Chapter 19: Agency Problems & Corporate Governance

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Welcome back to The Deep Dive.

This is the show where we take the big fundamental conflicts that shape global finance, strip them down to their core, and give you the essential knowledge you need.

And today we are wrestling with what might be the most persistent and critical conflict in all of corporate finance.

It's a tension that really dictates whether billions, even trillions of dollars of potential value get created or just destroyed.

We are diving deep into the agency problem and the structural solutions we've built to try and solve it, which we call corporate governance.

Right.

Okay, so let's get right into this because the whole foundation of financial making, you know, all the things we talk about, NPV, capital structure, it all rests on a pretty uncomfortable assumption.

It does.

We have to ask, are the people who are actually running the company, the managers, the CEO, are they really motivated to maximize value for the people who own it, the shareholders?

That is the big question.

And the fundamental answer is no, not perfectly.

Their interests just aren't perfectly aligned.

And that's because of this separation of ownership and control.

Exactly.

You have the shareholders who are the principals.

They own the company.

They want one thing for managers to take all the positive NPV projects and only those projects.

Simple enough.

But then you have the managers.

They're the agents and they're human.

They have their own incentives, which are perfectly natural things like personal glory, higher pay, or maybe just an easier, quieter life.

And that structural conflict right there, the agent acting for their own self -interest instead of the principals,

that's the agency problem.

And the damage it causes, that's what we call agency costs.

Right.

And you really have to understand these costs because if you can't measure the cost of this misalignment, you can't justify spending money on the governance structures you need to fix it.

And these costs fall into two big categories.

The first one is the indirect costs.

Yes.

And that's the lost value.

This is what happens when managers make decisions that don't maximize value.

Maybe they take on a bad negative NPV project.

An error of commission.

Right.

But more often and more destructively, it's an error of omission.

They fail to take on a good positive NPV project.

This is the cost that's harder to see, but it can be absolutely devastating.

Okay.

And the second category, that's the more direct quantifiable cost.

Those are the costs the specifically to try and mitigate the problem.

The costs of setting up monitoring systems, hiring auditors, creating rules and procedures, compensation committees.

And ultimately the cost of having the board step in and clean house.

Precisely.

So our mission today is to really unpack the specific behaviors that lead to these costs.

We're going to cover the five core agency problems, and then we'll explore the three main mechanisms, monitoring, incentive compensation, and external structures that are used all over the world to try and keep management focused on creating value.

So we're jumping right into the list of managerial temptations that end up causing shareholders money.

And the first problem sounds simple, but it's actually pretty nuanced.

It's reduced effort or what's often called the quiet life.

Yeah.

And when you hear reduced effort, you probably picture a lazy CEO out playing golf all day, but the sources are really clear that is what's usually not the case.

CEOs typically work incredibly long hours.

So it's not about being lazy.

Not at all.

The real effort reduction is much more subtle.

It's a preference for managerial comfort over maximizing value.

It's choosing to manage the existing predictable projects instead of launching a new high effort, high pressure, but also highly profitable new project.

So it's not physical laziness.

It's organizational inertia.

The energy would take to change direction to disrupt the status quo, maybe face some internal resistance.

It's just too high for the CEO to bother with, even if shareholders would benefit massively from it.

That's it.

Exactly.

And this is why the sources really stress that errors of omission failing to make a good decision can be so much more serious than errors of commission, you know, making a bad one.

Well, a bad decision, a bad project, it gets noticed pretty quickly.

The numbers don't lie, but the decision not to innovate, that's quiet.

It's easy to defend.

And the consequences often don't become catastrophic until years, maybe even decades down the line.

And the classic tragic example of that is Kodak.

This should be a warning sign for every financial manager out there.

It really should.

They invented the core technology for the digital camera.

Wait, they invented it.

They invented it back in 1975.

They had the first patents.

They were in the perfect position to lead that entire transition.

So what happened?

The internal resistance was just immense.

Their internal forecasts, which were, you know, pretty self -serving, suggested that film would take at least 10 years to be displaced.

So sticking with film was the comfortable choice.

Yeah.

The quiet life.

