We've been talking within this module about agency cost and agency problems. This issue has been around for a long time. As a matter of fact, Adam Smith and The Wealth of Nations in 1776 asked about these questions and then a very famous book in 1932 by Adolf Berle, who's pictured here, who was a law professor at Columbia University and Gardiner Means was an economist. So they came together and wrote a book called The Modern Corporation and on page 121 of that 1932 book, they asked the question, "Have we any justification assuming that those in control the modern corporation will also choose to operate in the interest of the stockholders?" That's essentially what in modern language is called the agency problem. So what we're going to focus on now is what are the institutions of capitalism or from the last set of slides, what we call mechanisms, which can lessen the problem of the separation of shareholder ownership and the risk bearing principals. That is those who provide the money, but do not have the control of the corporation, which are those that are providing the managerial decisions within the corporation. Keep in mind this is the question, why do managers care about the profitability of their company or division within the company? The first mechanisms of why they should care if they're a publicly traded company is if they don't keep the stock price at a certain level, there's the threat that they may be taken over. Sometimes this is called the market for corporate control. So if the company has egregiously poor management and people start selling off the stock. There can be many other reasons including the macro economy and there's many other reasons besides poor management about why stock price goes down. But if management is very poor, then you're certainly on the radar screen when the stock price starts dropping, people are going to ask questions, why is that the stock price decline occurring? The second reason why managers would care about profitability for example, their division is that if they have very good performance, then that's going to show up in the numbers and then there is a market for managers as well. So these executives may be recruited by other companies and on their resume they might have that, since they joined the organization, they increased the performance of all these different measures and so forth as a signal of their quality. Now of course, the catch to that too is the executives may be manipulating the numbers. They might reduce the investment base of the company and then their ROA looks real great, but it's not because they were making the income go up, they were actually making the asset base of the company go down. It's that ratio of those two numbers. So the more discerning person evaluating a manager will look at lots of different metrics to make sure that it's actually good performance by the manager. A third is we talked before about the role of the board of directors. The board of directors is certainly in charge of evaluating the CEO and top management team of the company. So the monitoring by the board of directors particularly in some corporations are more effective than others with their board of directors and that can also be a mechanism for reducing agency costs. A fourth is that compensation can be heavily weighted towards stock options. Why should managers care about the stock of the company? Well, they have lots of stock in the company. Now when I first heard that idea many years ago, I thought that was the no brainer way of solving the problem. Unfortunately, if you recall Enron a few moments ago or the last video which you may have seen very recently, the discussion there for Enron is that those executives had tons of stock options. But a matter of the fact that gave them then the incentive to manipulate the market to get the stock price higher in artificial ways. So in other words, you solve one agency problem. The managers don't care about the stock price and then you make the managers care a little bit too much about the stock price. So there clearly needs to be a Goldilocks principle somewhere in between. That is some intermediate range where you will get better performance in terms of compensation to the managers and other one is that if I'm an individual shareholder, my shares are so small in the company, it's just not worth my time and effort to monitor the actions of the company on a day-to-day basis. But if you're an institutional investor, then you have a large amount of investments in the organization then you may monitor very closely. As a matter of fact, institutional investors will even call up the CEO if they're displeased with a particular action of the managers and have a conversation with the manager. So if shareholder interest are not attended to by the manager, there will be feedback from the environment from large institutional investors. The next is debt. If you're a manager in a company that has a large level of debt, you have no room like many years ago, RJR Nabisco had a tremendous number of corporate jets and plush expenditures throughout the world for its top management team and it was an era of excess and many different ways. On the other hand if you're a company that's on the verge of bankruptcy, then you have you have no free cashflow to play with and so that's going to make you focus on being efficient and not being wasteful. That's on the plus side and I would also say that that mechanism is probably relevant if you're in the grocery business, and what I mean by that it's very low profit margin because high volume but low profit margin business, and there's not a lot of room for really high net present value or highs economic return projects. So therefore, being efficient in exactly what you do is a good thing. On the other hand, if you're a high-tech company and you're going to need a lot of free cash flow for the next big investment that may be a couple of 100 million in R&D if you're in the pharmaceutical industry, then if you have a large amount of debt, you're not very well positioned. In other words, what I'm saying is in some contexts minimizing agency costs is not the primary problem. The primary problem is being ready for the technology and the next big move you're going to make and minimizing the agency cost is small