THEORIES OF CORPORATE GOVERNANCE

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 hazard's 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.

Headnote

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 hazard's 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", "poststructural", "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 automaticall y 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 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 regulator y 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 be affected by the competing interests of managers in different decision-making circumstances.

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

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.

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 committee's 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 shareholder's 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 company's 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 isn't 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 don't 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 company's problems.

Steward theory model could be represented in graphical form as it follows:

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 company's 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 responsibility's view related to various categories of stakeholders.

In the graph below, we design the Stakeholder Theory Model as it follows:

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 company's 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 firm's 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 b y 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).

Certainly, in addition to transaction costs, agency costs resulting from divergent relationship between manager and shareholder's interests and information asymmetry, must be taken into consideration, costs which are based on two sources (Fulop, 2011): the costs inherent due to an agent's use (e.g., the risk that agencies use the company's 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 theor y 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.

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 recentl y 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..

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)

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 company's 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 & Poor's, 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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