Different types of corporate governance structures in market - Free Essay Example

Sample details Pages: 13 Words: 3913 Downloads: 6 Date added: 2017/06/26 Category Marketing Essay Type Cause and effect essay Did you like this example? Corporate governance structures today in most market based economies apply the separation of ownership from control model in large corporations and firms. This can be said to occur where ownership has been progressively diluted from complete ownership to minority control (Clarke, 2007). Much of this concept, particularly with regard to large corporations, directly results in an agency relationship between the owners (shareholders) and the controllers (managers) and it is from this concept that the agency theory in corporate governance arises. Don’t waste time! Our writers will create an original "Different types of corporate governance structures in market" essay for you Create order The practical reality today is that even smaller companies employ this same model in order to improve their efficiency as more shareholders (owners) prefer to engage others to run their businesses not on the basis of filial relationship but on the strength of qualifications, competence and experience although they usually retain ultimate control. Needless to say, there are inherent problems and challenges that also arise as a result of this sort of relationship. The most significant being the ultimate divergence of interest between the principal the agent as the latter may not always act in the best interest of the former or may only act partially in that interest (Mallin, 2010). Indeed a substantial and significant amount of literature has been developed in the agency theory in corporate governance and it has not been without its criticisms. While some contemporary assessments of corporate governance today note that this diffused ownership model (separation of control from ownership ) was to a larger extent, a purely Anglo-Saxon phenomenon which does not necessarily reflect the governance system of corporations in other parts of the world (Coffee, 2000), others have criticised the agency theory as over-simplifying the intricacies of corporate governance by reducing its scope to merely a term of contracts between principal and agents (Tricker, 2009). This essay will attempt to critically analyse some of the more relevant literature with the aim of first of all exposing the rationale behind the emergence and development of the separation of ownership from control, and how instrumental it has now become in ensuring proper corporate governance framework in todays global economy. In doing so, there will be extensive discussions on the agency theory in corporate governance in a bid to highlight the common problems and challenges that are inherent in this theory and identify ways by which these problems may be mitigated. The emergence of agency relationship in corporations: Separation of ownership from control. There exists a general consensus by academics and practitioners alike that market development and the era of industrialisation in the early to mid 19th century brought about a diffusion of ownership in many large corporations as individual or family owners were unable to, on their own, provide adequate capital to match and sustain the expansion of their businesses. The resultant implication of this situation, as identified by Berle and Means (1932) was the separation of ownership from control. They described this diffusion of ownership as the dissolution of the old atom of ownership into its component parts: beneficial ownership and control. Sorenson (1974) opines that this steady separation of ownership from control can be directly linked to the growth of corporate capitalism. It therefore followed that as the number of shareholders increased, their influence and corporate control progressively diminished leaving control in the hands of what has now developed into extensive salaried managerial hierarchies; professional managers (Dignam Galanis, 2009). This heralded the origin of the agency relationship between the parties and it is within the context of separation of ownership from control and this agency relationship between the parties that the agency theory in corporate governance was developed. This diffusion of ownership was however subject to a precondition that the shareholders retained ultimate control so as to protect them from stealth raiders with this protection formalised by statute (Coffee, 2000). Agency Theory Jensen and Meckling (1976) explained the theory of the agency relationship as a contract under which one party (the principal) engages another party (the agent) to perform some service on their behalf. In order to achieve this, the principal will delegate some decision-making authority to the agent. Thus the agency theory sees the corporation as a nexus of contracts which are constantly re-negotiated by individuals each aiming to maximise his own utility (Alchian and Demsetz, 1972). This notion of a multiplicity of constantly renegotiated contracts is borne out of the fact that it would be practically impossible to have a single contract with the capacity to holistically capture interests of both the principal and the agent (Mallin, 2010:17). The agency theory in corporate governance is a particularly dominant governance structure employed in large corporations and firms particularly in advanced economies like the UK, the US and in most other common law countries. Mallin (2010) posited that unlike countries that operate under a civil law system and are restricted by legal codes/rules which are merely administered without the flexibility to adapt to changing circumstances, the common law jurisdictions operate a legal system that consists an independent judicial system that employs the doctrine of judicial precedents with heavy reliance on case law and other legal principles that have afforded them the opportunity to make significant advancements and develop the codification of various laws/rules/principles that have over time, increased the level of protection for minority shareholders thereby encouraging a more diversified shareholder base within those jurisdictions. Dilemma of the agency theory The inherent dilemma within the agency theory was identified as far back as the 18th century. According to Smith (1838), the directors of companies however