Corporate Governance Concepts and Theories
Why theory matters
Governance theories are competing assumptions about human motivation and the purpose of the firm, and questions frequently ask which theory best explains a given arrangement. Be able to match theory to prescription.
Agency theory starts from the separation of ownership and control and assumes self-interested managers and information asymmetry. It generates agency costs - monitoring, bonding and residual loss - and justifies independent boards, remuneration linked to performance, disclosure and audit. Moral hazard (shirking once monitored) and adverse selection (misrepresenting ability) are its diagnostics. Stewardship theory assumes managers are intrinsically motivated to serve the organisation, so empowering structures such as CEO–chair duality are not automatically bad. Stakeholder theory (Freeman) holds the firm accountable to all who affect or are affected by it; it is primarily normative, though an instrumental version argues stakeholder management improves performance. Shareholder primacy (Friedman) limits the firm to maximising returns within legal and ethical bounds. Resource dependency theory sees the board as a provider of expertise, capital and legitimacy; managerial hegemony sees boards as rubber stamps; transaction cost economics (Williamson) designs governance to minimise contracting costs; legitimacy and political theories explain disclosure as a response to social and regulatory pressure.
Traps
Stewardship is not the mirror image of agency - it changes the assumption, not the structure's morality. Stakeholder and shareholder theories are often conflated, as are legitimacy theory (social licence) and stakeholder theory (accountability to identifiable groups). Expect distractors claiming agency theory requires an executive-dominated board.
Worked example
A board proposes a large equity-based bonus for the CEO. Agency theory predicts alignment of interests but also incentives for earnings management (self-interest, information asymmetry). A stewardship analysis warns that extrinsic pay may crowd out intrinsic motivation. The best answer names both and proposes safeguards - vesting periods, clawbacks, independent remuneration committee.
Rule of thumb: state the assumption about human nature before recommending a structure.