Chapter 1: Theory of governance
Chapter learning objectives
Upon completion of this chapter you will be able to:
- define and explain the meaning of corporate governance
- explain, and analyse, the issues raised by the development of the joint stock company as the dominant form of business organisation and the separation of ownership and control over business activity
- analyse the purposes and objectives of corporate governance
- explain, and apply in the context of corporate governance, the key underpinning concepts
- explain and assess the major areas of organisational life affected by issues in corporate governance
- compare, and distinguish between public, private and non-governmental organisation (NGO) sectors with regard to the issues raised by, and scope of, governance
- explain and evaluate the roles, interests and claims of the internal parties involved in corporate governance
- explain and evaluate the roles, interests and claims of the external parties involved in corporate governance
- define agency theory
- define and explain the key concepts in agency theory
- explain and explore the nature of the principal-agent relationship in the context of corporate governance
- analyse and critically evaluate the nature of agency accountability in agency relationships
- explain and analyse the other theories used to explain aspects of the agency relationship.
1 Company ownership and control
- A 'joint stock company' is a company which has issued shares.
- Since the formation of joint stock companies in the 19th century, they have become the dominant form of business organisation within the UK.
- Companies that are quoted on a stock market such as the London Stock Exchange are often extremely complex and require a substantial investment in equity to fund them, i.e. they often have large numbers of shareholders.
- Shareholders delegate control to professional managers (the board of directors) to run the company on their behalf. The board act as agents (see later).
- Shareholders normally play a passive role in the day-to-day management of the company.
- Directors own less than 1% of the shares of most of the UK's 100 largest quoted companies and only four out of ten directors of listed companies own any shares in their business.
- Separation of ownership and control leads to a potential conflict of interests between directors and shareholders.
- This conflict is an example of the principal-agent (discussed later in this chapter).
2 What is 'corporate governance'?
The Cadbury Report 1992 provides a useful definition:
- 'the system by which companies are directed and controlled'.
An expansion might include:
- 'in the interests of shareholders' highlighting the agency issue involved
- 'and in relation to those beyond the company boundaries' or
- 'and stakeholders' suggesting a much broader definition that brings in concerns over social responsibility.
To include these final elements is to recognise the need for organisations to be accountable to someone or something.
Governance could therefore be described as:
- 'the system by which companies are directed and controlled in the interests of shareholders and other stakeholders'.
Coverage of governance
Companies are directed and controlled from inside and outside the company. Good governance requires the following to be considered:
Direction from within:
- the nature and structure of those who set direction, the board of directors
- the need to monitor major forces through risk analysis
- the need to control operations: internal control.
Control from outside:
- the need to be knowledgeable about the regulatory framework that defines codes of best practice, compliance and legal statute
- the wider view of corporate position in the world through social responsibility and ethical decisions.
Joint stock company development
Governance is principally the study of the mechanics of capitalism. These mechanics differ greatly in different areas of the world.
The dominant systems of governance are the Anglo-American or Anglo-Saxon where ownership and control are separated and a stock exchange exists through which listed company shares are freely bought and sold.
The history of governance focuses on corporate ownership structure because although legal systems, culture, religion and economic events all affect governance, it is the ownership and the financing or funding this suggests that leads to organisation existence and growth and through this the need for governance.
Joint stock company development
The UK and US are examples of as to how such structures developed. There is no suggestion that this needs to be learnt. It is used to support the suggestion that governance has grown and developed over time to become a major concern today.
- In the UK medieval guild membership could be bought meaning that individuals had a share in an organisation.
- Internationalisation, particularly through the East India Company, led to the granting of a royal charter (like registering a company) in 1600 and the issuing of joint stock.
- The South Sea Bubble of 1720 involved massive share trading in the Company of Merchants of Great Britain trading in the South Seas. At its height the total invested in companies trading on the stock exchange in South Seas stock reached Â£500 million, twice the value of all the land in England. The subsequent crash launched governance as an issue. Joint stock companies were banned unless authorised by Act of Parliament (for specific projects such as building a bridge).
- The 1800s saw the railway boom and the need to raise huge amounts of cash. This also occurred in the US.
- In 1844, 910 companies were incorporated under the Joint Stock Companies Act, with unlimited liability.
- In 1855, the Limited Liability Act was passed in the UK to stop movement of capital to the US where limited liability already existed to fund growth.
- In 1865, the 14th amendment to the US Constitution provided corporations with the same rights as human beings (separate legal entity).
