Saturday, October 14, 2006
Posted by Jeff Lipshaw
It's Saturday afternoon and I could watch the Tigers-Athletics game over at Cooter Brown's or Fat Harry's or I can sit here in the faculty lounge and multi-task by following the game and reading The Prime Directive, posted last month on SSRN by Robert Rasmussen (Vanderbilt, left) and Douglas Baird (Chicago, right). The paper has at least four things going for it off the bat: (1) it is short; (2) it is highly readable; (3) it doesn't seem to be working off a political or theoretical agenda, and just wants to get it right; and (4) it makes a lot of sense. Here's the abstract:
Agency costs dominate academic thinking about corporate governance. The central challenge is to devise legal rules to align the interests of the managers (the agents) with those of the shareholders (the principals). This preoccupation is misplaced. Whether it is finding a baby-sitter or a dean, the challenge of hiring the right person dwarfs the challenge of aligning that person's incentives. The central task for corporate governance - its Prime Directive - is to ensure that the right person is running the business. In this essay, we suggest that the challenge of aligning the managers' incentives has been drastically overstated and the way in which legal rules affect hiring (and firing) decisions has been too often ignored.
Putting the emphasis on agency costs may lead to rules that slight what matters most. The current preoccupation with executive compensation runs the risk of inducing the board to worry more about the details of the employment contract rather than selecting the best person in the first instance. More important, the law can play an important role ensuring bad managers are fired. Once hired, all managers need to be mentored, monitored and, when necessary, replaced. There is little to suggest that a single entity is well-situated to perform all three. There is tension between the roles of confidant and policeman. Here, debt contracts play a crucial and largely neglected role. Covenants in debt contracts can insure that underperforming managers are called to task. Private debt holders' role in monitoring a business and ensuring that underperforming managers are replaced may be as important as the market for corporate control.
The fifth thing going for it is that the descriptive portion (I'll get to the prescriptive portion below the fold) comports with my own experience on the tensions that might exist between a board and a CEO. (See "Background of the Merger" beginning at page 29 of the S-4 Registration Statement filed in connection with the merger between Great Lakes Chemical Corporation and Crompton Corporation.) Board members are human beings. I think the paper's attribution of perceived inaction to commitment bias is far more plausible than attribution by Bebchuk, Fried and others to capture of the board by the CEO. There's an Occam's Razor aspect to this - does it make more sense that highly successful Type AAA directors are "captured" by another CEO, or that they are subject to the same bias as we would observe in any other group? Capture is certainly a possibility - for all my regard for Sidney Poiter as a man and an actor, I wasn't quite sure what he would bring to the Disney board. (I would have loved to see him stand up to Michael Eisner in the middle of a board meeting and announce: "They call me... Mr. ..." Well, you get it.) I agree with Rasmussen and Baird that capture ought to be the exception, not the rule.
For a little more, go below the fold.
I have more reservation about the prescriptive portion of the paper, which, consistent with Professor Baird's long-standing and iconic status in the creditors' rights area, suggests that the law somehow give lenders a place at the table in the board's deliberation over the retention or firing of the CEO. The reservation is simple: if, as the authors suggest, there is so little substance in the distinction between equity and debt investors in an enterprise, large institutional shareholders ought to have the same influence as lenders. (Nothing in the securities laws prevents a large shareholder from bitching to the board about a CEO's performance, as far as I know. Regulation FD deals with the flow of information in the opposite direction.) Now it may be that large shareholders do not act like lenders unless they have very large positions, but I wonder if there is empirical work out there on the relationship between concentrated institutional ownership and CEO turnover.
(I would mention that the Tigers just scored two runs to tie the game up (go get 'em, Tigers!), but that would probably jinx them, so I won't.)
UPDATE (on Sunday, Oct. 15): Well, I didn't jinx the Tigers. It was probably a little bizarre that a grown man was jumping up and down in front of a TV in an otherwise deserted faculty lounge in an otherwise deserted law school at 7:00 p.m. CDT on a Saturday evening, but I don't care.
In looking at the post again, I realize I made an inadvertent pun about what the article had going for it "off the bat." Let me add in retrospect, (a) the article does not come out of left field, (b) its position, in my mind, is right down the heart of the plate, (c) stylistically, it's a nice pitch, and (d) the topic is clearly right in the wheelhouse of both authors. In short, a home run.