Agency Theory And Stakeholder Theory Commerce Essay

The development of corporate governance is a global issue, the issue of corporate governance has come to prominence in various fields contains refers knowledge of finance, economics, accounting, law, management, organizational behaviour and so on. The term ‘corporate governance’ and its daily usage in financial fields have attracted more and more public attention in the last thirty years. There are sorts of theories adopt in the corporate governance, while I will concentrate on two main streams of them: one is agency theory which is based on the interests of shareholders; the other is stakeholder theory which is based on the profits of all the stakeholders. The main aims of this paper are introduce and explore the agency theory and the stakeholder theory, compare and contrast these two theories.

Apart from the introduction, the structure of this paper is as follows: the theoretical review of both agency theory and stakeholder theory is included in the next part; then, I will describe the contribution of the agency theory as well as how wrong is the agency theory; similarly, the fourth parts consist of two aspect of the stakeholder theory: the contributions and some criticisms; the final section is the conclusion.

Theoretical review

Agency theory

In the early literature, classical economics considered that majority of corporations were not only owned but also controlled by the shareholders who have funding proprietors. With respect to standpoint of separation of ownership and control, it was firstly pointed out by Smith in 1838. In the later work of Berle and Means (1932), they hold the view that with countries’ industrialization and markets’ development, the ownership and control of corporations has been separated. The purpose of this action is to give an important explanation for corporate behaviour and the problems confronting owners (fragmented and dispersed shareholders) who attempt to exert their rights over the managers who have gained control in the ‘modern’ cooperation.

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According to Arrow (1971), the origins of agency theory can be traced back to the 1960s and early 1970s, more and more economists detected and pay attention to the risk among individuals or groups. He mentioned that in the case of different argument toward risk insisted by the cooperating parties, the risk sharing problem occurred. 6 years later, Jensen together with Meckling pointed out ‘Agency theory’ in their article; in addition, they defined an agency relationship as “a contract under which one or more persons (the principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent”. For example, it is widely accepted that the agency relationship is between the owners (as the principal) and the managers (as agents).

The aim of agency theory is to provide necessary monitoring to reduce the so called agency problems arise in agency relationship between the principal and the agent. One problem is that whether the behalf of agent is applicable or not can not be testified by the principals. The expect or goals of the principal and agent conflict brings to the first agency problem; more over, when it is difficult or expensive for the principal to know what the agent is doing in details and exactly, agency problem rises either. The other problem is the risk sharing between the principal and the agent. Due to the different risk preferences, there is distance between the action of the principal and the agent. An overview of agency theory is given in Table 1 (Eisenhardt, K. M 1989).

Table 1 Agency Theory Overview

Stakeholder theory of the firms

Donna Card Charron (2007) reported that the stakeholder theory has gone through three stages until now. The first stage of stakeholder theory is from the 1960s through early 1980s, the stakeholder theory agenda was proposed by the corporate revisionists. During this period, a new idea” social institution” was advocated to replace the stockholder ownership in the firm. In the early 1970s, stakeholder theory was accepted by the business ethics professors. Between the late 1980s and 2000, the stakeholder theory is ongoing the second stage. Corporate managers turn to interest in the stakeholder theory until they know that stockholders are just one aspect of stakeholders among many. It is significant for them to defend themselves against stockholder rights activities. In the middle of 1990s until 2000, corporate revisionists look forward to build the claims of stakeholders. All the participants and assistants who share the risk and create profits for the firms are stakeholders. They should obtain a ‘balance share’ of the riches created by the joint efforts (Clarkson 2002: 1)). According to Donna Card Charron (2007), it is imperative for managers observe the following principles: (1).Monitor and respond to concerns and interests of all legitimate stakeholders. (2)Communicate with stakeholders about their concerns, contributions, and risks. (3).Act with sensitivity to each stakeholder group. (4)Attempt to achieve a fair distribution of benefits and burdens. (5)”Insure” that risks are minimized and harms are compensated. (6)Never jeopardize “inalienable human rights” or deceive concerning risks. (7). Deal with the conflicts of its self interest and the interest of stakeholders through public institutions, public reports, incentive systems, and third party review. The stakeholder theory was widely acceptable by the end of this stage. In the third stage of stakeholder theory currently, Value Based Management pointed out the effects of stakeholders toward to the firms can not be ignore and even important, there is a positive relationship between the wealth of stakeholders and that of stockholders.