- In 1897, Salomon v Salomon in the UK declared the body corporate to be a separate legal being.
- In 1932, Bearle and Means talked about corporate malaise and the separation of ownership and control where shareholders exit rather than use their voice.
- In 1950s and 1960s, there was growth of the corporation and globalisation.
- In the 1970s and 1980s, there was a decline in social cohesion, and the sense of community and trust in institutions from church to state to corporations.
3 The business case for governance
Providing a business case for governance is important in order to enlist management support. Corporate governance is claimed to bring the following benefits:
- It is suggested that strengthening the control structure of a business increases accountability of management and maximises sustainable wealth creation.
- Institutional investors believe that better financial performance is achieved through better management, and better managers pay attention to governance, hence the company is more attractive to such investors.
- The above points may cause the share price to rise â€“ which can be referred to as the â€œgovernance dividendâ€ (i.e. the benefit that shareholders receive from good corporate governance).
- Additionally, a socially responsible company may be more attractive to customers and investors hence revenues and share price may rise (a "social responsibility dividend").
The hard point to prove is how far this business case extends and what the returns actually are.
4 Purpose and objectives of corporate governance
Corporate governance has both purposes and objectives.
- The basic purpose of corporate governance is to monitor those parties within a company which control the resources owned by investors.
- The primary objective of sound corporate governance is to contribute to improved corporate performance and accountability in creating long-term shareholder value.
Test your understanding 1
Briefly describe the role of corporate governance.
5 Key concepts
The foundation to governance is the action of the individual. These actions are guided by a person's moral stance.
Importance of concepts in governance
Importance in governance
An appropriate level of morality or ethical behaviour is important for a number of reasons:
- Codes provide the principle to behaviour; it is the individual's ethical stance that translates this into action in a given business situation.
- The existence of given levels of ethical behaviour improves vital public perception and support for the profession and actions of individuals within that profession.
- Such moral virtue operates as a guide to individual, personal behaviour as well as in a business context.
- The existence of such moral virtue provides trust in the agency relationship between the accountant and others such as auditors. This trust is an essential ingredient for successful relationships.
Characteristics which are important in the development of an appropriate moral stance include the following:
- A sense of equality in dealing with internal stakeholders.
- A sense of even-handedness in dealing with external stakeholders.
- An ability to reach an equitable judgement in a given ethical situation.
- The creation of a transparent relationship with shareholders to reduce agency costs (see later in this chapter), and the development of accounting systems and standards to facilitate this openness.
- Lack of withholding relevant information unless necessary, leading to a default position of information provision (rather than concealment).
- Transparency in strategic decision making to assist in the development of an appropriate culture within the company.
- Independence from personal influence of senior management for non-executive directors (NEDs).
- Independence of the board from operational involvement.
- Independence of directorships from overt personal motivation since the organisation should be run for the benefit of its owners.
- Honesty in financial/positional reporting.
- Perception of honesty of the finance from internal and external stakeholders.
- A foundation ethical stance in both principles- and rules-based systems.
Illustration 1 â€“ Sibir Energy
In 2008 Russian oil giant Sibir Energy announced plans to purchase a number of properties from a major shareholder, a Russian billionaire. These properties included a Moscow Hotel and a suspended construction project originally planned to be the world's tallest building.
This move represented a major departure from Sibir Energy's usual operations and the legitimacy of the transactions was questioned. The company was also criticised for not considering the impact on the remaining minority shareholders.
The Sibir CEO's efforts to defend the transactions were in vain and he was suspended when it emerged that the billionaire shareholder owed Sibir Energy over $300m. The impact on the company's reputation has been disastrous. The accusations of 'scandal' led to stock exchange trading suspension in February 2009 and a fall in the share price of almost 80% since its peak in 2008.
- Willingness to accept liability for the outcome of governance decisions.
- Clarity in the definition of roles and responsibilities for action.
- Conscientious business and personal behaviour.
- Accounting for business position as a result of acceptance of responsibility.
- Providing clarity in communication channels with internal and external stakeholders.
- Development and maintenance of risk management and control systems.
- Developing and sustaining personal reputation through other moral virtues.
- Developing and sustaining the moral stance of the organisation.
- Developing and sustaining the moral stance of the accounting profession.
Illustration 2 â€“ BP Chief Executive
Lord Browne resigned from his position as CEO of oil giant BP in May 2007 due to media stories regarding his private life.
