Decades ago, Adams Smith proposed a philosophy on the ‘The Theory of Moral Sentiments’’ in 1776 which argued that individuals maximized their returns based on self-interest or personal benefits. This philosophy is still in existence even though various psychological studies have proven that human beings cannot be rational all the time.
The rationale behind maximizing their own utility has extended to the corporate world where one party (principal) concedes authority to another party (agent) to act on his behalf.
This breach in goal congruence has brought about the agency problem in the corporate environment as suggested by (Ross, 1973). However, (Jensen and Meckling, 1976), contemplated an ‘Agency Theory’ which analysed the relationship that develops in an exchange when an individual (principal) delegates activities to another (agent) to act on his behalf so as to increase the wealth of the principal.
Despite these arguments, (Freeman, 1984) argued that third parties (stakeholders) who have no financial interest in the organisations should also be catered for, in spite of, agents working towards achieving owners’ values. He developed a stakeholder theory to generate a greater total concern for the third parties because they equally contribute to the returns of the organisation.
This coursework examines the views of the two theories by linking them to actual corporate governance issues and providing practical examples. Finally, following the analysis and arguments, the coursework sets out its evaluations and conclusion.
Compare and Contrast Agency Theory with Stakeholder Theory.
The characteristics of individual countries may have a significant influence in the way corporate governance has developed. One of the initial governance codes and regulations in the UK was the Cadbury Report 1992, which suggested that there should be an introduction of an audit committee, the segregation of duties between the chairman and the chief executive, a remuneration committee and finally, a nomination committee for the board to ensure the effectivities of corporations in the country. In that, multinational companies whether big or small incorporated in the UK must follow this common law of jurisdiction whereas, a default on the part of a companies operating in Germany must comply to the civil law of the state.
According to Cadbury Report 1992 and OECD 1999, ‘Corporate Governance can be defined as the process by which companies are directed and controlled’. This report underpinned by agency theory suggested that, if well-functioning and reliable regulations are set out for company boards, the separation of ownership and control between principals and agents are performed well.
In agency theory, there is an analysed relationship that conceptualizes between shareholder (principal) and manager (agent) when there is a delegation of activity (Jensen and Meckling, 1976). Nevertheless, these policies are to ensure that managers perform their duties diligently in the best interest of their principals. An interesting reading that can be linked to this situation is the case of Robert Maxwell. He had a communication empire which run into high debts in the mid-eighties, thereafter his disappearance, it emerged that these debts were vastly financed from employees’ pension funds. Again, it was noted that these monies had also been used to buy Maxwell shares to buttress the companies falling share price against which the debt was secured. Since, no action was taken by the UK and US regulators against Maxwell Communications, this case triggered Adrian Cadbury to form Cadbury Report 1992 which suggested improvements that would restore investors’ confidence in the long term.
Alternatively, Enron (2001) scandal can be linked to the existence of agency problem within its board of directors. The agency problem at Enron often emerged because the CEO served as chairman of the company’s board of directors, relatively to blame for the companies’ misconduct and unprofessional behaviour. When the chairman is CEO for instance, there is the lack of asymmetry of information and this is often twisted out of shape. This and many other cases prompted a lot of re-thinking about the role of board of directors in various corporations. After numerous researches, the agency theory was formed to find solutions to the existence of agency problem in the long run.
Milton Friedman, originally proposed the agency theory stating that; the sole responsibility of businesses is to increase its profits. This denotes that company managers should concentrate solely on maximizing shareholders wealth.
The agency theory may be worth considering in cases where managers are overly concentrated on corporate social responsibility and disregarding company’s profitability, though the best option would be that managers have a balanced approach to maximizing profits and considering other company stakeholders.
Agency theory has been criticized for its limitations of scope in agent and principal problems and short-term approaches. Stakeholders have interest in the company and can affect or be affected by the company. These include shareholders, employees, suppliers, government, creditors, the entire public and local community and customers.
The agency theory approach may to some extent, suffice in the short-term but has proven wanting, unsustainable and in some cases detrimental. It has failed to take to account that companies run on a going concern basis and should therefore have a long-term approach in running the company. The theory also, has a narrow view and fails to address other company’s responsibilities including; environmental, social, economic, political, legal and ethical responsibilities.
Stakeholder theory as originally defined by Edward Freeman, (1984) suggested that as stakeholders are identified, management should give due regard to the interest of the group of stakeholders when decisions and recommendations are made in the corporation. It is our stand that corporate businesses have the responsibility to maximise interest of others in addition to the profit maximising of shareholders. In maximizing the returns to shareholders, managers must try to provide satisfactory returns to each group which comes under the stakeholder theory.
Numerous researches have been done after Freemans evidence on stakeholders’ theory, alternatively, (Mithchell et al, 1997) interests provided a comprehensive analysis of stakeholders based on the justification of stakeholders’ relationship with the firm, their power to influence the firm and how managers prioritize their relationship to the firm, in that, no matter what level of knowledge stakeholders holds they should equally benefit from projects undertaken by the corporation.
