The Effect Of Separation Of Ownership And Control Economics Essay

This paper analyzes whether stakeholder theory is better for the development of Corporate Governance in the 21ST century than agency theory. For solving this issue, first, this paper provides the differences of two theories and their importance for corporate governance in the 21st century. Secondly, it analyzes the influence that each theory has had on the development of corporate governance practice around the world. Thirdly, it offers an explanation for relationship of two theories and considers the variability of two approaches.

Introduction

Corporations dominate all aspects of our lives. Their power affects the quality of life, food, water, gas, electricity, seas, rivers, environment, schools, hospitals, medicine, news, entertainment, transport, communications and even the lives of unborn babies……Unaccountable corporate power is damaging the fabric of society, the structure of families, the quality of life and even the very future of the planet” (Mitchell & Sitka 2005).

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Corporate governance can be defined as: “the system by which companies are directed and controlled”(Haidar, Jamal Ibrahim, 2009). It protects the interests of all members of the company. In addition, it achieves a balance of rights and interests between shareholders and other stakeholders. Also, it is the premise and necessary for the establishment and development of enterprise.

In the current worldwide recession, which began in 2008, almost every economy has been affected. Due to the economic crisis, how to govern corporations has become a serious issue in 21st century, mostly including comparing with agency theory and stakeholder theory. Regarding as the two theories, they have their own merits and demerits depending on different Enterprise environments. Then, they play an important role for corporate governance and it is difficult to determine which of them is better. Through personal research, this paper is more inclined to stakeholder.

The differences of two theories

The traditional definition of a stakeholder is “Any group or individual who can affect or is affected by the achievement of the organization’s objectives” (Freeman 1984). However, with improvement of organization concept, the definition of stakeholder was vague and has changed over the years by Freeman. Contemporarily, Freeman (2004) defines stakeholders as “those groups who are vital to the survival and success of the corporation, such as customers, employees, local communities, suppliers and distributors, and also including shareholders.

As the modification of stakeholder concept, the definition of stakeholder theory was also alternative. Friedman (2006) states that the organization itself should be thought of as grouping of stakeholders and the purpose of the organization should be to manage their interests, needs and viewpoints. This stakeholder management is thought to be fulfilled by the managers of a firm. The managers should on the one hand manage the corporation for the benefit of its stakeholders in order to ensure their rights and the participation in decision making and on the other. In addition, He states “The principle of stakeholder recourse. Stakeholders may bring an action against the directors for failure to perform the required duty of care”

Comparatively, agency theory is narrower and in more detail to analyzing a contractual relationship between principles and agents. For example, according to agency theory, when a person is not only a manager but also is the owner of resources of organization, he is absolutely a stakeholder but there is no agency theory. It is because the manager is the residual claimant, risk bearer and owner of the company, therefore the agent is not existed.

Comparing with stakeholder theory, agency theory is more contradictory. For another example, with the corporation growing in size and issuing stocks, the modern corporation is reduced to a ‘nexus of contracts’ between principals and agents; the separation of ownership and control is created (Jensen et al. 1976). Due to an asymmetry of corporate information between principles and agents, agency theory is uncertain. That means the theory focus on whether the agents should hold the shares to lead the development of company. And it depends on different Enterprise environments.

The influences of two theories

In the modern financial management, agency theory has had a significant impact in corporations and it mainly contributes to financial planning controlling, and decision making.

The effects and the prescriptions can be made as follows;

ƒ  The Modern Corporation = The Separation of Ownership & Control and a Nexus of Contracts, where shareholders are the owners.

ƒ  The Effect of Separation of Ownership and Control = Conflict of Interest, Moral Hazard & Agency Costs.

ƒ  The Prescriptions of Control = Monitoring & Incentives.

In addition, the risk implication of agency theory is another contribution. with the corporation growing in size and being complicated, there are various uncertain future in financial that corporation may meet. 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 agency theory has become popular and acceptable in the US and the UK, increasing faults are exposed. In the US, typically, in Enron Plc, 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). Enron business is based on risk management. Enron protected Enron stock by inflating its funds when Enron stock price fell. At the same time, because of agency problem, the award for Andrew Fastow (CEO) remains a secret, and another CEO (Kenneth Lay) get much secrete money from the company. Following the agency theory, Enron cannot achieve a balance between insider and outsider in the board of directors. Therefore, due to the asymmetric information system, the deficiency of agency theory that covers several aspects is become obvious; moral hazard agency conflicts that are the root reason for the Enron failure.

Comparatively, in stakeholder theories, due to the shareholders are not the only stakeholders in corporations, the company Changed the objectives of corporate governance from the “maximize the interests of shareholders” to “maximize the value of the company”. Thus the moral hazard agency conflicts have been alleviated.

In case of HSBC, it announced the call centre of the bank was moved from the north of England to India. The directors claimed that their decisions were not base on cutting wage bills and other operating costs alone, but the bank was pursuing its mission statement and becoming an international local bank. HSBC also claimed “that through moving UK based call centres to India where efficiency and productivity were very high, (a call centre worker in India is a graduate, works long-hours and is paid £4,000 per year), the bank’s performance would improve and enable it to meet the needs of global customers, and global-stakeholders including those local stakeholders in both India and UK. Those stakeholders in the UK who lost their jobs, it claimed, would be retrained for other positions. ” following the stakeholder theory, HSBC expanded itself from developed countries to developing countries, which means, its stakeholder expanded to all over the would instead of maximize the interests of shareholder. The HSBC Bank is not alone, other major high street Banks in the UK have all moved their call centres to India. Furthermore, most of the FTSE-100 companies in the UK have already moved their call centre operations to India, and other Asian countries. (The Fortune Business Magazines ,July 2004)

This case provides an evidence to prove that stakeholder theory is exactly helpful for corporations to growing size instead of kinking the moral hazard agency conflicts.

However, whether the two approaches are exclusive to each other has become a popular debate in 21st century. According to Shankman(1999), he felt stakeholder theory encapsulates agency theory. First of all, agency theory analyzes the shareholdership in the corporations; stakeholder theory focuses on stakeholdership including shareholder and other stakeholder. Therefore, stakeholder theory is the necessary outcome of agency theory. Secondly, he stated that agency theory is at best a narrow form of stakeholder theory, because stakeholder theory is more generalized to indicate that principles and agents are all stakeholder to achieve their own interests.

Through analyzing two theories, they both have their own demerits, against for their demerits; the corporate governance should make appropriate adjustments. For example, following agency theory, when a company grows in size, the principle should share the appropriate number of stocks with agents and crease limited agency cost which included in agents’ remuneration. Thus no parties can damage the wealth of others as a consideration to increase their own wealth and the company will achieve the “Pareto Optimality”.

In term of stakeholder theory, it is necessary to realize that the company should care about the interest of all stakeholders but it is impossible to maximize the benefits of all stakeholders.

Conclusion

All in all, agency theory pays attention to asymmetric information and even avoids some conflicts and problems between principals and agents, but moral hazard and adverse selection bring difficulties to governance. Comparatively, Even though, stakeholder theory does not have a clear notion about the quantity and quality of stakeholders, it cannot be ignored that change the objectives of corporate governance from the “maximize the interests of shareholders” to “maximize the value of the company” To conclude, personally, stakeholder theory is much more appropriate for the modern companies for the long run.