THE THEORIES BEHIND CORPORATE

GOVERNANCE
This essay is derived from research performed by Dr John Roberts of the Judge Business School and the author for the
Performance and Reward Centre (PARC, www.parcentre.com.)
There has been much written about corporate governance. Report after report have been incorporated into the
compendious Combined Code on Corporate Governance - making UK companies some of the most comprehensively
'governed' in the world. Yet many questions still remain. For example, has the governance industry and its works actually
improved the performance of British companies?1 Some think not, quoting research that seems to indicate that, despite the
Enrons, Worldcoms and other scandals, it is strategic incompetence that destroys the vast bulk of shareholders' wealth 2. As
far as we know, Northern Rock was acting within governance rules - or so the regulators seemed to think.
So, what drives the passion for 'good' governance? The answer lies in a theory about corporate behaviour and behind that
a set of beliefs about human behaviour. The prevailing theory is called Agency Theory - it is the dominant philosophical
base behind the relationships between the financial markets and quoted companies.
Here is what the current governance movement is really all about.

Defining the Elements of a High Performing Board

In order to identify the components of a high performing board, and such a board's role in creating a high performance
business it is first necessary to be clear both as to the role of the board and the nature of high performance. Here our
research pointed to very different interpretations in different company boards as to the meaning of both governance and
performance. Crudely, the companies in our research can be placed along a continuum between those that followed either
a narrow or board view of both governance and performance. The narrow view, which often seemed to arise more by
default than design, was externally driven. Here the board's work was driven by shareholder demands for both good
financial performance and conformance with governance codes. In what follows we will argue that such investor
driven performance, whilst appearing responsive to shareholder demands, in practice involves an under-development of
the role of the board that has the potential to weaken or undermine long term performance. By contrast those following a
broader view of governance and performance saw the board's primary role in terms of the setting of long-term objectives
of the company and the monitoring of executive performance through a wide range of metrics in relation to these. Central
to the success of such a board was its involvement with the setting and achievement of the long-term strategy of the
business. Such strategy led performance, with its focus on the long term drivers of business success, requires a much
fuller development of board roles and relationships, and a much stronger set of links between the board and the business,
but in our view has much greater potential to deliver sustainable long-term value to shareholders.
1. The role of the board in creating a high performance organisation, John Roberts and Don Young, PARC 2006
2. Click on the link below to access Booz Allen research on the causes of poor performance:
http://www.strategy-business.com/resiliencereport/resilience/rr00014?pg=all

Rival theories of governance

To explore the origins of these contrasting conceptualisations of the board's role we want to begin with a review of some of
the key ideas that have shaped contemporary thinking about the role of the board, and explore how these ideas have
influenced the development of UK board practices.
In his recent review of the role of the non-executive director Derek Higgs observed that the work of boards is largely
invisible and hence poorly understood. Directors' understanding is heavily conditioned by their experiences of working on
particular boards, whilst investors must rely from a distance on received prejudice as to what constitutes a good board.
Our research suggests that both board and company performance often suffer from a lack of clear thinking about the
board's proper role. By way of an introduction we want to look briefly at four sets of ideas that have each played an
important part in shaping the UK governance system; agency theory, resource dependence and stewardship theories, and
stakeholder theory.
It is commonly the case, in our view, that individuals involved in corporate governance apply what they believe is common
sense, when in reality they draw sub-consciously on long-established economic theory and assumptions that are
challengeable. Probably the most influential one in this context is Agency Theory, which is the one that we first turn to, and
which has helped to shape recent codes of practice in governance.

