Nidup Dorji (03210194)

Pema Tenzin (03210221)

Pema Wangmo Dorji (03210225)

6th Act B
Introduction
Corporate Governance is defined as the way in which suppliers of finance to corporations
assures themselves of getting a return on their investment (Shleifer & Vishny, 1997). It
describes the processes, policies, and laws that directs the organizations operations by
supervising and controlling. Good corporate governance is the basis for decision making and
control processes, transparency and responsibility in all entrepreneurial decisions and
appropriate risk management system (Bezo & Dibra, 2020; Singh, 2021).

According to Gunay (2008) , agency theory was the first theory to make fundamental
contributions to the corporate governance and, on the other hand to supplement to this theory,
there is alternative theoretical framework known as Stakeholder Theory (Singh, 2021). So, the
main focus of this analysis will be on the two theories: Agency Theory and Stakeholder Theory,
which will give deeper insights on their strengths, criticisms, and their impacts on
organizational behavior and decision making.

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 1. Agency Theory

1.1. Overview:
Agency theory gives insights on the relationship between a principal (such as shareholders)
and an agent (such as managers or executives) within an organisation (Jensen & Meckling,
1976; Ross, 1973). The theory focuses on the potential conflicts of interest that can arise when
agents act on the behalf of principals but may prioritise their own interests over those of the
principals (Eisenhardt, 1989; Jensen & Meckling, 1976).

For instance, in the large corporations, principals entrust their investments to agents who are
responsible for making decisions that impact the organisation's performance and profitability.
However, managers may be tempted to engage in actions that benefit themselves, such as
excessive compensation packages or pursuing risky ventures for personal gain, rather than
maximising shareholder value (Jensen & Meckling, 1976)

The agency problem focuses on the importance of establishing effective monitoring and
incentive mechanisms to align the interests of agents and the principals. This can include
measures such as performance-based compensation, board oversight, and transparent
reporting (Eisenhardt, 1989).

1.2. Assumptions:

1.2.1 Information Asymmetry Exists between Principals and Agents.

In case of Enron, the company’s agent engaged in complex accounting fraud that concealed
the company’s true financial condition from principals. This information asymmetry allowed
Enron’s executives to misrepresent the company’s performance and concealed significant
liabilities (Healy & Palepu, 2003)

Example; Enron used special purpose entities (SPEs) to hide debt and increase profits,
keeping secret from shareholders and investors about the company’s actual financial condition
(Boswell, 2012).

1.2.2 Agents may Engage in Opportunistic Behavior

Due to the self-interest, Enron’s executives engaged in opportunistic behavior by manipulating

financial statements and engaging in fraudulent activities to secure personal benefits (Kulik,
2005)

Example; Enron’s Chief Financial Officer, Andrew Fastow, exploited the SPEs for personal
gain, receiving millions of dollars in undisclosed compensation (Boswell, 2012).

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 1.3. Implications:

1.3.1 Principal-Agent Contracts:

Enron's executive compensation structure, which relied on stock options and performance-
based bonuses, created misaligned incentives that encouraged executives to engage in
fraudulent activities to inflate the company's stock price and reported earnings (Healy &
Palepu, 2003)

Example: Enron's executives received substantial stock options and bonuses based on the
company's raised financial status, motivating them to perpetuate the fraud (Kulik, 2005)

1.3.2 Monitoring Mechanisms

The failure of Enron's Boards, auditors, and regulatory bodies to effectively oversee the
company's operation and financial reporting practices contributed to the agency problem
(Healy & Palepu, 2003).

Example: Enron's Boards lacked independence and was influenced by the company's
management, failing to provide adequate oversight and challenge the executives' decisions
(Bratton, 2002)

1.4. Strengths:

1.4.1 Clarity of Roles

The agency theory clearly defines the roles of shareholders (principals) and management
(agents) in a corporation like Enron. However, the failure to uphold these roles and
responsibilities contributed to the Enron scandal (Kulik, 2005)

1.4.2 Efficiency

The agency theory aims to enhance decision-making efficiency by aligning the interests of
management with those of shareholders. In the case of Enron, the misalignment of incentives
and lack of effective monitoring led to inefficient and fraudulent decision-making (Healy &
Palepu, 2003).

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 1.5. Weaknesses:

1.5.1 Simplifying Assumptions

The agency theory assumes rational behavior and perfect information, which did not hold true
in the Enron case. Enron's executives engaged in irrational and opportunistic behavior,
exploiting information asymmetries for personal gain (Boswell, 2012).

1.5.2 Costs

The agency theory acknowledges the costs associated with monitoring and enforcement
mechanisms. In the Enron scandal, the costs of effective monitoring and oversight were
underestimated, leading to significant agency costs and eventual bankruptcy (Healy & Palepu,
2003).

2. Stakeholder Theory

2.1. Overview
Stakeholder theory recognizes that organizations have responsibilities beyond maximizing
shareholder value. It suggests that companies must take into account the interests of all
stakeholders (Donaldson & Preston, 1995). This approach aims to achieve long-term
sustainability and create shared value for all stakeholders.

For example: Patagonia, a clothing company, has made environmental activism a core part of
its business model, donating 1% of its sales environmental organizations (Schatz & Pfoertsch,
2023).

