Sanjay Paul
Green Bay Press-Gazette
Aug. 18, 2002
Another day, another accounting scandal.
Sylvia was reminded of Professor Homer’s microeconomics class dealing with the principal-agent problem facing a corporation’s shareholders.
“The shareholders, or the owners, of a corporation are the principal,” said Homer. “They hire the agent — the managers — to run the corporations. But this leads to an immediate problem.”
The problem, as Sylvia learned, is that the shareholders and the managers may have vastly different goals.
“It is clear,” said Homer, “that the former are interested in earning the greatest possible income from their company’s stock. That, in turn, would require the company to earn maximum profits: Greater the profit, larger the dividends and thus, higher the price of a share.
So the owners’ objectives are clear. But what about the managers — the chief executive officer, the chief financial officer and others?”
Perhaps, Sylvia pondered, they wished to expend the least possible effort? After all, what a CEO might wish to do (after he had secured a handsome compensation package for himself) was to play golf every afternoon. And why not? Work for a few hours in the morning, go for a power lunch with associates and then hit the links. Ah, the good life.
And who was to stop him from setting such a routine for himself?
Not the shareholders — they couldn’t monitor his daily schedule, they had their own lives to lead. Not his underlings — why, he would fire them, the impertinent rascals! Yes, it was good to be CEO.
Investors not stupid
But investors were no dummies. They realized that their objective (of stock-price maximization) might differ from those of the people they hired to advance their goals. This is where, noted Sylvia, the board of directors comes in.
The company’s investors would appoint a Board to oversee the activities of the management. If the CEO and his officers failed to run the company effectively, if they neglected to take opportunities in their industry to increase profits, if they paid themselves excessive salaries, if they engaged in duplicitous behavior, the Board would hold them accountable and, in the most egregious instances, even sack the whole lot.
Yet another means of minimizing the principal-agent problem, noted Sylvia, was the award of stock options. In order to align the interests of the shareholders and managers, the Board tied the latter’s compensation to their performance. If the stock price rose, the CEO’s compensation would rise correspondingly; if it fell, the CEO would feel the pain. Just like the typical shareholder, noted Sylvia.
But, as recent events have shown, these measures have failed dismally.
Tawdry tales of opportunism and avarice implicating CEOs emerge almost daily. The cases of Global Crossing, Enron and WorldCom have revealed the lengths to which executive officers, abetted by unprincipled accountants and craven stock analysts, are willing to go in order to acquire wealth.
Where’s the failure?
What went wrong? Why did the “principal” fail to rein in the “agent”?
First, noted Sylvia, the board of directors, whose job it was to protect the shareholders’ interests, lacked objectivity.
In several cases, the Board, largely hand-picked by the managers they were supposed to oversee, meekly acquiesced in the management’s decision-making. Unwilling to risk confrontation — partly for fear of losing their sinecure positions on the Board — the directors neglected to ask tough questions about compensation, audits and other matters.
The second problem, noted Sylvia, had to do with the stock options themselves. With their compensation linked in large measure to the stock price, managers now had an incentive to boost short-term profits.
As compliant accountants looked on approvingly, the CEOs and CFOs employed a variety of dubious techniques to augment profits in the short run — by “transferring” future revenues to the current period, for instance, or spreading out operating expenses over a longer period.
What sort of reforms might be helpful, wondered Sylvia?
With regard to the Board, noted Sylvia, making the directors truly independent was crucial. If directors were in cahoots with the CEO, they would be more likely to overlook improprieties in the management of the company.
As for stock options, they could still serve a useful purpose, provided managers were required to hold them for as long as they remained with the company. Such a requirement would link the CEO’s compensation to long-term performance, and dissuade the CEO from adopting improper practices to boost stock prices in the short run.
But, Sylvia realized, such measures — or indeed any other measure — would only serve to mitigate the principal-agent problem, not, as Homer had noted, completely eliminate it.
The CEO, like other mortals, is no less susceptible to avarice — and, given his authority at the helm of a company, will occasionally abuse the position to further enrich himself.