being the managers of other peoples money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance as they would their own. This quotation simply summarises the problem with the agency theory. Tricker (2009) further notes that the real challenge is ensuring that the agent acts solely in the interest of the principal. However, these agency problems arise largely due to the impossibility of contemplating for every future action of an agent, whose decisions are sure to affect both his own welfare and the welfare of the principal (Brennan, 1995). It is at this point that we can clearly point out the divergence of interests between the principal and his agent as they both aim to maximise their respective aspirations. It is given that an agent will act with rational self interest and cannot be expected to act in the interest of the shareholders thus the need for them to be monitored to ensure that the interest of the principal is best served (Calder, 2008). In a sense, it is safe to assume that an agent will not act in the best interest of the principal and such matters in which he may display self interest may include a situation where an agent misuses his delegated authority for pecuniary advantage by remunerating himself disproportionately to his performance, taking hazardous and uncontrolled corporate risk or on the other hand refusing to take certain risks as both principal and agent may have developed different attitudes to risk in line with their respective interests. Thus certain corporate governance mechanisms for example, the board of directors, is seen as an institutional instrument of control and an essential monitoring device in corporate governance to ensure that the conflicts brought about by this divergence of interest between the shareholder and the managers (principal and agent) are kept to the barest minimum. Other mechanisms by which this divergence of interest is minimised include an assortment of codified rules both domestic, regional and international which seek to regulate transparency, disclosure, accountability etc. discussed later on in the essay. In identifying the inherent problems within this concept, it is also important to identify where this conflict arises within the context of the firm. Although there are various instances where a conflict between the parties may present itself, McColgan (2001) has been able to identify 4 key areas where extensive theoretical and empirical research has been conducted, from which these agency conflicts emanate. He has identified these areas as moral hazard conflicts, earnings retention conflicts, risk aversion conflicts and time-horizon conflicts. Moral hazard conflict as proposed by (Jensen) follows the notion that as the ownership stake of a manager decreases within a company, it raises the tendency to increase consumption of perquisites. This mainly applies to large corporations with dispersed ownership with an insignificant amount of the company shareholding held by the manager(s). According to Shleifer and Vishny (1989), a manager may, instead of objectively selecting investments or projects to be undertaken by the company, this selection may be done with a leaning towards areas directly aligned with the managers skill set. This increases his value to the company and vice versa and allows room for increased demands on remuneration. Another factor that may be responsible for the risk of moral hazard conflict is cash flow as Jensen (1986) is of the opinion that high cash flow level will also increase the likelihood of moral hazard as managers who are under no immediate obligation to make investments are more likely to incre ase consumption of perquisites due to the added difficulty in supervising corporate expenditure. A lack of managerial effort also applies here because the smaller the equity held by a manager, the more his motivation to work will dissipate and this is detrimental to company value. The earning retention hazard moves the focus away from one of aversion of effort as argued by (Brennan, 1995b) or lack of motivation or objective investment as espoused by the moral hazard conflict theory but instead sees the source of conflict in this case as resulting from the preference of managers to retain earnings for driving growth rather than cash distributions which is preferred by shareholders. A relative association has been determined connecting the size and a company and the compensation of managers thus creating an inducement for managers to focus on size growth and neglect growth in term of returns to shareholders. A third area identified as a potential originator of conflict is one related to timing. In general, shareholders are more concerned with the companys performance in terms of cash flow as projected into an indefinite future as opposed to managers who are seemingly only interested in cash flow projections for the period of their employment or contract. As a direct result of this, the managers have an inclination to engage in mostly short term projects at the expense of long-term projects. The problem becomes more visible in the build up to when the senior management personnel draw nearer to their disengagement or retirement. A typical example is the significant decline in research and development involvement which is a long term investment that usually has a negative impact on management compensation. A study by Dechow and Sloan (1991) indicate that there is a decline in this sort of investments as top management reach disengagement and explains their findings to be linked to the fact that the manager will not be available to partake in the benefits of such investments. Risk aversion conflicts arise as a result of managers being overly cautious of involving in projects that may put their self interest at risk. The Costs of Agency As explained in preceding paragraphs, the agency theory proposes that as a result of widely dispersed shareholdings, the stockholders are left with no choice but to delegate executive and other decision making authority to professional managers hired for purpose. However, these managers have a tendency to pursue their own interests which conflict with those of the stockholders who are more interested in avoiding firm specific risks. This conflict or divergence of interest most times results in the owners taking out certain measures to minimise the effect of this conflict. The