that individualistic,

opportunistic, and self-serving goals will be met if work is
done for the greater good of the organization.

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 Theories and Philosophies of Corporate
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• Lord Cairns 1874
– “No man, acting as agent, can be allowed to put
himself into a position in which his interest and his duty
will be in conflict”

• Concept of the company based on directors’ fiduciary duty

- the belief that directors can be trusted

• Motivated by intrinsic rewards, such as trust, reputational

enhancement, reciprocity, discretion and autonomy, level
of responsibility, job satisfaction, stability and tenure, and
mission alignment.

• Relies significantly on the principal’s and steward’s initial

trust disposition. Motivational support is positively linked to
stewardship
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 Theories and Philosophies of Corporate
Governance
Critics of stewardship theory argue that:

• Modern corporations unlike naïve 19th century model

• In listed companies shareholders are remote from the
company
– shareholders do not nominate the directors
– financial reports have become largely unintelligible
– complex corporations lack transparency
– directors are not really accountable to shareholders
– consolidated group accounts do not explain complex
groups
• Stewardship theory remains the theoretical foundation for
corporate governance codes, corporate regulation and
companies’ legislation.

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 Theories and Philosophies of Corporate
Governance
Resource dependency theory

• Resource dependency theory sees the governing body as the

link between company and the resources it needs

• Based on the principle that an organization, such as a

business firm, must engage in transactions with other actors
and organizations in its environment in order to acquire
resources

• These resources could include links to relevant markets such

as potential customers and competitors, access to capital and
other sources of finance, provision of know-how and
technology, and relationships with business, political and
other societal networks and elites

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 Theories and Philosophies of Corporate
Governance
• The directors are viewed as boundary-spanning nodes of
networks able to connect the business to its strategic
environment

• Studies from this perspective focus on the

interdependence of companies in a market and can serve
to reduce uncertainty in corporate decisions

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 Theories and Philosophies of Corporate
Governance
Managerial hegemony theory

• Managerial hegemony is that corporate management

members run the day to day operations of the company and
as a result directors lose control to a certain extent.

• Managerial hegemony focuses on the view that directors have

of themselves and the impact on corporate governance
practices

• Directors in some companies see themselves as an elite

group, dominating both the company organisation and
external linkages

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 Theories and Philosophies of Corporate
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• Top management appointments ensure that newcomers fit

into that elite and sustain its image

• Independent directors are likely to be appointed only if

they sustain the dominance of the ruling group

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 Theories and Philosophies of Corporate
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Class hegemony

• Class hegemony explains that directors view and perceive

themselves as an elite set of people at the top of the company
and they will recruit or appoint other directors who are of the
same caliber and can align with them (Fahr, 2010).

• Class hegemony recognises that directors' self-image can

affect board behaviour and performance.

• Executive directors, their self-image bolstered by access to

information, knowledge of ongoing operations, and decision-
making power, may dominate board decisions.

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 Theories and Philosophies of Corporate
Governance
• Critics of the case approach argue that case evidence is
– statistically irrelevant
– anecdotal
– influenced by personal prejudice, self-centred
reporting, and biased insights

• The counter argument is that corporate governance is

about human beings expressing themselves; not a
statistically-controlled economic experiment.

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 Theories and Philosophies of Corporate
Governance
The societal perspective - Stakeholder philosophies

• A view of capitalism that stresses the interconnected

relationships between a business and its customers,
suppliers, employees, investors, communities and others
who have a stake in the organization

• The theory argues that a firm should create value for all
stakeholders, not just shareholders

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 Theories and Philosophies of Corporate
Governance
• Stakeholder advocates argue that companies:
– Owe a duty to all those affected by their behaviour
– Should be responsible and accountable to all those
affected by companies’ decisions including: customers,
employees and managers, partners in the supply
chain, bankers, shareholders, the local community,
broader societal interests, and the state
– Directors should be accountable to a wide range of
stakeholders, far beyond their fiduciary responsibility to
shareholders alone
– Such responsible behaviour is the price society
demands for the privilege of incorporation, with limited
liability for corporate debts
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 Theories and Philosophies of Corporate
Governance
Stakeholder recommendations:

