The traditional view of companies' existence solely to make profit for its owners can be traced from the work of Berle and Means (1932) in Gamble and Kelly (2001), which suggests that the creed of shareholder value evolved from what used to be known as separation of ownership and control, but which is more accurately describe as the fragmentation of ownership. This conventional economic view of the firm, as presented by Hayek (1960) and Friedman (1970), in Watson and Head (2007), is that a company should drive towards maximising its economic profits. Further, the managers of companies should make decisions that maximise the value of the company for its owners - shareholders. Obviously, the shareholders' wealth increases by the dividend they receive and the capital appreciation of the company's share price.
Owing to the fact that the owners of the company are its shareholders (principals) and the managers (agents) of the company manage it on their behalf, this results to agency relationship between the agents and their principals; as a result of the separation of ownership and control of the company. The clear-cut implication of this is that, the agents are accountable to their principals and will run the companies for the benefit of its shareholders. This assumption was affirmed by Friedman (1962, 1970) in Letza, Sun and Kirkbride (2004) that the purpose of business in society is to maximise profits in a free market for its shareholders, which should not be confused with other social functions performed by governments and other institutions. Hence, the only function of business is to increase its profits.
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The Friedman's view implies that, companies are not in any way going to be socially responsible to other stakeholders other than purely maximizing the company's value for the benefit of its owners. This sparks a lot of criticisms and debate in the contemporary corporate governance. This is because the company does not operate in a vacuum, and as such should focus not only on its shareholders, but also the various stakeholders who made-up the environment where the company operates. Obviously, the company cannot exist without its employees, the suppliers of its input, the buyers of its output, the government that provides the infrastructural facilities, the creditors that provide it with funds, the general public and even the environment. Therefore, companies should focus on all stakeholders so as to maximize their value in the long-run.
Consequently, the stakeholder theory emerged in view of the short-comings of agency theory; as the nature, size and operation of companies keep changing and in some cases, the damage caused by these companies to the environment and society. There ensued a debate as to whether a company should operate solely for the benefits of its shareholders or the stakeholders in general. It has been suggested that, to appreciate the ferocious debate on these issues, it is better one remains neutral on the arguments. Because, profound thinking is really required in analysing the theorems. Albeit the debate has some redeeming features, yet remains static in advancing corporate governance in contemporary business world; where human asset, information technology and knowledge are more valuable than physical assets. It is the orthodox technique, mostly, employed by theorists that brought about the unwarranted dichotomy in theorising corporate governance. (Sun and Kirkbride, 2004).
This paper consists of four parts; the remaining three parts includes the following: the next part discourses the presumption of the existence of a company only for the benefits of its shareholders (agency theory). Afterwards, the alternative theories to agency theory are analysed in part three. Part four concludes the paper and calls for a novel way of theorising.
The origin of agency theory is dated back to 1960s and early 1970s; it was developed by economists as a by-product of risk sharing among individuals. Agency theory developed on this to address the problems that normally occur in an agency relationships between agents and principals, these include: (a) divergent interest between the agents and their principals and (b) the inability of the principal to verify what the agents are doing. This problem lies with their (both agents and principals) attitude towards risk. While the principals would like their value maximised, in long-term investments, the agents may be risk averse and prefer short-term investments that will ensure them their benefits. This resulted in the assumptions, about the agents, that mostly are driven by self interest, bounded rationality and risk aversion (Eisenhardt, 1989).
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Owing to its origin in economics, it was developed laterally in two perspectives: the positivist and principal-agent (Jensen, 1983) in (Eisenhardt, 1989). While positivist agency theory focuses more on the organisation and identifies various contract alternatives, the principal-agent theory focuses on the relationship between the principals and agents, and indicates which of the contracts is the best at different levels of outcome (Eisenhardt, 1989).
Solomon (2009) opines that, the way in which companies were managed was related to the introduction of limited liability and opening-up of corporate ownerships. The market system, among other things, is organised in such a way that the principal owners of listed companies, envoy agents to manage the company on their behalf. Thus, ensued the notorious 'agency problem'.
While managers are expected to run the business in a way that will maximise the shareholders wealth, whether this happens in reality is a source of concern. The agency problem arises when managers make decisions that are contrary to the sole aim of shareholders' wealth maximisation. Three factors aid the existence of this problem and these include: (a) fragmentation of ownership, (b) divergence of goals and (c) information asymmetry.