Different from agency theory which focuses exclusively on interests of shareholders, the Stakeholder theory concentrates on the interests of all the parties in the corporation. Stakeholder theory is considered as a theory of organizational management and ethics. Under this theory, what the managers should do is not only to maximize shareholder value, but also benefit the profits of the stakeholder group.

Groups or individuals in the corporation, whose interests and benefits have a close relationship (gains or loss) with the corporation action, are called stakeholders. Sometimes, the concept of stakeholders is a generalization of notion of stockholders who can propose some special claim on the firm (R.Edward). Stockholders are given the right to demand certain actions by management; similarly, stakeholders can also make claims.

The assumption of stakeholder theory is the values are imperative and tangible a part of doing business. R.Edwatd et al. (2004) propose that stakeholder theory is managerial, and it reflects and directs how managers operate rather than primarily addressing management theories and economists. Two key questions of the stakeholder theory are mentioned in Freeman’s article (1994). The first question is the purpose of the organization. This is very helpful and useful for managers to express the share awareness of the value they create and what brings its major stakeholder together. In addition, this push forward the firms itself expect it to create sound performance by considering both its aims and marketplace financial metrics. The second question asked in the stakeholder theory is what responsibility management has to stakeholders. These encourage managers to know how they want to do business. Particularly, they are looking for an appropriate kind of relationship with stakeholders to achieve their own interests. The core of stakeholder theory, economic value is that large numbers of people come and work together to advance their situation, is accordance with the fundamental modern economic realities. In order to impulse more and more workers to do their best for the firms, it is necessary and crucial for managers to develop relationships and create communication with stakeholders. (See R.Edward Freeman, Andrew C. Wicks, Bidhan Parmar 2004) It is widely accepted that shareholder is significant party in the firm and interests are a critical characteristic. In terms of profits, it is not the driver in the process of value creation while the results.

Contribution of the Agency theory

Perrow (1986) noted that the key point of the agency theory is focused on the significance of motivation and self interest. Under the agency theory, any ideas and activities of the organizations are based on self interests; furthermore, a common problem structure across the research topics is important either. There are two contributions to organizational thinking created by the agency theory in Eisenhardt, K. M’s work paper (1989).

First of all, information is considered as a good, in another word, information can be sold by people if it is necessary. It can be divided into formal information system and informal information system. The former includes budgeting, MBO, and boards of directors; while the later one consists of managerial supervision that just in organizational research. If the principals want to know what the agents are doing and whether their action is appreciate or not, invest the information system is a good approach. An explanation of this is ‘executive compensation’ (Kathleeen M. Elsenhardt 1989). A great many authors showed that they are surprised at the insufficient of performance found on executive compensations. On the contrary, since the compensation is affected by different kind of elements such as information system in the agency theory, the above argument is easy to accept.

In addition, the risk implication of agency theory is another contribution. There are various uncertain future such as prosperity, bankruptcy and some secondary consequence that corporation may meet. Whether the future of firms is bad or sound depends on the performance of organizational participates. The outcome of firms, to large extent, is affected by the environmental factors that cover government regulation, new similar competitors, science and technology innovation and so on. Agency theory encourages the ramifications of outcome uncertainly to indication for producing risk. For instance, some behaviour of principals in the companies such as ‘make or buy’ decision is not influenced by the uncertainty technology and demand (Walker and Weber 1984). Although they do not know that the reason is transaction cost framework; their conclusion covers the idea of agency if the managers of the firms are risk neutral. Walker and Weber concluded such a conclusion that outcome uncertainty is not associated with risk neutral principal. On the other hand, the outcome uncertainty is extremely sensitive to risk principals in new venture. If the firm is new and not big enough, the limitation of capital and resources for predicting the uncertainty will lead to the frequency of the failure. The managers on such firms are risk averse principals. From the agency theory perspective, the relationship between managers and outcome uncertainty is extremely close. For example, in order to maintain and develop the firm, managers are more likely to adopt ‘buy’ decision to transfer risk. On balance, agency theory predicts that risk neutral managers are likely to choose ‘make’ option (behaviour based contract), whereas risk averse executives are likely to choose ‘buy’ (outcome based contract).

How wrong is the agency theory?

