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Theories emd Ph;E*sophies

of eerporate Govermartee

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r"rrning outeomes

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ln which we consider:

nr The agency dilemma

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+r Agencytheory

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+

Resource dependency theory

lu

lr.4anagerial and class hegemony

u, Psychological and organizational perspectives

r,

The societal perspective: stakeholder philosophies

Enlightened shareholder theory

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ms'1he' ry

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This chapter is im portant for students studying corporate governance theory in, for example,
M BA

t'i

and Masters courses in corporate governance. Directors seeking information to improve their
board-level contributions and those studying for professional examinations in corporate gover-

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nance may not need this degree of theoretical background and may want only to scan this chapter.

)<

'j,v

The agency dilemma

A fundamental challenge underlying all corporate governance affairs is not new, as we saw in

Chapter

1:

The directors of companies, being rnanagers of other peopls'5 money, ran:ot be erpected rc
lvatch over it with the same vigilance with which they watch over their own.

Adam Smith, The Wealth of Nations (abridged) 1776

This is the agency problem. ln its simplest form, whenever the owner of wealth (the principal)
contracts with someone else (the agent) to manage his or her affairs, the agency dilemma
arises.

i.:

','

g-*_

ilow ic e nsur;ira'r the;gert aL;s s;ieiy in 'rhe :nt+i-est *r'ilre pr;i'rripa,i i: the chaile6ge. tr.: ihe
'l
l8th and 9th ceniuries, manv coniJ"acts were, indeed, beha,reen a singie pi"ine ipal anC a single

,hies

agent-involving trading ventures, construction projects, running a faetory.

The ariivai of ihe joint-stock iimiierl-liabiiiiy con.rpa.ny in ine r..rici- i9th ceni*ry increaseei
the number of principals (shareholders) and their agents (d irectors). The n um ber and increasing diversiry of the shareholders in public cornpanies meant, riloreover, ihat the interests of

nee

shareholders were no longer homogeneous. As Berle and Means (1932) showed in their influential analysis, as listed companies grew and their shareholders becarne more Civerse, the
separation betu/een o,runeriEnC directcrs tncreaseC and pcr,ver shifted to,,"a:Cs the Cirecio;.s,
which-some <if ihem abused.
Todiy, agency relaiionships in public companies can be complex. For example, an individual owner might invest his or her funds through a financial adviser, who invests the

funds in a mutual fund or investnrent trust, which in turn seeks to gear its portfolio by
investing in a hedge fund, which invests its resources in a range of equities, property, commodities, and other hedge funds. Tracing the agency chain in such cases can be difficult
and establishing the exposure to agency risk well nigh impossible. However, the agency
dilemma potential exists throughout the chain. The demands for transparency, reporting,
accountability, audit, independent directors, and the other requirements of company law
and securities legislation, plus the requirements of regulators and stock exchange rules
and the demands ofthe corporate governance codes, are all responses to the agenc;r diIemma. lndeed, the conceptual underpinning of corporate governance codes around the
vvorld and the demands of company law for checks and balances is the need to resccnd
to the agency problem.
The practice of stock borrowing, used by sophisticated investors such as hedge funds
means that not only can the fund benefit from a fall in a shares'value, but it can also use the
shares'voting rights. lt can thus build up a significant stake, in fact up to the ievel at which it,
and any other fund acting in concert with it, would be required to make a public offer for the
com pany. ln other word s, it is possible to acq uire voting rights in a com pany without
own ing
or investing in its stock. This is a long way from the original concept of the joint-stock company. lt also raises a potential dilemma for directors: are they the stewards of the interests
of
tl-re Iong term traditional shareholders, or short-term activist institutions? Their interests
are
unlikely to be the same.
Nor is the agency problem limited to relations between investors in listed companies and
iheir agents. The agency dilemma can occur in private companies,.1oint ventures, not-for
profit organizations, professional institutions, and governmental bodies. Wherever there is a
separation between the members and the governing body put in place to protect their interests and to deliver the required outcomes, the agency dilemma will arise and corporate governance issues occur. The members could be the shareholders in a corxpany, the mernbers of
a professional institution or a trade union, a group of owners in.a cooperative, or the holding
comPany in a corporate group;the governing body might be calied the board of directors, the
council, the committee, the governing body, or the holding company. But whatever names
are used, whenever responsibility for activities and assets are delegated by those in the principal position to those in the agent sjtuation, the agency dilemma will occur.
For example, consider a pyramid group-of companies. The board of the holding company
decides to operate the group wrth prcfit-responsible subsidiary companies in organizational

rample, MBA

nprove their
orate goverthis chapter.

rs

we saw in

pected to
1ed) 171 6

e principal)
mma artses.