The principals appoint agents to manage their company and this brought about the fragmentation of ownership. The agents may pursue some ways that would enable them maximise their wealth rather than that of the shareholders', and this creates the divergence in goals between them. Managers, as a result of managing the business on a day to day basis, have first-hand information about the business, where as the owners only get information periodically which may be manoeuvred by the management. When these complications are taken into consideration, it is obvious that managers are in a position to maximise their own wealth without necessarily being detected by the owners (Watson and Head, 2004).
This basically brought about the issue of morality, because if agents cannot do what is expected of them, as provided both in explicit and implicit terms in the relationship with their principals, then the expectation is that, they will not run the business in the shareholders' best interest.
Reflecting morality issue, it has been argued that, agency theory can only be applied effectively if four moral principles are adhered to: avoiding harm to others; respecting the autonomy of others; avoiding lying; and honouring agreements (Quinn and Jones, 1995, p. 36), in Solomon (2009). But the crux of the matter is how to determine such moral principles in human beings, as morality is assumed to be part of people's character, and once a person's character is bad, certainly that person cannot be trusted. As succinctly said '...no amount of corporate governance check balances, codes of practice or even regulation can change person's character' (Solomon, 2009, p. 52).
Consequently, the fundamental issue is, as questioned by Solomon (2009) how can shareholders exercise control over company's management? This is said to be possible by shareholders aligning with the management of the companies; via one-to-one meetings, passing of resolutions to advise the managers, voting for takeover and sometimes resort to the ultimate threat by divestment. But this 'shareholder activism' has with it some associated costs (agency cost). This includes the bonding costs incurred by the shareholders, the monitoring expenditure incurred by the principals and any other residual loss.
Stakeholder theory is viewed as a fabrication of many disciplines. Albeit, the stakeholder theory has many definitions, but one common thing amongst all the definitions is an exchange relationship between companies and stakeholders; stakeholders include employees, customers, suppliers, government, creditors and the general public (tax payers).
An exchange relationship exists when stakeholders supply companies with contributions and expect their own interest to be catered for in return, via inducement. The contributions include the taxes paid by the general public, infrastructural facilities provided by government to the companies, funds provided by creditors, a service rendered by employees and the communities in the vicinity of the companies' operations. Inducement on the other hand refers to the companies' efforts towards up-grading their (stakeholders) quality of life (Solomon, 2009).
Donaldson and Preston (1995) in Letza, Sun and Kirkbride (2004) categorised stakeholder theory into three: (a) normative, (b) instrumental and (c) descriptive; but the first two (normative and instrumental) are the major ones, and this paper examines the major two.
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Normative stakeholder theory
This emphasises intrinsic value in stake holding i.e. companies have an obligation to respond to stakeholders' needs because their operations affect many people both in welfare and potential risk. This implies pure ethics in business, informed by high moral standards of the managers of companies. But this assumption is certainly impracticable; as it is the fiduciary and legal duty of managers to maximize the companies' value, as enshrined in the company law Solomon (2009).
Instrumental stakeholder theory
'A basis for stakeholder theory is that companies are so large, and their impact on society so pervasive that they should discharge accountability to many more sectors of society than solely their shareholders' (Solomon, 2009, p. 23).
The benefits to a company for being socially responsible are too numerous to mention, among which include: the company is likely to retain the best brains of work-force and therefore reduce employee turn-over, the company is likely to gain its customers' loyalty and suppliers' confidence, there will also be less adverse publicity about the company and there is positive correlation between the social, ethical and environmental awareness and management quality Henry (2009).
Companies are really beginning to acknowledge the risk of reputational damage and are working towards embracing all stakeholders in pursuance of profit maximization. For example, The Royal Dutch Shell plc has realised the unquantifiable damage the pressure groups, from Niger Delta region, of Nigeria and the Human Rights Watch are making to its reputation. This is buttressed by the company's 2008 financial statements, under 'risk factors', the company expresses serious concern on its reputation:
'An erosion of Shell's business reputation would adversely impact our licence to operate, our brand, our ability to secure new resources and our financial performance.' (Shell Annual Review, 2008, p. 11)
Sometimes, the pressure group disrupts the company's operations, which in turn have negative effect on its earnings, and the acknowledgement of this, is categorically mentioned in the statement:
'An erosion of the business and operating environment in Nigeria could adversely impact our earnings and financial position.' (Shell Annual Review, 2008, p. 11)
These examples compelled companies, and shell in particular in this case, to state categorically in their financial statements, their commitments towards stakeholders. As stated by Shell, about it's social, economic and environmental performance:
'We recognise that our continuing business success depends on
helping to meet the world's growing energy needs in environmentally
and socially responsible ways. To manage today's business risks and
deliver our strategy, it is critical that we maintain the trust of a
wide range of stakeholders. To keep this trust, we must do many
things, including: behave with integrity, in line with the Shell
General Business Principles (Business Principles) and Code of
Conduct (Code); operate our facilities safely; be a good neighbour;
and help to find solutions to the energy challenge.' (Shell Annual Review, 2008, p. 14)
The use of Shell above as an example is informed by three reasons, as concord by Human Rights Watch (1999): Shell is the biggest oil producer in Nigeria, its facilities are largely onshore (near inhabited areas) and it was accused of collaborating in the alleged genocide of the Ogoni people. These obviously expose the oil company to a huge reputational damage.
