CLASS Assignement
Discuss the following principles and theories of Corporate Governance
The Agency Theory (10 marks)
Transactions Costs Economics (10 marks)
Stewardship Theory (10 marks)
The Agency theory
The agency theory of corporate governance, proposed by Jensen and Meckling (1976),
emphasizes the principal-agent relationship within a firm. According to this theory, the
principal (shareholders or owners) delegates decision-making authority to the agent
(management or executives) to act on their behalf in maximizing firm value. However,
agency problems arise due to the divergence of interests and information asymmetry between
principals and agents, leading to a potential conflict of interests.
Fama and Jensen (1983) extended the agency theory by proposing the concept of separation
of ownership and control. They argue that in large corporations, shareholders (principals)
have limited control over decision-making because they delegate authority to professional
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managers (agents). This separation creates potential agency problems as managers may
prioritize their own interests rather than shareholders' interests, leading to agency costs.
Eisenhardt (1989) provides an assessment and review of agency theory, highlighting its
significance in understanding corporate governance. She emphasizes that the theory helps
explain the role of contracts, incentives, and monitoring mechanisms in aligning the interests
of principals and agents. Moreover, agency theory provides insights into how governance
mechanisms can mitigate agency problems and reduce agency costs, enhancing firm
performance.
Shleifer and Vishny (1997) conducted a comprehensive survey of corporate governance,
acknowledging the agency theory's central role in understanding governance mechanisms.
They describe agency theory as providing insights into executive compensation, boards of
directors, and other governance mechanisms that aim to align the interests of principals
(shareholders) and agents (managers). The survey demonstrates the wide-ranging
implications and applications of agency theory in corporate governance research.
Relevancy of the agency theory in corporate governance.
Explains principal-agent relationship: The agency theory provides a comprehensive
framework to understand the relationship between principals (shareholders) and agents
(managers) in large corporations. It highlights the potential conflicts of interests and
information asymmetry that arise in this relationship, leading to agency problems.
Identifies agency costs: The theory emphasizes the existence of agency costs, which refer to
the expenses incurred by principals to mitigate conflicts of interests with agents. By
recognizing these costs, the theory helps stakeholders understand the importance of effective
governance mechanisms to reduce them and improve firm performance.
Provides guidance for governance mechanisms: The agency theory offers insights into
designing effective governance mechanisms to align the interests of principals and agents. It
explores the role of contractual agreements, performance-based incentives, monitoring
mechanisms, and boards of directors in mitigating agency problems and enhancing corporate
governance.
Limitations of the agency theory in corporate governance:
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Oversimplification: Critics argue that the agency theory overly simplifies the relationship
between principals and agents by portraying agents as self-interested and opportunistic. In
reality, the relationship is more complex, with various motivations and factors influencing
agent behaviour.
Focus on shareholder value: The agency theory primarily focuses on maximizing shareholder
value. This narrow focus may neglect other important stakeholders' interests, such as
employees, communities, and the environment. Critics argue that the theory's exclusive
emphasis on shareholder value can lead to short-termism and unethical behavior.
Limited attention to cultural and contextual factors: The agency theory does not adequately
address the influence of cultural, social, and contextual factors on corporate governance.
These factors can significantly impact the agency relationship and governance mechanisms,
yet they are often overlooked in the theory.
Lack of empirical evidence: While the agency theory is widely accepted and influential, some
argue that there is a lack of robust empirical evidence supporting its predictions and
assumptions. Critics claim that the theory may not fully capture the complexities and nuances
of real-world corporate governance practices.
Conclusion
The agency theory remains a valuable tool for understanding and analysing the principal-
agent relationship in corporate governance. It provides a foundational framework for
addressing agency problems and designing governance mechanisms that align the interests of
principals and agents. However, it is important to consider its limitations and complement it
with other perspectives to gain a more comprehensive understanding of corporate
governance.
