Studia Universitatis Vasile Goldi Arad Economics Series Vol 23 Issue 1/2013

THEORIES OF CORPORATE GOVERNANCE

Associate Professor Sorin Nicolae BORLEA PhD

Vasile Goldis Western University,
Faculty of Economics, Arad, Romania

Associate Professor Monica-Violeta ACHIM PhD

Babe-Bolyai University,
Faculty of Economics and Business Administration, Cluj-Napoca, Romania

Abstract
This study attempts to provide a theoretical framework for the corporate governance debate.
The review of various corporate governance theories enhances the major objective of
corporate governance which is maximizing the value for shareholders by ensuring good
social and environment performances. The theories of corporate governance are rooted in
agency theory with the theory of moral hazards implications, further developing within
stewardship theory and stakeholder theory and evolving at resource dependence theory,
transaction cost theory and political theory. Later, to these theories was added ethics theory,
information asymmetry theory or the theory of efficient markets. These theories are defined
based on the causes and effects of variables such as: the configuration of the board of
directors, audit committee, independence of managers, the role of top management and
their social relations beyond the legal regulatory framework. Effective corporate
governance requires applying a combination of existing corporate governance theories,
rather than applying an individually theory.

1. Introduction
"New economy" called "post-modern", "post-industrial", "post-capitalist", "post-
structural", "post-traditional" economy reflects the actual transition from industrial
society towards a new type of "informational "or" knowledge society" being
marked by complex and profound changes in all fields, with major implications in
the economic, social and environmental process.
Human society has gradually shifted focus from manufacturing to the automatically
production, from individual knowledge towards the group one, the importance of
communication being emphasized.
In the new framework for economic development, especially of the organization,
the management organization approaches is changing towards the corporate
governance mechanisms. Effective corporate governance allows shareholders to
ensure that companies in which they hold shares are managed in accordance to
their own interests.
The globalization of capital markets and competition in providing the funds impose
an increase in the adoption of corporate governance standards and procedures
internationally recognized this being particularly important for emerging

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economies and those in transition, which usually have regained credibility in the
investors view.
Fundamental Theories of corporate governance are rooted in agency theory with
the theory of moral hazard implications, developing further within stewardship
theory and stakeholder theory and evolving at resource dependence theory,
transaction cost theory and political theory. Later, to these theories was added
ethics theory, information asymmetry theory or the theory of efficient markets.
These theories are separated from the causes and effects of variables such as the
configuration of the board of directors, audit committee, independence managers,
the role of top management and their social relations beyond the legal regulatory
framework. These theories are defined based on the causes and effects of variables
such as: configuration of the board of directors and audit committee; the
independence of directors; the role of top management and their social relations
beyond the legal regulatory framework.

2. Debating about corporate governance theories

2.1 Agent Theory
Fundamental Theories of corporate governance rooted in agency theory were
developed in the early 70s American literature. The theory refers to the relationships
established between the owners of a company and its directors, relationships
embodied in a mandate (agent) contract which consists in one first part (the principal)
that engages the other part (the agent) to perform some services on their behalf.
Agency theory has been developed from the theory of the firm, stated by Alchian and
Demsetz (1972) and further developed by Jensen and Meckling (1976).
Fundamentals of agent theory can be found even in the writings of Adam Smith
(1976): "You can not expect those who manage other people's money to be as careful
and caring as it would belong to them. Waste and negligence are present, always,
more or less, in the management of every business."
Although the development of agency theory is found only in the 70s, the idea of
separating the control government has been highlighted since the 30s by Berle and
Means (1932). According to studies of these authors, the divergence between
ownership and control is a potential conflict between shareholders and
management.
Under the agency theory, shareholders (the principal) are expecting from the
directors (the agents) to lead and make decisions in their interest, and of those who
have mandated. On the other hand, the agent can not only adopt the decisions that
pursue only the interests of the principal. (Padilla, 2000). Such a conflict of
interests between owners and managers was first highlighted by Berle & Means
(1932) and Adam Smith (1976) followed by Ross (1973) and then expanded by
Meckling (1976). Specifically, the conflict is highlighted by Davis, Schoorman &
Donaldson (1997).
Agency theory leads to the need for harmonization of the interests of managers with
those of shareholders for the objective of maximizing the company value could not