His resignation was to save BP from embarrassment after a newspaper had won a court battle to print details of his private life. Lord Browne apologised for statements made in court regarding a four year relationship with Jeff Chevalier that he described as being 'untruthful' (he had actually lied, this relationship had existed).
Due to this 'untruthfulness' Lord Browne gave up a formidable distinguished 41 year career with BP, and did the honourable thing by resigning as the damage to his reputation would have impacted adversely on BP.
- The ability to reach and communicate meaningful conclusions.
- The ability to weigh numerous issues and give each due consideration.
- The development of a non-judgemental approach to business and personal relationships.
- Steadfast adherence to a strict moral or ethical code, high moral virtue.
- The highest standards of professionalism and probity.
- A prerequisite within agency relationships.
Test your understanding 2 - Key concepts
Fred is a certified accountant. He runs his own accountancy practice from home, where he prepares personal taxation and small business accounts for about 75 clients. Fred believes that he provides a good service and his clients generally seem happy with the work Fred provides.
At work, Fred tends to give priority to his business friends that he plays golf with. Charges made to these clients tend to be lower than others â€“ although Fred tends to guess how much each client should be charged as this is quicker than keeping detailed time-records.
Fred is also careful not to ask too many questions about clients affairs when preparing personal and company taxation returns. His clients are grateful that Fred does not pry too far into their affairs, although the taxation authorities have found some irregularities in some tax returns submitted by Fred. Fortunately the client has always accepted responsibility for the errors and Fred has kindly provided his services free of charge for the next year to assist the client with any financial penalties.
Discuss whether the moral stance taken by Fred is appropriate.
6 Operational areas affected by issues in corporate governance
Further detail of the impact on these areas will be covered in later chapters.
Is governance relevant to all companies?
Issues in corporate governance relate to companies, and in particular listed companies whose shares are traded on major stock markets. However, similar issues might apply to smaller companies, and certainly to many large not-for-profit organisations.
- Corporate governance is a matter of great importance for large public companies, where the separation of ownership from management is much wider than for small private companies.
- Public companies raise capital on the stock markets, and institutional investors hold vast portfolios of shares and other investments. Investors need to know that their money is reasonably safe.
- Should there be any doubts about the integrity or intentions of the individuals in charge of a public company, the value of the company's shares will be affected and the company will have difficulty raising any new capital should it wish to do so.
- The scope of corporate governance for private and not-for-profit organisations will be much reduced when compared with a listed company, especially as there are no legal or regulatory requirements to comply with.
- The ownership and control, organisational objectives, risks and therefore focus may be different from a listed company. However, many of the governance principles will still be applicable to other entities.
- The public and not-for-profit sectors have voluntary best practice guidelines for governance which, while appreciating the differences in organisation and objective, cover many of the same topics (composition of governing bodies, accountability, risk management, transparency, etc.) included within the UK Corporate Governance Code (2010).
- In not-for-profit organisations, a key governance focus will be to demonstrate to existing and potential fund providers that money is being spent in an appropriate manner, in line with the organisations' objectives.
Other governance codes
The Code of Governance for the Voluntary and Community Sector
- Principle 1: Board leadership â€“ every organisation should be led and controlled by an effective board of trustees which collectively ensures delivery of its objects, sets its strategic direction and upholds its values.
- Principle 2: The board in control â€“ the trustees as a board should collectively be responsible and accountable for ensuring and monitoring that the organisation is performing well, is solvent, and complies with all its obligations.
- Principle 3: The high performance board â€“ the board should have clear responsibilities and functions, and should compose and organise itself to discharge them effectively.
- Principle 4: Board review and renewal â€“ the board should periodically review its own and the organisation's effectiveness, and take any necessary steps to ensure that both continue to work well.
- Principle 5: Board delegation â€“ the board should set out the functions of sub-committees, officers, the chief executive, other staff and agents in clear delegated authorities, and should monitor their performance.
- Principle 6: Board and trustee integrity â€“ the board and individual trustees should act according to high ethical standards, and ensure that conflicts of interest are properly dealt with.
- Principle 7: Board openness â€“ the board should be open, responsive and accountable to its users, beneficiaries, members, partners and others with an interest in its work.
The Good Governance Standard for Public Services
- Good governance means focusing on the organisation's purpose and on outcomes for citizens and service users.
- Good governance means performing effectively in clearly defined functions and roles.
- Good governance means promoting values for the whole organisation and demonstrating the values of good governance through behaviour.
- Good governance means taking informed, transparent decisions and managing risk.
