Bob Tricker Corporate Governance Principles Policies and Practices

Theories and Philosophies of Corporate Governance in which we consider: - the agency dilemma - agency theory - transaction cost economics - 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, 3 rd edition

Theories and philosophies 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. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies • Whenever the owner of wealth (the principal) contracts with someone else (the agent) to manage his affairs the agency dilemma arises • In simple contracts there may be just one principal and one agent • 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. Berle and Means (1932) Tricker: Corporate Governance, 3 rd edition

Theories and philosophies • In public companies today agency relationships can involve strings of agency relations • 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 • tracing the agency chain in such cases can be difficult, and establishing the exposure to agency risk well nigh impossible. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies 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 Tricker: Corporate Governance, 3 rd edition

Theories and philosophies • 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 body. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies 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 Tricker: Corporate Governance, 3 rd edition

Theories and philosophies • 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) Tricker: Corporate Governance, 3 rd edition

Theories and philosophies 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. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies • Much published research has used agency theoretical methods • Based on aggregated, published data • Relationships between governance attributes and performance • Researchers need no access to directors or boards • Statistically rigorous insight into corporate governance processes • Agency theory and the related transaction-cost economics have become an important component of financial economics and organisational economics (Hesterley, 1990). Tricker: Corporate Governance, 3 rd edition

Theories and philosophies • Managerial theorists note relatively narrow theoretical scope of agency theory (Donaldson and Davis, 1992) • Agency-based research tends to focus on specific board practices and corporate performance • At level of specific issues not board or organisational level of analysis • The dynamics of board behaviour do not lend themselves to numerical analysis (Ada Demb, 1993). Tricker: Corporate Governance, 3 rd edition

Theories and philosophies • 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 • Plenty of anecdotal evidence to support • The legal concept of the corporation, and the basis of stewardship theory takes the opposite view. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Does good corporate governance produce better corporate performance? Recent research findings • Stock market pays premium for companies seen to be well governed - reduces their risk • Limited correlation found between good corporate governance and sound corporate performance • A significant study was published by the Association of British Insurers (ABI) in 2008 (Selvaggi and Upton, 2008) suggests there is a robust causal relationship between good corporate governance and superior company performance. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Transaction cost economics • 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. Williamson (1975 and 1988) argued that large corporate groups could overcome disadvantages of scale by 'the choice of governance structures • 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. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Stewardship theory • Underpins the legal concept of the company • Incorporated entity, shared ownership the basis of power • Conflicting societal objectives resolved by: – free markets – legislation to protect other stakeholders - employees (e. g. employment law, safety law) - consumers (e. g. consumer protection law) - suppliers (e. g. contract law) - society (e. g. environmental law). Tricker: Corporate Governance, 3 rd edition

Theories and philosophies • 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 • Under the law directors have a fiduciary duty to their shareholders. Directors are trusted to be stewards for the shareholders’ interest • Stewardship theorists argue that, clearly, this is what most directors actually do. Some fail, but this does not invalidate the basic concept. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Critics of stewardship theory argue that: • Modern corporations unlike naïve 19 th 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 theoretical foundation for corporate governance codes, corporate regulation and companies’ legislation. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Resource dependency theory • Resource dependency theory sees the governing body as the link between company and the resources it needs • These resources could include links to relevant markets such as potential customers and competitors, access to capital and other sources of finance, provision of knowhow and technology, and relationships with business, political and other societal networks and elites. • 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. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Managerial hegemony • 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 • 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. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Class hegemony • 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. • The theories of managerial and class hegemony are rooted in the socio-political disciplines, using case research, allied with biographical analysis. Essentially, these studies see corporate governance as an interpersonal, political process. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies • 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. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies 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. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies 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. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies The societal perspective - stakeholder philosophies • The concern is with values and beliefs about relationships between the individual, the enterprise, and the state • So, though often called stakeholder theory, the societal view of corporate governance is better thought of as a philosophy than a theory. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies 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. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Stakeholder advocates argue that: • 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. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies 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) Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Nader and Green 1980 : "(Giant corporations) can spend decisive amounts to determine which towns thrive and which gather cobwebs, corrupt or help overthrow foreign governments, develop technology that takes lives or saves lives. . . (The giant corporation) is largely unaccountable to its constituencies - shareholders, workers, consumers, local communities, taxpayers, small businesses, future generations". Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Millstein and Katsch 1981 “This strident and partisan concept of substantially unrestrained corporate power and discretion is, in a more moderate form, among the most important fundamental public concerns within large corporations. . . at issue is whether the nation. . . will accept larger private corporate size, accelerate the decline of pluralism by regulating or by giving greater responsibility to government, or by requiring fundamental changes in the internal governance structure of our major corporations. ” Tricker: Corporate Governance, 3 rd edition

Theories and philosophies 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. ” Tricker: Corporate Governance, 3 rd edition

Theories and philosophies • 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. ” Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Roberto Goizuetta, a former head of Coca-Cola: ‘saying that we work for our shareholders may sound simplistic – but we frequently see companies that have forgotten the reason they exist. They may even try to be all things to all people and serve many masters in many different ways. In any event they miss their primary calling, which is to stick to the business of creating value for their owners’ Pettigrew 1997 ‘The old cry of ‘what about the workers? ’ is being replaced by a new call ‘what about the stakeholders? ’ Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Differing boundaries and levels - systems theory 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. " Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Views differ on the focus of corporate governance • 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 • Corporations in society, social responsibilities (beyond fiduciary duty to shareholders) other stakeholders employees, customers, lenders, suppliers, and the community. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Systems theory • Systems have boundaries, levels of abstraction and functions i. e. what occurs between the systems inputs and outputs. Provides context for relating alternative views • Different spotlights on the stage. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies Figure 3. 3: Spotlights on the corporate governance stage Tricker: Corporate Governance, 3 rd edition

Theories and philosophies 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 explain how the modern corporation is run. ’ Tricker: Corporate Governance, 3 rd edition

Theories and philosophies 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. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies 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. Tricker: Corporate Governance, 3 rd edition

Theories and philosophies 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, 3 rd edition

Theories and Philosophies of Corporate Governance We have considered - the agency dilemma - agency theory - transaction cost economics - 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, 3 rd edition