This theory aligns with the principles and practices of the TATA Group, one of India's largest
conglomerates.

2.2. Assumptions:

2.2.1 Stakeholders' Interests Matter Beyond Shareholders

As stated in the Tata Code of Conduct, "A stakeholder is anyone who has an interest in the
company's business – be it employees, customers, shareholders, vendors, government or
society at large" (TATA, 2015). The TATA Group has long recognized the importance of
stakeholders beyond just shareholders. The company recognizes and considers the interests
of various stakeholders, not just shareholders, in its decision-making processes and business
operations.

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2.2.2 Ethical and Social Responsibilities are Integral

The TATA Group has a strong commitment to ethical and social responsibilities. The founder,
Jamsetji Tata, believed in the concept of "social welfare through economic activities". This
belief implies that businesses should not solely focus on profit maximization but should also
contribute to the betterment of society through their economic activities. This belief is deeply
ingrained in the TATA Group's values and practices.

2.3. Strengths:

2.3.1 Long-term Value Creation:

This theory promotes long-term value creation for all stakeholders, rather than solely focusing
on short-term profits. Ratan Tata's strategic vision and decision-making prioritized long-term
growth and sustainability. As stated by Khanna and Palepu (2006), "The Tata Group has a
well-deserved reputation for its long-term perspective" .

2.3.2 Employee Welfare:

The theory recognizes the importance of employees as key stakeholders. Tata Group, under
Ratan Tata's leadership, prioritized employee welfare and development. As stated by Khanna
and Palepu (2006), the Tata Group has a well-deserved reputation for treating its employees
well.

2.4. Weaknesses:

2.4.1 Lack of Clear Prioritization Framework:

Stakeholder theory does not provide a clear framework for prioritizing stakeholder interests,
which can lead to ambiguity and inconsistency in decision-making. This was evident in some
of the controversies faced by the Tata Group, such as the Singur issue, where the company's
approach was criticized for not adequately considering the interests of local communities
(Alfaro et al., 2009).

2.4.2 Limited Applicability in Highly Competitive Environments:

This theory focus on balancing stakeholder interests may be challenging in highly competitive
environments, where prioritizing shareholder value is often seen as crucial for survival. The
Tata Group faced criticism for its acquisition strategy, with some arguing that it prioritized
stakeholder interests over shareholder value (Khanna & Palepu, 2006).

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 2.5. Implications:

2.5.1 Decision-making Considers Multiple Perspectives

The TATA Group's decision-making process considers the perspectives of various

stakeholders. In an interview, Ratan Tata, the former chairman, stated, "We take into account
the interests of all stakeholders " (Thite, 2013).

2.5.2 Stakeholder Engagement Fosters Trust and Cooperation

The TATA Group actively engages with stakeholders to foster trust and cooperation. For
example, the Tata Consultancy Services (TCS), a subsidiary of the TATA Group, has
established a Stakeholder Engagement Committee to ensure effective communication and
collaboration with stakeholders (TCS, 2021).

2.6. Conflict or Complement:

In real world practice, depending on the organisational needs, the theories (agency theory and
stakeholder theory) can both conflict and complement.

The reasons are as follows:

2.6.1 Complements:

• According to Hoskisson et al. (1999), companies tend to adopt a balanced approach,

that is by taking into consideration both shareholders interest (agency theory) and
stakeholders interest ( stakeholder theory).
• The integration of factor such as ESG (Environment, Social, and Governance) in
decision making tend to help address both stakeholder problems and agency
concerns, thus making a complementary approach (Eccles et al., 2012).

2.6.2 Conflicts:

• The short-term goal of agency theory to maximize shareholders value may have
implications on the long-term goals of sustainability of stakeholder theory.
• During the time of financial downturn of a company, they may prioritize shareholders
interest over the stakeholders which results as the conflicts of these two theories.

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 2.7. Recommendations:

2.7.1 Integrated Approach:

The organization can adopt an integrated approach that combines elements of both agency
theory and stakeholder theory. While agency theory focuses on aligning the interests of
managers and shareholders (Eisenhardt, 1989; Jensen & Meckling, 1976), stakeholder theory
recognizes the importance of considering the interests of various stakeholders (Donaldson &
Preston, 1995). An integrated approach can help organizations strike a balance between
maximizing shareholder value and addressing the needs of other stakeholders, fostering long-
term sustainability and value creation (Parmar et al., 2010).

2.7.2 Transparent Communication:

Promote transparent communication and stakeholder engagement. Regularly disclose

relevant information to shareholders, employees, and other stakeholders, and establish
channels for open dialogue and feedback (Crane & Matten, 2007). This transparency can help
build trust, maintain accountability, and ensure that stakeholder concerns are addressed in
decision-making processes (Hörisch et al., 2014).

2.7.3 Ethical Leadership:

Cultivate ethical leadership that prioritizes long-term sustainability over short-term gains.
Leaders should set the tone by exemplifying ethical conduct, promoting corporate social
responsibility, and considering the broader societal and environmental impacts of business
decisions (Christensen et al., 2014). Ethical leadership can help align the organization's
practices with stakeholder interests and foster a culture of integrity and responsibility.

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