Tuesday, December 16, 2008

Blog Shout Out: Separation of Owners and Executives

Phil Goldstein guest-blogged on The Icahn Report recently advocating more inclusivity in proxy vote ballots. While I agree with him, I'm not sure I see it as the end-all be-all that he does. That's not why I'm giving him a shout out. It's his priceless intro. He had me at "nutshell" but went on to offer some awesome and appropos quotes:

What is fundamentally wrong with corporate governance in America? In a nutshell, it is difficult for stockholders to hold management accountable for its misdeeds.

This is not a new insight. In 1776, Adam Smith wrote in The Wealth of Nations: "The directors of such companies, being the managers rather of other people’s money than of their own, will not watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Negligence and profusion therefore must always prevail in such a company."

Let's fast forward to 1934. Here is what Congressman Lea of California said in the Congressional record of May 1, 1934: "In the main, the men controlling these great corporations are not large owners of the stocks of the corporations they control. Too often they have yielded to the temptation to control these great business institutions to their own interests, and with a zeal out of proportion to the loyalty they have shown their stockholders. Thus in recent years we have seen the directors of corporations, without the knowledge of their shareholders, voting themselves vast bonuses out of all proportion to what legitimate management would justify. We have had revelations of salaries paid to directors and officers of great corporations which showed shameful mismanagement; which showed that the men in charge of some of these corporations were more concerned in managing its affairs for their own benefit than for the benefit of the stockholders."

It is now 2008 and it is fair to say that the lot of shareholders has hardly improved, considering the trillions of dollars in lost shareholder value over the last year, along with the egregious bonuses and salaries paid for this dismal performance.

Yes, yes, yes. Intermediation between owners and managers clearly creates perverse incentive structures and thus, as you may have noticed, opens up a gaping chasm of opportunity for disaster.

Once again it's back to basics: incentives must be aligned. Any crack of variance between the interests of management and that of the owners will be found and exploited if not monitored like a hawk. My prior post on the ills of modern boards of directors tried to highlight this. I was so bold as to suggest a few incentive-alignment mechanisms for directors.

At root, corporations are organizational structures to facilitate the most effective decision making across a bazillion tiny capital allocation choices. Layers of management are supposed to enhance that "effective" part by setting strategy, establishing standards, reviewing decisions, training staff, monitoring success metrics, and so on.

For the most part, corps do the above successfully. The trick lies in how you define "effective."

For long-term shareholders, effective probably means profit-maximizing whilst risk-minimizing in order to maximize the company's valuation (NPV of future cash flows). For day traders, it probably means share price volatility, for a shareholder-CEO, it might mean meeting revenue or share price targets on certain dates in order to release his performance bonus ... You can already see that even a perfect board would have to arbitrate among conflicting goals of various owners.

For managers, it means getting a good perfomance review and keeping their boss happy so they get a nice promo or bonus. For a middle-aged staffer, it might be stability and healthcare. A Gen-Y up-n-comer's interest might be in flexibility, excitement, and recognition.

Each of this plethora of interests creates an incentive mechanism which guides the person's every action. There are a lot of smarties lately making a sport of disparaging the idea that humans make rational decisions. While I recognize we're not robots and thus mess up, I think that the vast majority of apparently "strange" or "bad" decisions would appear sensical if you could fully map the "context."

I use "context" as a shorthand term for the three factors I feel are at the heart of decision-making:

  • the complete incentive mechanism environment faced by the maker
  • all the information available at the point of the decision
  • and the (current) "horsepower" of the maker's brain process this information. Some humans are better than others at processing information and making decisions, but there are biological limits. Then environmental factors determine whether or not one's brain is working at full capacity like a well oiled machine.

And that's why I don't believe the board (or it's members) are always the cause and solution to every business problem. You can clean up a totally absentee board and improve the company's governance, but they're just a small group of humans. Not even Rain Man could process enough info to make enough decisions per hour to singlehandedly run GE, GM, or Microsoft.

For better and for worse, a board is just a bottleneck of power within an organization. Convenient in some cases, but inhibitory and ineffective if you try to cram too much through it. The daily scandals we see are the direct consequence of an absenteeism which arises less from lazy boards than from the skewed incentive structure under which each employee (especially management) operates.

So while I very much enjoy an agree with most of the gems that appear on Icahn's blog, I would argue that they need to spend a little less time inventing ways to gerrymander and a little more time getting the "context" right. This might require:

  • Mapping, measuring, assessing, and alining the incentive mechanisms. Here's a hint for all those newly out-of-work brains in finance and consulting: invent a demonstrably effective framework for rooting out perverse incentives and you'll have companies lining up at your doorstep like Macy's on the 26th of December.
  • Ensuring board members have enough information. Accurate information. This implys the need for a staff, as well as inciteful 3rd party analytics (are you listening entrepreneurs?)
  • Maximizing each member's computing capacity (for example, by limiting other demands on their attention as I suggested in my earlier blog), and then being realistic about how much you can expect the board to effectively handle. In a sense, this is just another incentive mechanism to be aligned. They're often incentivized to get through their agenda in set number of minutes, and will compromise on the other incentives to achieve that. Bad bad bad. Add board members, add time, and/or delegate power.

Just a start. Now You.

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