An article in the Wall Street Journal discusses a trend among some large US Corporation to base the compensation of outside members of their boards of directors partly on the performance of the corporation. “This growing practice more closely aligns the director to the company. (Some) companies link certain stock or stock-option grants for directors to improved financial performance, using a measure such as annual return on equity.”
How would such a linkage tend to reduce the agency problems between managers and shareholders as a whole? Why would directors be more efficient than shareholders at improving managerial performance and changing their incentives?
The linkage between the compensation of outside members of boards of directors and the performance of the corporation can help reduce agency problems between managers and shareholders in a few ways:
1. Alignment of interests: When directors have a financial stake in the company's performance, it aligns their interests with those of shareholders. This creates an incentive for directors to make decisions that benefit the company and its shareholders, rather than acting in their own self-interest.
2. Accountability: By tying director compensation to the company's performance, directors are held accountable for the outcomes of their decisions. If the company underperforms, directors may receive reduced or no compensation, which provides a strong incentive for them to take their responsibilities seriously and work towards improving the company's performance.
3. Informed decision-making: Directors typically have experience and expertise in various aspects of corporate governance, finance, and strategy. By giving them financial incentives based on the company's performance, it encourages them to contribute their knowledge and skills effectively in decision-making processes. Their expertise can help drive better managerial performance and strategic decisions that are in the best interest of the company and its shareholders.
Directors can be more efficient than individual shareholders at improving managerial performance and changing incentives due to a few reasons:
1. Time and expertise: Directors often have more time and expertise to devote to monitoring managerial performance and making informed decisions, compared to individual shareholders who may not have the necessary resources or knowledge. Directors are typically selected based on their qualifications and experience, making them well-equipped to assess managerial performance and drive necessary changes.
2. Broad perspective: Directors have a broad perspective of the company, as they oversee its strategic direction, financials, risk management, and corporate governance. This comprehensive view allows them to consider the company's long-term interests and make decisions that may transcend the individual interests of shareholders.
3. Independence: While shareholders may have their own specific interests, directors are expected to act in the best interest of the company as a whole. Their independence from management can enable them to objectively evaluate managerial performance, challenge executives when necessary, and implement changes to align incentives more effectively.
In summary, by linking director compensation to the performance of the corporation, it aligns their interests with shareholders and holds them accountable. Directors, with their expertise, time, and broader perspective, can contribute to improving managerial performance and changing incentives more efficiently than individual shareholders.