Transactions Costs Economics
The transactional cost theory, introduced by John R Commons in 1931 and popularized by
Oliver Williamson in 2008, explores the costs associated with economic transactions. It
relates to corporate governance by emphasizing the need for efficient governance structures
that minimize transactional costs and enhance organizational performance. The transactional
costs theory suggests that corporate governance structures and mechanisms are designed to
minimize the costs associated with conducting transactions between different stakeholders,
such as shareholders, managers, and employees. These costs include not only monetary
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expenses but also time, effort, and information asymmetry. The theory posits that governance
mechanisms are established to reduce these transactional costs and ensure optimal decision-
making and value creation.
According to Williamson (1985), transactional costs arise from the complex nature of
economic exchanges, bounded rationality, opportunism, and uncertainties. The theory
emphasizes the importance of selecting governance structures that align the interests of
different stakeholders, reduce information asymmetry, and mitigate opportunistic behaviour.
Relevance and Limitations to Governance:
The transactional costs theory has important implications for corporate governance practices.
It highlights the need for efficient governance mechanisms that can minimize transactional
costs and enhance organizational performance (Carter et al., 2003). By selecting appropriate
contractual arrangements, monitoring mechanisms, and incentivization systems, firms can
align the interests of shareholders and managers, reduce conflicts, and enhance overall
efficiency.
Critics argue that the transactional costs theory oversimplifies the complexities of corporate
governance and overlooks the social and political dimensions that can influence decision-
making (Aguilera et al., 2019). It assumes rational behaviour and fails to fully consider the
role of power dynamics, culture, and institutional factors in shaping governance mechanisms
(Lazonick & O'Sullivan, 2000).
Moreover, the transactional costs theory may struggle to account for the dynamic nature of
markets and the changing relationships between stakeholders. As firms expand globally and
face new challenges, governance mechanisms must adapt to address emerging issues (Qian et
al., 2018).
Conclusion
The transactional costs theory remains relevant as a foundation for understanding the design
and implementation of governance mechanisms. It provides insights into the costs and
benefits of different governance structures and informs decision-making in selecting optimal
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governance practices (Eisenhardt, 1989). By minimizing transactional costs, firms can
enhance their competitiveness, align stakeholder interests, and create long-term value.
Stewardship theory
Donaldson and Davis (1989) introduced stewardship theory. Stewards in the company means
the directors or the manager of the Company. According to this theory, as a steward, when
managers are given the power to work in the interest of the Company, they work responsibly
for the organisational success and balanced growth of all the stakeholders—the work in the
interest of the shareholders to maximise their wealth.
According to Davis et al. (1997, p. 3), the stewardship theory emphasizes intrinsic motivation
and personal responsibility in managerial behaviour. Managers are seen as stewards entrusted
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with the resources of the corporation, and they believe in acting in the best interests of
shareholders. The theory highlights the importance of trust, cooperation, loyalty, and
commitment between managers and shareholders, creating a sense of mutual accountability.
Trust and confidence: Stewardship theory emphasizes the importance of trust and confidence
between shareholders and managers. Shareholders should have confidence that managers will
act in the best interests of the organization.
Alignment of interests: Stewardship theory suggests that managers' interests should align
with those of shareholders. This alignment can be achieved through mechanisms such as
stock ownership, performance-based compensation, and long-term incentives.
Long-term focus: Stewardship theory promotes a long-term perspective in decision-making.
Managers are encouraged to make decisions that create sustainable value and ensure the long-
term success of the organization, rather than pursuing short-term gains at the expense of long-
term viability.
Delegation of authority: Stewardship theory advocates for the delegation of authority and
decision-making power to managers, who are considered experts in their respective areas.
This allows managers to act autonomously and make decisions in the best interest of the
organization.