- Good governance means developing the capacity and capability of the governing body to be effective.
- Good governance means engaging stakeholders and making accountability real.
7 Internal corporate governance stakeholders
Within an organisation there are a number of internal parties involved in corporate governance. These parties can be referred to as internal stakeholders.
Stakeholder theory will be covered again later in this chapter, and in more detail in chapter 7. A useful definition of a stakeholder, for use at this point, is 'any person or group that can affect or be affected by the policies or activities of an organisation'.
Each internal stakeholder has:
- an operational role within the company
- a role in the corporate governance of the company
- a number of interests in the company (referred to as the stakeholder 'claim').
The board of directors
- Has the responsibility for giving direction to the company.
- Delegates most executive powers to the executive management, but reserves some decision-making powers to itself, such as decisions about raising finance, paying dividends and making major investments.
- Executive directors are individuals who combine their role as director with their position within the executive management of the company.
- Non-executive directors (NEDs) perform the functions of director only, without any executive responsibilities.
- Executive directors combine their stake in the company as a director with their stake as fully paid employees, and their interests are, therefore, likely to differ from those of the NEDs.
- More detail on directors will be found in chapter 3.
The company secretary
- Often responsible for advising the board on corporate governance matters and ensuring board procedures are followed.
- Duties vary with the size of the company, but are likely to include:
- arranging meetings of the board
- drafting and circulating minutes of board meetings
- ensuring that board decisions are communicated to staff and outsiders
- completing and signing of various returns
- filing accounts with statutory authorities
- maintaining statutory documents and registers required by the authorities.
- Company secretary may act as the general administrator and head office manager. This role may include a responsibility for maintaining accounting records, corresponding with legal advisers, tax authorities and trade associations.
- Does not have the same legal responsibilities as directors.
- Should always act in the interests of the company in any event of conflict or dispute with directors.
- Is responsible to the board and accountable through the chairman and Chief Executive Officer (CEO) for duties carried out.
- Has the same interests and claims in the company as other employees.
- Remuneration package should be settled by the board or remuneration committee.
- Responsible for running business operations.
- Accountable to the board of directors (and more particularly to the CEO).
- Will take an interest in corporate governance decisions which may impact their current position and potential future positions (as main board directors, possibly).
- Individual managers, like executive directors, may want power, status and a high remuneration.
- As employees, they may see their stake in the company in terms of the need for a career and an income.
- Have a stake in their company because it provides them with a job and an income.
- Have expectations about what their company should do for them, e.g. security of employment, good pay and suitable working conditions.
- Some employee rights are protected by employment law, but the powers of employees are generally limited.
- Primary interest will be in the pay and working conditions of their members.
- Will be concerned by poor corporate governance, for example lack of protection for whistleblowers or poor management of health and safety risks, and hence assist in the checks and balances of power within a company.
- Can 'deliver' the compliance of a workforce, particularly in a situation of business reorganisation.
- Can optimise industrial relations, easing workforce negotiations, and hence ensure an efficient and supportive relationship.
- Can be used by management of the company to distribute information to employees or to ascertain their views, hence can play a helpful role in business.
- Power of trade unions will vary between countries, with it being much stronger in countries such as France where union rights are extended to all employees.
8 External corporate governance stakeholders
A company has many external stakeholders involved in corporate governance.
Each stakeholder has:
- a role to play in influencing the operation of the company
- its own interests and claims in the company.
Institutional investors and corporate governance
Pressure is being brought to bear on institutional investors to give more attention to corporate governance issues.
- Due to the size of their shareholdings, institutional investors can exert significant influence on corporate policy and take an active role in bringing under-performing companies to task.
- Guidelines issued by the Institutional Shareholders Committee in 2002 encourage institutional investors to develop a policy on corporate governance and to apply this policy when voting in company meetings.
- It is argued that just as directors have obligations to their shareholders, institutional investors have obligations to the many individuals (pension scheme holders, unit trust investors and so on) whose money they invest.
Refer to the Examiner's article published in Student Accountant in August 2009 â€œCorporate Governance: External and Internal Actorsâ€.
9 What is agency theory?
Agency theory is a group of concepts describing the nature of the agency relationship deriving from the separation between ownership and control.
Agency theory and corporate governance
Agency theory can help to explain the actions of the various interest groups in the corporate governance debate.
Agency theory and corporate governance
Examination of theories behind corporate governance provides a foundation for understanding the issue in greater depth and a link between an historical perspective and its application in modern governance standards.