Agency Theory

The debate about corporate governance is typically traced way back to the early 1930s and the publication of Berle and
Means' "The Modern Corporation and Private Property". Adolf Berle and Gardiner Means noted that with the separation of
ownership and control, and the wide dispersion of ownership, there was effectively no check upon the executive autonomy
of corporate managers. In the 1970s these ideas were further refined in what has come to be known as Agency Theory. In
a series of now classic articles writers such as Jenesen and Meckling, Fama, and Alchian and Demsetz offered a variety of
explanations of the dilemmas faced by the 'principal' who employs an 'agent' to act on his or her behalf. As applied to
corporate governance the theory suggests a fundamental problem for absent or distant owners/shareholders who employ
professional executives to act on their behalf. In line with neo-classical economics, the root assumption informing this
theory is that the agent is likely to be self-interested and opportunistic. (The assumption of owner/shareholder property
rights obviates any need to think about the principal's motives.) This raises the prospect that the executive, as agent, will
serve their own interests rather than those of the owner principal. To counter such problems the principal will have to incur
'agency costs'; costs that arise from the necessity of creating incentives that align the interests of the executive with those
of the shareholder, and costs incurred by the necessity of monitoring executive conduct to prevent the abuse of owner
interests.
It is important to note that agency theory is deductive in its methodology. Its assumptions have been the subject of
extensive empirical research but this has typically relied on the testing of various propositions in relation to large data sets.
Agency theorists take self-interested opportunism as a given. They feel no need to explore, as we have done in this
research, the attitudes, conduct and relationships that actually create board effectiveness. Instead they have busied
themselves with exploring the effectiveness of the various mechanisms designed to make executive self-interest serve
shareholder interests. To date such studies have proved entirely equivocal in terms of the relationship between good
governance and firm performance. Agency theory assumptions have nevertheless been highly influential is shaping the
reform of corporate governance systems. Here it is essential to distinguish between external, market-based governance
mechanisms and board-based mechanisms.
In relation to market governance then clearly the openness and integrity of financial disclosures is vital to the operation of
the stock market in determining a company's share-price and its underlying market valuation. Market governance relies for
its effectiveness on the remote visibility such financial information creates, and, as importantly, on the effects on the
executive mind of the knowledge of such visibility. Agency theorists point to the important disciplinary effects of two
further market mechanisms. The first is the 'market for corporate control', the potential for takeovers to discipline
executives by providing a mechanism whereby ineffective executive teams can be displaced by more effective executive
teams. The second - 'the managerial labour market' - operates at an individual level; poor executive performance will
threaten an individual's future employment potential whilst good performance will have positive reputational and hence
career-enhancing effects.
To these external 'market' mechanisms must be added the disciplinary effects on company and executive performance of
external monitoring, both direct and indirect. Formally, it is the Annual General Meeting provides an opportunity for
directors to report face-to-face to their shareholders. In practice, however, the formal accountability of the AGM has been
augmented and diverted by a variety of other mechanisms. At the time of results announcements, companies will typically
conduct presentations for sell-side analysts who then serve as key intermediaries between companies and their investors.
These general briefings are then supplemented by a large number of (typically annual) private face-to-face meetings
between executives and their key investors.
In addition to these external market and monitoring mechanisms, agency theory has also informed the internal reform of
boards of directors. One of its most significant direct contributions came in the form of the widespread adoption of
executive share-option schemes, which have only very recently fallen into disrepute in the UK. Such schemes follow
directly from the agency assumption that the exercise of executive self-interest must be aligned with the interests of
shareholders. Less directly, the influence of agency theory assumptions can be seen in the seminal reforms promoted by
the Cadbury Committee 'Code of Best Practice', and its subsequent elaboration by Greenbury, Hampel, Turnbull and most
recently Derek Higgs. With the possible exception of Turnbull, the work of these different committees was occasioned by
visible corporate failures or perceived executive abuses of power, and has resulted in a progressive elaboration of the
'control' role of the board. The 'independence' of the non-executives directors who must now constitute 50 per cent of the
board, their lead role on audit, nominations and remuneration committees where conflicts of interest between executive
and shareholder are potentially most acute, along with progressively more stringent provisions around the separation of
the roles of chairman and chief executive, are all consonant with agency theory's assumption that the interests of the
owner/ shareholder are potentially at risk from executive self-interest, in the absence of close monitoring by independent
non-executives.

