Corporate Governance: Management as a Constituency

1. Management Contracting

A large difficulty in treating management’s contract with the corporation like those of other constituencies is that management is thought to be in effective control of the corporation. Rather than being responsive agents of the stock- holders, managers operate the firm with a keen eye to their own interests. Any proposal to improve their terms of employment is automatically suspect, because managers are presumed merely to be adding another layer of down to their already well-feathered nests. This section will suspend judgment on that matter and treat managers like other constituencies: What attributes does the management-corporation contract have, and what ones should it have?

Since no firm-specific human assets are exposed by managers located at node A no specialized governance is needed. Like any other constituency with attributes of node A, such managers look to the market for basic protection.

Managers who develop a firm-specific asset relationship with the firm, however, are located at nodes B or C.

Those managers who contract with the firm in a node B manner will receive higher current compensation than those accorded internal governance protection of a node C kind. That is the familiar p‾ > pˆ result. To what types of governance protection do managers located at node C have access? The answers are unclear, partly because the proposition that governance structures can and do promote the mutual interest of contracting parties is relatively novel. Such structures have either been ignored or, as in the case of labor unions, treated as instruments of power whereby labor improves the wage bargain at the expense of the firm. To be sure, that sometimes occurs. But the collective organization of workers can also reduce hazards of contracting, to the benefit of both parties, if workers develop firm-specific skills in the course of their employment.

The same general approach applies to the study of contractual relations between management and firm, but there are added difficulties. Whereas labor organization has been the subject of repeated studies, and much of the relevant microanalytics there has been carefully described,116 contracting by management has received much less systematic attention. There are several reasons. Management contracts tend to be crafted individually rather than collectively, and they are not subject to public scrutiny. The protections or procedures to which an aggrieved manager turns are usually not formally organized and are more difficult to study for that reason. Further, treating the firm and its mangement as separate contracting entities is progressively more difficult as higher echelons of management come under review. Unless an independent compensation committee exists, for example, an understanding of the contract between firm and manager is complicated by the fact that managers apparently write their own contracts with one hand and sign them with the other. Also, management is often encouraged, for good reason, to thing of itself and the firm as one. As Alan Fox puts it, “High level managers and administrators whose decisions cannot be easily or quickly monitored are treated as members of a high-trust fraternity,” lest their moral involvement deteriorate (1974, pp. 170-71). It would not sit well with that conception for managers to develop a formal grievance machinery to which they could turn for relief and redress.

It is nonetheless true that managers who are asked to make firm-specific investments will presumably strike different (better) terms if they locate at node C than at node B. What kinds of protection are available?

2. Compensation Schemes 

Both the firm and its managers should recognize the merits of drafting com- pensation packages that deter both hasty dismissals and unwanted departures. Requiring firms to make severance payments upon dismissal and managers to sacrifice nonvested rights should they quit can serve to safeguard specific assets. The recent phenomenon of “golden parachutes” is germane to the assessment of compensation in several respects.

Golden parachutes are severance payments to senior managers that are contingent upon an “adverse” change in the ownership of common shares in the firm, usually as a result of unfriendly takeovers. The appearance and refinement of takeover techniques expose managers to new risks. Senior managers are often dismissed after takeovers. Even if the managers are kept on, the takeover often upsets their career expectations. Upon recognizing those hazards, managers will attempt to renegotiate their contracts to reflect the risks.

The golden parachute can be thought of as such a response. If an adverse change of ownership occurs, the senior management does not have to wait to be dismissed in order to receive severance pay. Instead, the management can trigger the award itself. Managers are thus provided with the option of “bail out” and collect a larger severance award than they would be entitled to after a “normal” dismissal (one independent of an ownership change). Without such protection the post-takeover management could give demeaning assignments to incumbent managers and force them to quit, thus denying them any severance award.

Granting the merit of seif-initiated severance pay, what explains a sever- ance premium? The defense for such a premium presumably resides in the differences between dismissals from normal employment and dismiss^ttthat occur in conjunction with takeovers. Dismissals from normal employment are generally for cause, and they activate some protection (albeit diffuse) under an internal due process machinery. After takeovers, an atmosphere of mutual suspicion and hostility often exists, and the successful bidders are concerned that incumbents will sabotage the transition. Dismissals after takeovers are commonly unrelated to job performance and relatively unprotected by an internal machinery. Because of the added risks, larger severance awards for terminations that occur in conjunction with takeovers are arguably war-ranted.