Absolutely.

The effort and the risk involved in pivoting a massive multi -billion dollar company into a space they didn't dominate yet was just just.

It was too much for the managers to bear, even if the NPV calculation was screaming at them to do it.

And that failure to act, that inertia led directly to bankruptcy in 2012.

You go from a company with a peak valuation of 31 billion dollars to, well, to a tiny fraction of that.

That is the definition of an agency cost from an error of omission.

And that required effort isn't just about starting new things.

It's also about stopping old ones.

Right.

Shutting things down is hard.

It's incredibly hard.

Think about the personal effort it takes to identify an underperforming division, to shut down plants, to manage thousands of layoffs, to face down union opposition, or just deal with the public backlash and the internal friction from colleagues whose budgets you have to slash.

It's often easier for managers to just postpone those tough but necessary decisions.

And the data actually backs this up, right?

It does, globally.

Studies have found that companies that are protected from market pressure, maybe they have strong takeover defenses, they show measurable increases in wages, but also reductions in productivity and profitability.

They build fewer new plants, and crucially, they shut down fewer old underperforming ones.

That market pressure cooker is absolutely essential to fight inertia.

Okay, that brings us to the second problem.

Private benefits.

Or perks.

This is where managers divert company resources for their own personal use.

Yes, and this is where you get into the real folklore of corporate finance, the really jaw -dropping stories.

We're talking gold -plated offices,

luxury resort meetings, and the classic tell,

the corporate jet.

Or jets.

The sources point to RJR Nodisco, the company at the heart of the leveraged buyout boom in the 80s.

They maintained 10 private jets and 36 pilots.

10 jets.

10.

And the most famous detail is that they actually listed the CEO's dog as a passenger, G.

Shepherd, so it could fly to golf tournaments.

And the luxury didn't stop there.

The hanger they used was refurbished with $600 ,000 worth of furniture and some very elaborate Japanese landscaping.

I have to pause on that.

$600 ,000 for furniture in a hanger.

That's not just being extravagant.

That signals a complete failure of control.

How does a board approve that?

That is the key question.

And while that RJR story seems extreme, the data shows it's a symptom, not a one -off.

Studies that look at U .S.

companies that disclose their corporate jet usage find that those companies go on to underperform their peers by 4 % a year.

4 % a year.

So the value being destroyed is way more than just the cost of the jet fuel.

Massively more.

The corporate jet, as the source puts it, is just the tip of the iceberg.

The expense itself might be small, but the signal it sends that the CEO feels entitled to use company assets for personal vacations.

It suggests a total lack of accountability and board oversight, which is likely destroying value everywhere else, too.

Like the Western Energy CEO, David Wittig.

He was using the jet for family holidays.

Right.

And he also spent $6 .5 million refurbishing his office and home, which apparently included a $1 ,200 bronze alligator.

Again, the cost of the alligator isn't the problem.

The mindset that lets an agent treat the principal's money as their own personal piggy bank, that's the agency problem in action.

And that mindset leads us right to the third temptation.

Yeah?

Overinvestment.

Or, as it's often called, empire building.

This is where managers pursue growth in size, not because it creates shareholder value, but because it satisfies their own personal desires.

And what drives that?

Well, there are three powerful incentives.

First, compensation.

There's a really well documented strong link between the size of a firm and how much the CEO gets paid.

So bigger company, bigger paycheck.

The quickest way to get a raise is to grow the firm, often through acquisitions or just rapid investment, even if the returns aren't great.

And managers are institutionally very reluctant to shrink the company, even if it means selling an unprofitable division, because that means shrinking their own kingdom.

Then there's the second driver,

prestige.

Absolutely.

Being the CEO of a hundred billion dollar firm comes with a massive social status premium.

You get the keynote speeches, the invitations to Davos, the media attention.

That status drives what we call empire building for its own sake.

And this isn't just about size, right?

It could also be donating company money to the local symphony or university to boost their personal prestige.

Exactly.

Things that burn cash without creating equivalent shareholder value.

And the classic example here is Countrywide Financial and its CEO, Angelo Morazzolo.

Right before the financial crisis.