E_

-,,
divisicns.Theboardbelievesthatmoirvatienanceor:rrllilnrreniwiiii:emaximizeelif'thedireerorsofeachsubsidiaryareheldrespcnsibleforgeneratingprofitsandaremeasuredbyiheir
ccmpany'sannualr"t"no''investment(ROi)'Theopportunitiesforthesubsidiarycornpany

otrectorstotakedeeisionsbenefieialtothesur,sldrar"v'butdetrimentaitotiregroup,are
legion-forexamplebypostponinglonger-termdecisionsonresearchanddevelopment,
or by manipulating the
or maintenance to improve the profii'
management deveiopment,

multiply'
the subsidiaries inter-trade' the opportunities
asset base in the Roi caLulation. lf

Takeasimpleexample:subsidiarycomPanyAmanufacturesacornponentthatisincorpeprice at whieh to sell

Company A needs a transfer

rated into subsidiary company B's product.
while
highest pri." io maximize its profits,
to com pany B. Of course, A wants the

wants the

Prgrrre

lowesttomaximizeitsreturns.lftheycannotagree,companyBmaybuyintheopenmarket,
the market'
Conversely, company A may sell to
leaving A with under-recovered overheads.

,,i

leavingBwithan.n,".u..*pply.Referringthetransferpricedecisiontotheholdingcom.

c5!

panymightresolvethedilemma,butatthecostofremovingthedecision-makingauthorityof
and is called'subthe directors of A and

B.

groups
This situation is typical in deceniralized

!ele

optimization'bysomeauthorities'lnessence'itreflectstheagencydilemma'

Theagencyproblemcanalsoariseinnot-for-profitentities.ConsidertheBritishNationalHealthService(Nrrs):theresponsiblegovernmentministrycontractswiththepro.
local doctors, hospitals' and other
medical ,"rri.", to deliver them though
viders of

institutions.Theauthoritiessetstandardsandtargetstomeasureachievement.Forex.
ample.theymightcallforahospitaltoimproveitsbedocCupancyrate,thusencouraging
Conversely,
in for longer than is really necessary.
the hospital ,ou"|.no|.,.o k."p puti.nt,

theauthoritymightcallforaspeedyreturnofpatientstothestreet,resultinginrising
emergencyreadmissions.lnfact,theNHSpromulgatesalargelistofperformancemeasures

withquantifiableoutputsinanattempttoreducethe"g.n.ydilemma.Butsuccessisonly
partialbecausetheagentsalwaysfindwaysofbenefitingtheirentrtytothedetrimentof
a whole'
Essentially,inagencysituations,thepartieshaveasymmetricalaccesstoinformation,The
who must trust

the sYstem as

situation than the shareholders'

directors know far more about the corporate

them.lndeed,shareholdershavetorelyonthedirectorstodecidewhatinformationthey
and company law.This

is

required by regulation
should have, overand abovethe minimum
the shareholders trust
the joint-stock limited-iiability company:
the underpinni.g.";;;,
governance takes
"f
funds. The agency theory of corporate
the directors to be steward, of th"i,
a less sanguine view of directors'behaviour'

Agency theory
i.i,-r

Agencytheory,orprincipai_agenttheoryassomewritersrefertoit,looksatCorporategoverthe
the lens of the agency dilemma' ln essence'
nance practices and UJu'iJ" through
(the princi-

?,.4(

'14

as a contract between shareholder

theory perceives the governance relationship

pal)anddirector(theagent).Directors,itisargued,seektomaximizetheirownpersonal
to the shareto themselves, but detrimental
benefit, to take actions ihut ur" advantaggous
holders (see Figure 3 1).

L---go

t-

,d if

the diree;ured by their

ary cornpany
re group. ar*

levelopment,

ipuiating the
ties multiply.
it is incorpowhich to sell
: B wants the

contracts with

who takes acivantage of

Figure 3.1 The governance relationship

rpen market,
,the market,

olding com;authority of
called 'sub-

British Na'ith the pro, and other

:nt. For exrn couraging
Conversely,

ng in rising
:e measures
:cess is

only

etriment of
nation. The
) m ust trust

ration they
taw. lhis is
olders trust
rance takes

'ate goversence, the

the princi-

personal

the share-

As the early proponents of agency theory, Jensen and Meckling (1916), explained:

agency theory involves a contract under which one or more persons (the shareholders) engage other persons (the directors) to perform some service on their behalf which includes
delegating some decision-making authority to the agent. lf both parties to the relationship
are utility maximizers there is good reason to believe the agent will not always act in the best
interests of the principal.