That explanation, however, merely establishes that golden parachute awards will exceed those that attend normal terminations. Some perspective on the magnitude of golden parachutes is needed. Golden parachutes ought to vary directly with the extent of the firm-specific investment that a manager has placed at risk. The absolute value of the pension and other benefits that an executive sacrifices should he voluntarily quit is one measure of those investments. Absence of penalties for voluntary quitting is prima facie evidence that the management skills are general purpose rather than firm-specific. Golden parachute protection for such managers is unwarranted and probably reflects self- dealing.

Note that failure to craft a node C response for managers located on the k > 0 branch will elicit a new node B bargain. To be sure, incumbent managers, whose human assets are committed, may be unable to insist that their compensation be adjusted to reflect the added risks. But successor generation managers who are asked to take assignments on the k > 0 branch are not similarly encumbered. If a node C bargain is not struck, they will insist that compensation at node B be increased to reflect the takeover hazard. Such managers will then have a great deal at stake should a takeover threat materialize. Not only do they lack golden parachute relief, but their large node B salaries will now be placed in jeopardy. Accordingly, those managers will expend inordinate energies to defeat a takeover effort. It is not, therefore, in the interests of the stockholders that golden parachute terms be denied to k > 0 managers.

3. Board Membership 

Suppose that the appropriate incentive alignments have been worked out. Can the firm realize additional improvements by including the management on the board of directors? Putting the issue that way presumes that the central function of the board is to safeguard the interests of the stockholders. Such a conception of the board has been described by others as the “monitoring model.” Kenneth Andrews characterizes the monitoring model as simplistic, overformal, and self-defeating (1982, pp. 44-46). Paul MacAvoy and his collaborators contend that serious efforts to implement the monitoring model could have a “pervasive negative effect… on risk taking” (MacAvoy et al., 1983, p. c-24).

Both, of course, may be correct. But neither Andrews nor MacAvoy and his collaborators advance an alternative conception of the board in which a clear sense of contractual purpose is described. Andrews’s favored model is what he refers to as the “participative board.” The outside board members are invited to join with the management to enhance the quality of strategic

  • C, T”f 8‘? Van°“S reasons for institul>ng golden parachutes. While most at least imply that their plans will ensure that top executives won’t arbitrarily oppose takeover bids that would reward shareholders, a few advance them frankly as anti-takeover measures For d,“,of Grey Advertising Inc. gave its chairman and president, Edward H. Meyer a $3 million parachute as part of a number of changes it said “may make the company less susceptible to a successful takeover attempt” by making a takeover more expensive. At the lime it was adopted, Mr. Meyer’s parachute was worth about 8% of tne value of all the company’s common [Klein, 1982, p. 56] decisions Such involvement can come at a high cost, however, if objectivity is thereby sacrificed. As Donald Campbell remarks, if an “administrative svstem has committed itself in advance to the correctness and efficacy of its reforms it cannot tolerate to learn of failure” (1969, p. 410). That defensive propensity is the origin of the tendency to throw good money after bad. A less informed but more skeptical posture by outsiders may well be superior.

Since managers enjoy huge informational advantages because of their full- time status and inside knowledge, the participating board easily becomes an instrument of the management. Notwithstanding the variety of checks against managerial discretion described by MacAvoy and his collaborators,25 the interests of the stockholders—indeed, of all principal constituencies26— are apt to be sacrificed as a consequence.

Rejection of the participating model in favor of a control model of the decision ratification and’monitoring kind does not, however,, imply that the management should be excluded altogether. So long as the basic control relation of the board to the corporation is not upset, management’s participation on the board affords three benefits. First, it permits the board to observe and evaluate the process of decision-making as well as the outcomes. The board thereby gains superior knowledge of management’s competence that can help to avoid appointment errors or correct them more quickly. Second, the board must make choices among competing investment proposals. Management’s participation may elicit more and deeper information than a formal presentation would permit. Finally, management’s participation may help safeguard the employment relation between management and the firm—an important function in view of the inadequacy of formal procedures for grievance.

