MGT 401 – Corporate Governance

Theories and Models of Corporate Governance

BBA S-8: Fall 2023

Instructor: Dr. Fahim Javed

Referenced text:
Chapter 3
Corporate Governance Principles, Policies and Practices
By A.C. Fernando

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 Outline of Chapter

Theoretical Basis of Corporate

1 Governance

2 Corporate Governance Mechanisms

3 Corporate Governance Systems

What is Good Corporate

4 Governance

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 Introduction

Chapter 3
“Corporate Governance is to conduct the business in accordance with owner or shareholders’
desires, which generally will be to make as much money as possible, while conforming to the
basic rules of the society embodied in law and local Customs”

Milton Friedman, Economist and Noble Laureate.

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Though the concept of modern corporate governance is of recent origin, it was deeply
rooted in the corporate history from the days the corporate form of business establishments
began. As this form of business passed through several stages of its growth to the present form,
corporate governance also passed through different stages to reach the present form. The
subject of corporate governance is based on strong theoretical foundation derived from
several disciplines as finance, economic, accounting, management, law, organizational
behavior, etc. As such it is multidisciplinary in nature
Different systems of governance are followed in different countries of the world. In some
countries like the UK, the USA, India, one tier board system exists while in countries like
Germany, France, Japan, etc., two tier board systems exist. Legal system of the country,
corporate structure and shareholding pattern, cultural and value system prevailing,
economic system of the country, etc., play a significant role with regards to the types of
corporate governance suitable for each country.
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 Theories of Corporate Governance

Chapter 3
 What Is a Theory?

Theory is a supposition or a system of ideas intended to explain something, especially one

based on general principles independent of the thing to be explained. In other words, it is a set
of principles on which the practice of an activity is based or it can be defined as a set of
assumptions, propositions, or accepted facts that attempts to provide a plausible or rational
explanation of cause-and-effect (causal) relationships among a group of observed
phenomenon.

 Theories of Corporate Governance

These theories are defined based on the causes and effects of variables such as the
configuration of the board of directors, audit committee, independence of managers, the role of
top management and their social relations beyond the legal regulatory framework. Effective
corporate governance requires applying a combination of existing corporate governance
theories, rather than applying an individual any theory.
.

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 Theories of Corporate Governance

Chapter 3
 Theories of Corporate Governance

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 Theories of Corporate Governance: Agency Theory

Chapter 3
 Agency Theory
The shareholders are the owners of any joint stock, limited liability company, and are the
principals of the same. By virtue of their ownership, the principals define the objectives of a
company. The management, directly or indirectly selected by the shareholders to pursue such
objectives, is the agent. While the principals generally assume that the agents would invariably
carry out their objectives, it is often not so. In many instances, the objectives of managers are
at variance with those of the shareholders.
For instance, a chief executive may want to increase his managerial empire and personal
stature by using the company’s funds to finance an unrelated diversification, which could
reduce long term shareholder value. The shareholders and other stakeholders of the company,
may not be able to counteract this because of inadequate disclosure about such a decision and
because the principals may be too scattered or even not motivated enough to effectively block
such a move. Such mismatch of objectives is called the agency problem; the cost inflicted by
such dissonance is the agency cost.
The core of corporate governance is designing and putting in place disclosures, monitoring,
“overseeing” and corrective systems that can align the objectives of the two sets of players as
closely as possible and, hence, minimize agency costs.

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 Theories of Corporate Governance: Agency Theory

Chapter 3
In the agency theory terms, the owners are principals and the managers are agents and there is
an agency loss which is the extent to which returns to the residual claimants, the owners, fall
below what they would be if the principals, the owners themselves, exercised direct control of
the corporation.
The agency theory specifies mechanisms which reduces agency loss. These include incentive
schemes for managers which reward them financially for maximizing shareholder’s interests.
Such schemes typically include plans whereby senior executives obtain shares, perhaps at a
reduced price, thus aligning financial interests of executives with those of the shareholders.
Other similar schemes tie executive compensation and levels of benefits to shareholders,
returns and have part of executive compensation deferred to the future to reward long-run
value maximization of the corporation and deter short-run executive action which harms
corporate value.

