The case for Corporate Governance

Mr. Lipton, the poisson pill inventor back in 1982, recently wrote “The shareholder as owner, principal-agent model is a flawed model as applied to the modem public company. It does not provide an affirmative basis for the adoption of shareholder access proposals”, (“Twenty-Five Years After Takeover Bids in the Target’s Boardroom: Old Battles, New Attacks and the Continuing War”.This led me to revisit the theories that back some usual Corporate Governance principles of our days.

Corporate Governance is supported by several theories, basically the Principal-Agent one, based on information asymmetries, but it is not the only one. Let`s review the different foundations, not always disconnected among themselves.

  1. The Agency Theory.

Adam Smith, (1776), Bearle and Means, (1932), first explain their concern about separation of management and ownership. But the seminar contribution arrives in 1976 with Jensen&Meckling`s “Theory of the firm; management behavior, agency costs and ownership structure”.

Managers, (agents), are hired to maximize shareholders`s returns, (they are principals). As they do not own the corporations`s resources, they may act in their own interest, at the cost of principals. What follows is, first, an efficient split of risk bearing among agents and principals, and second, a correct monitoring through contractual monitoring and bonding. The aim is minimizing the efficiency losses, or “agency costs”.These costs are (i) monitoring costs, (incentive systems, incomplete contracting, and monitoring), (ii) bonding costs, (resources spent in assuring principals that no action against their interests will be done), and (iii) residual losses, (those not prevented from occurring in any case).

Jensen and Meckling do not advance in their view on how corporations establish monitoring systems. Fama, (Agency Problems and the Theory of the Firm, 1980), develops the idea in that sense. Internal and external managerial labor markets are the discipline enhancers in the firm. Risk bearers, (security owners and residual claimants), can sell their stakes with no relevant transaction costs in the capital markets, but rely on an efficient market that correctly values securities. Managers can expect the human capital market to correctly value their services, according to their previous experiences related to firm failure or success, so that they have correct incentives to behave to maximize firm`s performance. On the other hand, internal managers` pressures also force managers at the top to pursue the firm`s best performance, (all managers putting pressure for their future wage maximization). This would work jointly with certain monitoring systems.  The board is the system through which top managers are monitored: it should not be controlled by security owners, (given their diversified portfolios), nor managers, (if they supervise themselves, they would tend to extract wealth from security owners), but include also outsiders, (they would be controlled by their services` markets); for other resources, there may be other more efficient features so that they defend their interests, (unions and so on would control managers on their behalf), rather than participating in the Board. The capital market takeover threat represents for Fama only a last resort mechanism, given the obstacles it confronts in the case of big corporations.

Fama and Jensen, (“Separation of ownership and control”, 1983), argue that firms efficiently separate decision management and decision control rights, both at the top, (managers and board) and lower levels, (managers and workers). Managers keep for themselves Initiation and Implementation, with the specific knowledge required. The risk bearers keep decision control rights, (ratification and monitoring). Whenever risk bearing is diffused, residual claimants are also separated from decision control, thus agency costs appearing. Separating decision management and control helps avoiding those costs, allowing valuable knowledge being hired at every corner of the organization. And the Board, as a body that holds ratification and monitoring powers, is helpful in that process.

  1. The Transaction Costs economic foundation for Corporate Governance.

Following Hart, (“Corporate Governance: Some theory and implications”, 1995), agency costs are not enough to justify governance principles, as contracts could be drafted to reward agents in a performance based system, (that would avoid agency costs). Nevertheless, contracts are incomplete, and cannot include all future events with the corresponding rewards, (because of the cost of thinking all possible events, the cost of negotiating them all, and the cost of writing an enforceable contract).Corporate governance establishes a mechanism to allocate residual rights of control over the firm`s non human assets, when their usage has not been settled previously.

Following Williamson, (Corporate finance and Corporate Governance, 1988), the transaction costs theory introduces the agent`s bounded rationality and opportunism. So, governance is about crafting governance structures that save on bounded rationality, while avoiding opportunism. “Incomplete contracting in its entirity”, introduces the need to be aware of prospective misinformation, and the need to (i) realign incentives and (ii) draft governance structures that fill the gaps. The Board is an endogenous development to safeguard equity financing. Transaction costs are considered ex post: (i) maladaptation costs when misalignment appears in relation to the “shifting contract curve”, (ii) bilateral costs incurred to obtain alignment, (iii) cost of governance structures, and (iv) bonding costs, the first being the key feature. Williamson introduces the idea that the debt equity choice is not only a corporate finance concern, but also a governance one, related to asset specificity, (that favours equity, with a more intrusive oversight and involvement through the Board of Directors). The boards reduce cost of capital when assets are specific and not redeployable, (a case in which debt imposes too high a burden).

  1. The Resource Dependence Theory.

Udayasankar, (The foundations of Governance Theory: a case for the Resource-Dependence Perspective, 2005), refers to a resource based view of firm performance, where the focus is on how the firm generates unique and valuable resources, and to the fact that Corporate Governance may help in that process, instead of being just a tool for the preservation of existing assets and profits in the firm, and their correct distribution. Following Pfeffer and Salanchik, (1978), directors, through their linkages can procure expertise, reputation and a positive valuation of the firm, legitimacy, and so on; they can also provide tools to afford uncertainty, and help for the firm to generate, maintain and develop specific assets and knowledge, which result in the competitive advantage of the firm. The model is compatible with shareholder maximization, as governance would help bring capital in a differential manner, (helping to deal with agency costs, thus this theory remaining embedded in Resource-dependence theory).

  1. The Stakeholder Theory.

Donaldson and Preston, (The stakeholder theory of the corporation: concepts, evidence and implications, 1995), argue with many that corporations have stakeholders, (owners of a constellation of cooperative and competitive interests with intrinsic value, all of them embedded in the firm). And their support relies on the Property Rights theory, (which is slightly ironic, if the theory is to be opposed to the maximization for shareholders theories). Property is a bundle of many rights, (Coase, and others), some of them restricted. If rights are relations among humans, property rights cannot be separated from human rights, and consequently that introduces restriction on the use of rights because of others`interests. So, managers do not act solely on behalf of owners. The managerial implications are: a) Who is a legitimate stakeholder, (one having a contract with the firm, belonging to its broad community, receivers of either benefits or costs, etc), and b) How do managers need tobehave? They need to be aware of those interests, but the danger of opportunism still remains, so the theory needs to be developed in rules and sanctions. Mahoney, Asher, and Mahoney argue that all the economic value generated for all stakeholders needs to be considered, and all relationships also, so as to understand how the value is distributed, (instead of only considering distribution of profits to shareholders).

Although it is difficult to disagree with Mr Lipton that all those theories may lack a sound empirical and thus normative foundation, there is just enough evidence that when corporations are controlled by managers, without an appropriate corporate governance framework, it is not guaranteed that all interests affected by the firm performance are well and fairly treated, that the distribution of economic value is fair, and survival assured.

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