In the early 2000s, Mozilla's stated goal was just market share dominance.

He became obsessed with being the number one US mortgage originator and he plunged recklessly into the subprime market to do it.

The focus completely shifted away from sound risk analysis to just growth at any cost.

And we all know how that ended.

That pure empire building led to near bankruptcy and a forced fire sale to Bank of America in 2008.

And we can't forget a more subtle form of over investment called entrenching investments.

What's that?

This is where managers might intentionally choose negative NPV projects that specifically require their unique skills.

So it makes them harder to fire.

It makes them indispensable and ensures their job security even if a different positive NPV project would be much better for shareholders.

And all of this over investment is most dangerous when you have the free cash flow problem.

A firm with tons of cash but not enough good investment opportunities.

That cash just becomes a magnet for managerial pet projects.

Okay, let's move to the fourth problem.

Risk taking.

And it's a bit ironic because managers can be criticized for taking both too little risk and too much risk depending on the situation.

Right.

And that's because managers and shareholders just have different relationships with risk.

A shareholder holds a diversified portfolio so they can diversify away what we call specific risk.

So they only care about market risk.

Exactly.

Managers though, they can't diversify their wealth, their job, their reputation.

It's all tied to the success of this one single firm.

So to protect themselves and maintain that quiet life, they become risk drivers.

They might reject projects with high specific risk even if those projects have a really strong positive NPV for shareholders.

That's the too little risk problem.

But then, when the business is already in trouble, on the ropes so to speak, the dynamic completely flips.

This leads to gambling for resurrection.

Doubling down on a losing bet.

Precisely.

If the company is failing, the manager is probably going to lose their job anyway.

So they might as well try a desperate, high risk, long shot strategy.

If it pays off, they're a hero and their job is saved.

If it fails, well, they lose their job, which was going to happen anyway.

The downside is already priced in for them.

They face an asymmetric risk.

And the sources bring us back to the pre crisis era for a perfect example of this.

The CEO of Citigroup, Charles Prince, was asked about the bank's rapid, very risky expansion into leveraged lending.

I remember this quote.

His famous line was when the music stops, things will be complicated.

But as long as the music is playing, you've got to get up and dance.

We're still dancing.

And that dancing led straight to a $1 .5 billion loss on that one business line.

It's a perfect example of just continuing a destructive, risky activity, maybe gambling,

that something will save you because admitting failure and bearing brothers.

One trader, Nick Leeson, just kept doubling down on his losing bets until he single -handedly bankrupted a 200 -year -old bank.

Okay.

Finally, we get to the fifth core problem, which really amplifies all the others.

Short -termism.

This is where managers focus on immediate actions that inflate today's profits or stock price at the expense of long -term value.

And this is a massive issue today, especially because so much of a modern company's value lies in intangible assets.

Things like brand reputation, patents, R &D pipelines, employee skills.

Things that take years to build.

Exactly.

Years to nurture.

And they don't always provide visible signs of progress for outside investors to see along the way.

And the tragic irony is that the very incentive schemes we design to solve the other problems, like basing pay on current profits or stock price, can actually make this short -term focus even worse.

It's true.

They can encourage the manager to artificially inflate those numbers.

And how do they do it?

By cutting discretionary long -term investments.

Like R &D and advertising.

Surveys show a staggering 80 % of CFOs admit they would cut spending on R &D, advertising, or maintenance just to hit an immediate earnings target.

They'll literally defer or reject positive NPV projects to make sure they meet the consensus number for this quarter.

But why are they so obsessed with hitting that one number?

Why is the reaction so drastic?

It's the psychological impact.

It's often called the cockroach analogy.

The cockroach analogy.

Yeah.

The market believes that a stable, well -run company should consistently hit its targets.

If a firm misses a forecast, even by a little, the market immediately assumes that the underlying stability is gone, that the company must have deep, maybe even fatal structural problems.

So if you see one cockroach.

You immediately assume there are hundreds more hiding behind the walls.

Missing an earnings target signals a deep infestation to the market.

And the market's own short -term reaction kind of validates this behavior, doesn't it?

