Chapter 1 - Principles and issues Flashcards
What is Corporate Governance?
- It’s a system by which companies are directed and controlled. Cadbury report committee 1992
- It is a set of relationships between a company’s management, its board, its shareholder and stakeholders. It also provides the structure through which objectives of the company are set, and the means of attaining those objectives and monitoring. OEC 2024
- It helps to build an environment of trust, accountability and transparency which is necessary for fostering long term investment, financial stability and business integrity, thereby supporting stronger growth and more inclusive society (G20/OCED 2026)
- Corporate governance is therefore about what the board of a company does and how it sets the values of the company.
What are the 2 main theories of corporate governance?
Two main theories of corporate governance:
- The shareholder primacy theory (agency theory) which forms the basis of the shareholder value approach to corporate governance and
- Stakeholder theory, which forms the basis of the stakeholder approach to corporate governance.
What is the Shareholder Primacy Theory?
The shareholder primacy theory of corporate governance focuses on maximising the value to shareholders before considering other corporate stakeholders, such as employees, customers, suppliers and society as a whole.
It is based on the premise that shareholders own companies and that directors, managers and employees are engaged by the company for the purpose of maximising shareholder wealth.
What are the main criticism shareholder primacy
The main criticism shareholder primacy:
- Inappropriate stewardship. It is argued that the changes in shareholder structure from direct investment by individual shareholders to wealth invested under management (asset managers, pensions, insurance) has led to ownerless companies’, where no single investor has a large enough stake in the company to act as the responsible owner, checking the performance and behaviour of the board and management of the company.
- Short termism defined by the Kay Report (2012) as both ‘ tenancy to under-investment, whether in physical assets or in intangibles such as product development, employee skills and reputation with customers, and as a hyperactive behaviour by executives whose corporate strategy focuses on restructuring financial re-engineering or mergers and acquisitions a the expense or developing the fundamental operational capabilities of the business’.
Explain the agency theory and the four agency conflicts (5 marks)
The agency theory is concerned with the separation of ownership and control of a company and the relationship and alignment between the shareholders as owners and the managers running the company. Jensen and Meckling.
Where there is a relationship conflicts can arise:
- Moral hazard – a manager has interest in receiving benefits from his position
- Level of Effort – Managers may work less hard than they would if they were owners
- Earnings retention – remuneration of managers is often related to the size of the company, leading to managers seeking to re-invest profits
- Time horizon – Managers may be more interest in short term results
How does an Agency conflict arise?
Conflict arises in an agent – principal relationship when agents and principals have differing interests. The main conflict between shareholders and managers are:
- Shareholders usually want to see their income and wealth grow over the long term so will be looking for long term year on year increases in dividends and share prices
- Directors and managers, on the other hand, will be looking more short term to annual increases in their remuneration and bonuses.
Explain the agency theory and the four agency conflicts
Jensen and Meckling 1979 identified 4 areas of conflict. What are they and explain each ?
- Moral Hazard
- Level of effort
- Earning retention
- Time horizon
The agency theory is concerned with the separation of ownership and control of a company and the relationship and alignment between the shareholders as owners and the managers running the company.
Where there is a relationship conflicts can arise:
- Moral hazard – a manager has interest in receiving benefits from his position - these include all the benefit that come from status, such as company car, house or flat, etc.
- Level of Effort – Managers may work less hard than they would if they were owners. The effect of the this lack of effort could be smaller profits and lower share price.
- Earnings retention – remuneration of managers is often related to the size of the company, leading to managers seeking to re-invest profits, (measured by annual sales revenue and value of assets) rather than its profits. This gives managers an incentive to increase the size of the company (acquire another company), rather than to increase the returns to the company’s shareholders. The owners are happy to have a dividend each year (distributed and therefore no longer available).
- Time horizon – Managers may be more interest in short term results - This is partly because they might receive annual bonuses based on short term performance, and partly because they might not expect to be with the company for more than a few years.
i.e. Bonus based on profits and this could inform the behaviour of the manager and therefore the manager will be only interested in short term results. They could sell assets of the business to deliver a particular profit in that year of which they will get a bonus for. However, those assets are not available to the company for future years to come. Therefore a conflict.
Corporate governance practices can be used to align interests of shareholders and managers. one way of doing this is remuneration.
How should companies avoid conflict?
Agency theory suggests that companies should use corporate governance practices to avoid or manage these conflicts.
Examples of how companies can achieve this:
- The use of long-term incentive share award or stock option schemes based on total shareholder return to align the interests of shareholders and management.
- Adoption of conflict of interest and related party transactions policies
Agency Costs?
Agency Costs
- Bonding costs – the costs associated with maintaining the agent principal relationship. i.e.
a. The costs of monitoring the performance of the board and executive management (includes cost of general meetings, annual reports and financial statements). Although argued that electronic communications have reduced costs
b. Residual loss i.e. the costs to shareholders associated with actions by the directors and executives which in the long run turns out not to be in the best interest of shareholders i.e. major acquisition or disposal, fraud or foray of new businesses
What is Stakeholder theory?
This is in contrast the shareholder theory and states that the purpose of corporate governance should be to meet the objectives of everyone that has an interest in the company. These are:
a. Investors
b. Employees
c. Suppliers
d. Customers
e. Government
f. Regulators
g. Creditors
h. Local communities and general public
How should companies act in the stakeholder theory?
The stakeholder theory also states that companies should act as good corporate citizens when making decisions and carrying out their activities, taking into account the impact these will have on society and the environment.
Companies should be accountable to society and should conduct their activities to the benefit of society.
What is the main difference between the agency and stakeholder theories?
Agency theory:
deals with the relationship between shareholder and directors where there is a separation between ownership.
The shareholder playing the part of the principal and the directors and managers playing the part of the agent.
Challenges associated with the agent-principal relationship occur. These relate to conflicts of interest and the costs associated with avoiding / managing those conflicts.
The stakeholder theory:
is in direct contrast to the agency theory, which states that the purpose of corporate governance should be to meet the objectives of everyone that has an interest in the company.
How does the Agency theory affect the objectives of a company?
A company whose governance is based on the agency theory will be focusing on creating and maintaining shareholder value through managing conflicts of interest and the costs associated with avoiding / managing those conflicts.
This is usually reflected in a focus on financial objectives such as return on investment, sales, and profit targets. Objectives tend to be short term.
How does the Stakeholder theory affect the objectives of a company?
In contrast the agency theory, the stakeholder theory requires boards to balance the interest of the different stakeholder groups when making decision, deciding on a case-by-case basis which interest should take priority in a particular circumstances. Therefore non-financial objectives, such as employee relations or limiting environmental impact would be considered.
Objectives tend to be longer term.
How can companies manage conflict of interest between shareholder and directors and managers?
Examples of how companies can manage conflict:
- The use of long-term incentive share award or stock option schemes based on total shareholder return to align the interests of shareholders and management
- Adoption of conflict of interest and related party transaction policies.
