A corporation's ownership and control are separated between two parties ”shareholders and officers. The shareholders own the firm, and the officers (or executives) control the firm. This situation comes about because public firms are owned by thousands, even hundreds of thousands, of investors. Obviously, thousands of people could not possibly join together to make the daily decisions needed to operate a business. They hire managers to do this.
Besides, most shareholders are not interested in being involved in the firm's business activities. These shareholders act like investors, not owners . The difference is subtle, but important. An owner is focused on the business performance of the firm. An investor is focused on the risk and return of his or her stock portfolio. In other words, investors spread their wealth around rather than have it staked into one or a few investments. Many investment professionals and academics know the mathematics and logic of portfolio diversification, but perhaps the best way to understand it is to think about the old adage that one should not put all of one's eggs in one basket . While diversifying reduces risk for the investor, it also makes participation and influence in that many companies less likely. Therefore, investors tend to prefer to be inactive shareholders of many firms.
There is a problem with this separation of ownership and control, and it exists at a simple level. Why should the managers care about the owners? It is not far- fetched to imagine that managers may do what's best for them if they can get away with it ”even if it is at the expense of owners. This idea is usually attributed to Adolph Berle and Gardiner Means in their book The Modern Corporation , published in 1932. The argument that they put forward makes just as much sense today as it did when it was first published. In academic jargon, the problem with the separation of ownership and control is known as the principle-agent problem, or the agency problem. Consider the owner of a nightclub (the principle) who hires a bouncer (the agent) to check IDs at the front door and take a cover charge from the customers who enter. The bouncer may pocket some of the cash if he thinks that no one is looking. That is, he may try to maximize his own wealth at the expense of the owner. If the owner cannot effectively monitor the transactions and the activities of the bouncer, she could lose money. Thus, monitoring is important to help overcome the agency problem.
The shareholders of a corporation are the principals, and the managers who run the company are the agents . If shareholders cannot effectively monitor the managers' behavior, then the managers may be tempted to use the firm's assets to increase their own lifestyle. Or, as James Burnham put it in his 1941 book The Managerial Revolution , managers will behave as if they are the owners. Executives may enjoy perks such as liberally charging the corporate expense account, chartering the company jet, ordering top-grain leather office equipment, and so on at the expense of shareholders. Of course, we have recently seen abuses that make these examples seem petty. We discuss the astonishing abuses throughout this book.
Solutions to this problem tend to come in two categories: incentives and monitoring. The incentive solution is to create situations in which the executive's wealth is tied to the wealth of the shareholders. That way, the executives and the shareholders want the same thing. This is called aligning executive incentives with the shareholders. Executives would then act and behave in a way that is also best for the other shareholders. But how can this be done? For most U.S. companies, executives are given stock and/or stock options as a significant component of their pay. The advantages and disadvantages of this form of incentive solution are explored in the next chapter. Suffice it to say, there are problems.
The second type of solution is to set up mechanisms for others to monitor the behavior of managers. Indeed, there are several mechanisms for monitoring executives, which we discuss shortly.