Governance

This article has been written by Naveen Talawar, a law student at Karnataka State Law University’s law school. The article gives insight into the concept of corporate governance and the agency theory of corporate governance.

This article has been published by Sneha Mahawar.

Introduction 

The shareholder-manager relationship, which functions as the principal and agent in a corporation, has always been one of the issues discussed by scholars as a factor in determining whether a corporation succeeds or fails, depending on the nature of the relationship and the incentives upon which this relationship in a firm is based. This connection is governed and examined by the agency theory. The dilemma was defined and examined by Jensen and W.H. Meckling in their paper “Theory of the Firms” in 1976 on the basis of a relationship between a ‘Principal’ who appoints someone to duty and an ‘Agent’ who is appointed to act on the Principal’s behalf. 

Agency theory looks into the issues and solutions that arise when tasks are delegated from principals to agents in the context of competing interests. It examines the circumstances under which various types of incentive instruments and monitoring arrangements can be used to minimise welfare loss, beginning with clear assumptions about rationality, contracting, and informational conditions. Agency theory has had a significant scientific impact on social science due to its clear predictions and broad applicability, but it has also received significant criticism. This article deals with the agency theory of corporate governance in detail.

Concept of corporate governance

Corporate governance (CG) is a new phenomenon founded on a variety of complicated disciplines, including but not limited to legal, cultural, ownership, and other structural differences. However, its foundations are undoubtedly weak. The evolution of corporate governance was influenced by the growth, complexity, and advancement of the economy as well as the development of corporate structures.

What is corporate governance

The idea of corporate governance is ambiguous. In essence, there is no single, accepted definition of corporate governance; rather, it is subjective. The term ‘Corporate’ legally refers to a business transaction. Similarly, the term ‘Governance’ is the act of exerting authority, direction, or control. Thus, the concept of ‘Corporate Governance’ refers to the system by which a business entity’s management directs and controls activities in the best interests of the stakeholder. Corporate governance is the term used to describe how a corporation is operated. It is the method used to lead and manage businesses. It all comes down to striking a balance between social and economic as well as individual and societal aims.

Definitions of corporate governance

The following are some definitions of corporate governance:

According to the Cadbury Report (1992), it is defined as “the whole system of controls, both financial and otherwise, by which a company is directed and controlled.

According to the Organisation for Economic Co-operation and Development (OECD) report 1999, corporate governance is “A set of relationships between a company’s board, its shareholders, and other stakeholders. It also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined” 

According to the report of the N.R. Narayana Murthy Committee on Corporate Governance constituted by SEBI (2003), “Corporate Governance is the acceptance by management of the inalienable rights of shareholders as the true owners of the corporation and their own role as trustees on behalf of the shareholders. It is about commitment to values, about ethical business conduct and about making a distinction between personal and corporate funds in the management of a company.

In general, corporate governance refers to a set of practices that protect the interests of all stakeholders in a company. Corporate governance is a system of regulations, customs, and procedures for managing and guiding a business.

Pillars of corporate governance

The three pillars of corporate governance are as follows:

Transparency

The quality of something that allows one to easily understand the truth is referred to as transparency. In the context of corporate governance, this involves providing stakeholders with accurate, sufficient, and timely information about the operating results of the corporate enterprise.

In simple terms, transparency means having nothing to hide. This means that a company makes its processes and transactions accessible to outsiders. It also makes required disclosures, informs everyone affected by its decisions, and follows all applicable laws. Transparency is an important component of corporate governance because it ensures that an outside observer can scrutinise all of a company’s actions at any time. This makes its processes and transactions verifiable, allowing the company to provide a clear answer if a question arises about a step taken.

Accountability

Accountability is the obligation to explain the results of choices that were made in the interests of others. Accountability in the context of corporate governance refers to the Chairman’s, Board of Directors, and the CEO’s obligation to use the company’s resources (over which they have authority) in the best interests of the company and its stakeholders.

Independence

The top management of the company must be independent in order for good corporate governance to exist, which means that the Board of Directors needs to be a powerful, nonpartisan body that can make all corporate decisions based on business wisdom.