This theory is also seen as one of the frameworks in corporate social responsibilities which aimed to provide assistance to all groups of stakeholders. For example, the public and government under the stakeholder group in 2009, faced a brake pedal problem from Toyota company violating the transportation agencies rules in US. Therefore, with corporate governance, the recall resulted $16milion in fines for Toyota for not releasing the problem and hiding the defect. Another, interesting example was from Sir Philip Green of BHS. He failed his mission to secure a better future and foundation for the home stores when he and his wife used employees’ pension funds to buy some properties for themselves. This resulted to him selling BHS for £1 in March, 2015 to some little-known group of investors, rendering most of his retailers and employees in huge losses. Hence, if the stakeholders’ views were addressed as part of the corporations plans these won’t have happened.
In the recent years, there has been a signifi
cant increase in public demand for firms to be environmentally responsible (Sharma and Henriques, 2005). Consumer’s demands for ‘green products’ has increased manager’s pressure in addressing the needs of firm’s stakeholders rather than sorely addressing shareholder’s needs (Kassinis and Vafeas, 2009). Green products are products that aim at conserving the environment.
The United States government also put in place stringent regulations and penalties for firms polluting the environment (Berning, 2000). In 2010, BP spilled oil in the Gulf of Mexico and was fined $18.7 billion as a result of the legal claim brought against them. The oil spillage at the Gulf of Mexico was considered by the courts as water pollution which proved a hazard to the community in that area.
Firms are considered to have a clear, visible and legitimate duty of care to the public, on environmental issues (Bansal, 2005). Firms should therefore recognize the explicit contract between them and shareholders as well as the implied contract between themselves and other stakeholders (Kassinis and Vafeas, 2013).
During the financial crisis, it became apparent that firms needed to consider all their stakeholders. This was due to the financial institutions’ lack of integrity and negligence in giving mortgages to customers who would not afford, with the aim of maximizing shareholders wealth by securitizing these mortgages.
Despite these happenings, (Samuel Mansell, 2013) offered a detailed critique on this claim arguing that the stakeholders’ theory undermines the main principle on which a market economy is founded. In spite of the theory provides executives with mechanisms to ensure prolonged survival of the firms, he argued that the stakeholder theory does not provide clear corporate purpose of maximizing shareholders values that comply with the market economy.
Agency theory fails to recognize that neglecting other stakeholder’s results to ultimate neglect of shareholder’s need to maximize profits. Customers tend to shy away from companies that are negligent towards other stakeholders and firms may have to cope with massive revenue loss thus affecting shareholder’s wealth.
Nike, a multi-national company selling sports ware was involved in employing children as young as 10 years as factory workers in Pakistan and Cambodia. This act of child labour caused public distrust where Nike massively lost its’ customer base. Nike’s customers would not want to associate or be seen as supporting child labour. A company’s reputation, growth and profitability is pegged on the extent to which it considers its stakeholders.
It is appropriate and ethically acceptable that the stakeholder theory argues that interests of the people who own the stock and those work as agents are not the only interest group, pragmatically, we have been witnessing that there are other people who are significantly affected by conduct of corporate businesses. It is also acceptable that the stakeholder’s theory pointed out that those businesses have obligations to other parties. Because of their massive sizes, corporate businesses have the capacity to impact wide range of society and their actions have resulted in spill over effects that affect well-being of many people other than shareholders. As depicted above, several cases of corporate failures are evidences that support the stakeholders’ theory and have shown that the agency theory involves only in self interest assumptions. Social and environmental issues that affected well-being of many stakeholders need to be considered.
CONCLUSION
The agency theory, due to its focus on self-interest assumptions, has been involved in maximising interests and objectives of managers and shareholders, Priorities setting have been governed by ownership and control structures to overcome the principal-agency problems. Shareholders direct and indirect monitoring (concentrated, diverse and via corporate boards who demand huge agency cots) and control on agency behaviour have been exercised regardless of the free ride problems in diverse monitoring.
Nevertheless, as (Freeman, 1984) appropriately identified, the agency theory failed to consider third party interests and consequently conducting businesses without considering others have significantly impacted stakeholders’ interests.
In contrast to the stakeholder theory, (Samuel Mansell, 2013) argued against the stakeholders’ approach.
Both the agency theory and stakeholder’s theory, regardless of their respective pros and cons, have contributed in explaining the actions of interest groups in the corporate governance debates. As an impact of this, nowadays shareholders and managers are realising their goals, at the same time, stakeholders would have the right to take action against businesses that failed to fulfil their obligations through international organisations and governments.
Despite the fact that principles and rules of corporate governance try to protect rights and interests of different groups, it is noted that it has been very difficult to find a common ground that aligns all the diverse interests. It is expected that in the future researches may bring better solutions that optimises all the diverse interests.