BWRR3123/ CORPORATE

GORVERNANCE

CHAPTER 3
THEORETICAL ASPECTS OF
CORPORATE GOVERNANCE

Mallin: Corporate Governance 4e

Learning objectives
To understand the various main theories that
underline the development of corporate
governance

Mallin: Corporate Governance 4e

Introduction
A number of different theoretical framework
have evolved to explain and analyse corporate
governance.
Each of these theories approaches corporate
governance in a slightly different way, using
different terminology, and views corporate
governance from a different perspective,
arising from a different discipline.

Mallin: Corporate Governance 4e

Summary of theories

Agency theory
Transaction costs theory
Stakeholder theory
Stewardship theory
Class hegemony
Managerial hegemony
Path dependence
Resource dependence
Institutional theory
Political theory
Network governance

Mallin: Corporate Governance 4e

Agency theory
The agency theory paradigm arises from the
fields of finance and economics.
The work of Jensen and Meckling (1976) and
Jensen (1983) was important to the
development of agency theory.
Much of agency theory as related to
corporations is set out in the context of
ownership and control as described in the work
of Berle and Means (1932).

Mallin: Corporate Governance 4e

Agency theory
Agency theory identifies the agency relationship
where one party, the principal, delegates work to
another party, the agent. In the context of a
corporation, the owners are the principal and the
directors are the agent.
In other words, the shareholders, who is the
owner or principal of the company, delegates
day-to-day decision making in the company to
the directors, who are the shareholders agent.

Mallin: Corporate Governance 4e

Agency theory
The principal assumptions of agency theory is
that the goals of the principal and agent conflict.
In finance theory, the primary objective for
companies is shareholder wealth maximization.
However, in practice this is not necessarily the
case.
It is likely that company manager prefer to
pursue their own personal objective, such as
aiming to gain the higher bonuses possible.

Mallin: Corporate Governance 4e

Agency theory :
Another assumptions of agency theory is that it is
expensive and difficult for the principal to verify
what the agent is doing.
Agency costs arise from:
1. Principals monitoring expenditure.
2. The agents bonding expenditure.
3. Any remaining residual loss.

Mallin: Corporate Governance 4e

Agency cost
1. Principals monitoring expenditure.
shareholders attempt to monitor company
management..
Incentive schemes and contracts are examples of
monitoring techniques.
These include remuneration contracts for
management and debt contracts.
These contracts seek to align the interest of the
management with those of the shareholder.

Mallin: Corporate Governance 4e

Agency Cost
2. The agents bonding expenditure.

Agency costs are also incurred from the agent side.

Managers are keen to demonstrate to the
shareholder that they are accountable and following
the shareholder wealth maximization objective.
The may provide extra information about risk
management in their annual reports, which will add
costs to the accounting process.

Mallin: Corporate Governance 4e

Transaction cost theory

The transaction cost theory paradigm arises
from the fields of economics and organizational.
Transaction cost theory views the firm itself as a
governance structure. The choice of an
appropriate governance structure can help align
the interests of directors and shareholders.
The work of Coase (1937), Williamson
(1975,1984) and Hart (1995) contributed to the
development of Transaction cost theory
Mallin: Corporate Governance 4e

Transaction cost theory

Transaction cost theory is based on the fact
that firms have become so large that they, in
effect, substitute for the market in determining
the allocation of resources.
The organization seems to determine the
boundaries beyond which the companies can
determine price and production.
In other words, it is the way in which the
company is organized that determines its
control over transactions.
Mallin: Corporate Governance 4e

Transaction cost theory

Assumptions:
1. Bounded rationality
Managers and other economics practice
bounded rationality behavior that was
intentionally rational.
2. Opportunism
Managers are opportunistic by nature the
active tendency of the human agent to take
advantage
Mallin: Corporate Governance 4e

Transaction cost theory vs Agency theory

1. The use of different taxonomy to describe the
same issues and problems
Transaction cost theory Agency theory
Assumes people are Discusses moral hazard
often opportunistic.
and agency cost
Managers
Considers managers
opportunistically
pursue perquisites
arrange their
transaction

Transaction cost theory vs Agency theory

1. Unit of analysis
Transaction cost theory
The individual agent

Agency theory
The transaction

Stakeholder theory
Stakeholder theory takes account of a wider
group of constituents rather than focusing on
shareholders. Where there is an emphasis on
stakeholders then the governance structure of
the company may provide for some direct
representation of the stakeholder groups.
Edward Freeman, the original proposer of the
stakeholder theory, recognised it as an important
element of Corporate Social Responsibility
(CSR), a concept which recognises the
responsibilities of corporations in the world today
Mallin: Corporate Governance 4e

Stakeholder theory
Edward Freeman, the original proposer of the
stakeholder theory, recognised it as an important
element of Corporate Social Responsibility (CSR),
a concept which recognises the responsibilities of
corporations in the world today

Mallin: Corporate Governance 4e

Stakeholder theory

Mallin: Corporate Governance 4e

Stewardship theory
Stewardship theory views directors as the
stewards of the companys assets and so they
will be predisposed to act in the best interest of
the shareholders.
Donaldson and Davis (1991) contributed to the
development of this theory.

