It has been over two years since the Enron scandal broke and well over a year since Congress passed its sweeping reform legislation, the Sarbanes-Oxley Act. Enough time, perhaps, to gain some perspective on a series of scandals that continue to shock the senses of even the most jaded business observer.
Look carefully at the recent accounting scandals, and you will see a pattern writ large. A faltering company is unable to meet earnings targets fully endorsed by management and set to fulfill analysts’ expectations. Staring down the barrel of an earnings gun they locked and loaded, management sets out to meet those targets using every means possible—including, at the extreme, resorting to fraudulent accounting methods. And, while pundits have written much about the causes and consequences of infamous cases such as Enron and WorldCom, one thing stands out. They all involved a fundamental breakdown in what economists call agency—the persistent, inherent problem all corporations face in aligning the interests of those who manage the company (executives) with those who own the company (shareholders).
Once considered primarily an academic issue, agency costs arose prominently in the aforementioned cases when the interests of managers and the interests of the shareholders diverged dramatically. While the dry ruminations of academics are of little interest to board members, mastering agency costs must stand at the top of any board’s agenda. As the duly elected representatives of a dispersed and varied group of shareholders, directors must arbitrate between the shareholders’ interest and the very real market constraints executives contend with daily. Indeed, boards sit at the intersection of this historic conflict. Managing—or, at the very least, understanding and accounting for—agency costs, then, becomes a priority for all boards.
The Origins of Agency Costs
The public corporation, almost by definition, carries a fragmented set of owners. This continues to be one of its great advantages as well as an unavoidable, structural weakness. Public ownership spreads the entrepreneurial risk inherent in any particular venture. And it allows shareholders to diversify their portfolio efficiently and tailor that mix to reflect their appetite for different types of risk at different points in time.
However, a dispersed shareholder group brings with it its own inherent risks. In all but the rarest circumstances, no individual shareholder possesses the stature to command management’s attention. Moreover, none has the incentive to invest substantially in a detailed understanding of any individual company’s risk profile. (See “Erosion of the Power of Large Shareholders,” at the end of this article.) Indeed, the evolution of the public accounting industry and the criticality attached to the integrity of corporate financial reporting reflects the supposition that most shareholders require a limited amount of accurate data to inform them in making investment choices.
As Andrew Carnegie once said, “Anybody’s business can become nobody’s business” with public ownership. Today even sophisticated institutional shareholders find themselves at a loss to explain the apparent ineptitude or even criminality of once lionized executives and the evaporation of value in once feted companies. Why? Because large corporations are so complex, the transactions they consummate so sophisticated, and the markets in which they compete so vast as to bewilder even sitting board members. As a result, even the best-equipped investor cannot possibly hope to understand much of what goes on inside a company beyond a superficial level.