CORPORATE GOVERNANCE

Theories of corporate governance

 Theories of Corporate governance

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1 INTRODUCTION 3

2 AGENCY THEORY 4

3 STAKEHOLDER’S THEORY 6

4 RESOURCE DEPENDENCY THEORY 7

5 STEWARDSHIP THEORY 8

6 SOCIAL CONTRACT THEORY 8

7 LEGITIMACY THEORY 9

8 POLITICAL THEORY 9

9 CONCLUSION 10

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 Theories of Corporate governance

Introduction:
Corporations have become a super powerful and a dominant institution in the world.
They have reached almost to every corner of the globe, as a matter of fact it is easy to list the
countries which is doesn’t have the influence of corporations yet. It has grown in various
sizes, and to capability which we can’t imagine and influence. Such governance has
influenced economies of all kind and too in various dimensions of the society. Moreover, in
the era of globalization, there is greater deterritorialization and less of governmental control,
which results is a greater need for accountability (Crane and Matten, 2007). Thus, corporate
governance has become an important factor in managing the organizations in the current
world.

To understand what corporate governance is, it is important to know about its definition.
Even though, there is no worldwide accepted definition for corporate governance, it can
however be defined as “a set of processes and structures for controlling and directing an
organization “. It constitutes a set of rules, which governs the relationships between
management, shareholders and stakeholders. The term “corporate governance” has a clear
origin from a Greek word, “kyberman” meaning to steer, guide or govern. From a Greek
word, it moved over to Latin, where it was known as “gubernare” and the French version of
“governer”.1

Owing to the corporate failures in the recent years, the condition of corporate has been
scared. Corporate governance even includes non-economic activities. Literatures in corporate
governance provide some form of meaning on governance, but fall short in its precise
meaning of governance. Such ambiguity emerges in words like control, regulate, manage,
govern and governance. Owing to such ambiguity, there are many interpretations. It may be
important to consider the influences a firm has or affected by in order to grasp a better
understanding of governance.

Thus, summarising on the above arguments, it is found clearly that corporate governance is
concerned with the social, political and legal environment in which the corporation entity
operates. In not shell corporate governance is very vital in every organization, because good

1
Haslinda Abdullah & Benedict Valentine, Fundamental & Ethics Theories of Corporate governance, (ISSN:
1450-2889) (issue 4) (2009),
https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.320.6482&rep=rep1&type=pdf.
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 Theories of Corporate governance

corporate governance contribute to better firm performance, it is expected from every other
organization to enforce corporate governance policy, in order to achieve the stated goal. 2

Corporate Governance Theories

Various types of corporate governance theories are:

1. Agency theory,
2. Stakeholder’s theory,
3. Resource dependency theory,
4. Stewardship theory,
5. Social contract theory,
6. Legitimacy theory and
7. Political theory.

1. Agency Theory

According to this theory, in simple terms managers act as 'Agents' of the

corporation. The owners or directors of the corporation set the central objectives for the said
corporation. Managers are responsible for carrying out these objectives in day-to-day work of
the company. In this theory, the owners are the principals, but principals may not have
knowledge or skill for getting the objectives executed. The principal authorises the mangers to
act as 'Agents' and a contract is drafted between principal and agent. Under the contract of
agency, the agent should act in good faith. He should protect the interest of the principal and
should remain faithful to the goals. In modern corporations, the shareholdings are widely
spread. The management (the agent) directly or indirectly selected by the shareholders (the
Principals), pursue their objectives set out by the shareholders. The main thrust of the Agency
Theory is that the actions of the management differ from those required by the shareholders to
maximize their return. The principals who are widely scattered may not be able to counter this
in the absence of proper systems in place as regards timely disclosures, monitoring and
oversight3.

2
WAN FAUZIAH WAN YUSOFF & IDRIS ADAMU ALHAJI, INSIGHT OF CORPORATE GOVERNANCE THEORIES, 1
Journal of business and management (ISSN 2291-1995) (2012)
3
Theoretical perspectives, corporate governance theories, Brain kart,
http://www.brainkart.com/article/Corporate-Governance-Theories_7427/ (last visited on 18 Jan 21)
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 Theories of Corporate governance

Much of the research into corporate governance derives from agency theory. In the
early times corporate governance has focused upon the separation of ownership and pedals
which results in principle-agent problems arising from the dispersed ownership in the modern
corporation. They regarded corporate governance as a mechanism where a board of directors
is a crucial monitoring device to minimize the problems brought about by the principal-agent
relationship. In this context, agents are the managers, principals are the owners and the boards
of directors’ act as the monitoring mechanism.

