A little history may be worth while.
Once upon a time -- say a hundred years ago -- companies were largely run by their owners. When JP Morgan or Henry Ford decided on his compensation, he mostly consulted himself, because what he paid himself in salary and bonuses, largely came out of his pocket as shareholder.
But as the twentieth century wore on, companies grew bigger and more complex, and the heirs of the founders didn't want to be bothered with running things any more. So was born a new class of professional managers. They had the missing skills, by and large.
But they didn't have an ownership stake. As Berle and Means recognized as early as the 1930s, there was a huge corporate governance problem. What was to stop managers from pursuing their own private interests, rather than the interests of the shareholders (and of other security-holders)? Shareholders couldn't monitor tightly enough. After all, it was precisely because they were not ready to devote that much effort that the professional managers were hired in the first plase. And even if managers could be constrained, that would remove their discretion. They would no longer have the flexibility to take advantage of new opportunities or react to changes in the market.
So from the 1910s through the 1970s, shareholders lived with managers who delivered enough profit not to incur a shareholder revolt (which was unlikely anyway), and mainly spent their time building private empires -- or relaxing on the golf course. Industry in those days was not very competitive -- indeed, competition was a dirty word for many years after the Great Depression -- and mediocrity was acceptable, as long as investors did not actually
lose their investment.
Many things happened starting in the 1960s, including takeovers and buy-outs, since many corporations were such tempting targets. But one of the things that happened was the thought that maybe, just maybe, top management would perform better if their incentives were better aligned with those of shareholders. Michael Jensen at Harvard, and others, preached the theory. Venture capitalists, and their predecessors, illustrated the practice. It was very simple: make executive compensation dependent on how well shareholders did.
One way was to oblige top management to own a significant number of shares in the company. But a rising executive might not have that much money. And so a way was invented to tie compensation to share price without requiring a larger investment up front -- stock options.
It is important to stress that granting stock options was a solution to a real and pressing problem -- how to align executives' ince4ntives with those of shareholders, and get out of the trap that Berle and Means had identified fifty years earlier.
Unfortunately, executives quickly learned how to "game" the compensation plans. This ranged from rapid vesting, to repricing options when the stock price
fell -- instead of letting the options expire worthless, as had been intended -- and so on.
Why did this happen? First, boards of directors were captured by management, and shareholders seemed not to care. Even if they had cared, management as a whole had succeeded in getting various legislatures to pass laws that made it extremely difficult for shareholders to act. Not that that mattered much anyway -- widely dispersed investors have no incentive to monitor management and take any action.
So we got rid of one problem -- passive management that took actions contrary to shareholder interest, out of self-aggrandizement or sheer inertia. And we substituted another problem -- hyperactive management that has a time horizon equal to the vesting of their stock options, or bonuses, etc.
In my view, the problem is that we still haven't learnt to set up effective corporate governance mechanisms. The solution
is not to return to some mythical golden age when all executives were virtuous and integrity ruled the land. The solution is to give shareholders sufficient incentives, and instruments, to get involved.
Of course, some are sceptical that shareholders, or indeed boards of directors, will ever exercise any control over management.
Jonathan Macey, in an excellent book, recommends two measures instead
(1) Make hostile takeovers easier. Inparticular, take away management's ability to block takeover bids without getting shareholder approval for such measures. (Ironically, Recommendations 38 and 39 of the
Final Report of the Canadian Government's Panel on Competitiveness -- the major driver of this government's industrial strategy (sic) -- wants to make takeovers harder.)
(2) Encourage hedge funds and private equity, hoping that large or concentrated shareholders will take an interest in what management is doing.
Both of these approaches are worth trying, in my opinion. Preaching a return to virtue is not.
George