Separation of ownership and control means that resource investment decisions in corporations are not made by the holders of capital. The effect of this is that the corporate market is no longer efficient. Traditionally, solutions to the principal–agent problem that is inherent in the separation issue have been proposals to redesign contracts and organizational structures with the object of aligning the incentives of managers to those of shareholders. A primary mechanism to accomplish this is through modified compensation packages that include manage- rial stock options and bonuses so that managers share in profit outcomes along with shareholders. This solution proposes to alter the manager’s objective function from individual managerial utility maximization to owner’s (and their own) profit maximization, that is, in the managerial model of decision behavior. Aligning incentives is also important in the behavioral model of decision behavior. Here owner and manager goals differ in substance even though they are difficult to articulate precisely and both owners and managers are subject to limitations on obtaining and processing available information.
What does the property rights model predict for unbounded and bounded rational decision behavior? Economic agents, or managers, are expected to respond to the incentives derived from the rights system in place. The stock option component of managerial compensation pack- ages gives managers, like shareholders, the right to share in the gain and also the risk associated with firm performance and profitability. In the unbounded rational model of decision behavior, the manager would be expected to promote those firm activities which increase his or her share of the gain relative to his or her share of the risk. The property rights model unambiguously predicts that the unbounded rational manager who has control rights will allocate resources within the firm to shift relative gain from resource use to management and relative risk to outside shareholders, for example, by increasing firm leverage to allow greater firm growth. Unbounded rational shareholders would not permit this to happen, however, at least to the extent that their expected addi- tional profit outweighs the cost of monitoring these decisions. Unbounded shareholders would know, and they would act.
Shifting gain from shareholders to managers and risk from managers to shareholders can only occur, therefore, if shareholders are bounded rational while managers are not, or if shareholders are, in a sense, ‘more bounded’ in their information access and processing than are man- agers.3 In a relative sense, that is, comparing the position of sharehold- ers and managers, this likely to be the case. Shareholders, who typically and rationally diversify their investment portfolios, have a wide variety of investment alternatives to consider than a manager of one organiza- tion is likely to face, so that the decision problem for shareholders is less well defined. That is, the shareholder decision problem is subject to greater requirements for and variation in information than the man- ager’s decision problem.4
Under conditions of bounded rational behavior, therefore, the property rights model predicts that more shifting by managers to benefit them- selves at the expense of shareholders is possible. The limitations placed on both shareholders and managers affect the ability of managers, even with control rights, to fully shift the relative gain to themselves and the relative risk to other shareholders. If shareholders are disproportionately affected by information processing, as is likely, then managers are less monitored and are in a better position to engage in opportunistic behavior.
In either context, when considering the implications for resource allocation in the corporation as a system of property rights, the distinc- tion between legal and economic property rights becomes important. In the corporate setting, the legal property rights structure is that share- holders are owners and have legal residual rights and managers are employees who are granted legal control rights through their contractual role as decision makers (agents) on behalf of shareholders (principals). The legal role of the corporate board of directors (elected by share- holders) is to represent shareholder interest as a trustee, with corre- sponding fiduciary responsibility (Hart, 1988). This is accomplished in part through board participation in hiring and monitoring the man- agers to whom control rights are granted. The design of managerial compensation packages to align managerial and shareholder incentives is approved by the board as part of its fiduciary responsibility and/or by shareholder vote directly. What property rights system has evolved?
First, empirical evidence shows that salary and bonus packages have been created as incentives to align management and shareholder inter- ests. However, as annual surveys in Business Week, Fortune, and The Wall Street Journal have shown these have not been tied empirically to firm performance (Samuelson, 2002). In the US, CEO salaries have risen sig- nificantly higher even as lower level wage earners are asked to take cuts in pay (Samuelson, 2003). When managerial salary levels are excessive and bonuses are paid with no relationship to owner profitability, the connection to incentives is undermined.
Second, the manager’s share of holdings is a relatively small percent- age of total shares outstanding and is typically only part of the total compensation package. The benefits of long run profitability resulting from increased firm efficiency are shared across all shareholders. The cost of greater efficiency is felt directly by the manager, however, in the form of reduced managerial preferences and corresponding utility.