However, the agency problem depends on the ownership characteristics of each country. In
countries where ownership structures are dispersed, if the investors disagree with the
management or are disappointed with the performance of the company, they use the exit
options, which will be signalled through reduction in share prices. Whereas countries with
concentrated ownership structures and large dominant shareholders, tend to control the
managers and expropriate minority shareholders in order to gain private control benefits. The
agency model assumes that individuals have access to complete information and investors
possess significant knowledge of whether or not governance activities conform to their
preferences and the board has knowledge of investors’ preferences. Therefore, according to the
view of the agency theorists, an efficient market is considered a solution to mitigate the agency
problem, which includes an efficient market for corporate control, management labour and
corporate information. According to Johanson and Ostergen (2010) even though agency theory
provides a valuable insight into corporate governance, it applies to countries in the Anglo-
Saxon model of governance as in Malaysia. Various governance mechanisms have been
discussed by agency theorists in relation to protecting the shareholder interests, minimizing
agency costs and ensure alignment of the agent-principal relationship. Among the mechanisms
that have received substantial attention, and are within the scope of this study, are the
governance structures. 4

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 Theories of Corporate governance

2.Stakeholder Theory

According to this theory, it is the corporation which is considered as the property of

shareholders/ stockholders. They can dispose of this property, as they like. They want to get
maximum return from this property. The owners seek a return on their investment and that is
why they invest in a corporation. But this narrow role has been expanded into overseeing the
operations of the corporations and its mangers to ensure that the corporation is in compliance
with ethical and legal standards set by the government. So the directors are responsible for any
damage or harm done to their property i.e., the corporation. The role of managers is to
maximize the wealth of the shareholders. They, therefore should exercise due diligence, care
and avoid conflict of interest and should not violate the confidence reposed in them. The agents
must be faithful to shareholders.5

This theory centres on the issues concerning the stakeholders in an institution. It stipulates that
a corporate entity invariably seeks to provide a balance between the interests of its diverse
stakeholders in order to ensure that each interest constituency receives some degree of
satisfaction. However, there is an argument that the theory is narrow because it identifies the
shareholders as the only interest group of a corporate entity. However, the stakeholder theory
is better in explaining the role of corporate governance than the agency theory by highlighting
different constituents of a firm.

In order to differentiate among stakeholder types classification was adopted; consubstantial,

contractual and contextual stakeholders. Consubstantial stakeholders are the stakeholders that
are essential for the business’s existence. Contractual stakeholders, as their name indicates,
have some kind of a formal contract with the business. Contextual stakeholders are
representatives of the social and natural systems in which the business operates and play a
fundamental role in obtaining business credibility and, ultimately, the acceptance of their
activities argue that the company has to safeguard the interests of all who contribute to the
general value creation, that is, make specific investments to a given corporation. These firms-
specific investments can be diverse and include physical, human and social capital6.

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 Theories of Corporate governance

3. Resource Dependency Theory

The Resource Dependency Theory focuses on the role of board directors in providing
access to resources needed by the firm. It states that directors play an important role in
providing or securing essential resources to an organization through their linkages to the
external environment. The provision of resources enhances organizational functioning, firm’s
performance and its survival. The directors bring resources to the firm, such as information,
skills, access to key constituents such as suppliers, buyers, public policy makers, social groups
as well as legitimacy. Directors can be classified into four categories of insiders, business
experts, support specialists.7

The basic proposition of resource dependence theory is the need for environmental
linkages between the firm and outside resources. In this perspective, directors serve to connect
the firm with external factors by co-opting the resources needed to survive. Thus, boards of
directors are an important mechanism for absorbing critical elements of environmental
uncertainty into the firm. Williamson held that environmental linkages or network governance
could reduce transaction costs associated with environmental interdependency. The
organization’s need to require resources and these leads to the development of exchange
relationships or network governance between organizations. Further, the uneven distribution
of needed resources results in interdependence in organizational relationships. Several factors
would appear to intensify the character of this dependence, e.g. The importance of the
resource(s), the relative shortage of the resource(s) and the extent to which the resource(s) is
concentrated in the environment

Additionally, directors may serve to link the external resources with the firm to overwhelm
uncertainty, because managing effectively with uncertainty is crucial for the existence of the
company. According to the resource dependency rule, the directors bring resources such as
information, skills, key constituents and legitimacy that will reduce uncertainty. Thus,
considering the potential results of connecting the firm with external environmental factors and
reducing uncertainty is decrease the transaction cost associated with external association. This
theory supports the appointment of directors to multiple boards because of their opportunities
to gather information and network in various ways.

