A Review of the Corporate Problems

Remember from Chapter 2 that the U.S. corporate system experiences the problem that the control of a public company is in the hands of one group of people (the executives), while the ownership of the firm is in another (the shareholders). This separation between ownership and control can lead to misbehavior by the executives. There are two mechanisms for influencing executive behavior ”incentive systems and monitoring.

We examined the executive incentive systems in Chapters 3 and 4. The main device used in the incentive program is the stock option. Both stock and options compensation plans are used to try to align manager goals with shareholder goals. We demonstrated that stock options also create other incentives that are not aligned with stockholder interests. Owning a large amount of stock can also cause the misalignment of interests between the CEO and public investors. Specifically, the equity incentives like stock and options cause executives to benefit from "timing the market." By timing, we refer to maximizing earnings in a future period and then selling the stock before the ensuing earnings and stock price decline.

There are several different groups that monitor the decisions and behavior of company executives. Specifically, we discuss the monitoring role of auditors (Chapter 5), boards of directors (Chapter 6), investment banks (Chapter 7), analysts (Chapter 8), and credit rating agencies (Chapter 9). Of course, the SEC as the primary securities regulator is an important monitor (Chapter 10), and we also noted that even the investors themselves can monitor the firm and try to influence company management (Chapter 11). We provide a summary of the problems facing the corporate system in Table 12-1. It is useful to review these problems now in order to see if the solutions proposed by the government and the stock exchanges actually address them.

Table 12-1. Summary of Problems in the Corporate System

Incentive or Monitor	Problem
Stock and Options	They give executives the ability to time the market and sell out at possibly artificially high levels. They reward and punish executives for influences outside of their control (like a stock market bubble or an economic recession ).
Auditors	If auditors provide consulting and auditing services to the same company, auditing quality is inhibited. Auditors desire to maintain a long- term relationship with a company, and this inhibits auditing quality.
Boards of Directors	They lack independence from the executives. They lack expertise in business and industry. They lack the incentive to monitor. Accepting consulting fees from executives creates the wrong incentives.
Investment Banks	The incentive is to raise capital for companies regardless of whether the firm deserves the capital or of its impact on shareholders and other firm stakeholders.
Analysts	Analysts' pay derives from investment banking services rather than accuracy of predictions . Analysts are too dependent on relationships with corporate executives for information. Analysts suffer serious conflicts of interest with their employers ' investment banking business.
Credit Rating Agencies	Agencies have very little discipline because they are protected from competition by government regulations and are legally protected in lawsuits. There is little interaction with customers (the investors).
SEC	The commission is underfunded and overburdened.
Shareholders	There is little incentive for small shareholders to monitor a firm. Management- backed proposals nearly always pass. Institutional shareholders have had only marginal success with investor activism.