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be affected by the competing interests of managers in different decision-making

circumstances.
The agency theory can be represented in graphical form as follow:

Figure no. 1 Agency Theory Model

Source: Abdoullah and Valentine (2009)

2.2 Hazard Moral Theory

The conflict of interest determined by the separation between power and control
(on which agency theory is foundated) can cause opportunistic behaviour of the
managers (as agents) which is not necessarily converged with the shareholders
interest (as principals), that of maximizing shareholders wealth. (Demsetz et al.,
1985, Bonazzi et. al.,2007; Lan et al.,2010; Abdullah,2009; Smith,2011)
Thus, managers are prone to moral hazard and opportunistic behaviour guided by
their own interests.
The theory of moral hazard is central within agency theory and also refers to hidden
actions or opportunistic behaviour of managers (Hendrik, 2003). Hidden action
arises as a consequence of asymmetric information held by counterparties.
(Arrow,1968), Eisenhardt ,1989) and opportunistic actions occur as human
inclination. (Jensen 1994)
Hendrik (2003) and Smith (2011) identify moral hazard as being determined by two
issues: the conflict of interests of the counterparties (principal and agent), hidden
actions and opportunistic behaviour as a result of asymmetric information. The
result can only be extremely dramatic such as decreasing performance and even
business failure.
Dinga (2009) considers moral hazard to be a result of a high degree of insurance
against risk in the context of the financial crisis which began in 2007, when banks
were launched in loans because they expected the government to intervene in
restoring liquidity (for example, by relaxing the requirements minimal legal
reserve).
Therefore, the hazard moral theory is strongly connected to the remuneration
manager policy. The concerns to define the managers remuneration policy
according to the need to develop a common interest between manager and
shareholders (to mitigate moral hazard) are current and they are the subject of
various economic, financial and management researches.
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Regarding the managers remuneration policy, Corporate Governance Code issued

by the Bucharest Stock Exchange in 2008 states that (in art. VI, Recommendation
21): The board should establish a remuneration committee among its members to
assist in formulating a remuneration policy for directors and managers and it
should define the committees internal regulations. Until a remuneration committee
has been set up, the board should deal with these tasks and responsibilities at least
once a year. The remuneration policy shall be subject to AGM approval.
In conclusion, the way of expressing the moral hazard may result in the managers
remuneration policy (the bonuses system) and the in use of various actions such as
handling financial communications in order to increase their prestige and
management reputation or adopting risky decision.

2.3 Stewardship Theory

Stewardship theory describes the role of management leadership in maintaining
and developing the organization's value, although it works temporarily therein.
Stewardship theory has its origins in the psychology and sociology areas and from
this perspective this theory assumes that managers are faith, responsive and
effective people and therefore, they are good administrators of the resources
entrusted.
According to this theory Schoorman & Donaldson (1997) state that "an
administrator protects and maximizes shareholders' wealth, thus, the shareholders
utility functions are maximized. From this perspective, directors and managers
work for shareholders ensuring the growth of shareholders wealth.
In comparison with agency theory, where the managers are tempted to take
decisions for their own advantage, not for the owners, the steward theory assumes
that managers act not in their own interests, but in a given conflict of interest
situation they put the companys interests in front of the personal ones.
The conceptual foundation of the theory is related to the development of work
motivation theories by McGragor in the 60s and more specifically to the Y Theory
that assumes that managers are rational beings, so there isnt any need to
excessively monitor their behaviour as the agency theory assumes. (Nicholson &
Kiel 2007)
According to Fulop (2011), because steward theory considers as an important
factor the board director structure, it must be composed of company intern
members because they know best the company's problems and can react
accordingly. If the board of directors is composed only of external members, they
dont react as promptly to the daily problems of the company.
As Solomon (2007) highlights, the outside directors (outsiders directors) can
monitor the maximizing of the business performance only on a short-term because
their knowledge about the work activities is less compared to the directors coming
from inside the company (the insiders) who closely know the daily companys
problems.
Steward theory model could be represented in graphical form as it follows:

