Wednesday, 7 December 2011

Corporate governance theories

There are five major theoretical frameworks that can be identified from the corporate governance literature: agency, stewardship, resource dependence, stakeholder and managerial-hegemony . These theories have evolved from many disciplines such as finance, economics, accounting, law, management and organizational behavior. For example, agency theory arises from the field of finance and economics and stakeholder theory from a more social-oriented perspective on corporate governance. All these disciplines have contributed to the development of theoretical aspects of corporate governance . Two of the theories; agency and stewardship were generally associated with several previous corporate governance researches in Malaysia and East Asia.

Nevertheless, a number of characteristics of the five governance theories are embedded in Malaysia’s business and corporations. This is because, Malaysia has the business culture and environment of a developing country combined with a unique socio-political background. As such, multi-faceted theories exist in Malaysia.

The first is Agency theory

The agency relationship is seen as a contractual link between the shareholders (the principals) that provide capital to the company and the management (agent) who runs the company. The principals engage the agent to perform some services on their behalf and would normally delegate some decision-making authority. However, as the number of shareholders and the complexity of operations grew, management, who had the expertise and essential knowledge to operate the company, increasingly gained effective control and put them in a position where they were prone to pursue their own interests .

The literature on agency theory addresses three types of problems that could transpire from the separation of ownership and management, which might consequently affect firm value. They are the effort problem, the assets’ use problem and differential risk preferences problem. The effort problem concerns whether or not managers apply proper effort in managing corporations so as to maximize shareholders’ wealth. Problems arise because principals are not able to determine if the managers are performing their work appropriately. Managers may not exert the same high effort levels required for firm value maximization as they would if they owned the firm.

The use of assets problem concerned the insiders who control corporate assets. They might abuse these assets for purposes that are harmful to the interests of shareholders such as diverting corporate assets, claiming excessive salaries and manipulating transfer prices of assets with other entities they control . The differential risk preferences problem arises because the principal and managers have different views on risk taking. Managers may not act in the best interest of shareholders and may have different interests and risks preferences. For example, managers have a wider range of economic and psychological needs (such as to maximize compensation, security, status and to boost their own reputation), which may be adversely affected by a project that increases a firm’s total risk or has rewards in the longer-term. This may result in managers being too cautious in making investments and thus failing to maximise shareholders’ wealth.

Hence, agency theorists recommended that corporate governance mechanisms are needed to reduce these agency conflicts and to align the interests of the agent with those of the principal. These mechanisms include incentive schemes for managers which reward them financially for maximising shareholder interests. Such schemes typically include strategies whereby senior executives acquire shares, conceivably at a bargain price, thus aligning financial interests of executives with those of shareholders. Other mechanisms include fixing executive compensation and levels of benefits to shareholders returns and having part of executive compensation deferred to the future to reward long-run value maximisation of the corporation. Besides that, appointing more NEX on the boards to check on managers’ behaviour could also reduce agency costs.

I will discuss the other four corporate governance theories in my next posting.

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