Need for corporate governance

Corporate governance is necessary to promote a workplace culture of transparency, accountability, and disclosure. It refers to upholding all moral and ethical standards, the law, and voluntarily adopted practices. This enhances shareholder value and wealth, as well as customer satisfaction. The following factors emphasise the importance of corporate governance:

Corporate performance

Improved governance structures and processes help to ensure quality decision-making, promote effective succession planning for senior management, and boost a company’s long-term prosperity, regardless of size or source of finance. This is related to improved corporate performance, whether in terms of share price or profitability.

Wide spread of shareholders

A company today has a large number of shareholders dispersed across the nation and even the globe, the majority of whom are unorganised and uninterested in corporate affairs. The idea of shareholder democracy is still only recognised by the law and the articles of association, so it needs to be put into practice through a code of conduct for corporate governance.

Changing ownership structure

In the present era, institutional investors (both foreign and Indian) and mutual funds have radically changed the pattern of corporate ownership, becoming the largest shareholders in the large corporate private sector. These investors have emerged as the greatest challenge to corporate management, requiring it to adhere to a set of established corporate governance principles to enhance its reputation in society.

Combating corruption

Companies that are transparent allow for transparency in all business dealings and foster an environment where corruption will undoubtedly disappear. Such businesses also have sound systems in place that fully disclose accounting and auditing practices. Corporate governance allows a company to compete more successfully by preventing fraud and other wrongdoing within the organisation.

Reduced risk of corporate crisis and scandals

Effective corporate governance ensures the effectiveness of the risk mitigation system. By making the board of a company aware of all the risks associated with a particular strategy, corporate governance is a transparent and accountable system that enables different control systems to be put in place to monitor the related issues.

Theories of corporate governance

Numerous theories of corporate governance cover the issues that arise in firm and company governance from time to time as well as describe the relationship between various stakeholders of the business while carrying out the business’s activity some of them are as follows 

Agency theory 

The basis of agency theory is the distinction between ‘the principals,’ or the owners (shareholders) of a business or organisation, and ‘the agents,’ or the managers hired to run the organisation. According to agency theory, there is a conflict between the agent’s and the principals’ goals because they are different. The next part of the article discusses in detail about this theory.

Stewardship theory

This theory holds that managers desire to produce quality work and maximise company profit, which generates a favourable return and raises the value of the shareholders. This theory contradicts the agency theory. As in this case, the theorist assumes that company managers are stewards whose actions, intentions, and behaviour are connected to the principal’s objectives.

Stakeholder theory

A stakeholder is a group of people who have influence over or are affected by an organisation’s processes, systems, and efforts to accomplish its objectives. If the competing interests of all the firm’s stakeholders were balanced, the goal could be accomplished. This strategy explains how the firm is managed by a variety of stakeholders, each of whom has specific demands. Stakeholders are interested in making the most of the company by managing it effectively. It also implies that when formulating policies, all organisations must take into account the needs of all stakeholders.

Resource dependency theory

According to the resource dependency theory, the board of directors’ responsibility is to give the company access to resources. It asserts that, through their connections to the outside world, directors are crucial in providing or securing essential resources for an organisation. The provision of resources enhances organisational performance, the firm’s performance, and its ability to survive. The directors bring legitimacy to the company as well as resources like knowledge, skills, and connections to important stakeholders like suppliers, buyers, public policymakers, and social groups. The four categories of directors are insiders, business experts, support specialists, and community influencers.

Agency theory of corporate governance

One of the most significant and widely discussed theories of corporate governance is the agency theory, which is used by many systems in the modern world. The debate over agency theory and corporate governance began in the 1930s. It is typically traced back to the 1930s with the publication of Berle and Means’ “The Modern Corporation and Private Property,” in which they noted that there was no effective check on the executive autonomy of managers due to the separation of ownership and control and the wide desperation of ownership. This concept was refined in the 1970s by writers such as Jensen and Meckling, Fama, Alchian, and Demsetz, who provided various explanations for issues that became known as the agency theory. At the time, writers defined and examined the dilemma in terms of the relationship between a ‘Principal’ who appoints someone to duty and an ‘Agent’ who is appointed to act on the principal’s behalf.

