It’s Application to Corporate Governance in the 21st Century.
Corporate governance has been defined differently by various authors. According to Turbull (1997, p.1), “corporate governance describes all the influences that govern the institutional processes, including those for controlling and regulators, involved in the production and sale of goods and services”. As such, this definition indicates that corporate governance encompasses all types of firms (Donaldson, & Preston, 1995). Another school of thought has suggested that the system to govern companies, which entails controlling and directing the activities of those companies, is what constitutes corporate governance (Cohen, 1995). In essence, this system includes the market mechanisms, as well as regulatory frameworks that govern the relationships and roles among an organization’s stakeholders, shareholders, customers, employees, government and environmental groups (Easterbrook & Fischel, 1991). Although there are many corporate governance theories, shareholder and agency theories are the most prominent theories (Etzioni, 2008).
Agency theory illustrates the role of mangers as the agent. Engineered by Alchian and Demsetz (1972) and further enhanced by Jensen and Meckling (1976), the agency theory posits that managers act on behalf investors (Frooman, 1999). In regard to this, it is the interest of shareholders that is prioritized in this theory. As such, the investor/shareholder (principal) has the powers to regulate the actions of managers (agents) (Jones & Wicks, 1995). On the other hand, the stakeholder theory posits that stakeholders rather than shareholders constitute the system of corporate governance. Other scholars view the stakeholder theory as a combination of sociological and organizational disciplines (Gugler, 1999). The engineer of this theory, Freedman (1970), argues that it is vital to perceive the network of relationships in diverse stakeholder networks as well as understand the web of corporate governance and not focusing on the owner/manager/employee relationship.
The stakeholder theory tends to challenge the assumption held by the agency theory; the primacy of shareholder interests. It opposes the notion of prioritizing the interest of stakeholders; this theory argues that an organization must be managed in accordance with the interests of all its stakeholders (Jensen, 2002). These interests range from those of shareholders to direct and indirect interests of others. For instance, the employee, according to some scholars, is a shareholder. Scholars such as Margaret Blair argue that employees are residual risk takers in the organization (Maher & Anderson, 1999). Employees must have a voice in the governance of the firm of they have invested their skills in their firm. On top of that, stakeholder theory posits that other groups such customers, suppliers and the community have indirect interests in the firm, which must be taken into consideration (Mayer, 1996). The society and the environment also have indirect interests in the organization and must therefore be honored.
Opponents of this theory argue that in view of the organization, it is somewhat difficult to operationalize owing to the difficulties involved in deciding what weight should be granted to different stakeholder interests (Norman & Heath, 2004). With respect to corporate governance, there is an assumption that were executives made be accountable to all stakeholders, then in effect, they would be answerable to none (Norman & Heath, 2004). In light with this, proponents of stakeholder theory argue that effective accountability to shareholders is geared towards the interest of the firm as a whole (Quinn & Jones, 1995).
This theory has made significant contributions to company performance. This theory has been influential in the enactment of business ethics (Reed, 1999). However, in the current era, excess levels of executive pay and concomitant company downsizing are contradicting the stakeholder theory principles because it undermines employees and local communities (Reed, 1999). In addition, corporate failures and associated corporate fund collapses have threatened the foundation of psychological license and certificate to operate that govern the privileges afforded by the society at large to corporate entities (Shankman, 1999). Furthermore, globalization has resulted into single issue pressure group, as well as heightened visibility to corporate practices, for instance, the use of child labor, corruption and environmental damage (Scholl, 2008). In essence, the significance being accorded to corporate value statements and the boards’ role with respect to the creation of corporate ethics codes, as well as social and environmental reporting all are a reflection of a wider set of corporate obligations, beyond the execution of shareholder value.
Ethical codes have been found to have a significant impact on the pursuance of performance, and this is the most notable impact stakeholder theory has on company performance (Scholl, 2008). Kaplan and Norton have stressed the significance of power in the assessment of performance, not forgetting the distortions that affect operational effectiveness that can stem from poor financial accounting practices (Young, 2013). The application of the stakeholder theory in the corporate governance arena has dwindled in the last two decades. A majority of countries seem to employ the agency theory in their corporate governance.
The agency theory holds that professional executives are hired by stakeholders or shareholders to act on their behalf (Schrader, 1996; Stieglitz et al., 1989). This theory is anchored on neo-classical economics, but opponents of this theory warn that those agents/executives are likely to act in accordance of their interests, rather than those of their principals (stakeholders/shareholders) (Young, 2013). In order to counter such challenges, the principal is likely to incur agency costs; such costs include decent compensation so as to rally the executives to act in light with their bosses expectations (Young, 2013).
The agency theory is deductive in its methodology. With respect to market governance, this theory holds that the openness and integrity of financial disclosures is significant to the operation of the stock market (Young, 2013). This is geared towards estimating a company’s share price as well as its underlying market valuation. Proponents of this theory argue that market governance depends on the visibility of financial information and the effects of the executive mind on such information (Young, 2013). Two additional market mechanisms are further pointed out by agency theorists. The market for corporate control is the first market mechanism; it entails potential takeovers to take disciplinary measures on executives who go overboard (Young, 2013). The second one is the managerial labor market, which takes center stage at the individual level (Young, 2013). In essence, poor executive performance limits one’s future employment potential, but good performance is likely to boost an individual’s future employment prospects (Young, 2013). It is evident that the independence of the non-executives directors who according to the current regulations must constitute 50 percent of the board and are involved in the conduction of audit.