- Historically, companies were owned and managed by the same people. For economies to grow it was necessary to find a larger number of investors to provide finance to assist in corporate expansion.
This led to the concept of limited liability and the development of stock markets to buy and sell shares.
- Limited liability: limited risk and so less interest in the firm.
- Stock market: wide and limited individual ownership and the ability to simply sell without the need to take any interest in the firm.
- Delegation of running the firm to the agent or managers.
- Separation of goals between wealth maximisation of shareholders and the personal objectives of managers. This separation is a key assumption of agency theory.
- Possible short-term perspective of managers rather than protecting long-term shareholder wealth.
- Divorce between ownership and control linked with differing objectives creates agency problems.
This relates to a tendency to foreshorten the time horizon applied to investment decisions or to raise the discount rate well above the firms' cost of capital.
- This can come from within through managers operating in their self interest.
- This can come from outside through investors and large institutional investors churning shares to maximise return on investment (ROI) for their investment funds and individual fund manager bonuses.
10 Key concepts of agency theory
A number of key terms and concepts are essential to understanding agency theory.
- An agent is employed by a principal to carry out a task on their behalf.
- Agency refers to the relationship between a principal and their agent.
- Agency costs are incurred by principals in monitoring agency behaviour because of a lack of trust in the good faith of agents.
- By accepting to undertake a task on their behalf, an agent becomes accountable to the principal by whom they are employed. The agent is accountable to that principal.
- Directors (agents) have a fiduciary responsibility to the shareholders (principal) of their organisation (usually described through company law as 'operating in the best interests of the shareholders').
- Stakeholders are any person or group that can affect or be affected by the policies or activities of an organisation.
- Agent objectives (such as a desire for high salary, large bonus and status for a director) will differ from the principal's objectives (wealth maximisation for shareholders).
Examples of principal-agent relationships
Shareholders and directors
The separation of ownership and control in a business leads to a potential conflict of interests between directors and shareholders.
- The conflict of interests between principal (shareholder) and agent (director) gives rise to the 'principal-agent problem' which is the key area of corporate governance focus.
- The principals need to find ways of ensuring that their agents act in their (the principals') interests.
- As a result of several high profile corporate collapses, caused by over-dominant or 'fat cat' directors, there has been a very active debate about the power of boards of directors, and how stakeholders (not just shareholders) can seek to ensure that directors do not abuse their powers.
- Various reports have been published, and legislation has been enacted, in the UK and the US, which seek to improve the control that stakeholders can exercise over the board of directors of the company.
Shareholders and auditors
The other principal-agent relationship dealt with by corporate governance guidelines is that of the company with its auditors.
- The audit is seen as a key component of corporate governance, providing an independent review of the financial position of the organisation.
- Auditors act as agents to principals (shareholders) when performing an audit and this relationship brings similar concerns with regard to trust and confidence as the director-shareholder relationship.
- Like directors, auditors will have their own interests and motives to consider.
- Auditor independence from the board of directors is of great importance to shareholders and is seen as a key factor in helping to deliver audit quality. However, an audit necessitates a close working relationship with the board of directors of a company.
- This close relationship has led (and continues to lead) shareholders to question the perceived and actual independence of auditors so tougher controls and standards have been introduced to protect them.
- Who audits the auditors?
Different ownership models in other countries raise additional principal-agent relationships which need to be considered in the context of corporate governance.
- Institutional arrangements in German companies, typified by the two-tier board (see chapter 3), allow employees to have a formal say in the running of the company.
- In Japan, there is an emphasis on a consensual management style through negotiation between the interested parties.
- In the US, there is a much greater likelihood of debt holders/major creditors or chief executives of other companies being represented on the board.
The cost of agency relationships
Agency costs arise largely from principals monitoring activities of agents, and may be viewed in monetary terms, resources consumed or time taken in monitoring. Costs are borne by the principal, but may be indirectly incurred as the agent spends time and resources on certain activities. Examples of costs include:
- incentive schemes and remuneration packages for directors
- costs of management providing annual report data such as committee activity and risk management analysis, and cost of principal reviewing this data
- cost of meetings with financial analysts and principal shareholders
- the cost of accepting higher risks than shareholders would like in the way in which the company operates
- cost of monitoring behaviour, such as by establishing management audit procedures.
This is an additional type of agency cost and relates to directors furnishing themselves with expensive cars and planes etc. These costs are above and beyond the remuneration package for the director, and are a direct loss to shareholders.