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 Theories of Corporate Governance: Agency Theory

Chapter 3
Problems with the Agency Theory
Total control of management is neither feasible nor required under this theory. The underlying
assumption in the trade-off that shareholders make on employing agents is that they must
accept a certain level of self-interested behavior in delegating responsibility to others. The
objective of agency theory is to check the abuse in this trade-off, but its limited success raises
the question of its utility as a theoretical model to promote corporate governance. Besides, in
the agency theory the assumption is with the complexities of investor-board relationship in
large organizations, shareholders should have correct and adequate information to wield
effective control. Equity investors rarely get these and besides they rarely make clear their
exact target returns, and yet delegate authority to meet the target. It is also to be understood
that in terms of controls, equity investors hardly have sanctions over boards. Instead, they have
to rely on self-regulation to ensure that an orderly house is maintained.

There are two broad mechanisms that help reduce agency costs and hence, improve corporate
performance through better governance. These are:
 Fair and accurate financial disclosures
 Efficient and independent board of directors
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 Theories of Corporate Governance: Agency Theory

Chapter 3
 Fair and accurate financial disclosures:
Financial and non-financial disclosures, relate to the role of the independent, statutory auditors
appointed by shareholders to audit a company’s accounts and present a “true and fair” view of
the financial health of the corporation. Indeed, the quality and the independence of statutory
auditors are fundamental to achieve the purpose. While it is the job of the management to
prepare the accounts, it is the responsibility of the statutory auditors to scrutinize such
accounts, raise queries and objections (if the need arises), arrive at a true and fair view of the
financial position of the company, and report their independent findings to the board of
directors and, through them, to the shareholders and the investors of the company.

A company that discloses nothing can do anything. Improving the quality of financial and non-
financial disclosures not only ensures corporate transparency among a wide group of investors,
analysts and the informed intelligentsia, but also persuades companies to minimize the value-
destroying deviant behaviour. This is precisely why law insists that companies prepare their
audited annual accounts, and that these be provided to all shareholders and is deposited with
the Registrar of Companies. This is also why a good deal of effort in global corporate
governance reform has been directed to improving the quality and the frequency of
disclosures.
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 Theories of Corporate Governance: Agency Theory

Chapter 3
 Efficient and independent board of directors:
A joint-stock company is owned by the shareholders, who appoint directors to supervise
management and ensure that it does all that is necessary by legal and ethical means to make the
business grow and maximize long-term corporate value. Directors are fiduciaries of the
shareholders, not of the management. They are accountable only to the shareholders.
“Independence” has of late, become a critical issue in determining the composition of any
board.

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 Theories of Corporate Governance: Stewardship Theory

Chapter 3
 Stewardship Theory
The stewardship theory assumes that managers are basically trustworthy and attach significant
value to their own personal reputations. It defines situations in which managers are stewards
whose motives are aligned with the objectives of their principles. A steward’s behavior will
not depart from the interests of his/her organization.

Control can be potentially counterproductive, because it undermines the pro-organizational

behavior of the steward by lowering his/her motivation. The market for managers with strong
personal reputations serves as the primary mechanism to control behavior, with more reputable
managers being offered higher compensation packages.

Financial reporting, disclosure and auditing are still important mechanisms, but there is a
fundamental presumption that these mechanisms are needed to confirm managements’ inherent
trustworthiness.

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 Theories of Corporate Governance: Stewardship Theory

Chapter 3
Stewardship theory can be reduced to the following basics:
 The theory defines situations in which managers are not motivated by individual goals, but
rather they are stewards whose motives are aligned with the objectives of their principles.
 Given a choice between the self-serving behavior and the pro-organizational behavior, a
steward’s behavior will not depart from the interests of his/ her organization.
 Control can be potentially counterproductive, because it undermines the pro-organizational
behavior of the steward, by lowering his/her motivation.

Some scholars state that the owner-manager relationship depends on the behavior adopted
respectively by them. Managers choose to act as agents or as stewards according to certain
personal characteristics and their own perceptions of particular situational factors. Principals
choose to create a relationship of one type or the other depending on their perceptions of the
same situational factors and of their managers’ psychological mechanisms.

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 Theories of Corporate Governance: Stewardship Theory

Chapter 3
The following tables set out these variables and the differences between the two theories.

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Theories of Corporate Governance: Stewardship Theory

Chapter 3
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 Theories of Corporate Governance: Stewardship Theory

Chapter 3
The following tables set out these variables and the differences between the two theories.

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