An article in The Wall Street Journal discusses a trend among some large U.S. corporations 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 problem between mangers and shareholders as a whole? Why could directors be more efficient than shareholders at improving managerial performance and changing their incentives?
The linkage between the compensation of outside board members and the performance of the corporation can help reduce the agency problem between managers and shareholders in several ways:
1. Aligning Interests: By tying directors' compensation to the company's performance, their incentives become aligned with the shareholders. Directors have a greater motivation to make decisions that will benefit the company and its shareholders in order to maximize their own financial rewards.
2. Accountability: Linking director compensation to performance introduces a level of accountability. Directors are incentivized to actively monitor and oversee management decisions to ensure that they are in the best interest of the company. This can help reduce the likelihood of conflicts of interest or poor management decisions.
3. Focus on Long-Term Performance: By incorporating measures like annual return on equity or other financial metrics, directors are encouraged to take a long-term perspective in evaluating company performance, rather than focusing solely on short-term gains. This can lead to more sustainable decision-making and strategic planning that benefits the long-term interests of shareholders.
Directors can be more efficient than shareholders at improving managerial performance and changing incentives due to several reasons:
1. Expertise: Directors are typically chosen for their expertise in relevant industries or areas of business. They bring a wealth of knowledge and experience that can help guide and advise management in making more informed decisions. Shareholders, on the other hand, may not have the same level of expertise or understanding of the intricacies of the company's operations.
2. Independence: Directors are supposed to act independently and in the best interest of the company and its shareholders, rather than being influenced solely by their own individual interests. This independence allows directors to objectively evaluate management performance and advocate for necessary changes in incentives or strategies when needed.
3. Time and Resources: Directors can dedicate more time and resources to monitoring and improving managerial performance than individual shareholders who may have limited availability or expertise. Directors have the opportunity to thoroughly analyze company performance, engage in discussions with management, and make informed recommendations on changes that can enhance managerial performance and align incentives with shareholder interests.
It's important to note that while such a linkage can help improve corporate governance and reduce the agency problem, it is not a foolproof solution. Other mechanisms, such as proper board composition, regular evaluations, and shareholder activism, may also play an important role in addressing the agency problem and ensuring effective corporate governance.