The adoption of the agency theory for corporate governance become widely accepts all over the world, especially in the UK and the US. The agency theory indeed brings some merits for the corporations. However, more and more faults are showed by the recent literature research and firm practice like Enron, Xerox, and WorldCom. This paper will focus on the Enron to explain how wrong the agency theory is.

Thousands of employees losing their life savings tied up in the energy company’s stock due to the collapse of Enron which is considered as the largest bankruptcy in US history (Thomas Clarke 2004). The following introduction about the Enron is based on the lecture notes of Bob Wearing (2008). Generally speaking, Enron is an “intelligent gambling” that covers many aspects: firstly, allow high risk accounting; secondly, allowing 50% of assets to be shifted into off balance sheet entities; thirdly, waiving the ethics code to allow self dealing transactions; fourthly, ignoring directors’ conflicts of interests; Finally, failing to monitor executive compensation. The foundation of the Enron business is risk management. It expects to get ahead to traditional, vertically integrate kind of institution by using risk management. Enron adopt its own methods to protect the Enron stock, its funds will be inflated when Enron’s share price fell. Bankruptcy is the destination of Enron once credit agencies decreased Enron’s rating. Most non executive directors are paid as consultant from the directors’ fees; consequently, they can not be characterized independently. At the same time, directors received various types of gifts from Enron. The award for Andrew Fastow (CEO) remains a secret, and another CEO (Kenneth Lay) get much secrete money from the company. In the case of decreasing of the company’s stock in 2001, board members and senior employees obtain profit by cashing in share options, meanwhile, the rest of employees do not loss anything as they let their pension plans out of Enron stock.

All in all, the shortcomings of the agency theory become obvious. In the first place, due to the asymmetric information system, the deficiency of agency theory that covers several aspects is become obvious. The first one is called moral hazard agency conflicts that are the root reason for the Enron failure. Moral hazard agency conflicts were mentioned by Jensen and Meckling in 1976. “Moral hazard arises when the agent’s action, or the outcome of that action, is only imperfectly observable to the principal. A manager, for example, may exercise a low level of effort, waste corporate resources, or take inappropriate risks” (Joseph Heath et al. 2004). Jenson (1986) hold the view that fresh cash flow will face much more difficulties from moral hazard problem in big and developed companies. In addition, moral hazard problem is relevant with the inefficiency of managerial effort. The motivation and enthusiasm of managers will be dropped off for small equity stakes they own. Thereby, company value will be affected or even harmed. The second one is named adverse selection. “Adverse selection can arise when the agent has some private information, prior to entering into relations with the principal. Individuals with poor skills or aptitude will present themselves as having superior ones, people with low motivation will apply for the positions that involve the least supervision, and so forth (Joseph Heath et al. 2004). In the second place, shareholders, the owner of the company, are able to enjoy the company’s residual claims. They shoulder the operating and capital risk rather than whole risk. Other stakeholders such as creditors, managers, employees who shares risks should be given the similar rights.

Contribution of stakeholder theory

According to the stakeholder theory, the objective of corporate existence is nor the shareholders only. The close nexus in the corporate social responsibility (CSR) that is the main stream of the corporate tendency is a apparent contribution of the stakeholder theory. A large number of literature and research find out that companies concentrate on CSR which is considered as origin of competition advantages is more likely to accept and get benefits. It is, to some extent, benefits the corporation as a whole, in the long runs at least.

Changing the objectives of corporate governance from the “maximize the interests of shareholders” to “maximize the value of the company”. Stakeholder theory breaks through the traditional framework. The stake of firms owned by a large number of dispersed shareholders in modern enterprise. The maximization of the interests of shareholders does not mean the maximization of corporate value, or even damage the interests of other stakeholders, such as the hostile takeover. Stakeholder theory suggests that the other individuals and parties should also be considered stakeholders, such as creditors, employees, suppliers, customers, government and community, corporate governance should be the stakeholders of the coordination mechanisms of conflict of interest, balance and co ordinate conflict of interest to all stakeholders to maximize the benefits (Liu Dan 2003).