Resource Dependence and Stewardship Theory

Resource dependence ideas were originally developed by Pfeffer and Salancik (1978) in the late 1970s. Unlike agency
theory, their original ideas were inductively derived from empirical studies. Their key contribution is the observation that
the board, and in particular the constitution of the non-executive element of a board, can provide the firm with a vital set
of resources: 'When an organization appoints an individual to a board, it expects the individual will come to support the
organization, will concern himself with its problems, will variably present it to others, and will try to aid it' (1978:173).
Seeing the board as a source of resources for a company opens up a very different way to think about the board's role in

creating high performance. Resources can take a variety of forms each of which can be argued to add to the 'capital' of a
company (Hilman and Dalziel 2003).
Non-executive directors can be a source of expertise which executives can draw upon, both in the form of specific skills as
well as advice and counsel in relation to strategy and its implementation. They can also serve as an important source of
contacts, information and relationships that allow executives to better manage some of the uncertainties in the
environment. These relational resources can be both practical and symbolic; the association of particular individuals with a
company has the potential to enhance the reputation or perceived legitimacy of an executive team.
Resource dependence theory allows us to think of the very different needs that companies have at different stages of their
life-cycle. The young entrepreneurial firm, even if owner managed, can look to its non-executive directors as a source of
skills and expertise that it cannot afford to employ full time. Here, the non-executive is a relatively cheap source of parttime legal, financial or operational management skills that are not otherwise available to the entrepreneur. Once a firm is
publicly listed, then the provision of expertise will have to be blended with what one of our participants called 'grown-up
governance'. Here the value of the non-executive lies not only in their expertise but also through their networks that give
the company ready access to new markets or to sources of finance, as well as in the reputation benefits that arise from an
individual's association with the company.
More mature businesses might draw upon the non-executive as a source of relevant market or managerial experience, and
board composition would hence be managed primarily in terms of the relevance for the company of the non-executive's
past experience rather than in terms of formal independence. But even in a more mature business, the non-executive
directors who are needed to manage radical processes of organisational change might be very different from those needed
to support the roll-out of a successful business model. The non executive might be vital as a source of expertise in relation
not only to the delivery of financial performance but also in the management of other key sources of business risk; for
example in relation to regulation or government policy, or consumer confidence or their knowledge of campaign or
pressure groups. In sum, whereas the agency view of the non-executive emphasises their local policing role on behalf of
investors, resource dependence theory sees the non-executive primarily as a context specific resource to support the
performance of both the executives and the company.
Stewardship theory (Donaldson, Kay) makes a related set of observations about the motives of senior executives.
Contrary to agency theory's pessimistic assumptions about the self-interested and self-serving motives of executives,
stewardship theory suggests the potential for what it calls the 'pro-organizational' motives of directors. What drives
performance here is not the aligned greed of an executive but their personal identification with the aims and purposes of
the organisation. Stewardship theory refutes the assumption that executive aims and motives are opposed to those of the
shareholder; both, it insists, have an interest in maximising the long-term stewardship of a company and are therefore
already well aligned. From this stewardship theory suggests the potentially negative impact of a division of responsibilities
between a chairman and chief executive. The roles, it suggests, should remain combined in order to protect a key aspect of
high performance; the strength and authority of executive leadership. Arguably the key contribution of stewardship theory
lies in its questioning of agency theory's pessimistic assumptions about human nature. Like Douglas MacGregor's contrast
between theory X and theory Y managers, it suggests that the problem of governance may lie not in the self-interest of the
executive but rather in the assumptions that distant others - notably investors and regulators - make as to their selfinterested motives. The danger it highlights is that negative investor assumptions may inadvertently distort or weaken the
leadership of a company.