This view was recently affirmed by Tunnicliffe (2009) who states, 'Even in the heartland of capitalism there is a realisation that they must embrace a sense of responsibility to the individuals, communities and even the global market they serve. Getting this requirement wrong introduces massive reputational risk which is impossible to cover through insurance'. Freeman (1984), also argues that, as the intensity of stakeholder groups is becoming inescapable to companies and in turn affects their performance and survival, companies must be responsive to ensure that stakeholders' interest are contained in their corporate strategy.
Still on Shell, one could ask, if what the company puts on paper sees the light of the day, the answer is yes and no. Yes because, the company partners with government in addressing some of the problems in the region. Recently, it was reported (Olajide, 2009) about Shell's commitments towards active stake holding in Nigeria. The new Chief Executive Officer of Shell, Mr. Peter Voser, paid a courtesy visit to Yar'adua, the Nigerian president, and stated in his speech:
'The company was planning to hold workshops to train former militants on how to form and run business, while using its small and medium enterprise Fund to assist the militants set up businesses.'
His statement, of the company's commitment towards partnering with government in its developmental issues was highly appreciated by the president, and he responded:
'President Yar'adua thanked Shell for its plan to contribute to the successful implementation of the post-amnesty programme of his administration...
...the president also expresses appreciation to Shell for investing in power production at Adam, as well as its robust local content.'
Could this be the instrumental stakeholder theory in practice? Instrumental stakeholder theory suggests that, there should be sufficient limit to keep stakeholders quite, so that they do not border us. Should it be that, companies consider only those in exchange relationship with them to keep them happy, and that will make them maximise their profit or should the companies go beyond that and consider the impact of the company on the environment? This results to the problem of what constitutes stakeholders and the relationship between social performance and financial performance.
The contentious issue is to ascertain the correlation between companies' social performance and financial performance; in addition to the contextual problem of what constitutes companies' stakeholders. For example, Hillman and Keim (2001) argued that if companies extent their activities beyond their primary stakeholders (shareholders, customers, suppliers, employees, local communities and government) then the companies are simply addressing problems that should ordinarily be handled by governments and other charitable organisations. The secondary stakeholders may include, as opined by Letza, Sun and Kirkbride (2004): academics, media and politicians. They also affirmed that managing the companies' primary stakeholders results to shareholders' wealth maximisation, where as social issue participation reduces shareholders' value. This affirms what Friedman (1962, 1970) said, that the sole purpose of business is to maximise value for its shareholders, which should not be confused with government and charities functions.
The dispersion of ownership and control degenerates into agency problem. Company managers are driven by self-interest rather than shareholders' wealth maximisation as provided in agency theory and shareholders are impotent to control the managers. The excessive power of the companies' board is one of the major reasons for this agency problem. Alignment between shareholders and managers is possible, but at a cost; via shareholder activism and having more competent non-executive directors on board.
The other side of the coin portrays a different thing, and this is deduced from considering the position of businesses in the contemporary world. It would be very myopic to think companies exist only for the benefit of its owners, and as such need to consider all stakeholders. This seems the solution to inherent problems in agency theory, but it is more difficult than it seems. As the crux of the matter is the problem of identifying the stakeholders and properly establishing correlation between social performance and financial performance.
The bottom-line of the debate is how to bring together the two theoretical paradigms, so as to enable the company managers carry-out their fiduciary duty expected of them by shareholders, as enshrined in the business law; at the same time being socially responsible. This appealing view has been reaffirmed by Hill and Jones (1992) in (Solomon 2009, p. 28):
'...there is a parallel between the general class of stakeholder-agent relationships and the principal-agent relationships articulated by agency theory. Both stakeholder-agent and principal-agent relationships involve an implicit or explicit contract, the purpose of which is to try and reconcile divergent interests. In addition, both relationships are policed by governance structure.'
(Hill and Jones, 1992, p. 134)