Corporate Governance Mechanisms

In this assignment I will be extensively analysing the effectiveness of Corporate Governance Mechanisms, paying particular attention to Executive Incentives. This assignment will be broken down into various subsections, each further enhancing our understanding. Due to its global interest, The concept of Corporate Governance only came about in the 20th Century, after the events which occurred in the Wall Street Crash of 1929. Corporate Governance has developed into a broad and complex subject to comprehend.

There have been many attempts to derive a definition which is spot on, which is why we have to understand that there is no single, accepted definition of Corporate Governance. Here are a few definitions which describe the role of Corporate Governance: "the process of supervision and control intended to ensure that the company's management acts in accordance with the interests of shareholders" (Parkinson, 1994) "the governance of an enterprise is the sum of those activities that make up the internal regulation of business in compliance with the obligations placed on the firm by legislation, ownership and control.

It incorporates the trusteeship of assets, their management and their deployment" (Cannon, 1994) The most correct definition in my view is that of Jill Solomon in her text titled ' Corporate Governance and Accountability' : " the system of checks and balances, both internal and external to companies, which ensures that companies discharge their accountability to all their stakeholders and act in a socially responsible way in all areas of their business activity" ( Solomon, 2007) Theory

There are several theories which give an explicit review of executive incentives as a means of governance. Tournament theory can be defined as: "the disparity in pay between organizational levels leads to higher levels of high performance" (Bloom and Michel, 2002) Tournament Theory was examined in depth by economists Edward Lazear and Sherwin Rosen (1981), where they argued that Tournaments were an integral part of a workplace. Where employees were being ranked according to their individual ordinal rank as opposed to their productivity.

This theory assumes that ' overpaying executives motivates others to work hard because they can rise to the same position' . Therefore those lower in hierarchy have an incentive to work. Although we know fundamentally that employees will become de-motivated due to rewards being decided unfairly. As a result there are no incentives in place for the executives to perform well. This then lead to the popularity rise of the Social Comparison Theory. It was initially formed by Leon Festinger to explain why individuals rely on others to evaluate their own attitudes and abilities. It was defined as:

"how people evaluate their own opinions and desires by comparing themselves with others, and how groups exert pressures on individuals to conform with group norms and goals. " (Festinger, 1950) This is a theory which is based on comparison made at the top level of a firm and with executives externally to the organisation. (Otten, 2008) With this theory it was argued that when executive pay is being set, they use others who are in a similar position to yourself as a source of comparison. Therefore it is seen preferable to compare with others who are seen to be in a better or higher position.

This is seen as the benchmark. Although from that we can conclude that, as result of this it will lead to overpayments for executive as a result leading to market inefficiencies, which this framework is trying to combat. The most dominant framework in Corporate Governance in recent years has been Agency theory. Although it also has its limitations as well as it benefits. Agency Theory is a branch of Corporate Accountability that looks at conflicts of interests between people, who have different interests but the same assets:

"Agency theory suggests that the firm can be viewed as a nexus of contracts (loosely defined) between resource holders. An agency relationship arises whenever one or more individuals, called principals, hire one or more other individuals, called agents, to perform some service and then delegate decision-making authority to the agents. " (www. enotes. com) The managers of a business are defined as 'agents' and the shareholders as the 'principal'. Therefore in a business the shareholders (Principal) delegate the managers (Agents) to handle decision making for the business.

This is where the problem arises (Agency Problem). The agents do not always make decision in the best interests of the principal. We make the assumption that the main aim for business, is shareholder wealth maximisation, although this is rarely the case. Agency theory suggests that managers look to maximise their own wealth at the expense of their shareholders. This is a fundamental problem in business, self-interested behaviour. Agency theory suggests that agents can operate in their own interests because of asymmetric information, where managers have better expertise in meeting shareholders' objectives.

Another possible stumbling block which is highlighted by Agency Theory, is that there are levels of uncertainty involved, as it may not be evident whether the agent directly caused the outcome. The main reason these conflicts arise is due to the company structure. A sole trader managed by the owner, will always acts in his/her best interest in order to maximise his/hers wealth. They will measure their trade off decisions. Whereas in large public businesses, managers have to prioritise. This is known as Agency Conflict.

For example managers may have the objective to maximise the size of the firm, which will create more opportunities for other employees, as a result enhancing their job security. One important principle agency theory mentions is agency costs. This is the costs borne by the shareholders when trying to encourage them to act in their best interests. If this was not used, there is a chance the shareholder wealth may be lost due to inappropriate managerial actions. Therefore there has to be an optimal level where agency costs increase with shareholder wealth.

There are a couple of mechanisms in place in order to deal with the shareholder-manager agency conflict. One mechanism that could be used is by direct intervention by shareholders, i. e. shareholders monitoring every managerial action. Although in the long run, it could be extremely costly and inefficient. Another mechanism commonly used by Shareholders is the threat of firing. This encourages managers to act in the shareholders interests, although as mentioned earlier it is difficult to determine whether or not agent caused the outcome, both positively and negatively.