Shareholder corporate governance, Stakeholder corporate governance and the current situation in the UK

Table of Contents

1. Introduction

2. Corporate Governance

3. Shareholder theory
3.1 Shareholder theory and its critiques

4. Stakeholder Theory
4.1 Stakeholder Theory and its critique

5. Corporate governance and the financial crisis
5.1 Possible avoidance - Instruments of corporate governance

Conclusion

Reference List

1. Introduction

Although the beginning of the banking crisis, where some banks needed a bailout by taxpayers, is seven years ago, the consequences are still observable in the global economy. Further, the crisis pointed out the grievances of actual regulations as well as succinctly regulated corporate governance. While some economists argue that the banking crisis is evidence that the shareholder theory failed and a shift towards a more stakeholder oriented theory is indispensable (Bakan, 2004), others note that the shareholder theory is still applicable by pointing out that the managers did not act in the intention of the shareholder theory by contravening basic principles of the theory (Smith, 2003). The bailout by taxpayers further extended the discussion that not only should the managers reconsider several aspects, but also the policy makers who initially had the obligation to prevent the scenario, where banks needed to be bailed out by stakeholders.

This essay will first provide an overview of stakeholder corporate governance as well as shareholder corporate governance theory and the associated critiques. Further this essay takes a glance into the practice by reporting the influences of corporate governance towards the financial crisis with a special focus on the UK. Finally, the essay will conclude possible changes towards corporate governance to prevent crises in the future.

2. Corporate Governance

Due to various reports and suggestions (Cadbury, 1992; Greenbury, 1995; Higgs, 2003) about how to act in a business world there is no standardised definition of corporate governance. Cadbury (1992, para 2.5) defines corporate governance as “the system by which companies are directed and controlled”.

While the UK and the US corporate governance use a more shareholder-oriented approach, where the focus is set on shareholders value, German corporate governance is structured towards a stakeholder-oriented approach. Accordingly, main difference is in the structure of the board of public companies. While UK and US implement a unitary board, Germany applies a two-tier board, whereby employees control the actions of the executive board.

3. Shareholder theory

The shareholder theory is based on Adam Smith’s assumptions that free markets will automatically lead to social welfare and originates from the neoclassical theory of the firm (Friedman, 1962). Milton Friedman (1962) articulates, that the increase in profit is the only social responsibility of a company. Accordingly, if managers focus on profit only, without deception, the society will benefit from it, even if it was not the intention of the managers (Sundaram and Inkpen, 2004; Friedman, 1962). Friedman (1962) further argued, that managers are obligated to a legal framework, which should be created by the society in order to ensure that no stakeholders are being disadvantaged. Shareholder oriented models of corporate governance therefore aim for an increase in profit, which leads to an increase in shareholders’ return, by arguing that shareholders own the company and therefore also bear the financial risk (Sundaram and Inkpen, 2004). Accordingly, shareholders are the owners of the company and managers act on their behalf (Smith, 2003).

Consequently, it is the task of the shareholders to ensure and control that managers use the provided fund in a way that maximises their return (Tse, 2011).

3.1 Shareholder theory and its critiques

Jensen and Meckling (1976) articulate however that the control mechanism of the shareholders towards the management only works if shareholders invest considerable time and money in order to control decisions of the management. Because shares are widely spread, meaning there are numerous shareholders with a small number of shares, the incentive to control the management on a daily basis is small. The costs incurred during the control process inhibits the shareholder further and leads to a free-rider problem, where every shareholder hopes that the other shareholder is controlling the management (Hart, 1995). Berle and Means (1932) found that a large number of firms is manager controlled and not, as the neoclassical theory assumes, owner controlled. While this is pointing out the limitations of the neoclassical theory, it strengthens the argument of Berle and Means (1932) that there is a separation of ownership and control. Ross and Crossan (2012) articulate that corporate governance is a result of the proven limitations of the neoclassical theory.

As a result of the principal-agent problem managers of large public companies do not aim for maximisation of profit after they reached an adequate level of profit. Accordingly, after shareholders earned a satisfying return, managers strive for goals that maximise their own utility and therefore pursue their own goals at the expense of shareholders (Crossan, 2007; Hart, 1995). Such conflicts could lead to empire building, where managers aggressively grow the firm by for example acquisitions or increasing number of employees, which however can have a negative impact towards profit (Hope and Thomas, 2008). Further, managers may take actions which has a positive impact on the stock market in the short run, however have a negative impact towards the value creation of an organisation in the long run, for example by underinvestment of research and development (R&D), which can be ascribed to the Myopic model (Mizik, 2010). Figure 1 illustrates the reaction of the stock market on missing long-term orientation of managers. Grant et al. (1996) argue, that such problems arise because of asymmetric information between managers and shareholders.

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