Wednesday, January 12, 2005

The Market and Agency Problems in Corporate Governance

by Tom Bozzo

Continuing with the executive compensation theme (I'm not sick of it yet, either) at Pub Sociology, Brayden King drops the MF (1) bomb:
Just because the market produces a specific outcome doesn't mean that it is necessarily the best outcome.
This is sufficiently obvious for the executive pay system that even "director primacy" advocate Prof. Bainbridge, discussing Bebchuk and Fried's Pay Without Performance, acknowledges the underlying market failure:
[T]he system by which agency costs are to be checked is itself tainted by an agency cost problem.

What Prof. Bainbridge doesn't accept is Bebchuk and Fried's solution, a shift to "shareholder primacy" in corporate governance. He promises a scholarly discussion soon. I'll grant that there is good economic cause to exercise caution, insofar as it may be worse to "solve" the shareholder-director agency problem with some combination of collective action and control problems.

However, the pushback under the rubric of "regulatory overreach" against such obvious remedies to the agency problems as requiring independence of directors (at the link, specifically, mutual fund director independence is at issue) provides some prima facie evidence that segments of the corporate world aren't serious about solving the problem within the existing governance system. Why could that be?

Also not passing the laugh test so much is the argument that we must have a compensation model that is equivalent to arm's-length relationships between directors and managers because the Market wouldn't stand for it. Here's an example of the argument, from Marginal Revolution's Tyler Cowen (quoted by Prof. Bainbridge here), from a WSJ review of Bebchuk and Fried:
But the arm's-length model is not so easily defeated. Assume the worst -- that CEOs and boards are in cahoots. Outside capital still approaches this corrupt bundle from its own arm's-length point of view. If the problem were a big one, surely some firms would set up truly rational and fair executive-pay incentives to attract capital at a lower cost. And over time we would expect those firms to succeed in the marketplace. But there is no evidence of this happening. One would think that new firms would be in the best position to correct the inefficient status quo, but the data do not suggest that they are set up with more "rational" models of governance.
With this argument, Prof. Cowen makes me think first of Robert Waldmann's brilliant blog tag line, "Asymptotically we'll all be dead." It's funny if you're an econometrician, really!

Among the objections one might raise, some firms are trying very hard to keep private the true cost of their executives' pay packages. Also, it's not clear that new firms would correct the "inefficient status quo." Apart from the inefficient-for-whom question, it's worth considering that new firms may seek to acquire instant credibility by recruiting boards of directors that resemble the feckless boards of older firms.
(1) Market failure.
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