Third, the part of a manager’s compensation related to corporate shares is typically in the form of stock options. The manager can use these options to buy shares at the option exercise (strike) price during a given time period. To protect the value of his or her own options (and compensation value) the manager thus has an incentive to promote firm profitability and would be expected to make efficient decisions. This raises the market value of shares relative to the exercise price of the options held by the manager. Managerial and shareholder incentives appear to be more aligned.
Two problems may occur related to the use of stock options as mana- gerial compensation. One problem is that the actual return to investors may be obfuscated when options are not expensed. This practice can underestimate costs of the firm and so overstate earnings. This practice has been well documented for a number of US corporations (see, for example, Stern, 2003). This increases the degree of information asym- metry, and increases the bounds on rational decision making by making it more difficult for investors to determine the true state of the firm’s profitability.
The second problem is that an incentive problem occurs if managerial utility maximizing behavior gives rise to promoting short run prof- itability rather than long run profitability. This short run view is likely to prevail, however, particularly in view of the short run time period provided for exercising the options. The incentive problem occurs because once the option time period begins the manager can profit in the short run by exercising the options while simultaneously control- ling firm resources. The manager is therefore in the position to direct resource use to this short run purpose. Egregious examples of this type of short run decision behavior have been observed in the US in 2002 where such behavior has led to the downfall of corporations such as Enron and WorldCom, with the extreme effect of damaging shareholder value while managers profited.
Fourth, as predicted by Alchian (1969) and Fama and Jensen (1983a), shareholders are able to respond to managerial opportunistic behavior. The major incentive problem here is that shareholder response is ex post. The signal of falling share prices is sent, which may affect the manager’s reputation and potential marketability and income. But even though the share price signal is sent, managerial decisions that prompted the signal have already been made. The primary monitoring system for shareholders then is one which has the effect of locking the stable door after the horses have run off! Owners incur a relatively greater cost of managerial decisions (lost share value) than do the man- agers who have benefited in the short run.
One outcome of incentive compensation devices as designed has been the perverse effect of reassigning economic property rights from share- holders to managers, even though legal property rights have not changed. This outcome is exacerbated in situations where board compo- sition includes management. The degree of managerial influence on the board would be expected to affect the design of managerial compensa- tion packages favorably toward the manager and to reduce the effective monitoring role of the board. Williamson (1963) provided some support for this effect. This effect is likely to be stronger under conditions of bounded rationality when shareholders are relatively more limited in their ability to fully comprehend the implications of this arrangement and of the intricacies of managerial compensations packages.
How is the corporation a set of economic property rights? Given (1) the lack of clear connection between managerial compensation and performance, (2) the short run managerial view, (3) the ex post response of shareholders to managerial opportunism, and (4) managerial repre- sentation on the board of directors, the economic property rights struc- ture is effectively based on control rights. This outcome is exacerbated under conditions of managerial unbounded rationality (that is, utility maximization) and shareholder bounded
To paraphrase the epigram: control is nine-tenths of the law. The economic property rights structure reverses the legal rights structure: residual rights of shareholders are not the objective but are instead a constraint to the managers in either context, and may even be regarded as a nonbinding constraint. The constraint becomes binding when reported profit is much lower than normal profit, with two results: stock selloff which causes share prices to decline and imposition of cost reduc- ing measures which leads to layoffs. The cost of the former effect is borne by shareholders in general and retirees (or near retirees) in particular, whose incomes (or near-future incomes) are likely to depend largely on share prices. Shareholders may benefit from the latter effect if they inter- pret layoffs to be a cost reducing measure that should improve future profitability. Employees, however, even if they hold stock, bear most of the risk and the cost of the unemployment that follows from managerial opportunism (Garud and Shapira, 1997). In this event managers may be shifting risk to both shareholders and employees. Employee risk bearing provides a rationale for the German policy of codetermination, a point not considered by Pejovich (1990), but with which Furubotn and Richter (2000) appear to agree. I consider this point further in Chapter 11.
Source: Carroll Kathleen A. (2004), Property Rights and Managerial Decisions in For-Profit, Nonprofit, and Public Organizations: Comparative Theory and Policy, Palgrave Macmillan; 2004th edition.