Stakeholder Theory
The final set of influential ideas about governance and performance that we want to introduce here is stakeholder theory.
These ideas were originally developed by Ed Freeman in the 1980s, but have achieved a wider currency in the UK, in part
through initiatives such as the RSA's 'Tomorrow's Company' project. Stakeholder theory challenges agency assumptions
about the primacy of shareholder interests. Instead it argues that a company should be managed in the interests of all its
stakeholders. These interests include not only those of the shareholder but also a range of other direct and indirect
interests. The employee is obviously a key stakeholder and there have been long-running arguments amongst governance
academics such as Margaret Blair that employees just as much as shareholders are 'residual risk-takers' in a firm. An
employee's investment in firm-specific skills means that they too should have a voice in the governance of the firm. But
stakeholder theory would also insist that other groups - suppliers and customers - have strong direct interests in company
performance while local communities, the environment as well as society at large have legitimate indirect interests.
The argument that is repeatedly raised against a stakeholder view of the firm is that it is hard to operationalise because of
the difficulties of deciding what weight should be given to different stakeholder interests. In terms of corporate governance
it is argued that, were executives to be made accountable to all of a company's stakeholders they would, in effect, be
answerable to none. Enlightened stakeholder theory therefore suggests the practical value of accountability to shareholders
even if a board takes other interests into account in its conduct of a firm.
In relation to company performance, however, stakeholder theory has made a number of key contributions. The recent
profusion of interest in business ethics can be traced to stakeholder ideas. Excessive levels of executive pay and the way
that these have often gone hand in hand with company downsizing and all its negative impacts on employees and local

communities undermine the legitimacy of the demand for 'shareholder value'. Corporate failures and associated pension
fund collapses threaten both the basis of the traditional psychological contract as well as the 'licence to operate' that
underpins the privileges afforded by society to corporate entities. Globalisation has also brought with it the rise of the
single-issue pressure group and a heightened visibility to corporate practices - the use of child labour, environmental
damage, corruption - that might formerly have remained hidden from sight. The importance that is now given to corporate
value statements, as well as the board's role in creating corporate ethics codes, and social and environmental reporting all
reflect an acknowledgement of a wider set of corporate obligations beyond the delivery of shareholder value, or at least
insist that such performance must be realised within certain ethical constraints.
While ethical codes have the potential to constrain how performance is pursued, arguably the most direct contribution of
stakeholder ideas to company performance is to be found in Kaplan and Norton's (1992) ideas about the Balanced
Scorecard and the revolution in performance measurement that this has encouraged. Kaplan and Norton acknowledge the
power of measurement on performance, as well as the potential distortions on operational effectiveness that can arise from
purely financial accounting measures like earnings per share or return on investment.
The Balanced Scorecard embodies key stakeholder interests in a firm-specific set of measures that link important
operational drivers to financial performance. It therefore provides managers with a way to explore the inter-dependencies
between customers' needs, and what the company must do operationally to meet these needs and sustain competitive
success. It has both an immediate performance focus as well as pointing to key areas for continuous improvement and
innovation. Kaplan and Norton suggest that the orientation of traditional performance systems is the 'control' of individual
behaviour through measurement. By contrast the focus of the Balanced Scorecard, they suggest, is 'strategy and vision',
that establishes goals but then promotes initiative and learning - both individual, team, and across-functions - in pursuit of
such goals. From this perspective the key role of senior executives and the board lies in the setting of company strategy
and vision. High performance depends on the board's understanding of the key business and competitive drivers, its
capacities for strategic thought, as well as its communication and leadership skills in relation to both staff, customers and
financial markets.