Unfortunately, yes.

Studies have compared firms that narrowly beat their forecasts, often by cutting R &D or using aggressive accounting with firms that narrowly missed them.

And in the short term, the beaters outperformed the missers by 2 to 4%.

The market took the inflated earnings at face value.

What about the long term?

And here is the critical data point for any long -term financial manager.

Over the next three years, those beater firms, the ones that cut R &D to hit the number, underperformed the missers by a massive 15 to 41%.

The short -term manipulation destroyed enormous long -term value, and eventually the market figured it out.

Okay, so the conflict is crystal clear.

We have these five powerful agency problems that are constantly eating away at shareholder value.

The solution is corporate governance, and that starts with the internal structures designed to make sure managers are working for us, the owners.

And the first, most critical line of defense is monitoring by the board of directors.

Right.

The board's role is really multifaceted.

They're elected by the shareholders, and their duties include scrutinizing what management does, approving major expenditures and strategy,

proactively monitoring profitability, and of course, the most powerful tool they have.

The power to fire the CEO.

The ultimate authority to fire the CEO.

And we're seeing that power get used more and more frequently around the world.

In recent years, you've seen high profile CEO departures at Boeing, GE, McDonald's.

It suggests boards are becoming less willing to tolerate underperformance.

In the US and the UK, we mostly use a single board structure.

What does that look like?

It includes inside executive directors, that's the CEO, the CFO, people who work for the company, and outside non -executive directors who are not employees.

And the effectiveness of this whole structure really hinges on a few key factors.

Let's start with the most obvious one.

Board independence.

This seems intuitively necessary.

It's absolutely critical.

Independent directors are defined as those who aren't linked to the company by business relationships that could, you know, bias them towards management.

If they have no personal or financial stake in keeping the CEO happy, they're much more likely to hold management accountable.

And the research confirms this.

It does.

Boards with a higher percentage of outside directors are more likely to fire the CEO after a period of poor performance.

And now regulations from the NYSE and NASDAE actually require large US companies to have a majority of independent directors.

And in practice, it's usually around 85%.

Okay, next factor.

Board size.

You'd think more heads are better than one, but we often hear about the free rider problem in monitoring.

That's right.

When a board gets too big,

individual directors feel less incentive to put in the hard work of monitoring because they assume someone else will do it.

The individual cost of doing the homework outweighs the individual benefit.

And empirically, smaller boards are associated with higher firm valuations and greater CEO accountability.

But we shouldn't just assume small is always best, right?

A huge, complex, diversified company might actually need a larger board just to have expertise in all its different business lines.

That's a fair point.

The goal is efficiency, not just smallness for its own sake.

And this is closely related to another modern challenge.

Overboarding.

This is when directors are just spread too thin.

Exactly.

The most sought after directors often serve on so many boards that they physically cannot devote enough time and attention to each one.

Is there data that shows this hurts value?

Definitely.

Studies define a busy board as one where most of the outside directors have three or more directorships.

And these busy boards are found to be less profitable, less highly valued, and critically, the CEO is less likely to be fired after poor performance.

It's a clear capacity constraint.

Okay.

And finally, within this single board structure, there's the debate over the frequency of elections and specifically about staggered boards.

Most US and UK companies reelect their entire board every single year, which gives shareholders regular full control.

A staggered or classified board, on the other hand, only reelects one third of the directors each year.

Which makes it much harder to take over the board.

Much harder.

Activist investors argue, and the evidence generally agrees, that staggered boards entrench management.

A dissident shareholder group has to wait two full years just to gain a majority of seats, which makes a proxy fight much more expensive and time consuming.

And the finding that staggered boards reduce firm value has led to these widespread, de -staggering campaigns we've seen.

Now, let's pivot away from the Anglo -Saxon model and look at Germany, which uses a fascinating two -tiered system.

This is really important context for anyone operating globally.

Right.

German firms are split into two boards.

There's the supervisory board, Elfsixrat, which is responsible for overall strategy and oversight.

And then there's the management board, Vorstand, which handles the day -to -day running of the company.

The management board reports to the supervisory board, which has the power to hire and fire them.

