September 17, 2011 Theoretical Aspects of Corporate Governance Faisal AlSager MGT Corporate Governance

Objectives ✤ To understand the various main theories that underline the development of corporate governance ✤ To be aware of the impact of the form of legal system, capital market, and ownership structure on the development of corporate governance

No Single Universal Theory ✤ Development of corporate governance is ✤ a global occurrence, and ✤ a complex area including legal, cultural, ownership, and structural differences ✤ Thus, some theories might be more appropriate and relevant to some countries than others ✤ Or, more relevant at different times depending on what stage an individual country, or group of countries, is at

Theories Associated with the Development of Corporate Governance ✤ There are 4 main theories that have affected the development of corporate governance: ✤ Agency Theory ✤ Transaction Cost Economics ✤ Stakeholder Theory ✤ Stewardship Theory

Agency Theory (Principle-Agent Framework) ✤ Agency theory identifies the agency relationship where one party, the principle, delegates work to another party, the agent. ✤ Disadvantages: ✤ The opportunism or self-interest of the agent; he/she does not act in the best interests of the principle, or acts partially in the best interest of the principle. ✤ Information asymmetry; agent has more information.

The Agency Theory - Corporate Governance ✤ Agency theory views corporate governance, especially the board of directors, as being an essential monitoring device to try to ensure that any problems that may be brought about by the principle-agent relationship, are minimized.

Aspects of the Agency Theories ✤ Parties (in corporate governance context): ✤ Mangers (agents) ✤ Owners (principles) ✤ Managers must be monitored and institutional arrangements must provide some checks and balances to make sure they don’t abuse their power ✤ Agency Costs: ✤ the costs resulting from managers misusing their position, as well as the costs of monitoring and discipling them to prevent abuse.

Transaction Cost Economics (TCE) ✤ TCE views the firm as a governance structure (while the agency theory views it as a nexus of contracts) ✤ Firms grow to achieve economies of scale ✤ by technological advances, or ✤ by the fact that natural monopolies have evolved

How can companies raise capital? From the capital market with a wider shareholder base

In this case.. ✤ A: In TCE, transactions are undertaken internally rather than externally Q: What’s the difference between TCE and the agency theory?

TCE and Agency Theory ✤ Both theories are concerned with managerial discretion ✤ Both assume that mangers are given to opportunism and moral hazard ✤ Both assume that managers operate under bounded rationality ✤ Both regard the board of directors as an instrument of control

Bounded Rationality ✤ From the previous slide we said: “Both [theories] assume that managers operate under bounded rationality”. This means that managers will tend to satisfice, or satisfy and suffice, rather than maximize profit (not being in the best interest of shareholders)

Stakeholder Theory ✤ In agency theory, maintenance or enhancement of shareholder value is paramount ✤ Here, in the stakeholder theory we take into account a wider group of people: ✤ shareholders, employees, providers of credit, customers, suppliers, government, local community ✤ Should we favor shareholders over other stakeholders?

Corporate Governance Anglo-American Model ✤ Emphasis on shareholder value ✤ Board totally comprised of executive and non-executive directors elected by shareholders

✤ Certain stakeholder groups, like employees, have a right enshrined in law for their representatives to sit on the supervisory board alongside the directors Corporate Governance German Model

Stakeholders or shareholders? ✤ “Enlightened value maximization utilizes much of the structure of stakeholder theory but accepts maximization of the long-run value if the firm as criterion for making requisite trade-offs among its stakeholders... and therefore solves problems that arrives from multiple objectives that accompany traditional stakeholder theory” ✤ -Jensen, 2001

Stewardship Theory ✤ It’s an alternative approach to corporate governance, in the agency theory (by Donaldson and Davis) ✤ “Stewardship theory stresses the beneficial consequences on shareholder returns if facilitative authority structures which unify command by having roles of CEO and chair held by the same person.” -Donaldson and Davis ✤ So, stewardship theory does not put manager under control of owners, it empowers managers to take autonomous executive action

General Comments on the Theories ✤ Always consider the legal system and capital market development ✤ Also, consider the ownership structure ✤ Some countries tend to give good protection for shareholder rights, while other countries emphasize more on on the rights of certain stakeholder groups

Important notes.. ✤ Companies cannot operate in isolation without having regard to their actions on different stakeholder groups. ✤ Companies should be able to ✤ Attract and retain equity investment ✤ Be accountable to their shareholders ✤ Give real consideration to the interest of the wider stakeholder constituencies

References ✤ Corporate Governance: Mallin, Tina. Oxford.