What is the agency theory

Agency theory is defined as the relationships between principals, such as shareholders, and agents, such as corporate executives and managers. The shareholders, who represent the owners or principals of the business, are said to employ the agents to carry out tasks. Directors or managers, are the shareholders’ agents and are given authority by principals to manage the company. According to the agency theory, shareholders expect agents to act and make decisions in the best interests of the principal. On the contrary, the agent may not always act in the best interests of the principals. In the 18th century, Adam Smith identified such a problem, and Jensen and Meckling presented the first detailed description of agency theory in 1976. 

Features of agency theory

Agency theory is a popular theoretical framework in corporate governance. Its popularity stems from two features. Firstly, it is straightforward because it divides large corporations into managers and shareholders, each with clearly defined conflicting interests. Second, it operates under the widely accepted premise that because every rational person is inherently egoistic, they will always seek to advance their own interests.

There are generally three sets of interest groups within the company: directors, shareholders, and creditors (such as banks). Since banks and managers have different overall priorities, stockholders frequently disagree with both of them. Shareholders are more interested in slow and steady growth over time, whereas managers look for quick profits that increase their own wealth, power, and reputation.

Purpose of agency theory 

The purpose of agency theory is to highlight areas where corporate interest groups are in conflict. Banks want to reduce risk, whereas shareholders want to make the most money possible. The ability of managers to turn profits and then impress the board is what makes them even riskier when it comes to maximising profits. There are costs involved with each group trying to control the others because modern corporations are established on these relationships.

Agency problems/conflicts 

Agency theory is used to understand the interactions of agents and principals. The agent represents the principal in a particular business transaction and is required to act in the principal’s best interests, regardless of personal financial benefit. Conflicting interests of principals and agents may arise because some agents may not always act in the best interests of the principal. Miscommunication and disagreement can lead to a variety of issues within businesses. Each stakeholder may become divided due to incompatible desires, which can lead to inefficiencies and financial losses. It brings up the principal-agent issue. The principal-agent problem occurs when a principal’s and an agent’s interests conflict. When owners’ and managers’ interests diverge, agency conflicts take place. They appear in various forms. They arise in several ways.

Moral hazard

The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. A manager has an interest in receiving benefits from his or her position as a manager. These include all the benefits that come from status, such as a company car, a private chauffeur etc.

Risk aversion

The company for which executive directors and senior managers work typically provides the majority of their income. As a result, they are concerned about the company’s stability because it will protect their job and future earnings.   This suggests that management might be risk-averse and reluctant to fund more risky projects. Shareholders, on the other hand, may want a company to take bigger risks if the expected returns are sufficiently high. It matters less to shareholders if one company takes risks because they frequently invest in a portfolio of various businesses.

Time horizon

Shareholders are concerned about their company’s long-term financial prospects because the value of their shares is based on long-term expectations. On the other hand, managers might only have short-term concerns. This is because they might only expect to work for the company for a short period of time and because they might receive annual bonuses based on short-term performance. Managers may thus be motivated to increase the accounting return on capital employed (or return on investment), whereas shareholders are more concerned with long-term value as measured by net present value.

Effort level

It’s possible that managers put in less effort than they would if they were the company’s owners. This “lack of effort” could lead to lower earnings and a lower stock price. Both the middle and upper levels of management in a large corporation will be affected by the issue. Managers’ interests and senior managers’ interests may diverge, particularly if senior managers receive pay incentives to boost profits while managers do not.

Earnings retention

The size of the company, not its profits, is frequently a determining factor in how much directors and senior managers are paid. Instead of increasing shareholder returns, this gives managers an incentive to expand the business by raising sales and assets. Instead of paying out dividends, management is more inclined to want to reinvest earnings in the business to expand it. When this happens, businesses might make investments in capital projects with low expected profitability and a negative net present value.

Reducing the agency problem

Certain measures and principles can be followed by both the principal and the agent to reduce the likelihood of conflict. They are mentioned below.

Full transparency

When there is limited knowledge between the agent and the principal, agency problems are most frequent. The agent has far too much opportunity and too much temptation to use the knowledge gap for their own gain. When agent-principal relationships arise in business, full transparency can aid in closing the knowledge gap and preventing the agency problem from arising.