THE HEART OF THE MATTER

1. Agency Theory rules

It is quite clear that, for quoted companies, Agency Theory is still firmly in the driving seat, backed by the media,
governments, financial markets and a comprehensive governance industry. The PARC research revealed that most
executive directors of large quoted companies strongly felt that governance 'political correctness' had gone too far and was
severely damaging the capacity of boards to exercise strategic leadership, using the wisdom of non-executive directors,
because of the schisms caused by the policing role of non-executives. They quoted growing animus between executive and
non-executive directors. Several chief executives said that they regarded the role of the chairman as being to keep
legalistically nervous non-executives 'off their backs'.
This legalistic, box-ticking governance does not bug family companies, private equity backed companies, smaller nonquoted companies, partnerships and the like. This is probably why many of them perform better than quoted companies. 3

2. Agency theory is based on increasingly dysfunctional

notions of what constitutes 'ownership'
Governance and the purposes of business
Charles Handy, in his excellent article, What's a Business For? in the 'Harvard Business Review of December 2002, wrote:
Capitalist fundamentalism may have lost its sheen (following corporate and financial scandals), but the urgent need now is
to retain the energy produced by the old model while remedying its flaws.
Corporate governance will now surely be taken more seriously by all concerned, and watchdogs appointed. But these will
be plasters on an open sore. They will not cure the disease that lies at the core of the business culture.
We cannot escape the fundamental question, what is a business for? The answer once seemed clear, but no longer. The
terms of business have changed. Ownership has been replaced by investment, and a company's assets are increasingly
found in its people, not its buildings and machinery.
In the light of this transformation, we need to rethink our assumptions about the purpose of business. And as we do so, we
need to ask whether there are things that (UK and American) business can learn from Europe, just as there have been
valuable lessons that the Europeans have learned from the dynamism of the Americans.

Both sides of the Atlantic would agree that there is, first, a clear and important need to meet the needs of a company's
theoretical owners: the shareholders. It would, however, be more accurate to call most of them investors, perhaps even
gamblers. They have none of the pride or responsibility of ownership and are, if the truth be told, only there for the money.
......to turn shareholders' needs into a purpose is to be guilty of a logical confusion, to mistake a necessary condition for a
sufficient one. We need to eat to live, food is a necessary condition for life. But if we lived mainly to eat, making food a
sufficient or sole purpose of life, we would become gross.
The purpose of a business, in other words, is not to make a profit, full stop. It is to make a profit so that the business can
do something more or better. That 'something' becomes the real justification for the business. Owners know this. Investors
needn't care.
Since Handy penned this article in 2002, matters have deteriorated further. He was writing just after the high-profile
scandals of Enron, Worldcom and Tyco in America, and the debacles of Marconi, Invensys and many others in Britain. One
interesting fact connecting all of these companies is that at some time in their recent histories, not long before the true
facts emerged, they were lauded by the investment markets as being ground-breaking or paradigm-shifting.
Since 2002, the nature of investment has dramatically changed, driven by the speculative tendencies of investment banks,
hedge funds and private equity investors. All of these investment vehicles are rapacious and short-term in their orientation.
The fact that some in the private equity industry claim that they take a longer term view when investing in assets for five
years just demonstrates what has happened to the investment industry. It takes much more than five years for the
development of a new technology-based system from invention to finished product and the innovative process that gives
us Airbus aircraft, Sony home electronics, Nokia telephones, BMW, Mercedes, Toyota and Honda cars is very long-term
indeed, as innovation is progressive, each step building on the experience gained in the previous one.
Companies are living organisms, animated by their histories and the learning, skill and commitment of the people who
work in them. This has been very well demonstrated by such as Arie de Geus in his 'Living Company' books 4. This profound
truth is completely ignored by most investors, who are more interested in numbers and physical or financial assets, which
of course are 'dead' in the longer term, hence the drive towards short-term gain and asset and value extraction as the
primary means of making money.
So the fact that huge amounts of money are sloshing around in the global investment markets looking for short-term hits
has drastically altered the nature of ownership. Investor/owners like Warren Buffett, who buy for the very long term after
careful study of their potential investments are completely different animals from the modern gamblers of the private
equity and hedge fund industries. In this regard, the latter should not be considered as owners at all and the rights
afforded under company law and governance codes should be stripped from them. Until this is done, we will continue to
witness underinvestment in technology and the dismembering of companies in the name of 'shareholder value'. If all of this
speculation and pressure led to markedly superior performance, there might be some justification for it, but it doesn't. This
is shown by a Bank of England comparison of company profitability for the years 2000/2001. In manufacturing sectors,
which include nearly all-technology and advanced knowledge companies, the UK comes 13 th after such countries as Korea,
Norway, Denmark, Holland, Finland, Belgium, Australia and the US. It is also clear from research that UK investment in
technology is far lower than that of most developed countries. In service sectors, supposed a major UK strength, UK
companies come 5th, after Finland, Norway, US and Spain. The UK is strong in banking, services and mineral resources, but
weak in the crucial sectors of science and technology. To compound the problems, investment in Research and
Development and capital equipment are low. A study by Nuffield College Oxford and the Institute for Fiscal Studies
concluded that the probable reasons for low UK company investment were a combination of low R&D, the reluctance of the
capital markets and low skills.5

