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?
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Linking the compensation of outside directors to the performance of the corporation can help reduce the agency problem between managers and shareholders in a few ways:
1. Increased alignment: By tying director compensation to the company's performance, the directors' interests become more closely aligned with those of the shareholders. This alignment helps ensure that directors are motivated to act in the best interests of the company and its shareholders.
2. Accountability: When director compensation is tied to financial performance metrics, such as return on equity, directors have a direct stake in improving the company's financial performance. This creates a higher level of accountability for directors, as their own financial gain is tied to the success of the company.
3. Monitoring and oversight: Directors play a crucial role in overseeing and monitoring managerial performance. By linking their compensation to performance metrics, directors have a stronger incentive to actively engage in their oversight responsibilities. This can lead to more effective monitoring and evaluation of managers, helping to prevent any potential agency conflicts.
Directors can be more efficient than shareholders in improving managerial performance and changing incentives for a few reasons:
1. Expertise: Directors are typically selected based on their industry expertise, experience, and qualifications. Their specialized knowledge and understanding of the industry can provide valuable insights and guidance to managers on how to improve performance. Shareholders, on the other hand, may not have the same level of expertise or detailed understanding of the company's operations.
2. Focused attention: Directors have a limited number of board positions, allowing them to dedicate more time and attention to each company they serve. This gives them a deeper understanding of the company's challenges and enables them to actively engage in decision-making processes. Shareholders, who may hold investments in multiple companies, may not have the same level of involvement or ability to influence managerial performance.
3. Independence: Independent outside directors are often chosen to serve on the board to bring an objective perspective and provide a check on management. They are not influenced by personal or financial interests that may bias their decision-making. Shareholders, on the other hand, may have their own conflicting interests and may not always act solely in the best interests of the company.
Overall, by linking director compensation to company performance, and leveraging their expertise, focused attention, and independence, outside directors can provide effective oversight and drive improved managerial performance in a way that shareholders may not be able to achieve alone.
The linkage between the compensation of outside members of boards of directors and the performance of the corporation can help reduce the agency problem between managers and shareholders in a couple of ways:
1. Alignment of interests: By tying a portion of the directors' compensation to the company's performance, their interests become more aligned with those of the shareholders. This means that if the company performs well, the directors benefit, and if it performs poorly, they stand to lose. This alignment of interests creates an incentive for directors to make decisions that are in the best interest of the company and its shareholders.
2. Accountability: Linking compensation to performance creates a sense of accountability for the directors. When their pay is tied to specific financial metrics like return on equity, they have a direct stake in driving the company's profitability and value. This can lead to increased diligence and oversight on the part of directors, as they have a financial interest in ensuring that management is performing effectively.
Directors can be more efficient than shareholders at improving managerial performance and changing incentives for a few reasons:
1. Information and expertise: Directors typically have a deeper understanding of the company's operations, industry dynamics, and governance practices compared to individual shareholders. They often have industry-specific knowledge and experience that can be valuable in guiding managerial decision-making. This expertise enables directors to provide informed advice and oversight to management, which can lead to improved performance and incentive structures.
2. Objectivity and independence: As independent fiduciaries, directors are expected to act in the best interests of shareholders as a whole. They are not as susceptible to bias or self-interest as individual shareholders might be. Directors have a responsibility to objectively evaluate managerial performance and recommend necessary changes to ensure the long-term success of the company. This independence allows them to focus on the bigger picture and make decisions that may be in the best interest of the company, even if they are not popular with individual shareholders.
3. Authority and influence: Directors have the authority and influence to implement changes in management and incentive structures. They can use their oversight powers to hold management accountable and make sure that appropriate incentives are in place to encourage desired performance outcomes. Shareholders, on the other hand, may face challenges in coordinating their efforts and influencing managerial decisions, especially in large publicly traded corporations.
In conclusion, linking the compensation of directors to the performance of the corporation can help reduce the agency problem by aligning their interests with those of shareholders and creating accountability. Directors, with their expertise, objectivity, and authority, are often better positioned to improve managerial performance and ensure appropriate incentives are in place compared to individual shareholders.