According to the contractual conception advanced here, however, those are supplemental purposes. To the extent that management participation permits reviews on the merits to be done more responsibly and serves to safeguard an employment relationship that would otherwise be exposed to excessive risk, management may be added to the core membership. But the .principal function of the board remains that of providing governance structure protection for the stockholders. Management participation should not become so extensive as to upset that basic board purpose. Where it does, managerial discretion is apt, sooner or later, to manifest itself in self-dealing or subgoal pursuit.

4. Management Centrality 

That management is centrally implicated in all contracts is scarcely evident from the above. Instead, the fiction that all contracts are struck with a legal entity called “the firm” is maintained. Not only is the contractual relation between the firm and each constituency assessed in an instrumental way, but a symmetrical orientation is maintained throughout. The very same contractual apparatus is thus uniformly applied to each constituency. Upon disclosing its attributes, the appropriate contractual node to which to assign a constituency follows directly.

That the management’s relation to the firm is largely, much less wholly, instrumental is widely disputed. More often the management is regarded as the locus of power. Strategic rather than instrumental considerations are thus brought under scrutiny. Managerial discretion and abuses are made the focus of attention. This book principally employs and traces out the consequences of an efficiency (instrumentalist) perspective. That this is instructive is illustrated by the numerous insights that this viewpoint afford—illustrated most recently by the interpretation of golden parachutes set out above. But just as it is possible to insist that markets are marvels and to concede market failures (even comparative market failures) in the same breath—“markets, albeit imperfect, are marvels”— so too is it possible to adopt an efficiency orientation, yet make concessions to strategic behavior. Such concessions are specifically needed in assessing the management’s contractual relation to the firm.

The aforementioned centrality of the management distinguishes it from all other constituencies. This difference has been acknowledged before and is responsible for much of the managerialist literature set in motion by Berle and Means (1932). The main point here is this: Strategically situated as it is, the management is able to present (screen, digest, distort, manipulate) information in ways which favor its own agenda. Albeit subject to limitations of the kinds discussed in section 4 below, managerial discretion is not for nought (Williamson, 1964; Alchian, 1965).

A somewhat narrower but previously neglected ramification of centrality is emphasized here. This involves the possibility that a constituency which strikes what it believes to be a well-informed, bilateral deal with the corporation is thereafter exposed to undisclosed hazards because the management subsequently strikes bilateral deals with other constituencies in a strategic manner.

Thus suppose that labor is asked to make firm specific investments in human capital and that a node C bargain (with a wage of wˆ and safeguards s) in truck as a consequence. Assume that an employment agreement is also lS ached between the firm and the management and that this agreement fea- wres high- powered incentives. Extensive profit sharing is thus provided. And assume finally that a contract between the firm and its customers of a p‾ kind is negotiated. This is a troublesome triad.

Thus rather than require customers to provide safeguards (which would serve both to deter the likelihood of cancellation and to mitigate the losses which attend cancellation) in exchange for a lower (pˆ) price, the management of the supply firm agrees to accept the high risks that a node B bargain entails. If adverse demand realizations do not occur, the customer will take delivery at the price of and the seller will show a large profit. If, however, adversity does appear, then delivery will be canceled and the full costs will be borne by the seller. Low profits will result.

Given high-powered incentives, the management will participate hand- somely when favorable outcomes obtain, and it will evidently be penalized when adversity materializes. Considering, however, the specific asset commitments of the labor, labor may be vulnerable to requests for give-backs, thereby to save its jobs. The profit consequences of adversity would then be buffered by labor rather than borne by management—whence the resulting set of contracts would place the management in a “heads I win, tails you lose” posture.

This outcome is more likely in the degree to which (1) labor contracts are long term, (2) human assets are more highly firm specific, and (3) the man- agement is believed to be more opportunistic. This last may sometimes be inferred from earlier experience—although, as discussed in Chapter 15, repu- tation effects can be elusive. Plainly, however, where management incentives are of a more high-powered kind, greater precautions are indicated. Insistence upon contractual disclosure and contract reopeners so as to deter strategic inconsistencies across successive contractual interfaces may be warranted in such circumstances. Informational participation could materialize.

Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.

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