And a really unique feature of that supervisory board is co -determination, where a certain number of seats are legally reserved for employee representatives.

What's the trade -off there?

The trade -off is basically stability and worker protection versus operational flexibility and pure shareholder value maximization.

How so?

Well, research looked at German firms just above and just below the 2000 employee threshold, which is where employee representation on the board jumps from one -third to one -half.

And it found that more representation protects jobs.

The firms with 50 % employee representation cut employment much less severely during big industry downturns.

So it's a form of job insurance.

Does the company pay for that insurance in other ways?

It does.

That job protection is found to come with lower wages, about three to three and a half percent lower on average.

And what's more, the representation often only seems to benefit skilled white -collar and blue -collar workers, suggesting the representatives are primarily looking out for their own specific group of labor, not the entire workforce.

Okay, moving on from the board.

The next pillar of governance is monitoring by shareholders themselves.

Even if the board isn't doing its job,

shareholders have powerful tools for what we call stewardship.

And those tools are traditionally categorized as voting, engagement, and exit.

Let's start with voting.

This is the most basic, formal, control -approving directors, mergers, and casting that advisory vote on executive pay, say on pay.

And when that doesn't work, investors can launch an expensive proxy fight proposing their own directors.

Which is a multi -million dollar process.

But just the threat of one is a massive source of leverage over a complacent board.

And we should also note the rise of ESG issues in shareholder voting.

It used to be all about governance, but now a huge percentage of proposals are about climate change, diversity, and social issues, which shows how shareholder priorities are evolving.

Now, the voting structure itself is complicated by the rise of dual -class equity.

This is where different shares have different voting rights.

Facebook is a famous example.

Mark Zuckerberg's B shares have 10 votes each, allowing him to keep control without owning a majority of the company's equity.

Snap even went public with shares that have zero votes.

Which raises the obvious question.

Why would any rational investor buy a share with no say in how the companies run?

And the research seems to validate that concern.

It does.

Generally, dual -class shares are associated with lower firm value, higher CEO pay, and worse overall investment decisions.

They fundamentally concentrate power in the hands of a few insiders.

And the reason owners want this is to capture the private benefits of control.

They want the security to pursue their long -term vision without shareholder interference.

And we can actually measure this by comparing the price of high vote shares versus low vote shares.

In the U .S., that voting control premium is pretty low, only about 2%.

But if you look in a country like South Korea, it's a staggering 48%.

Which suggests that in countries with more concentrated ownership, the majority owners are capturing immense private benefits, often at the expense of minority shareholders.

This moves us perfectly to the second tool, engagement.

And specifically, activist investors.

These are large investors who specialize in finding and turning around underperforming companies.

Right.

You think of names like Carl Icahn or Nelson Peltz.

They buy up a significant stake and then launch these very confrontational, very public campaigns, always holding that threat of a proxy fight over management's head.

But the criticism you always hear is that they're just swarms of locusts, right?

Forcing short -term gains at the expense of long -term health.

Like by cutting necessary R &D.

Is that true?

Well, the initial stock price reaction certainly supports the activist.

The stock price jumps by about 7 % as soon as they announce a large stake.

And that gain isn't reversed in the long run.

Okay.

But where does that value come from?

From genuine productivity increases.

Studies show plant and labor productivity rise.

And critically, wages and hours worked do not decline, which means the gain isn't just coming from squeezing the workforce.

But what about that R &D cut?

Activists do often demand cuts to R &D spending.

They do.

But the data suggests it's not universally destructive.

Studies found that while activists may cut R &D spending, the amount of innovation measured by the number and quality of patents the company generates actually rises.

And they're producing more with less.

It suggests that the R &D that was cut was probably just wasteful or inefficient to begin with.

The key isn't whether R &D is cut, but whether effective R &D is cut.

And the third tool is the one that management fears most.

Exit or the Wall Street Walk.

This is governance through selling.

If a firm is performing poorly or if management seems adrift, shareholders just sell their shares.

And if enough of them do it, the stock price tumbles, which damages management's reputation, hurts their condensation, and forces the board to take corrective action.