Anecdotal evrdence of such behaviour is not hard to find. There are myriad cases in which
directors treat a listed public company as though itwere their own property, exploiting theiiposition, receiving unsanctioned benefits, and taking remuneration unrelated to their perforrnance to the shareholders'detriment. Bob Monks (2008), a shareholder activist, reckons
;hattrillions of dollars of shareholders'wealth have been wrongly extracted from US corporatrons over the years by directors abusing their power.
Directors may also take a different view from that of their shareholders on corporate risk.
After all, it is not their money they are risking. Of course, successfui management involves
taking controlled risks. But directors might hazard corporate funds on riskier ventures, a hostile take-over bid for example, than many of their shareholders would expect or want. Potential investors can only.ludge the ability of the board-level decision-makers and their risk
profile from the company prospectus, reports, and past performance.
Most scholarly research into corporate governance has used agency theory, which has
been developed within the discipline of financial economics (Fama and Jensen, 1983). Looking at corporate governance through the agency lens, researchers have explored links between corporate governance processes and corporate performance. ln other words, they
have looked for causal links between governance systems and their effects. For example, a
study m ight test whether there is a correlation between the proportion of independent d ii.ectors to executive directors and long-term corporate performance.
Agency theory focuses at the level of shareholders and.boards as entities. Board-level

activities and interpersonal relations between directors are outside their scan.rConsequently, researchers do not need access to the boardroom or to individual directors. Most
agency theoretical research uses data about governance practices and company performance that are readily available in the public domain using, for example, directors'reports
' Some authorities refer to thts as being trealed as a 'black box', but that can confuse since the black box
on an aircraft contains all ofthe vital data.

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iig,.jilr:,j:i.:,;:rr::iiqt;": r- !_rr.It5:::rii;.i.i.iBCinu5 i;:si5i ri:lto

$cvii'rr&r":c Droces!e5. Because cf its slmpitciay and ine avaiiabrliiy
'orilcr'ate
of both reiiable cata an.i statisrical tests, ag,^ncy theoi"y has prcii:ded
a pcv.,,e;.ful appi"ea.h io r:oipo_
raie gorrern2n r:e th eor,v bLt I !d i n g.
e

aLtal:jit.!,,..

ritieisnrts of egeneytl.leory

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some critics of agency theory emphasize its relatively

narrow theoretica! scope. Tc study ihe
intricacies of corporate governanee in terms of contracts
i:etweel pr.incipa!s and agents, ihey
argue, is naive' They criticize the focus on purely quantitative
metrics, such as board structure

or corporate compensation packages, or on the building

of a governance index through

r'r

f: liG

ai) il (
n;1

oth"rug"n.ytheo-

retical research Boards with well connected, executive

directors perform better, they found,
than those that followed corporate governance codes
on the use of independent directors.
Other critics have challenged the sharehoJder/drrector
agency model as simplistic in prac_
tice' lVhere, for example, the ultimate beneficial
owner has rnvested through a pension fund,
which invests in a hedge fund, which jnvests in a private
equity company, which praces funds
in the hands of a financial institution, which invests in
the shares of a listed company, but
lends them as collateral fo r another transaction,
who is agent for wh om, they ask? These days,
they say, pension funds, hedge funds, and other
institutional investors can behave like imperial traders, even corporate raiders, rather than
the long-term investors perceived by the
agency paradigm. Also, the short-term outlook
of stock markets in the UK and USA may pro_
duce different agency relationships from the longer-term
and bank-related investment seen
in countries such as Germany and.Japan.
B ut there is also a deeper issue:
in h erent in agency theory rs a ph ilosoph ical,
m oral assu m ptron about the nature of man. The theory assumes
that people are seif-interested, not altruistic; they cannot be expected to look after the interests
of others. ln other words, directors
cannot be trusted The legal concept of the corporation,
and the basis of stewardship theory,
as we shall see, takes the opposite view.
ln summary, critics of agency theory argue that it
has been erec.ted on a srngre, questiona
ble abstraction that governance introl,res a contract
between f,rvo parties, and is basecj oii a

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dubious con.lectural morality that people

maximize their personal utility. Nevertheless,

agency theoretical research has remained the mainstay
of pubiished papers in corporate governance for the past two decades. An interesting
research frontier of the sub1ect bridges the
disciplines of economics and law, applying the
agency theoretical insights of economics to
the legal context of the corporatron.

i1

'box-ticking approach'where compliance with

governance criteria mechanically feeds into a
broad governance index, which is then compared with
some measure(s) of corporate perforrnance' such cr"itics believe that boai"c! behaviour
does noi consist of sets of contractuai
relationships, but is infruenced by interpersonar behaviour,
group dynamics, and poriticar
intrigue" They question whether the subtle and
complex dynamics of board behaviour iend
themselves to measurement and numerical analysis.
.l993, ,statistical
As Ada Demb wrote in
methods will not explain the reality of the boardroom.,
other contemporary scholarship has discovered that
not only does increasing governance
conformance and compliance not necessarily add
to corporate performance, but it can actu-

allydetractfrornit.MuthandDonaldson(1991)challengedthefindingsof

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