Alternatives
Defenders of the current state of affairs will object violently to radical changes in governance arrangements, but radical
change is badly needed. Why?

Because of the changes already mentioned in the very nature of investment - from thoughtful selection of
companies to support into short-term betting and speculation on share prices and even more dysfunctional
gambling on investment vehicles that have nothing to do with corporate health or performance.

Because the nature of business is changing from very capital and plant-intensive enterprises, where people were
an adjunct to machines to knowledge-intensive, highly people-dependent, less physical asset-based forms of
organisation. Even in capital-intensive industries, the level of knowledge intensity has increased massively. The
investment banking industries find it increasingly difficult to understand or value people-dependent industries,
because they are firmly stuck in a 19th century time-warp.

Because the investment markets have become destructive of well-founded, future-oriented companies, especially
those in vital science and technology industries.

Because there are already vastly superior models of governance, in place and el-tried, in the UK and
elsewhere......

A quick scan of the largely hidden world of business away from the limelight of the failing quoted company sector will
reveal many different and successful examples:

The John Lewis Partnership, arguably Britain's most sustainably successful retailer, certainly the best rated by its
customers, is an employee partnership, with arrangements for employee involvement that obviously create great
commitment. As an ex-chairman observed, "Our shareholders meet our customers every day". Readers can visit
their website to learn about their governance arrangements.

The Co-operative Group is a non-quoted company, based on customer involvement and local devolution of most
operations, but central direction of strategy. The Co-op is a leader in retailing, ethical banking and investment,
insurance, travel, funeral undertaking and farming.

Many family companies have formal 'constitutions' that spell out the duties of the owners towards employees,
customers and the community, as well as the family owners.

Organisations such as Housing Associations, which have a massive involvement in building, development and
community regeneration, have governance arrangements which formally involve customers and communities.

A visit to the Nordic countries, the Netherlands and Germany will reveal vastly different and very successful
governance philosophies.

So the argument that there is no alternative to Britain's 19th century governance arrangements is simply based on
ignorance, special interest pleading or a blinkered resistance to healthy change. The time has come to revise our legal
structures and governance arrangements to be compatible with the modern world.

The final word

The degradation of the investment markets into speculative casinos has, in our view, robbed them of any rights to be
regarded as owners of companies. Until this is recognised and enshrined in more modern and balanced legal arrangements
that accept the truth that people that create value in a knowledge economy and should have equal rights alongside
financial investors, or 'rentiers' as John Maynard Keynes called them, we will continue to see value leach from the
economy.
Let us leave the final words with Lord Eustace Percy, erstwhile minister of education. In 1944, with remarkable prescience,
he said,
"Here is the most urgent challenge to political invention ever offered to statesman or jurist. The human association which
in fact produces and distributes wealth, the association of workmen, managers, technicians, and directors, is not an
association recognised by law.
The association which the law does recognise - the association of shareholders, creditors and directors - is incapable of
production or distribution and is not expected by the law to perform these functions.
We have to give law to the real association and to withdraw meaningless privileges from the imaginary one".