costs of providing these checks and balances to ensure that managers do not abuse their authority or even the costs of managers allocating to themselves excessive perquisites at the expense of shareholders and the cost of monitoring and dealing with any such infraction can all be classified as equity agency costs. As succinctly put by McColgan (2001), Agency costs can be seen as the value loss to shareholders, a rising from divergences of interests between shareholders and managers. Agency costs are a sum of various parts and as posited by Jenson and Meckling (1976), monitoring costs, bonding costs and the cost of residual loss are the sum parts of this cost. I will further expatiate on these three sub groups as in my opinion, they satisfactorily cover the main heads under which agency costs are incurred. Monitoring Costs Where a principal delegates decision making authority, particularly executive or financial, to his agent it is important that there a mechanisms in place to check any excessiveness, misuse of authority or bad decision making. In other words, the agent is monitored. These monitoring costs are thus, the expenses incurred by the principal in the process of evaluating, examining and even managing an agents activities. Such costs may include but are not limited to the cost of conducting regular audits, the cost of developing reporting lines along the hierarchy of managerial staff, sometimes the hiring of external consultants and will even include the cost of disciplining erring managers. The burden of paying these costs is on the principal. However, Fama and Jensen (1983) have submitted that this burden is eventually passed on to the agent as the monitoring costs will have a direct impact on the agents remuneration. Asides these methods mentioned above, there are other self-regulatory mon itoring mechanisms that are imposed by statute. For example, domestic regulations under various sections in part 16, chapters 1 and 2 of the Companies Act UK 2006 stipulate the mandatory requirement for company accounts to be annually audited. Similarly recommendation contained in the Cadbury report of 1992 (reporting and control mechanisms) and the Greenbury (1995) reports on corporate governance are usually also employed. The requirement under the Combined Code 2010 dubbed comply or explain means that a company, in the event of non-compliance must disclose and explain its reasons for not doing so which in itself is capable of attracting to the company sufficient attention from regulatory bodies to provide a certain level of monitoring. Within a corporate structure, probably the most effective monitoring mechanism over the agent (managers) is the board of directors. The board is usually made up of individuals who possess the necessary skill and expertise required to carry out this duty. They must also be properly incentivised. Denis, Denis and Sarin (1997) are of the opinion that for monitoring to be effective, the mechanism employed must prove a formidable challenge to managements control of the company. However these mechanisms must be deployed in such a manner as to strike a perfect balance with regard to the peculiarities of the firms working environment as too much interference or over-monitoring will invariably restrict managerial independence and may have an adverse effect on the companys performance Burkart, Gromb and Panunzi (1997). Bonding Costs. As posited by Fama and Jensen (1983), the notion that agents eventually bear the burden of monitoring costs makes it more likely that they will initiate internal framework to ensure an alignment of interests between the agent and the principal or recompense for any eventual divergence if not. The cost of setting up structures of this nature and implementing them are known as bonding costs. Examples may include developing enhanced marketing strategies towards set profit targets, improved dispersion of information to the principal or even budgetary considerations and expenditure that are in sync with the principals objectives. These costs are borne solely by the agent, but are not always financial as they usually involve a re-alignment of corporate strategy to realise the principals interests. The relationship between monitoring costs and bonding costs are relative as a marginal increase in bonding costs will invariably lead to a marginal reduction in monitoring and its associated cost s. Denis and Kruse (2000) are of the opinion that the optimal bonding contract should aim to entice managers into making all decisions that are in the best interests of the shareholders. This is the most desirable outcome which would lead to a drastic reduction, or even wishfully, an elimination of the agency problem itself. However a more realistic outcome would be that bonding provides a means of making managers actually meet the expectations of shareholders to a certain extent even if not completely. McColgan (2000) remarked on a particularly interesting bonding structure popular in the UK which is imposed upon management; the requirement of closely held companies to distribute all income after allowing for business requirements (declaration and distribution of dividends) and was of the opinion that it presented the problem of retention of earnings in UK companies. He however concluded that the effectiveness of bonding structures may be treated with scepticism as it is a mechanis m utilised at the discretion of management. Residual Loss As we have noted earlier in this essay, it is practically impossible to prepare and guard against all conflicts that may emerge between shareholders and managers, thus the development of the notion that their relationship consists a multiplicity of constantly renegotiated contracts. Therefore, it is an acceptable conclusion that regardless of the outcomes of monitoring and bonding, a divergence of interest between managers and shareholders would still exist and any expenditure made in the resolution of these remaining conflicts are still reflected under the costs of the agency relationship. These remaining costs are known as residual loss. These costs remain because enforcing contracts between the principal and the agent is as mentioned earlier, very costly and in practice; far outweighs the advantages to be achieved from enforcement. It is practically impossible to fully contract for every contingency by way