These market mechanisms ought to be added to the disciplinary effects of on executive and company performance. The annual general meeting (AGM), which is a critical aspect associated with this theory, gives the executives a chance to report to their bosses, the stakeholders on the progress of the company/organization (Young, 2013). The formal accountability of the AGM has in practice been diverted and augmented by other mechanisms. During such meetings, companies give analyses of key intermediaries who serve between the company and their investors (Young, 2013). In addition to this, there are face to face meetings between executives and their key investors (Young, 2013).
The agency theory, in addition to the aforementioned external and market monitoring mechanism, has informed the internal board of directors. The most significant contributions were manifested in the form of widespread executive share option schemes. Corporate governance of the UK seems to dwell on this theory (Young, 2013). In the recent terms, these have been realized significantly in the UK (Young, 2013). These schemes can be associated with the agency assumption that the exercise of executive self interest should be match with the interests of the shareholders. The influence of the agency assumptions can be traced from the Cadbury Committee Code of Best Practice and most recently elaborated by Turnbull, Hampel, Derek Higgs and Greenbury (Young, 2013). Corporate failures which stemmed from abuse of executive powers were evident in a number of these reports, and this has illustrated the control role of the board as stipulated by the principles of the agency theory (Young, 2013). Apart from the UK, the agency theory is also employed in the corporate governance of other countries including the United States of America, Australia, Japan, China, Kenya, Nigeria, South Africa and the Philippines among other nations (Mulili, 2010).
Perceptions on good corporate governance practices vary between nations owing to differences in the business environment. The Cadbury Report (1992), the Business Roundtable (2002), the Australian Stock Exchange Council on Corporate Governance, and the Sarbanes-Oxley Act (2002) attempt to provide some insights of key elements of corporate governance. According to the Cadbury report (1992), good corporate governance encompasses several important aspects. For instance, it is important to establish a board of directors with well defined responsibilities, and the board should be involved I the governance of the firm, but must be different from that of the firms’ managers. This aspect is clearly evidenced in the agency theory. It is common in corporations in the UK, Australia, USA and other developing nations such as Kenya (Mulili, 2010).
Let us look at the example of Kenya and Safaricom (a subsidiary company of Vodafone) and how the aspects of the agency theory are administered (Mulili, 2010). Safaricom has a board of directors, who are mainly investors in the company. The board of directors has appointed a CEO who manages the firm. There are annual AGMs where the CEO informs the board on the progress of the company (Mulili, 2010). In addition, the board evaluates the progresses made by the firm, direction of future investments and the direction the company ought to take in the future. Apart from Safaricom, other privately and non-privately owned companies in Kenya employ this form of corporate governance and it can be confidently stated here that the agency theory is widely used in Kenya’s corporate law (Mulili, 2010).
The heart of the matter suggests that the agency theory has taken control of corporate governance across the globe. It is evident that for quoted companies, agency theory is in the driving seat, and it has been backed up by financial markets, governments, media and the comprehensive governance industry. Proponents of the current state of the art in the corporate governance arena might object change, but it is evident that change is needed. This is because there is change in the nature in which business is conducted. Businesses are shifting from capital and plant intensive enterprises to knowledge intensive, less physical-asset based form of organization.
There have been several successful alternatives which need to be embraced elsewhere. A good example is the John Lewis Partnership, which has been voted by many as Britain’s most successful retailer; it is in the form of employee partnership (Young, 2013). This arrangement boosts employee commitment. Employees are seen in this model as the chief stakeholders and according to Lewis his stakeholders (employees) meet the customers on a daily basis (Young, 2013). Another model has been proposed by the Co-op group (Young, 2013). Unlike the Lewis model that champions employee involvement, the Co-op group model prioritizes customer involvement (Young, 2013). In addition, a host of family companies have decent constitution which spells out clearly the role of the owners towards the employees, customers as well as the community. Other forms of promising corporate governance champion the involvement of the community and customers (Young, 2013). These alternatives are needed so as clean up the mess that has been created in the corporate governance arena by outdated or rigid corporate governance theories.
In summary, this paper has shown that the system to govern companies, which entails controlling and directing the activities of those companies, is what constitutes corporate governance. In essence, this system includes the market mechanisms, as well as regulatory frameworks that govern the relationships and roles among an organization’s stakeholders, shareholders, customers, employees, government and environmental groups. The heart of the matter suggests that the agency theory has taken control of corporate governance across the globe. It is evident that for quoted companies, agency theory is in the driving seat, and it has been backed up by financial markets, governments, media and the comprehensive governance industry. The application of the stakeholder theory in the corporate governance arena has dwindled in the last two decades. A majority of countries seem to employ the agency theory in their corporate governance. This paper concludes that stakeholder theory does not offer a better basis for the understanding of corporate governance in the 21st century than the agency theory. There have been several successful alternatives which need to be embraced such as those that focus on employees, customers and community involvement.
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