But the risk here is that managers will try to inflate short -term profits to stop people from selling, which brings us right back to the short -termism problem.

We have to distinguish between an investor's holding period and their orientation.

That distinction is absolutely crucial.

You can be a short -term trader who holds a stock for years, or a long -term investor who trades frequently.

What matters is whether you trade based on long -term information.

You have an example for that.

Look at Ford in 2017.

The stock price fell 21 % over two years.

Not because current profits were bad, they're actually quite high, but because investors were deeply concerned about the lack of investment in electric and self -driving car technology.

That was a long -term concern driving the selling.

Which brings us to the vital role of blockholders.

Yes, these are large shareholders who own enough of the company that it's actually worth their time and money to do the deep detailed research needed to understand whether management is making a genuinely far -sighted investment, or if they're just mismanaging the company's assets.

Blockholders are essential for making sure the market is trading on long -term value, not just temporary earnings.

Okay, our final set of monitors are the external checks.

Auditors, lenders, and potential acquirers.

Right.

Auditors are the external accountants hired by the board's independent audit committee.

Their job is to issue an opinion that says the financial statements are a fair representation of the company's condition according to Generally Accepted Accounting Principles, or GAP.

And managers will fight tooth and nail to avoid a bad opinion.

A qualified opinion.

Which means the accounts aren't fully presented by GAP, or worse, an adverse opinion.

Which means there are material misstatements.

They'll negotiate fiercely to avoid those.

But unfortunately, we know this system can fail spectacularly.

The classic case is Enron.

Enron systematically hid huge amounts of debt by using these special purpose entities, or SBEs, that failed to meet the technical accounting rules to be kept off the balance sheet.

When the whole house of cards collapsed, Enron had to retroactively consolidate all that debt, which wiped out past earnings and led directly to his bankruptcy.

And it also brought down its auditor, Arthur Anderson, highlighting the immense cost of failed auditing.

And we've seen similar, more recent scandals like Ted Baker or Patisserie Valerie, where accounting problems led to huge share price drops, and in Patisserie Valerie's case, bankruptcy.

Transparency is the oxygen of the market system.

Then you have lenders.

Banks and bondholders monitor the firm to make sure they can service their debt.

Banks, in particular, often demand really strict control, like monthly financial info, regular plant visits, or even daily caseload data if a loan is collateralized.

And by protecting their own debt, they usually end up protecting shareholders, too.

But not always.

That's a key distinction.

Banks are generally more conservative than shareholders.

They might turn down a high -risk, but positive NPV project that shareholders would love because the bank's top priority is just the quiet safety of getting its loan repaid, not maximizing equity value.

And finally, the ultimate external check.

This is the system of continuous vigilance.

Rival management teams are constantly monitoring other firms, looking for inefficiently managed assets.

If they spot a significant agency problem, they have a powerful financial incentive to take over the firm, replace the bad management, and capture the value they unlock.

Just the constant threat of a takeover is a powerful deterrent against managerial complacency.

So we've established that monitoring only goes so far.

Managers will always have better internal information.

And that's why the second major pillar of governance is incentive compensation, which is all about trying to align managerial self -interest with shareholder interests.

Right.

And compensation is governed by the board's independent compensation committee.

They rely heavily on outside consultants to figure out the level and structure of pay.

And they have to detail all their reasoning in a document called the Compensation Discussion and Analysis, or CDNA.

And shareholders get a vote on this through the say -on -pay rule.

And even though this vote is non -binding in the U .S., boards that ignore repeated no votes do so at their own peril.

The Bed Bath & Beyond case is a good example.

After they ignored an initial no vote, they faced so much backlash that after a second one, they were forced to cut the CEO's compensation by 21 percent.

That shareholder voice, even if it's just advisory, is powerful.

So let's tackle the big controversy.

The sheer size of U .S.

executive pay.

The data shows U .S.

CEOs are by far the most highly paid in the world, often double or triple what their European counterparts make.

And the ratio of CEO pay to the average worker's pay was 264 to 1 in 2019, up from 42 to 1 in 1980.

Why is American pay so high?

There are two competing theories here.