of conflict that may arise as a result of the agency relationship therefore a balance must be struck between over monitoring of management which leads to restricted initiatives, and enforcing contractual mechanisms designed to reduce agency problems in order to achieve the optimal level or residual loss. The Mitigation of Divergence The main challenge arising from this agency problem is how to induce the agent to act in the best interests of the principal or, in the context of corporate governance, how to mitigate the divergence of interest between shareholders and managers. Empirical and theoretical research has shown that a principal can limit the agents divergence from his interest by incurring both monitoring costs; designed to restrict deviant activities of the agent, and bonding costs; designed to ensure the agent does not take any action detrimental to the principal. So in mitigating this divergence, both monitoring and bonding costs are necessarily incurred by the principal. The common solution is usually to provide sufficient incentives for managers that would align their interests with that of the shareholders but it must be noted that asides the advantage of mitigating the clash of interest, this policy carries along with it, a secondary negative effect in the sense that managers would now only look t o the short term benefit they would stand to gain based on the incentives offered them and will not look into engaging in long term projects. This can be detrimental to business activity. There however arises the issue of effectiveness with regard to these mechanisms. The test of effectiveness propagated by Denis and Kruse (2000) is simple and constant in determining the relevance of any of these mechanisms in the context of the corporation and is in two parts. First, does it effectively narrow the gap between the interests of managers and shareholders? Secondly, does it have a significant positive impact on corporate performance and company value? If these two questions are answered in the affirmative then the issue of effectiveness is resolved. There are several different methods that may be employed to mitigate issues of divergence. Here we will focus on three of the more prominent methods that were highlighted by Crutchley and Hansen (1989). The first method is by increasing the managers equity ownership in the firm which would directly result in an alignment of interest between the shareholder and the manager. This method can be particularly effective because where the manager now has an equity stake in the firm; he would share the same expectations as other shareholders thus closing the gap of divergence. Monitoring costs would also be invariably reduced as a direct consequence. This method is however in itself not costless and the increase in a managers equity stake is relative to reduced diversification of his personal wealth and the balance would be an increase in remuneration. The second method proposed to assist in mitigating divergence is to increase dividend payments. This may seem unrealistic and maybe even unrelated to mitigating the divergence of interest but according to Easterbrook (1984) the rationale behind this is that the lower the financial resource available to the managers, the higher the chances of the company having to seek external equity capital. This would entail venturing into the capital market to raise funds either by way of private placement or public offer. In this case, the company would become subject to rules regulating capital market operators and therefore managers would be more closely monitored by relevant stakeholders including prospective or new investors and relevant government agencies like the Securities and Exchange Commission. This increased monitoring would motivate managers who are intent on retaining their positions to redirect their actions to be more in line with the interests of shareholders. Another method of r educing the costs of agency to result in diminishing divergence of interest is the use of debt financing. Jensen and Meckling (1976) indicated the importance of this method by explaining that using more debt finance reduces total equity financing, which has a diminishing effect on the level of the manager-stockholder conflict. In what was referred to as the control hypothesis he submits that by replacing dividend payments with debt issue managers are bound to apply future cash flow to shareholder recipients of this debt in ways otherwise unachievable by dividend payments. The controls are increased in this case because where the agreement to repay principal and interest is not maintained, shareholders reserve the right to initiate insolvency proceedings. Debt financing also reduces the cash resource available to be fritted away at the discretion of the managers. It further enhances efficiency as the constantly looming threat of redress as a result of failure to service debt payments also act as a sufficient motivational tool in making the firm more efficient. In this case the managers are more concerned with policy behaviour that will further the interest of creditors which in turn reduces the likelihood of incurring agency costs. However, debt financing may give rise to certain debt agency costs which may include the cost of contractual protection and insolvency proceedings or bankruptcy. Conclusion In conclusion we have looked at the concept of separation of ownership from control and the notion of an agency relationship that develops as a direct result. The agency theory and its inherent problem being that of an ultimate divergence of interest between the shareholders and managers, the control of which leads to expenditures termed the costs of agency have also been summarily discussed with suggestion proffered to assist in the mitigation of this divergence. It is however a contrasting outcome that despite the existence of a myriad of problems afflicting this agency theory imbibed in the separation of ownership from control, the model still remains very popular within todays modern firms and corporate governance structures. The simple explanation is that popularity of this corporate governance structure can in any case be ascribed to the continuous development of institutional control mechanisms both internal and external which are specifically targeted at resolving or minimisi ng these conflicts as they arise.