Corporate Behavior and Sustainability

Doing Well by Being Good

Güler Aras, Coral Ingley

• Publisher: Gower
• Year: 2016
• ISBN:
  9781317159544
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Companies can no longer expect to engage in dubious or unethical corporate behaviour without risking their reputation and damaging, perhaps irrevocably, their market position. Irresponsible corporate behavior not only deprives shareholders of long-term returns but also ultimately imposes a cost on society as a whole. Sustainable business is about ensuring that entities contribute toward positive social, environmental, and economic outcomes. Bad business behaviour is costly for stakeholders, for markets, for society, and the economy alike.

To ensure that a company behaves well, the buy-in of the leadership team is crucial. The full commitment of the board of directors, in conjunction with the senior managers of the organization, is required if an organization is to be socially responsible. In this sense, leadership does not reside with an individual (the CEO) within the organization but with all of those at the apex of corporate power and control. Effective change management requires enlightened and capable leadership to instigate and drive the process of embedding a sustainable and socially responsible corporate philosophy and culture that supports good business decision-making. A profound understanding of the requirements of such a leadership process will help corporate managers become highly effective change agents.

Governance will be the main driver of this change. For the economy and financial markets to become sustainable and resilient, radical changes in corporate leadership need to take place. Integrated reporting, government regulation, and international standards will all be important factors in bringing about this change.

As well as understanding the effects of corporate behavior on financial markets, such an understanding is also now imperative in relation to the social and environmental contexts.

Part I

Market behavior, stakeholders’ approach and good governance

Chapter 1

Agency theory

Explaining or creating problems? Good governance and ethical behaviour for sustainable business

Güler Aras and Paul Williams

Introduction

Corporate scandals (e.g., Enron, WorldCom) and the magnitude of the 2008 financial crisis has raised consciousness that Corporate Governance is an important issue for all institutions but particularly for corporate business. Weak internal controls, insufficient board oversight and lack of supervisory impact on corporate governance were detrimental to the trustworthiness of business and financial markets. Since the financial crisis, all countries are more aware of the importance of strong governance structures and good governance systems. Corporate governance can be considered as creating an organisational environment of trust, ethics, moral values and confidence among the organisation’s stakeholders, including government and the general public. This is complicated by the fact that a corporation as a legal being has legal and ethical responsibilities, but without there being anyone explicitly charged with ensuring those responsibilities are fulfilled (Greenfield 2006). Many countries are now evaluating their legislation and regulatory policies pertaining to governance structures and taking steps to safeguard the sector and reduce the risk of severe financial distress in the future. Getting the right governance principles, standards and tools in place to support and promote responsible business practices is important for securing a sustainable business environment. However, businesses themselves need to be proactive and implement good governance principles and practices.

The latest financial crisis is a negative lesson in how good corporate governance is essential for a sound economy and fundamental to the operations of any good corporate citizen. In this chapter we will focus on how we can implement good governance principles for a sustainable and sound business environment. We will try to make the case that corporations conceived as merely a nexus of private contracts is inadequate as a perspective from which to consider how corporations should be governed. Corporations’ role in the Great Recession, their role in the growing income inequality within even countries with advanced economies and their role in climate change all suggest that we need to rethink the way we approach their governance.

Many corporations are already adopting new perspectives motivated by their recognition that their long-term survivals depend on new modes of operations. Increasingly CSR, ethics and sustainability issues are regarded as strategic with potential to generate important competitive advantages for companies that recognise their success depends on engaging in good business practices – or business practices that are good.

Managing managers via agency theory principles

A very simplistic characterisation of management describes managers as having the power to commit the organisation to whatever contracts and transactions they feel appropriate but as also having a fiduciary responsibility towards the owners of the business. For some four decades agency theory has provided the most prominent rationale upon which this dual, but conflicting, nature of management is allegedly rationally harmonised and corporate actions justified. Agency theory claims that the management of an organisation is undertaken on behalf of the shareholders of that organisation. It is a theory grounded in the ontology of neoclassical economics. It is not simply an economic theory but also a political ideology in that it presumes the superiority of free market solutions to social problems and the priority of protecting property rights as the legitimate priority of government. Consequently the management of value creation by the organisation is only pertinent insofar as that value accrues to the shareholders of the firm. Implicit within this view of the management of the firm, as espoused by Rappaport (1986) and Stewart (1991), amongst many others, is that society at large, and consequently all other stakeholders to the organisation, will also benefit as a result of managing the performance of the organisation in this manner. From this perspective therefore the concerns of management are focused upon how to manage the corporation performance for the exclusive benefit of shareholders. Corporate reports are, perforce, reports focused exclusively upon that kind of performance (Myners 1998). However, this view of an organisation has been extensively challenged by many writers,¹ who argue that the way to maximise performance for society at large is to both manage on behalf of all stakeholders and to ensure that the value thereby created is not appropriated by the shareholders but is distributed to all stakeholders. Others such as Kay (1998) argue that this debate is sterile and that organisations maximise value creation not by a concern with either shareholders or stakeholders but by focusing upon the operational objectives of the firm and assuming value creation and its equitable distribution are consequences of achieving proper corporate objectives (see, Aras and Crowther 2009).