Agency problem resolution measures
- Meetings between the directors and key institutional investors.
- Voting rights at the AGM in support of, or against, resolutions.
- Proposing resolutions for vote by shareholders at AGMs.
- Accepting takeovers.
- Divestment of shares is the ultimate threat.
Need for corporate governance
- If the market mechanism and shareholder activities are not enough to monitor the company then some form of regulation is needed.
- There are a number of codes of conduct and recommendations issued by governments and stock exchanges. Although compliance is voluntary (in the sense it is not governed by law), the fear of damage to reputation arising from governance weaknesses and the threat of delisting from stock exchanges renders it difficult not to comply.
- These practical elements make up the majority of the rest of governance issues discussed in subsequent chapters.
Examples of codes
Examples of codes of conduct include:
- The UK Corporate Governance Code (2010) for Corporate Governance adopted by the Financial Services Authority (FSA) in the UK.
- OECD code on ethics.
- ACCA codes.
- Specific regulation regarding director remuneration and city code on takeovers.
Accountability relates to:
- the need to act in shareholders' interests
- the need to provide good information such as audited accounts and annual reports
- the need to operate within a defined legal structure.
With specific regard to directors:
- Directors are accountable to shareholders.
- Directors must prove that they are discharging their responsibilities in line with shareholder expectations in the form of financial results, a clean audit report and reported compliance with codes of corporate governance.
- If the shareholders do not like what they see, they ultimately (although not necessarily practically) have the power to remove the directors and replace them.
Other accountabilities that exist within a company:
- Managers to directors â€“ the day-to-day operation of companies is usually delegated to sub-board level management by the directors. Senior managers are therefore accountable to the directors for their actions, which are usually demonstrated through the results of the company.
- Employees to managers â€“ managers delegate the 'doing' of the company to their employees, holding them accountable for the success, or otherwise, of how their job is done.
- Management to creditors â€“ suppliers hold the management of a company accountable for payment of invoices on a timely basis.
- Auditors to shareholders â€“ the audit is viewed as an essential component of corporate governance, providing an independent review of the company's financial report. Shareholders hold the auditors accountable for ensuring their review is conducted on an independent, competent and adequate basis, so that they can rely on the outcome.
Test your understanding 3
For each of the following scenarios, decide which kind of principal-agent conflict exists.
11 Transaction cost theory
Transaction cost theory is an alternative variant of the agency understanding of governance assumptions. It describes governance frameworks as being based on the net effects of internal and external transactions, rather than as contractual relationships outside the firm (i.e. with shareholders).
Transaction costs will occur when dealing with another external party:
- Search and information costs: to find the supplier.
- Bargaining and decision costs: to purchase the component.
- Policing and enforcement costs: to monitor quality.
The way in which a company is organised can determine its control over transactions, and hence costs. It is in the interests of management to internalise transactions as much as possible, to remove these costs and the resulting risks and uncertainties about prices and quality.
For example a beer company owning breweries, public houses and suppliers removes the problems of negotiating prices between supplier and retailer.
Transaction costs can be further impacted
- Bounded rationality: our limited capacity to understand business situations, which limits the factors we consider in the decision.
- Opportunism: actions taken in an individual's best interests, which can create uncertainty in dealings and mistrust between parties.
The significance and impact of these criteria will allow the company to decide whether to expand internally (possibly through vertical integration) or deal with external parties.
Impact on transaction costs
The variables that dictate the impact on the transaction costs are:
- Frequency: how often such a transaction is made.
- Uncertainty: long term relationships are more uncertain, close relationships are more uncertain, lack of trust leads to uncertainty.
- Asset specificity: how unique the component is for your needs.
Transaction costs still occur within a company, transacting between departments or business units. The same concepts of bounded rationality and opportunism on the part of directors or managers can be used to view the motivation behind any decision.
The three variables are said by Williamson to operate as an economic formula to determining behaviour and so decisions:
- Asset specificity: amount the manager will personally gain.
- Certainty: or otherwise of being caught.
- Frequency: endemic nature of such action within corporate culture
The degree of impact of the three variables leads to a precise determination of the degree of monitoring and control needed by senior management.
Possible conclusions from transaction cost theory
- Opportunistic behaviour could have dire consequences on financing and strategy of businesses, hence discouraging potential investors. Businesses therefore organise themselves to minimise the impact of bounded rationality and opportunism as much as possible.
- Governance costs build up including internal controls to monitor management.
- Managers become more risk averse seeking the safe ground of easily governed markets.