The first is what's called a scalability argument, which was proposed by the economists Gabbay and Landier.

And this theory basically argues that the high pay is justified by competitive market forces, not necessarily by corruption or bad governance.

Precisely.

They argue that top talent has become vastly more valuable because the companies they run are so much larger now.

They use the analogy of a superstar athlete like Mike Trout.

He's not necessarily a better baseball player than Babe Ruth was, but because baseball is now a multi -billion dollar global industry, Trout's marginal impact on winning is worth astronomically more money.

So you translate that to the boardroom.

The average S &P 500 firm is huge today, maybe $22 billion in value.

If a top tier CEO is only slightly better than the next best candidates say, they add just 1 % more to the firm's value.

That 1 % translates to $220 million in new value created.

And when you compare that to an average pay package of say $14 .8 million, it still seems justified by the value they generate.

The key mechanism is scalability.

A CEO's decisions, a new strategy, a change in culture, they roll out across the entire enterprise.

That small talent gains scales up and the financial impact becomes enormous.

Okay, but the competing view is the poor governance argument.

This holds that the high pay is a reflection of weak boards and dispersed shareholders, which allows CEOs to basically set their own pay because of chummy links with directors.

If it were just market forces, why would we see so many high pay packages go along with terrible performance?

And that's a powerful challenge.

The evidence really supports both sides to some degree.

The rise in pay in other scalable professions like sports or entertainment does suggest that competitive market forces are a big part of it.

However, the data also shows that CEO pay is measurably lower when there's an outside blockholder who owns at least 5 % of the firm.

So focus monitoring does put a lid on it.

It confirms that a single powerful shareholder can and does limit excessive compensation.

So it's likely a combination of market forces driving up the demand for talent and, in some cases, poor governance failing to impose enough discipline.

So let's shift from the absolute amount to the structure of CEO pay, which is arguably more important.

The composition has changed dramatically.

Only about 12 % is salary now.

The vast majority comes from bonuses, stock grants, stock options, and these long -term incentive plans, or LTIPs.

And that shift toward equity is the primary way we try to align interests.

The stock price is a really attractive performance measure because it aligns directly with what shareholders care about, it captures expected future profits and growth opportunities, and it even reflects non -financial factors like employee satisfaction.

And the real incentive isn't the annual salary or bonus.

It's the fact that the CEO has a huge amount of their personal wealth tied up in their own holdings of stock and options.

That's the key.

The accountability is enormous.

Critics sometimes focus too much on the link between a bonus and short -term stock performance, but they miss the real wealth that's at risk.

A 10 % drop in the stock price cost the average Fortune 500 CEO about $6 .7 million out of their own pocket.

And the evidence suggests these incentives work.

Firms where the CEO owns a large stake generally outperform those with small stakes.

But stock -based pay has some big disadvantages.

First, the stock price depends on macroeconomic factors that are completely outside the CEO's control.

Economy, interest rates, industry trends.

And that creates two problems.

First, it introduces risk for the CEO, and to compensate them for that volatility, the firm has to pay them more in cash.

And second, the CEO can get unjustly rewarded for just being lucky.

We see this with oil company CEOs whose pay goes up when oil prices spike, even if they had nothing to do with it.

The most dramatic example cited is the CEO of Persimmon, Jeff Fairburn,

who got a massive $110 million windfall from his options in 2017.

Was that because he was a genius manager?

Not really, no.

The windfall was driven almost entirely by external factors.

Sustained low interest rates and huge government housing schemes that were propping up the market.

The public outrage over this pay -for -luck was so intense that it led directly to the resignation of the board's chairman.

It was a clear governance failure.

So how do you strip out the luck component?

You use performance shares and long -term incentive plans, LTIPs.

Performance shares are often valued based on relative measures, like how your earnings per share growth compares to the rest of your industry.

That helps strip out market -wide factors.

And LTIPs can use a combination of financial targets and increasingly non -financial targets, like safety metrics or climate change goals.

But even those performance targets can fall into the short -termism trap, right?

Absolutely.

Managers can still manipulate the numbers to just barely hit the threshold they need for the payout.