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Figure no. 2 Steward theory model

Source: Abdoullah & Valentine (2009)

2.4 Stakeholders Theory

As a development of the agency theory the stakeholder theory rises up. The term
"stakeholders" refers to all persons, groups or organizations that have an impact on
the companys activity or are influenced by the company. It's about: the owners,
shareholders, investors, employees, customers, suppliers, business partners,
competitors, the government, local government, NGOs, pressure groups,
communities, media and so on. Each of these parts somehow interacts and
influences the business of a company.
In the years 1980 -1990, Stakeholder Theory has changed the shareholders
paradigm of Milton Friedman (1970) who considers that maximizing the financial
results for shareholders is the highest concern of a company. Stakeholder theory
was developed by Freeman (1984) and it is focused on the corporate
responsibilitys view related to various categories of stakeholders.
In the graph below, we design the Stakeholder Theory Model as it follows:

Figure no. 3 Stakeholders theory model

Source: own view

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Stakeholder theory rises from an increasingly acute need for corporate social
responsibility in the current context of transition from an industrial society to a new
society called "post-modern", "post-industrial", "post-capitalist", "post- structural",
"post-traditional" society. The new economy is characterized by a complex and
profound change in all fields, with major social and environmental implications in
corporate social responsibility areas.
In the actual context of world economy globalization, the performing company is
an "enterprise that creates added value for its shareholders, customers demand,
taking into account the views of employees and protecting the environment. So, the
shareholders are satisfied that the company has achieved the desired return,
customers have confidence in the future of the company and the quality of its
products and services. The companys employees are proud of where they work,
and society benefits of environmental protection. (Jianu, 2006) The concept is
based on the stakeholder theory and managers acting to maximize the company's
value in order to avoid ignoring the interests of their social partners. The
harmonization of these interests is ensured by the corporate governance system.
(Robu, 2004)
This theory of corporate governance based on maximizing the interests of all
stakeholders has proved to be the most efficient in history, not only because it
conducts to the economic success of the company, but also because it works to
achieve a competitive advantage due to gain people's trust and consequently a
goodwill on the market. (European Commission, 2005)

2.5. Transaction Cost Theory

Unlike agency theory, transaction cost theory explicitly uses the concept of
corporate governance. (Fulop, 2011) This theory states that the company is a
relatively efficient hierarchical structure that serves as framework to run the
contractual relationships. The main concern in transaction cost theory is "to explain
the transactions conducted in terms of efficiency of governance structures."
(Wieland 2005).
The fatherhood of "transaction costs" was attributed to Ronald Coase, who in his
famous article The Nature of the Firm, in 1937, has built the judgment regarding
the firms existence without using, explicitly, the concept of "transaction costs" but
that of "cost of using the price mechanism" (Coase, 1988). Coase substantiates his
argument about the nature of the firm by emphasising that organizing the
production through the market channels (contracting by market) involves some
costs. So, by creating an organization which has the responsibility for resources
allocation, some expenditure can be avoided.
Going forward, transaction cost theory is developed by Kenneth Arrow who
defines transaction costs as "operating costs of the economic system." (Arrow,
1969) Later, Williamson, founder of the transaction cost economics, believes that
"the study of governance include: identifying, explaining and combating all types
of risky contracts" (Williamson, 1996).