potatoes relative to the problem of being positioned for new technology. The economist Joseph Schumpeter was the one who emphasize it's the new technologies that at the end of the day are the key for companies. So while this whole section is on agency costs, keep in mind that it's a problem in cases like Enron and Tyco and WorldCom, it gets out of control. But it's not the only problem that managers have. The seventh mechanism is in general, when you have the chairperson and the CEO as two different people in the organization, then you have the chairperson of the board of directors being the monitor of the CEO. Sometimes when you have the CEO who is also the chairperson of the board of directors, then the CEO chairperson can be very influential on the board of directors to the point where the rest of the board is not particularly effective at monitoring the CEO. So if you're a company like in a grocery business. So my takeaway and this is just a conjecture that I'm giving right now, is if you're in the grocery business, it's probably good to focus on minimizing agency costs and to have a separation of CEO and chairperson. On the other hand, if you're in a high tech market where you need rapid decisions, maybe having a separate chairperson, CEO is going to slow you down and you're not going to be there for the new technology and you're going to be solving the agency cost problem. But you have other things that are also maybe even more critical than that. One of the things really for the takeaway for this subject we call strategy it's contextual, it depends on the problem at hand and furthermore even the problem that's the right solution in 2016 may not be the right solution 2018. The interesting thing I'll say about that is I get a lot of feedback that these videos are things that we can leverage for multiple years. But the reality and strategy is strategy is always changing. So that the right answer in 2016, I may have to be back here two years ago and seeing all the different areas that used to work that no longer work and that often happens. So the key phrase I would use is strategy changes, and then finally, the last point eight is that we've talked earlier in our course about the multidivisional. You can think of the multidivisional is also why managers care about profitability. If you have five divisions of a company and they're all measured by the corporate staff in terms of return on asset, then they're all competing with each other and they all want to whatever numbers and metrics the corporate staff is using, they all are being evaluated on those numbers of course, the managers are going to care about those profitability metrics within their own division. So these are the eight major mechanisms of why managers will care about the financial performance of the division or company that they're running. We also talked about the directors and we can talk here, drill down about some of the responsibilities that they have, and the other thing I'll say about this slide this is more normative than descriptive. This is what the board of directors should be doing. If you look in particular companies, they may be very far away from what they actually do and what they should do can be pretty dissociated or pretty far apart. But here are the functions of the board of directors; selecting, evaluating and compensating the CEO, overseeing CEO succession plans, providing guidance on executives and their compensation, reviewing, monitoring and approving the strategic initiatives, conducting a risk assessment and mitigating those risks. So matter of fact for our last case for this module, we're doing the BP case and the risk assessment they had in terms of the Horizon disaster that occurred for BP. So in some sense you can say that the board of directors is also in some ways responsible for or at least evaluating where were they in terms of evaluating these plans. Next step is ensuring that the firm's audited financial statements are done correctly. That's much more a focus of the board of directors today than 15 years ago, and finally ensuring a firm's compliance with the laws and regulations which gets back to our pyramid discussion that we had earlier. Your question for discussion is in 2011, there were 17 members of the board of directors for General Electric, with a market capitalization of about $325 billion. Fifteen members were independent outside directors. One of the inside directors was CEO Jeffrey Immelt, the Chair of the Board of Directors, and roughly two-thirds of US public firms the CEO of the company also serves as Chair of the Board of Directors. What arguments can be made for and against splitting the roles of the CEO and the Chair of the Board of Directors? Please reflect on this question and post your response in the discussions for this video. Thank you. Finally to finish up, we noted early in the first module for this or the first video for this module that the different states in the United States can have different corporate charters or the state of Nevada has a different corporate charter and different rules of the game than the state of Delaware. We also can see that governance is quite different throughout the world. So we have what are called free market economies. But there is no such thing as a perfectly free market economy. They're all hybrids. It's more a matter of degree than in kind. So we have one end of the market economy spectrum you can have state directed capitalism like China with a lot of control and on the other hand, relatively speaking a free market capitalism in the US where there's more freedom in the corporations. So going into the other countries then, some countries have much more focus on like stakeholder capitalism in Germany focuses on labor representation on the board of directors, which is very rare in the United States. So the interest, not only of shareholders, but also labor and the balance and the trade-offs between are discussed within people who sit at the table of the board of directors in Germany. France has a lot of state-owned enterprises and it's another type of stakeholder capitalism, and then finally, as we mentioned China has state owned enterprises where they often will be involved in the strategic plans of those companies in addition to the CEO of that company.