Transaction cost theory vs agency theory
- Transaction cost theory and agency theory essentially deal with the same issues and problems. Where agency theory focuses on the individual agent, transaction cost theory focuses on the individual transaction.
- Agency theory looks at the tendency of directors to act in their own best interests, pursuing salary and status. Transaction cost theory considers that managers (or directors) may arrange transactions in an opportunistic way.
- The corporate governance problem of transaction cost theory is, however, not the protection of ownership rights of shareholders (as is the agency theory focus), rather the effective and efficient accomplishment of transactions by firms.
12 Stakeholder theory
The basis for stakeholder theory is that companies are so large and their impact on society so pervasive that they should discharge accountability to many more sectors of society than solely their shareholders.
As defined in an earlier section, stakeholders are not only are affected by the organisation but they also affect the organisation.
Stakeholder theory may be the necessary outcome of agency theory given that there is a business case in considering the needs of stakeholders through improved customer perception, employee motivation, supplier stability, shareholder conscience investment.
Agency theory is a narrow form of stakeholder theory.
More will be covered on stakeholders in chapter 7.
Test your understanding 4
Founded in 1983 as a long distance phone operator, GlobeLine has relied heavily on acquisitions to fund its growth. In the last decade it has made over 60 acquisitions, extending its reach around the planet and diversifying into data and satellite communications, internet services and web hosting. Almost all acquisitions have been paid for using the company's shares.
This high fuelled 'growth through acquisition' strategy has had a number of outcomes. One is the significant management challenge of managing diversity across the world, straining manpower resources and systems. In particular, the internal audit department has been forced to focus on operational matters simply to keep up with the speed of change.
Shareholders have, on the whole, welcomed the dramatic rise in their stock price, buoyed up by the positive credit rating given by SDL, GlobeLine's favoured investment bank, who have been heavily involved in most of the acquisitions, receiving large fees for their services. Recently, some shareholders have complained about the lack of clarity of annual reports provided by GlobeLine and the difficulty in assessing the true worth of a company when results change dramatically period to period due to the accounting for acquisitions.
Ben Mervin is the visionary, charismatic CEO of GlobeLine. Over the course of the last three years his personal earning topped $77 million with a severance package in place that includes $1.5 million for life and lifetime use of the corporate jet. He is a dominant presence at board meetings with board members rarely challenging his views.
Recently, a whistleblower has alleged financial impropriety within GlobeLine and institutional shareholders have demanded meetings to discuss the issue. The Chairman of the audit committee (himself a frequent flyer on the corporate jet) has consulted with the CEO over the company's proposed response.
(a) Discuss agency costs that might exist in relation to the fiduciary relationship between shareholders and the company, GlobeLine, and consider conflict resolution measures.
(b) Assess the position of GlobeLine's CEO using transaction cost theory and consider the negative impact of shareholder action taken to reduce this cost.
13 Chapter summary
Test your understanding answers
Test your understanding 1
The role of corporate governance is to protect shareholder rights, enhance disclosure and transparency, facilitate effective functioning of the board and provide an efficient legal and regulatory enforcement framework.
Test your understanding 2 - Key concepts
Overall, it can be argued that Fred is providing a professional service in accordance with the expectations of his clients.
However, the moral stance taken by Fred can be queried as follows.
- The guessing of the amounts to charge clients implies a lack of openness and transparency in invoicing and has the effect of being unfair. Friends may be charged less than other clients for the same amount of work. If other clients were aware of the situation, they would no doubt request similar treatment.
- The lack of questioning of clients about their affairs appears to be appreciated. However, this can be taken as a lack of probity on the part of Fred â€“ without full disclose of information Fred cannot prepare accurate taxation returns. It is likely that Fred realises this and that some errors will occur. However, Fred does not have to take responsibility for those errors; his clients do instead.
- While Fred does appear to be acting with integrity in the eyes of his clients, the lack of accuracy in the information provided to the taxation authorities eventually will affect his reputation, especially if more returns are found to be in error. In effect, Fred is not being honest with the authorities.
- Fred may wish to start ensuring that information provided to the taxation authorities is of an appropriate standard to retain his reputation and ensure that clients do trust the information he is preparing for them.
Test your understanding 3
Test your understanding 4
(a) Agency costs
Agency costs exist due to the trust placed by shareholders on directors to operate in their best interests. These costs will rise when a lack of trust exists, although misplaced trust in a relationship will have hidden costs that may lead to poor management and even corporate failure.