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Certainly, in addition to transaction costs, agency costs resulting from divergent

relationship between manager and shareholders interests and information
asymmetry, must be taken into consideration, costs which are based on two sources
(Fulop, 2011): the costs inherent due to an agents use (e.g., the risk that agencies
use the companys resources for their own purpose) and costs involved by
protecting against the risks associated with the use of an agent (e.g., the costs of
preparing the financial statements or costs consisting in the use of Stock-options
techniques to align the managers and shareholders interests.)
Therefore, as Abdoullah & Valentine (2009) notice, Transaction Cost Theory faces
a complex theory incorporating interdisciplinary issues related to organizational
economics and legal sciences

2.6 Resource Dependency Theory

Resource dependency is an explanatory model of organization activities that
emphasizes the fact that they are open systems and the environment in which they
operate and the social relations are the basis in decision making about resources
allocation.
In this context, Pfeffer and Salancik (1978) highlighting the resource dependence
perspective on inter-organizational behaviour, argue that: To understand the
organization behaviour you must understand the context in which that behaviour
occurs [...] this is understandable from the perspective that organizations activity
is inevitably linked with the environmental conditions in which they operate."
Hillman, Canella and Paetzold (2000) argue that the resource dependence theory
focuses on the role that managers play in providing essential resources for the
organization in relation to the external environment.
According to studies conducted by Hillman, Canella and Paetzold (2000), in the
decision making process, the managers contribute with information resources,
skills, access to key business partners of an organization such as suppliers,
creditors, government, social groups, etc..
According to Abdoullah & Valentine (2009), the managers responsible for leading
a business are classified into four categories:
a) insiders, meaning the current and former managers of the company offering
expertise in specific areas of the company and finance law;
b)business experts, meaning the managers of big companies who provide
expertise in business strategy, decision-making and solving economic problems
facing the company;
c) support specialists represented by lawyers, bankers and insurance companies,
public relations experts and all those experts who provide specialised support in
their individual specialization area;
d)"community influential, meaning political leaders, academic leaders, religious
leaders or social and community organization leaders.
From the point of view of allocated internal resources the power engaged in the
process of allocated resources can be stronger or weaker and it depends on the
extent to which managers belong to one of the four categories listed above.
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The resource dependency theory emphasizes the complex character of "network"

concept underlying the corporate governance concept.

2.7 Political Theory

There are other areas and theories that could explain corporate governance. One
such area would be the law, based on the idea that many of the corporate
governance practices are based on laws. For these reasons, many definitions of
corporate governance encapsulated the political impact of corporate governance
mechanisms. For example, Cosma (2012) defines corporate governance as the
"branch of economics that studies how businesses can become more efficient by
using the institutional structures such as constituted act, organizational chart and
legal framework."
Political Theory refers to political influence in the governance structure of
companies, evidenced by the participation of the government in the capital of
companies or laws adopted by political structures which have a significant
influence on corporate governance.
The political model emphasizes the governmental favours on corporate decision-
making activities related to the distribution of corporate power, profits or various
benefits. (Abdoullah & Valentine, 2009) Regarding dividend policy, for example,
there may be legal rules that give special importance of dividends as a potential
tool for solving possible agency problems related to hold shares. In this respect,
countries such as Brazil, Chile, Columbia, Greece and Venezuela make mandatory
dividend provisions. In other countries, the role of legal environment is more
subtle. Thus, in the UK there have been formed several boards that make
recommendations for improving corporate governance practices used by the board
of director. (Ileana, 2008)
The political model of corporate governance can have a huge influence on the
development of corporate governance. We can mention the case of the communist
or the former-communist countries which are still struggling to emerge from
political influence. The case of Romania is an illustrative example in this regard.
Although being a former communist country for more than 20 years, it still faces
major problems related to government shareholding in the governance structures of
the Romanian companies.
Mark Mobius, executive chairman of Templeton Emerging Markets Group recently
stated (September 2012) that the reason for investors not coming in Romania is the
jam in profitability recorded by the companies with government companies,
stressing the need that the government should bring more companies on the market.
Further, Mobius stressed that these companies will become attractive to local and
foreign investors only if a change will be produced in the governance system and
new governance models will be imposed.
Political manifestation of corporate governance structures concerned the
governments from many countries towards drawing the framework of the
separation between power and control..

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In this regard, extensive research conducted by various authors (Roe, 1994;

Thomsen, 2008) has shown that the policies adopted by the countries governments
have had a growing importance in explaining the development of corporate
governance national systems and it is also being closely related to sociological
issues such as culture or religion specific to that country.