Restrictions on the agent’s capabilities

Giving the agent excessive authority to act on your behalf invites future issues and could influence the financial advisor to make poor decisions. Most successful governments use checks and balances because it limits the power of any single individual or entity, reducing corruption. Imposing restrictions is an effective method of limiting the agent’s power.

Commission and bonus structures

Relationship conflicts are less likely when incentives and bonuses are introduced and removed. Bonuses are a great way to encourage an agent and enable them to act in the principal’s best interests in order to achieve the desired incentive. Contrarily, bonuses may drive an agent to act solely in the interest of their own financial gain, disregarding the principal’s best interests in the process. Since every principal-agent relationship is different, it’s essential to choose the right strategies for every circumstance in order to maintain a decent, healthy relationship.

Criticisms of agency theory

Various authors have criticised agency theory. Numerous authors, in particular, have criticised the assumptions underlying the standard agency model as too restrictive, that is, not generalizable to the vast majority of humans but rather specific to a subset of individuals.

  1. This theory is one-sided, emphasising economic factors while ignoring (among other things) political factors, internal government problems, and the roles of other stakeholders.
  2. Numerous legal concerns are raised by some authors when presenting shareholder-manager relationships based on agency theory. For instance, not only shareholders are subject to risk. Other parties involved in value creation contribute resources that are essential to the company and take on the risk associated with its operations.
  3. By assuming that people behave opportunistically, some authors contend that agency theory paints an extremely negative picture of human nature.
  4. Several academics are skeptical of the concerns about ownership of a firm. From a legal standpoint, shareholders own only the shares of a company, and thus they should not be considered the sole residual claimants. The exclusive rights of shareholders modify the risk taken by various stakeholders, because managers controlled by shareholders will choose strategies that result in relatively safe financial returns, even at the expense of a lack of innovative development or ignoring other important goals for the firm.

Conclusion

Agency theory examines the issues and potential solutions that arise when tasks are delegated to agents by principals in the context of conflicting interests. Beginning with clear assumptions about rationality, contracting, and informational conditions, it examines the circumstances under which various types of incentive instruments and monitoring arrangements can be used to reduce welfare loss. Since agency theory makes precise predictions and has a wide range of applications, it has had a significant scientific impact on social science. At the same time, it has received a lot of criticism. The majority of this criticism is directed at the assumptions underlying agency theory, specifically those underlying simple models. These assumptions are frequently very restrictive in order to promote the mathematical tractability of the problems. However, some of the polemical criticisms levelled at it are unjustified.

FAQs 

What are the main characteristics of the agency theory?

Agency theory is concerned with relationships between parties in which one delegated some decision-making authority to the other. The principal would delegate some decision-making authority to the agent, who would then be responsible for maximising the principal’s investment in exchange for an incentive. Agency relationships are intended to add value to the parties involved. However, there are costs associated with engaging in the relationship, monitoring its progress, and enforcing it.

What is the principal-agent problem? 

The principal-agent problem is a conflict in priorities between a person or group and the representative authorised to act on their behalf. An agent may act against the best interests of the principal. The principal-agent problem is as varied as the principal and agent roles. It can happen in any situation where the owner of an asset, or a principal, delegates direct control over that asset to another party, or agent.

What are the most effective methods of reducing agency loss?

An agency loss is an amount that the principal claims was lost as a result of the agent’s acting against the principal’s interests. Offering incentives to corporate managers to maximise their principals’ profits is one of the most effective strategies for resolving disputes between agents and principals. 

References

  1. https://citeseerx.ist.psu.edu/
  2. https://www.researchgate.net/publication/273979161_Agency_Theory_Corporate_Governance_and_Finance
  3. https://portal.abuad.edu.ng/lecturer/documents/1508187226AGENCY_THEORY. 
  4. https://www.redalyc.org/journal/3579/357966632010/357966632010.pdf
  5. https://www.academia.edu/5582502/Corporate_Governance_and_Agency_Theory_3
  6. https://www.investopedia.com/ask/answers/031815/what-role-agency-theory-corporate-governance.asp

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