Mallin: Corporate Governance 4e

Stewardship theory
Stewardship theory assumes that managers are stewards
whose behaviors are aligned with the objectives of their
principals.
Managers are viewed as loyal to the company and
interested in achieving high performance. The dominant
motive, which directs managers to accomplish their job, is
their desire to perform excellently.
Specifically, managers are conceived as being motivated
by a need to achieve, to gain intrinsic satisfaction through
successfully performing inherently challenging work, to
exercise responsibility and authority, and thereby to gain
recognition from peers and bosses.
Mallin: Corporate Governance 4e

Class hegemony
'Hegemony means the success of the dominant
classes in presenting their definition of reality, their
view of the world, in such a way that it is accepted by
other classes as 'common sense'.
According to class hegemony, directors view
themselves as an elite at the top of the company and
will recruit/promote to new director appointments
taking into account how well new appointments might
fit into that elite.
Class hegemony theory recognises that directors seftimage can affect board behaviour and performance.
Mallin: Corporate Governance 4e

Managerial hegemony
The dominant theory of board power has been
managerial hegemony theory,
According to managerial hegemony, the
management of a company, with its knowledge of
day-to-day operations, may effectively dominate
the directors and hence weaken the influence of
directors.

Mallin: Corporate Governance 4e

Managerial hegemony
Although shareholders may legally own large
corporations they no longer effectively control
them, that control having been effectively ceded to
a new professional managerial class.
This theory suggests that managers, through their
professional knowledge and control of key power
sources such as information and other
organisational resources, are able to exert most
influence over key organisational decisions.

Mallin: Corporate Governance 4e

Path dependence
Corporate structures depend on the
structures with which an economy started.
May be structure driven and rule driven.
Bebchuk and Roe (1999) made a significant
contribution to the development of a theory of
path dependence.

Mallin: Corporate Governance 4e

Resource dependence
Directors connect the company to the
resources needed to achieve corporate
objectives.
Resource dependence theory has
implications for various key areas including
the optimal structure of organizations and the
recruitment of board members and
employees.

Mallin: Corporate Governance 4e

Resource Dependence Theory

Organizations are dependent on their environment
for the resources they need to survive and grow
Resource dependency theory can be used to help
an organization manage its environment
Resource dependency theory argues that the
goal of an organization is to minimize its
dependence on other organizations for
the supply of scare resources in its environment
and to find ways of influencing them to secure
needed resources

Mallin: Corporate Governance 4e

26

Resource Dependence Theory

The strength of one organizations dependence on
another depends on:
How vital the resource is to the organizations survival
The extent that other organizations control these
resources
An organization has to manage two aspects of its
resource dependence:
It has to exert influence over other organizations so
that it can obtain resources
It must respond to the needs and demands of the
other organizations in its environment
Mallin: Corporate Governance 4e

27

Institutional theory
Institutional theory adopts a sociological
perspective to explain organizational
structures and behaviour.
It draws attention to the social and cultural
factors that influence organizational decisionmaking

Mallin: Corporate Governance 4e

Institutional theory
Institutional environment influences societal
beliefs and practices which impact on various
actors within society.
Different countries/cultures may react
differently to the same challenge/event.

Mallin: Corporate Governance 4e

Political theory
Political theory influences significantly the
ownership and governance structures.
Includes, inter alia, impact of government,
law, justice system, etc on society.
Roe (2003) made a significant contribution to
the development of this theory.

Mallin: Corporate Governance 4e

Network governance
A structure of network governance would allow
for superior risk management.
Jones et al (1997), and Pirson and Turnbull
(2011) contributed to the development of
network governance which is seen as a logical
way to extend the science of cybernetics to
organizations.
Aspects include organic and more informal
structures/processes rather than a rigid
bureaucratic approach.
Mallin: Corporate Governance 4e

Network governance
Network governance involves a select,
persistent and structured set of autonomous
firms (as well as non-profit agencies)
engaged in creating products or services
based on implicit and open-ended contracts
to adapt to environmental contingencies and
to coordinate and safeguard exchanges.
These contracts are socially, not legally,
binding.

Mallin: Corporate Governance 4e