Accountability and transparency: Stewardship theory highlights the importance of
accountability and transparency in corporate governance. Managers expected to be
accountable for their actions and decisions, and shareholders should have access to relevant
information to evaluate managerial performance. Stewardship theory stands in contrast to
agency theory, which assumes that managers are self-interested and may pursue their own
objectives at the expense of shareholders
Relevancy and Limitations to Governance:
Relevant studies have discussed the relevancy and limitations of the stewardship theory in
corporate governance. Some scholars argue that the stewardship theory can contribute to
effective governance by fostering a long-term focus, aligning interests, and encouraging
responsible decision-making (Davis et al., 1997). Stewardship-oriented behaviour can lead to
better firm performance, strategic decision-making, and risk management (Rajafar, 2016).
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However, the stewardship theory also has limitations. Researchers have criticized the theory
for being idealistic and lacking empirical support (Mishra & Hansen, 2012). The assumption
that managers will act in the best interests of shareholders might not always hold true in
practice, especially when managers have conflicting personal interests or when external
pressures influence their behaviour (Donaldson & Davis, 1991).
Additionally, the stewardship theory overlooks potential agency conflicts and fails to account
for the separation of ownership and control in large corporations (Jensen & Meckling, 1976).
It may not provide sufficient guidance on how to align managerial behaviour with
shareholder interests when conflicts arise. Moreover, the theory does not address the
changing dynamics of corporate governance, such as the rise of institutional investors and
increasing shareholder activism (Donaldson & Davis, 1991).
Conclusion
The stewardship theory is relevant as a complementary perspective in corporate governance.
It highlights the importance of trust, ethical behaviour, and positive relationships between
managers and shareholders. Incorporating stewardship principles into governance practices
can enhance firm performance and create a culture of accountability and responsible
decision-making (Anderson &Sun, 2017).
References:
Aguilera, R. V., Desender, K. A., & Kabbach de Castro, L. R. (2019). Human Governance:
Four Propositions. Academy of Management Perspectives, 33(2), 113–127.
Anderson, G., & Sun, H. (2017). A Stewardship Approach to Corporate Governance:
Balancing Shareholder Interests and the Common Good. Journal of Business Ethics, 146(2),
313–324.
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Carter, C. A., McNulty, P. J., & Verbeke, A. (2003). Product Market Change and the Impact
of Heterogeneity on Business and Corporate-Level Strategy: Theoretical Framework and
Empirical Evidence. Journal of Management Studies, 40(1), 55–79.
Davis, J. H., Schoorman, F. D., & Donaldson, L. (1997). Toward a Stewardship Theory of
Management. Academy of Management Review, 22(1), 20–47.
Donaldson, L., & Davis, J. H. (1991). Stewardship Theory or Agency Theory: CEO
Governance and Shareholder Returns. Australian Journal of Management, 16(1), 49–64.
Eisenhardt, K. M. (1989). Agency theory: An assessment and review. Academy of
management review, 14(1), 57-74.
Fama, E. F., & Jensen, M. C. (1983). Separation of ownership and control. The Journal of
Law and Economics, 26(2), 301-325.
Jensen, M. C., & Meckling, W. H. (1976). Theory of the Firm: Managerial Behavior, Agency
Costs, and Ownership Structure. Journal of Financial Economics, 3(4), 305–360.
Lazonick, W., & O'Sullivan, M. (2000). Maximising the Surplus Benefits from Mergers and
Acquisitions: The Role of Organizational Capability and Market Competition. Industrial and
Corporate Change, 9(4), 641–665.
Mishra, A., & Hansen, U. (2012). Stewardship Theory: Meaning, Examples, Advantages and
Limitations. Journal of Management Research, 12(2), 88–99.
Qian, G., Li, L., & Anwar, S. T. (2018). From Individuals to Multinationals: Exploring the
Complexities of the Transaction Cost Economics in International Business Research. Journal
of World Business, 53(4), 415–426.
Shleifer, A., & Vishny, R. W. (1997). A survey of corporate governance. The Journal of
Finance, 52(2), 737-783.