7
Papertyari, Theories of corporate governance, https://www.papertyari.com/general-
awareness/management/theories-corporate-governance-agency-stewardship-etc/, (last visited on 18-jan 21)
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 Theories of Corporate governance

4. Stewardship Theory
In contrast to agency theory, stewardship theory presents a different model of
management Stewardship theory has its roots from psychology and sociology and is defined as
“a steward protects and maximises shareholders wealth through firm performance, because by
so doing, the steward’s utility functions are maximised”. In this perspective, stewards are
company executives and managers working for the shareholders, protects and make profits for
the shareholders. Unlike agency theory, stewardship theory stresses not on the perspective of
individualism, but rather on the role of top management being as stewards, integrating their
goals as part of the organization.8
According to Smallman where shareholder wealth is maximized, the steward’s utilities
are maximised too, because organisational success will serve most requirements and the
stewards will have a clear mission. He also states that, stewards balance tensions between
different beneficiaries and other interest groups. Therefore, stewardship theory is an argument
put forward in firm performance that satisfies the requirements of the interested parties
resulting in dynamic performance equilibrium for balanced governance.
Stewardship theory sees a strong relationship between managers and the success of the firm,
and therefore the stewards protect and maximise shareholder wealth through firm performance.
Therefore, stewardship theory takes a more relaxed view of the separation of the role of
chairman and CEO, and supports appointment of a single person for the position of chairman
and CEO and a majority of specialist executive directors rather than non-executive directors.9

5. Social Contract Theory

Among other theories reviewed in corporate governance literature social contract
theory, sees society as a series of social contracts between members of society and society
itself. There is a school of thought which sees social responsibility as a contractual obligation
the firm owes to society. An integrated social contract theory was developed as a way for
managers make ethical decision making, which refers to macrosocial and microsocial contracts.
The former refers to the communities and the expectation from the business to provide support
to the local community, and the latter refers to a specific form of involvement. 10

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6. Legitimacy Theory
Another theory reviewed in the corporate governance literature is legitimacy theory.
Legitimacy theory is defined as “a generalized perception or assumption that the actions of an
entity are desirable, proper, or appropriate with some socially constructed systems of norms,
values, beliefs and definitions”. Similar to social contract theory, legitimacy theory is based
upon the notion that there is a social contract between the society and an organisation.
A firm receives permission to operate from the society and is ultimately accountable to
the society for how it operates and what it does, because society provides corporations the
authority to own and use natural resources and to hire employees. Traditionally profit
maximization was viewed as a measure of corporate performance. But according to the
legitimacy theory, profit is viewed as an all-inclusive measure of organizational legitimacy.
The emphasis of legitimacy theory is that an organization must consider the rights of the public
at large, not merely the rights of the investors.
Failure to comply with societal expectations may result in sanctions being imposed in
the form of restrictions on the firm's operations, resources and demand for its products. Much
empirical research has used legitimacy theory to study social and environmental reporting, and
proposes a relationship between corporate disclosures and community expectations.11

7. Political Theory
Political theory brings the approach of developing voting support from shareholders,
rather by purchasing voting power12. Hence having a political influence in corporate
governance may direct corporate governance within the organization. Public interest is much
reserved as the government participates in corporate decision making, taking into consideration
cultural challenges. The political model highlights the allocation of corporate power, profits
and privileges are determined via the governments’ favour.
The political model of corporate governance can have an immense influence on
governance developments. Over the last decades, the government of a country has been seen
to have a strong political influence on firms. As a result, there is an entrance of politics into the
governance structure or firms’ mechanism. 13

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Conclusion:

Thus, from this article we come to know about the various types of theories of corporate
governance and their key aspects in the modern day to day atmosphere. Moreover, an effective
corporate governance cannot be explained by one theory but it has to combine a variation of
theories. Literature has proven that even with strict regulations, there have been infringements
in corporate governance. Hence it is crucial that a unreal realization has to be driven across the
corporate world that would bring about a different perspective towards corporate governance.
The stone age days of corporate governance has passed and the need to get to know about the
modern corporate governance is essential.

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