"Character is the one thing we make in this world and take with us into the next."
- - Ezra Taft Benson
October 23, 2012
Monitoring Management
by Adam Smith

In a small business where there is a single owner and she runs the business and is active in the business, there is perfect alignment of the company's objectives for the owner and the manager of the business. Having the manager and owner of a company be the same person ensures there is no misalignment of interests between ownership and management.

For example, if this owner wants to accumulate as much money as possible, she could start by having her employees paid stingy wages and have the employees work in a sub-standard workplace. (Think of Ebenezer Scrooge prior to ghostly visits.) Or if the owner is more benevolent, she has every right to lavish money and benefits on her employees as much as she would like.

Once all the money the company has or earns is hers, she is free to spend it however she wants.

On the other extreme, consider a large Fortune 500 company with disperse ownership (shareholders) and a CEO who runs the company. There is a divergence of interests between the shareholders and management. The shareholders want to maximize the value of the company and the CEO wants to maximize his income. Income for this example includes the money the CEO makes and also all the perquisite consumption he gets from the company.

For example, the CEO may have a company car and a company plane for his use. He may be allowed to bring in a catered lunch and dinner to his office every day. He could play golf more than he is in the office and play for free when the company has a membership at a country club.

How do you align the interests of the shareholders with a corporation's management?

It turns out that this is not an easy question to answer. There are professors doing research trying to answer this question. In fact, there is an entire line of research/articles that try to address this issue. Let me go over a few ideas that have been put forward as solutions.

First, you should know that all public companies have a board of directors (BOD) that is supposed to oversee the management of the company. The BOD meet at least four times every year to review the company's results, ask management questions about what is going on with the company, and give approvals for any major mergers, acquisitions, or capital projects, and perform other assorted tasks.

The BOD is put in place by a vote of the shareholders. The BOD is generally nominated by the company's management and then voted on by the shareholders. This process does not provide a lot of comfort that the directors are going to be rigorous in defending the interests of the shareholders since management is the one that really got them the position. (A member of the BOD usually makes in excess of $30k per meeting).

Many companies even tried to have most, if not all, members of the board be people from management of the company. It took awhile, but people did notice that this arrangement was not optimal for the shareholders.

Research showed that companies that had directors from outside the company performed better than those that had only directors from the management of the company. Now public corporations have at least a few directors from outside the company. It was an improvement.

Then research suggested that management's compensation should be structured to help align interests. Upper management started getting bonuses based on the company's performance. This also meant that management was making decisions that benefited the short term profitability but not really the long term. So…

Management's compensation started to include stock options. It the price of the stock went up then they could make a lot of money. Generally, the options had to be held a year before they could be exercised, but this still did not really make management start thinking about longer time horizons. So….

A portion of management's bonuses started to include profitability for an extended time period (three years is popular). This seems to be forcing management to reluctantly make decisions that hurt current year earnings but are very profitable in the future.

It is the BOD that determines the compensation of management. It is interesting to note that most CEOs or CFOs of big corporations sit on the BOD of other big companies. There certainly is an incentive for them to increase each other's compensation and, in fact, compensation for senior management has grown rapidly over the past 40 years.

The BOD are supposed to be looking out for the interests of the owners (shareholders), but they of course are looking out for their own interests (and really their interests are more closely aligned with management than with the shareholders). If the BOD are supposed to monitor management, who monitors the monitors?

It seems to me that the BOD needs to be held to a higher standard than is currently expected and bear more responsibility when things go bad for a company. During the last financial collapse everyone was pointing fingers but almost none were pointing at the BOD of the failing companies.

Everyone concludes that if you hold the BOD responsible then no one would be willing to be on these boards. If this is true, so be it. It would be better for shareholders to know that no one is looking out for their interests than to conclude incorrectly that the board is really doing its job.

This question of aligning interests continues to have no answer. Improvements are being made but they seem to come very slowly. The government definitely has a role to play, and the SEC is constantly trying to protect shareholders.

In the government, there is normally some agency that reviews expenditures and makes sure that money is being spent wisely. When someone knows that all their actions will be critiqued it can help them make good choices. At the federal level, the agency that reviews expenditures at other federal government departments is the General Services Administration (GSA).

For many years, this agency had a reputation of being very fair and was highly respected. This past year it was determined from whistleblowers that the GSA was having lavish parties at taxpayers' expense. (What happens in Vegas apparently does not always stay in Vegas.) It was a huge scandal that rightly cost people their jobs. So the question was raised: "Who is supposed to monitor what the GSA does?"

This is the same question I asked earlier about the BOD. Who monitors the monitors?

In the government, just as in private business, there can never be perfect monitoring. The best monitor is when we monitor ourselves. A strong ethic of what is right and wrong would help prevent most of the lapses we see in private industry and in the government. There are now ethics classes required at most business schools.

Our economy, government, and civilization are reliant on most of us doing the right thing. As members of the LDS faith, we have a responsibility to be a shining example of ethical behavior. As a society, we can never have enough monitors to make sure everyone is acting ethically, but let it be said of you and me that no monitoring was ever needed.

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About Adam Smith

Adam Smith is obviously not the actual name of the author of this column. The real author has worked for two Fortune 500 companies, one privately held company, and a public accounting firm. His undergraduate degree was in accounting, and he earned an MBA for his graduate degree. He also has completed coursework for a PhD. in finance. He continues to be employed by one of the Fortune 500 companies.

The author grew up in the Washington D.C. area but also lived for several years in Arizona. He currently resides with his family on the East Coast.

The author has held various callings in The Church of Jesus Christ of Latter-day Saints.

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