The power of corporate is redistributed in the process of game among stakeholders. Modern companies are characterized by separation between ownership and control; thereby a principal agent relationship is formed between the principal and the agent. Unfortunately, the interests of these two parties are not always consistent. The managers tend to abuse their special power and damage the interests of shareholders by the reason of their ‘insider’ status. The agency cost problem occurs when an efficient monitoring system is needed. The main purpose of corporate governance is not only monitoring managers effectively but also minimizing agency costs. The traditional way to adjust the dimension of the structure of the board of directors are enhancing the independence of the board of directors; improving the control of shareholders in order to strengthen their position; developing institutional investors to effective the rights of shareholders (Liu Dan 2003). But these ideas only deal with problems partly. It is difficult to change the level of corporate governance fundamentally. Stakeholder theory suggests that the key point of corporate governance is as follows: it is unavailable to deliver much more rights and control to shareholders. On the contrary, managers should be separated from shareholders who usually give pressure and leave enough rights and interests to other stakeholders such as employees, creditors and so on. For instance, one important programme is allowing the key stakeholders become the company’s board of directors and supervisors by increasing the ownership and control of the company (Liu Dan 2003).

The highlight of human capital is advocated in stakeholder theory. Traditional theory holds that the owner of firms is the investors who provide capital for firm; accordingly, the ultimate goal of company is to safeguard the interests of investors. Here the word “capital” is limited to physical capital, but not human capital. This argument is acceptable and suitable in the early era of large scale industrial machinery, while not appropriate and outdate in current era of knowledge economy. The existence and development of the organization is increasingly affected not only by the management degree of managers but also the advanced technology of workers. Technology and other human capital contribution to the enterprise are far more than physical capital (Liu Dan2003).

Criticism of the stakeholder theory

On the whole, stakeholder theory is incompatible with good corporate governance for it is with business (see Elaine Sternberg 1997). Accountability is one of the most important concepts in corporate governance. It consists of directors to shareholders, firm workers and other corporate agents to the incorporation as well. The notion that the owner of firms is responsible for their corporation is disapproved in stakeholder theory. On the other hand, what the stakeholder theory calls for is all the stakeholders are responsible for corporations. Such key principle is not realistic checked and work out wholly. Everyone take charge of company means no one will take charge of company. Various accountability make sense if all the stakeholders have a clear similar goal, otherwise it does not make sense at all. However, the stakeholder theory prefer to the later.

More over, there is not an effective standard to judge and evaluate corporate agents given by stakeholder theory (Elaine Sternberg 1997). Duo to the unclear balancing stakeholder profits, it is not a good way evaluate objective performance of firms. It is discretional for managers to seek their own interests which are always selfish by using this method. Consequently, stakeholder theory has comprehensive control of haughty and selfish managers as well as lavishness wages, perquisite and premises. At the same time, the phenomenal of empire building acquisitions that make little business sense exists widespread in the stakeholder theory. Even though the original purpose and expectation of the stakeholder theory is hopeful, it is difficult to carry on and enhance corporate performance as well as corporate governance.

Unlike the traditional theory which described that objective of firms is maximizing economic profits; objective in the stakeholder theory covers social, political as well as economic field. The efficiency of the business operation will be weakening in such situation. This leads to a dilemma for the company: firstly, pursuit of profit maximizing hence enhance the social costs and increase the loss of social welfare. Secondly, negative externalities of business activities will be reduced by using various types of control means, but they worse the inefficiency of economy.

Conclusion

To sum up, two popular theories used by corporate governance, agency theory and stakeholder theory are introduced and compared in this paper. The original purpose and expectation of these theories is to develop and enhance the level to corporate governance. The key diversity towards corporate interests between these two theories is: for agency theory, the interests of shareholders mean the corporate profits; with respect to the stakeholder theory, corporate interests should cover the profits of all the stakeholders.

Different from traditional theories, agency theory pays unprecedented attention on information system, outcomes uncertainty and risk. These performance are beneficial for corporate alleviate or even avoid some conflicts and problems between principals and agents. However, after the case of Enron which is a characteristic failure, people become aware of shortcomings of agency theory. Due to the asymmetric information, moral hazard and adverse selection bring difficulties to governance. Even though, stakeholder theory does not have a clear notion about the quantity and quality of stakeholders, and it is, to some extent, unrealistic to carry on; the contribution of stakeholder theory can not be ignored. Changing the objectives of corporate governance from the “maximize the interests of shareholders” to “maximize the value of the company”. The power of corporate is redistributed in the process of game among stakeholders. The highlight of human capital is advocated in stakeholder theory. To conclude, I pose that the stakeholder theory is much more appropriate for the modern companies for the long run.