Residual costs are a part of agency costs. These are costs that attach to the employment of high calibre directors (outside of salary) and the trappings associated with the running of a successful company. The corporate jet and possible proposed severance pay could be seen as residual costs of employment. Ensuring incentives exist to motivate directors to act in the best interests of shareholders is important. These incentives typically include large salaries such as the multi-million dollar remuneration of the CEO. Stock options will also be used to assist in tying remuneration to performance.
Agency costs also include costs associated with attempts to control or monitor the organisation. The most important of these will be the annual reports with financial statements detailing company operations. Shareholders have complained about the opaqueness of such reports and the costs of improving in this area will ultimately be borne by them.
Large organisations are required, usually as part of listing rules, to communicate effectively with major shareholders. Meetings arranged to discuss strategy, possibly involving the investment bank, and certainly involving the CEO, will take time and money to organise and deliver.
A hidden cost associated with the agency relationship, and one of particular significance here, relates to the increased risk taken on by shareholders due inevitably through relying on someone else to manage an individual's money, and specifically due to the acquisitive strategy employed by the company and the difficulty in gauging the financial performance and level of internal control within the corporation.
The market provides a simple mechanism for dealing with unresolved conflict, that of being able to divest shareholding back into the market place. This option is always available to shareholders if they consider the risks involved too great for the return they are receiving.
A less drastic measure might be to pursue increased communication and persuasion possibly via the largest shareholders in order to ensure the organisation understands shareholders concerns and is willing to act upon their recommendations. The threat of a wide scale sale of shares should have an impact since this will affect directors share options and the ability to continue its acquisitive strategy.
Since acquisition is a two-way street it might be possible for shareholders to persuade another company to bid to take over the organisation should the situation become desperate, although this seems unlikely in this scenario since, although the situation is dire, it does not appear to be terminal.
Shareholder activism may simply require interested parties to propose resolutions to be put to the vote at the next AGM. These might include a reluctance to reappoint directors who may have a conflict of interest in supporting the management or the owners of the company. Such a conflict may exist between the CEO and the Chairman of the audit committee.
(b) Transaction cost theory
Transaction cost theory relates to the costs that occur when transacting with a party outside of the organisation. These include information, contract and control costs. In its true form transaction cost theory can be seen in the acquisitive strategy of the organisation and the way in which it purchases companies rather than growing organically. In this case there will be premiums paid for goodwill and current performance of the target.
The CEO's position is one of evaluating these costs and making decisions regarding possible acquisitions. A large proportion of his salary could be considered to be made up of these costs since the majority of his time may be involved in seeking out, negotiating and purchasing such companies.
His obvious expertise in this field may limit the effect of bounded rationality, the ability of any individual to understand a situation fully, although this may be countered by the global nature of the corporate market place and an inability to fully appreciate the diversity of operating cultures of proposed acquisitions around the world.
Success in this field often relies on opportunistic behaviour, being able to grasp opportunities as they arise. The financing of the company through its own shares and the assistance of the investment bank in facilitating such purchases assist in this opportunistic behaviour.
Transaction cost theory can also be considered from an internal perspective in relation to the motives and factors that influence the CEO within GlobeLine. At this level bounded rationality may be considered problematic with his inability to take advice (see boardroom rules) operating against shareholders interests through balanced, informed decision making. Opportunism may relate to self ingratiation through financial rewards and providing himself with a powerful position within which he is not accountable to anyone, including the owners of the company. This is likely to be of some concern to shareholders.
Transaction cost theory also suggests that the size of the reward (asset specificity), the frequency with which the transaction occurs (60 takeovers in recent years) and the prevalent certainty of success (through the powerbase culture in the company) may heighten the potential for poor decision making. These are key factors that are of some concern to shareholders.
In seeking to redress these problems through actions mentioned in part (a), shareholders are faced with a number of counterbalancing considerations. Firstly, stifling the brilliance and initiative of the CEO may affect his future performance and willingness to stay within the company. This in turn affects share price.
Secondly, shareholder pressure may have a negative impact on his risk seeking strategy should he decide to stay. This may dampen performance and returns and make the company less competitive.
Finally, within the organisational structure, improvements in internal control and reporting are overheads, raising costs and limiting the essential flexibility and speed that has made the company successful over a number of years. Corporate governance is always a careful balancing act between these opposing forces.
Created at 5/24/2012 11:49 AM by System Account
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Last modified at 8/15/2012 10:13 AM by System Account
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