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?
If the company does better the shareholders get happier.
The directors have direct say in decisions about paths the company takes. Outside directors of course often are officers in other corporations and know how to run companies batter than most shareholders do. If you pay them more when your company does better, they will focus on your company doing better.
Such a 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 by aligning the interests of the directors with those of the shareholders.
The agency problem arises due to the separation of ownership and control in corporations. Managers, who control the day-to-day operations, may prioritize their own interests over those of the shareholders. This misalignment of interests can potentially lead to actions that do not maximize shareholder value.
By linking director compensation to company performance, directors have a vested interest in maximizing shareholder value. If the company performs well and generates higher returns on equity, the compensation of the directors will increase. This creates an incentive for the directors to actively monitor and guide management decisions in ways that maximize shareholder value.
Directors may be more efficient than shareholders at improving managerial performance and changing incentives for several reasons:
1. Expertise and Experience: Directors often bring a wealth of industry knowledge, experience, and expertise to the table. They can provide valuable insights and guidance to management, leveraging their skills and experience to improve the company's performance.
2. Objective Oversight: Directors are typically independent and have a fiduciary duty to act in the best interests of the shareholders. This objectivity allows them to provide unbiased oversight of managerial decisions, ensuring that actions are aligned with shareholder interests.
3. Access to Information: Directors have access to confidential and critical information about the company's operations, strategies, and financial performance. This information can help them assess management's performance objectively and make informed decisions on compensation based on actual outcomes.
4. Accountability: Directors are accountable to shareholders, and their reputations and careers are at stake. This accountability can motivate them to actively engage in monitoring and improving managerial performance to protect their own interests and reputation.
By having a strong and independent board of directors that is incentivized to improve company performance, the agency problem can be mitigated, leading to better alignment of interests between managers and shareholders.