Agency theory argues that managers merely act as custodians of the organisation and its operational activities and places upon them the responsibility of managing in the best interest of the owners of that business. According to agency theory all other stakeholders of the business are largely irrelevant and if they benefit from the business then this is coincidental to the activities of management in running the business to serve shareholders. This focus upon shareholders alone as the intended beneficiaries of a business has been questioned considerably from many perspectives, which argue that it is either not the way in which a business is actually run or that it is a view which does not meet the needs of society in general. For example, agency theory formed the primary rationale for stock-option compensation as a preferred method for rewarding managers since it allegedly aligned better their economic interests with the economic interests of shareholders. As Thomas Piketty’s (2014) data have shown the biggest single factor contributing to the historically unprecedented gap in US income from labour between the top ten percent of earners and the bottom ninety percent is the tremendous growth in the compensation to corporate management precipitated by the advent of agency theory inspired compensation schemes.

An alternative theory of corporate management – stakeholder theory (Freeman 1984) – argues that there are a variety of stakeholders involved in the organisation and each deserves some return for their involvement. Management is the process of balancing these various interests. According to stakeholder theory therefore corporate value is maximised if the business is operated by its management on behalf of all stakeholders and returns are divided appropriately amongst those stakeholders in some way which is acceptable to all. However, a single mechanism for dividing returns amongst all stakeholders which has universal acceptance does not exist, and stakeholder theory is significantly lacking in suggestions in this respect. Nevertheless this theory has considerable traction and is based upon the premise that operating a business in this manner achieves as one of its outcomes the long-run optimisation of returns to shareholders. Stakeholder theory is premised on the recognition that corporations are “externality machines” (Greenfield 2006) and without due consideration of these externalities shareholder value maximisation may come at a very high cost to everyone else. The optimisation of returns to stakeholders is achieved in the long run through the optomisation of performance for the business in achieving a balanced consideration of all stakeholders’ interests.² Consequently the role of management is to optimise the long-term performance of the business in order to achieve this end and thereby reward all stakeholders appropriately, including themselves as one stakeholder in a community of stakeholders. Agency and stakeholder theories can be regarded as competing normative theories of the operations of a firm; they lead to different operational foci and different conceptions of management’s responsibilities and to different implications for the measurement and reporting of performance. It is significant however that both theories have one feature in common. This is that the management of the firm is believed to be acting on behalf of others, either shareholders or stakeholders more generally. They do so, not because they are the kind of people who behave altruistically but because they are rewarded appropriately and much effort is therefore devoted to the creation of reward schemes which motivate these managers to achieve the desired ends.

From agency theory to corporate governance

The problem of managers’ power to decide being exclusively harnessed for the benefit of others was remarked upon by Adam Smith (1776), the alleged father of “free markets.” Smith (1776) noted this problem with management by remarking that it cannot be expected that the managers will watch other people‘s money and their own with the same anxiety. Therefore, negligence and profusion must always be, more or less, present in the management of a company. Almost 150 years later, when the business corporation had become dominant in the economic world, Berle and Means (1932) emphasised this problem of the separation of firm owners (the principals) and firm managers (the agents). They point out some of the key problems inherent in the separation of ownership and control.

An implication of Berle and Means study is that market forces could not be solely relied upon to countervail management power, suggesting that large corporations need more regulation by government of their affairs. A contrary argument to this conclusion about corporate governance was provided by Jensen and Meckling’s (1976, 1994) study. It is the classic work on the application of agency theory in finance, and developed the concerns and ideas about owner-management separation into explicit, economic models on the behaviour of the agents. The principal-agent model provided a rational, economic decision theoretic solution to the conflict between managers and shareholders’ interests. Jensen and Meckling provide important insights into the impact of agency relations within the firm and describe the nature of the agency relationship between the principal, owners of the firm, and the agents, managers of the firm. As both of the parties are rational economic actors, concerned only with maximising their own utilities, agency problems of equity will arise. Eisenhardt (1989, p. 58) states that “the origins of agency theory is directed at the ubiquitous agency relationship, in which one party (the principal) delegates work to another (the agent), who performs that work.” However, this is done at the risk to the principals that the agents will not see their interests as consonant with those of the principals. Thus, the problem of corporate governance reduces itself to devising mechanisms to reduce the costs of agency, e.g., shirking, misdirection of resources, excessive risk aversion. Further, the theory claims that these mechanisms will emerge through the actions of economically rational principals and agents – mutual economic rationality leads to solutions to the agency problem. Persistent exploitation of principals by their agents would mean there is persistent economic irrationality, which agency theory assumes away. Thus, as a theory of corporate governance it could be accused of being tautologous. The classical papers by Fama (1980) Jensen and Meckling (1976), Ross (1973), Spence and Zeckhauser (1971), are examples of this economic formulation of the agency within the economics and finance disciplines.

Agency theory has profound implications about how to govern a modern corporation with a large number of shareholders whose collective capital is controlled and directed by separate shareholders. Miozzo and Dewick (2002) state that corporate governance is an important device as a means of reducing agency costs imposed by managers who are acting in their own interest. Jensen and Meckling (1976) model of agency costs and ownership structure holds a central role in the corporate governance literature. As the main problem is the conflict between the principal and the agent, the focus of this theory is on determining the proxies of agency costs and the most efficient mechanisms governing the principal-agent relationship. Some of the primary benefits of good governance are long-run viability, more efficient resource allocation, more or higher credibility, new market enhancement and the awareness of the needs of all stakeholders (Aras and Crowther 2008a). According to agency theory, corporate governance mechanisms serve to bring agents’ behaviours into alignment with their principals’ interests. The mechanisms of corporate governance define structures and rules forming the system and they will have significant effects on solving the agency conflict. A broa...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of figures
• List of tables
• About the authors
• Series editor’s preface
• Introduction: doing well by being good for sustainable business
• Part I Market behavior, stakeholders’ approach and good governance
• Part II Effective business behavior for corporate sustainability
• Part III Monitoring and reporting on sustainability
• Part IV The requirements for implementation of sustainability
• Conclusion
• Index