Theories of Corporate Governance

In a firm, multiple stakeholders exist, ranging from Directors, Chairpersons to customers and employees. Corporate governance ensures that the firm is directed and controlled to bring proper management and efficiency. Corporate governance is concerned with laws, procedures, shareholder affairs, and rules that aid a firm's ability to make decisions that are beneficial to all stakeholders. Corporate bodies are guided by a governance mechanism or system that includes a board of directors, shareholders, employees, and other stakeholders. The term indicates the process of decision making as well as its implementation.

Since companies comprise multitudes of stakeholders, conflicts of interest between various groups are bound to happen, for example, between

shareholders and managers. In this regard, different corporate governance theories have emerged to avoid conflicts, find solutions and reduce problems among the stakeholders.

These theories we have captured here are not exhaustive as they keep evolving to achieve corporate goals. The fundamental theories concerning corporate governance are agency theory, stewardship theory, stakeholder theory, resource dependency theory, transaction cost theory and political theory. These theories address the cost and effect of variables such as the configuration of board members, audit committee, independent directors and the role of top management and their social relationships rather than its regulatory frameworks.

Agency Theory

This theory is primarily used to understand relationships between the owners of a company and its directors or agents and principals. The agents are expected to represent the best interests of the principal without regard for self-interest. This theory originated from the writings of Adam Smith, who supposed that the managers could not be expected to carry out the transactions as carefully as they would carry their own money. This problem is solved by giving sufficient incentives that can be used to redirect the agent's behaviour and realign the agent's interests with the principal's concerns.

Stewardship Theory

While Agency theory focuses on managers' opportunistic behaviours, stewardship theory assumes the opposite. This theory articulates that managers are hired for handling the firm's operations in a good manner and a manager's achievement and success are measured by the satisfaction he gets from the firm's performance; therefore, the manager's primary objective is to maximize the firm value. It supports management empowerment in the firms. This theory however falls short as it ignores the human mind's intrinsic nature, such as self-interest.

Stakeholder Theory

It was proved that both agency and stewardship theories have a narrow approach and focus only on the shareholders - and their interests. Stakeholder theory perhaps explains corporate accountability better than any other corporate governance theory. It incorporates philosophy, ethics, political theory, economics, law and organizational science. It suggests that managers in organizations have a network of relationships to serve, including suppliers, employees, and business partners. This theory holds relevance because it emphasizes the impact of corporate activities on the external environment and makes all the stakeholders accountable.

Resource Dependency Theory

This theory emphasizes the need for different resources for the success of the business. The previous theories have not given due importance to the accessibility of resources. This theory addresses these shortcomings and understands that resources are a crucial dimension of corporate governance. According to its proponents, a company's success depends on maximizing its power over specific resources that are essential for running smooth operations. These resources could be information, skills, access to raw materials, buyers, social groups and policymakers. One of the main features of Resource Dependency Theory is the independent board of directors who would assist in gaining resources.

Transaction Cost Theory

Transaction Cost Theory sees the firm as a place consisting of people with different motives and objectives. This theory assumes that corporate governance frameworks are based upon the net effect of business transactions (internal and external) rather than the traditional view of contractual relationships outside the firm with shareholders. According to it, the organization and structure of a firm can determine price and production. The unit of analysis in transaction cost theory is the transaction. It also considers that managers are opportunists and only work for their self-interest. It calls for corporate governance mechanisms to effectively monitor business activities and reduce opportunistic behaviours of firms' insiders.

Political Theory

This theory proposes the idea of having a political influence in corporate governance. It stresses developing voting support of the shareholders, rather than purchasing voting support to influence the company's management. It is concerned with the distribution of ownership between shareholders that affects the corporate governance structure's decision-making. Lately, it has been observed that Governmental agencies have substantial political influence on the firms thus bringing politics into the governance structure or firms' mechanism. This theory is also closely related to sociological issues such as culture or religion.

Apart from these above-mentioned fundamental theories, there are other theories that are closely associated with corporate governance as well. These include Business Ethics Theory, Virtue Ethics Theory, Feminist Ethics Theory, Discourse Ethics Theory, and Postmodern Ethics Theory. These theories speak about corporate governance as more of a social relationship than a process-oriented structure.

At the end of the day, a single corporate governance theory cannot fully explain the complexity and heterogeneity of corporate business. There are cultural, legal, religious and sociological aspects that need to be considered. Hence, a combination of various theories would work depending on individual firms’ countries' cultural and economic contexts.