• Proposals for new company ordinances US

• Ralph Nader v Business Roundtable 1970
• Nader and Green 1980
• Millstein and Katsch 1981

• The Corporate Report 1975

• UK Accounting Standards Steering
• Committee discussion paper

• Tomorrow’s Company (RSA UK 1999)

• (Elaine Sternberg v Shann Turnbull)

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 Theories and Philosophies of Corporate
Governance
Tomorrow’s Company

“Shareholder value is the imperative commanding a lot of

attention, but you cannot create shareholder value by
talking to your shareholders. You create it by looking at
the four drivers of a successful business: how good you
are at involving and motivating your staff; how close you
are to your customers; how good you are at removing
wastage from the supply chain and maintaining good
relations with suppliers; what your reputation is in the
community at large. We don’t believe that the board is
there purely to create shareholder value.”

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 Theories and Philosophies of Corporate
Governance
• Sternberg (1997) argued that stakeholder ideas are
fundamentally flawed, because conflicts between
expectations of different stakeholders are irreconcilable.
She emphasized ownership rights

• Turnbull (1997) took the opposite view, advancing the

benefits of a broader cybernetic (and stakeholder) view

• The 1998 UK Hampel Committee dismissed stakeholder

notions, saying: “directors are responsible for relations
with stakeholders, but are accountable to the
shareholders.”

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 Theories and Philosophies of Corporate
Governance
Systems theory - Differing boundaries and levels

• A conceptual framework based on the principle that the

component parts of a system can best be understood in the
context of the relationships with each other and with other
systems, rather than in isolation

• Systems have boundaries, levels of abstraction and

functions i.e. what occurs between the systems inputs and
outputs

• The whole is greater than the sum of its parts.”

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 Theories and Philosophies of Corporate
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Views differ on the focus of corporate governance

• First bibliography of corporate governance published in 1988

by Cochran and Wartick:

"Corporate governance is an umbrella term that includes

specific issues arising from interactions among senior
management, shareholders, boards of directors, and other
corporate stakeholders."
• Principles and good practice
- board structures, board membership, independence of
directors, board committees, and board level effectiveness

• Relationships between owners and corporations, auditors and

regulators, shareholder power
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Psychological and organisational perspectives

• Theories studied so far are at the level of the firm and its
interactions with its environment

• But governing bodies are made up of individual players, with

different mind-sets, personalities, and foibles

• Practitioners recognise that knowing what goes on in the

board room, and during interactions between directors, is
vital to understanding corporate governance

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 Theories and Philosophies of Corporate
Governance
Psychological and organisational perspectives

• Psychological theories have yet to make a significant

impact in understanding corporate governance

• But the relevance of individuals at board-level in the

overall governance process gives this field potential

• Little focus in organisation theories on board level issues

• Some contributions from the psychology of behavioural

and leadership studies and the sociology of organisational
and managerial work.
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 Theories and Philosophies of Corporate
Governance
A subject in search of its paradigm

Pettigrew (1992):
‘corporate governance lacks any form of coherence, either
empirically, methodologically or theoretically with only
piecemeal attempts to try and understand and explain
how the modern corporation is run.’

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 Theories and Philosophies of Corporate
Governance
The present theoretical position:

• The theoretical underpinnings of the subject are still weak

• We lack a conceptual framework that adequately reflects the

reality of governance

• We need a new underpinning theory that explains corporate

governance activities.

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 Theories and Philosophies of Corporate
Governance
• Corporate governance theory needs a taxonomy of
organisational types - public, private, family, subsidiary
associate, joint venture, complex ownership structures -
pyramids, chains, nets, and the rest - to be able to present
a comprehensive and coherent view of the governance
arrangements and structures around the world

• Systems theory and cybernetic-based control system

concepts such as networks, system boundaries, goals,
and sub-optimisation might provide insights.

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 Theories and Philosophies of Corporate
Governance
A general theory of corporate governance:

• The relationship between individual, enterprise and state

• A broader definition of corporate entities to cover every
organisation where governance and management are
separate from the members
• A mapping of all the elements that affect and are affected
by the governance of such organisations
• The expectations, requirements, and demands of each
participant
• The duties and responsibilities of each participant
• The powers, sanctions, and accountabilities of each
participant

Tricker: Corporate Governance, 3rd edition