2.8 Ethics Theories

In addition to fundamental theories of corporate governance such as agency theory,
steward theory, hazard theory, stakeholder theory, resource dependence theory,
transaction cost theory or political theory, the authors have identified the ethical
theories that can be closely associated with corporate governance.
These relate to business ethics theory, virtue theory, feminist theory and discourse
ethics theory or post modern ethics theory. (Abdoullah & Valentine, 2009)

2.9 Theory of Information Asymmetry

Information asymmetry theory is based on the study of Akerlof (1970) in which the
behaviour of buyers and sellers of used goods is analysed by abandoning the
hypothesis of perfect information on the market and assuming the contrary, the
uncertainty of regarding the quality of products purchased. (Raimbourg, 1997)
The arguments of Akerlof result by analysing the market place of some product
where the seller has more information about the quality of products than the buyer.
He analyses second-hand cars market which is called lemon market.
The conclusions of Akerlof show that hypothetical information difficulties can lead
either to the collapse of the entire market, or to its transformation by adverse
selection, being chosen the poor quality products instead of the higher quality ones.
Initially, the theory of asymmetry information marked the first research in the field
of buyer behaviour (Spence, 1977; Leland, 1979, Heinkel, 1981; Allen, 1984) and
the advertising one ((Nelson, 1970, 1974 and 1978) but then rapidly expanded in
financial theory and considerably affected the classical theories of the firm. (Robu
& Sandu, 2006)
The hypothesis concerning the informational asymmetry is closely related to the
agency theory and to the existence of agency relationships. Dividend or financing
policies adopted by directors can be characterized by different interests between
the directors and shareholders
In the context of this theory, an explanation for dividends paid to shareholders is
provided, although it is known that they will pay an additional tax for this
additional income. An answer in the "signalling" theory area is that dividends can
be a good sign for future investments, the investor pay more for a share because, on
the market, a big level of dividend is interpreted as a good sign which will mean a
higher price for the shares.
Likewise, signals of a strong company can be emitted through debt policy
because it is considered that a strong company is one which can afford a high rate
of indebtedness in order to finance ambitious investment projects. (Stancu, 2006)

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In conclusion, effective corporate governance will determine the reduction of

informational asymmetry effect and prevent the manifestation of unfair actions of
the managers to gain prestige and reputation but affecting the companys growth.

2.10 Theory of Efficient Markets

In connection with the informational asymmetry theory it is the efficient markets
theory which focuses on the investors, as the main stakeholders.
In the context of corporate governance, as its mechanisms it will be stronger and
more effective, ensuring a transparency of internal processes of governance, as
market will reflect the stock value closer to the real (economical) value of the
company. (Credit Lyonnaise Securities Asia CLSA, 2001; McKinsey 2001;
Standard & Poors, 2002; Klapper & Love, 2004; Stiglbauer, 2010).
In summary, related to the efficient markets hypothesis, all information available at
a given time is included in the share price and reflect the real value of the
company. The results consist in decreasing risks and uncertainties for investors.

3. Concluding remarks
History emphasized the development of theories and models of corporate
governance and the fact there is no final, single or optimal form of effective
governance.
Together with the transition to capitalism, companies become stronger while
governments have had to give out the domination and the economic implications
Theories of corporate governance are rooted in agency theory with the theory of
moral hazard implications, developing further within stewardship theory and
stakeholder theory and evolving at resource dependence theory, transaction cost
theory and political theory. Later, to these theories were added the ethics theory,
informational asymmetry theory or the theory of efficient markets. These theories
are separated from the causes and effects of variables such as the configuration of
the board of directors, audit committee, independence managers, the role of top
management and their social relations beyond the legal regulatory framework.
These theories are defined based on the causes and effects of variables such as:
configuration of the board of directors and audit committee; the independence of
directors; the role of top management and their social relations beyond the legal
regulatory framework.
Effective corporate governance requires application of a combination of existing
corporate governance theories, rather than application of an individual theory.

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