We see this in the data.

Firms that just meet a target show less R &D and higher accounting accruals than firms that just miss, which suggests they cut long -term investment just to get the bonus.

This highlights the final, and maybe most crucial, element of good compensation structure.

Ensuring a long -term commitment.

If a CEO can pump up the stock price now, sell all their shares, and then leave before the long -term consequences hit, the incentive is still all wrong.

And the case of Countrywide's Mozilla is notorious for this.

He pursued those risky growth -at -any -cost strategies, which boosted the stock price, and then he sold $140 million worth of his shares right before the company completely collapsed.

He cashed out before the consequences of his actions became clear.

So what is the robust structural solution to this cashing out before the crash problem?

It's the use of restricted stock, where the shares are locked up for several years.

And this is the critical part.

That lockup must be extended beyond the CEO's departure.

Why is that post -departure lockup so vital for shareholder interests?

Because if the CEO can only sell the rest of their substantial wealth after they have retired, they have a powerful incentive to make sure the stock price holds up after they're gone.

So they have to think about succession.

It forces them to focus on truly long -term investments, to avoid catastrophic strategic failures, and most importantly, to ensure a smooth, high -quality management succession plan.

The example given is Unilever's former CEO, Paul Paulman, who had to hold stock worth five times his base salary for the first full year after he retired.

That is true long -term alignment.

So far, we've mostly been analyzing the market -based system of the US and the UK, which is defined by dispersed ownership, a strong reliance on the board, and stock -based pay.

But if you look globally, that model is often the exception, not the rule.

In many places, ownership is much more concentrated, and they rely on very different monitoring mechanisms.

Let's start with Japan, which for decades relied on the kuretsu structure and the main bank system.

A kuretsu is a loose network of affiliated companies, often organized around a major bank.

And the unique feature is cross -holdings, where the companies all own shares in each other.

Right, which severely limits the amount of stock available to the public and reduces any outsider influence.

This concentration of power offered two key advantages.

First, stable internal financing was always available from the main bank in the group.

And second.

And second, crucially for governance, if a company in the group got into financial distress, the group would arrange an immediate workout.

They'd install new management from another company in the kuretsu and provide internal funding.

This stability made investments less exposed to volatile public markets.

So the benefit was stability for long -term planning.

But the governance environment for an outside shareholder sounds pretty restrictive.

Oh, it was.

Historically, ordinary shareholders had almost no power.

Boards were huge, 40 or 50 members, and hostile takeovers were virtually nonexistent.

Dividends were very stingy, which reflected that lack of outside shareholder influence.

But on the other hand, Japanese CEOs are not nearly as highly paid as their U .S.

counterparts, which suggests their agency problem leans more towards inertia and lack of pressure rather than excessive perks.

What changed this traditionally stable model?

Primarily the Japanese banking crisis of the mid -1990s.

The need for capital forced banks and industrial firms to start selling off those cross holdings, and the percentages dropped dramatically.

More recently, the Abenomics reforms in Japan explicitly pushed for more transparent corporate governance, mandating independent outside directors and greater disclosure, really moving the system closer to a market -based model.

Germany also had a historically strong bank -based system.

Traditionally, massive German banks like Deutsche Bank were the primary corporate monitor.

They provided the loans, they held significant equity stakes, and they exercised proxy votes on behalf of their customers.

And the sources use the ownership history of Daimler to show just how quickly this changed.

What does that show?

In 1990, Deutsche Bank owned 28 % of Daimler, and only about 32 % of the company was widely held by the public.

Fast forward to 2014 and Deutsche Bank had no direct stake, and 90 % of the company was widely held.

That is a fundamental governance shift in just two decades would cause it.

It was a simple tax rule change in 2002.

It exempted capital gains on shares that were held for over a year from corporate taxation.

Since the old tax rate was prohibitively high, this change basically unlocked all these corporate sellers, and it led to a massive divestiture of bank and industrial holdings across the country.

So stepping back, we recognize that concentrated ownership is still the global norm.

In countries like France, Germany, Russia, the largest shareholder owns a huge percentage of the stock.

That's right.

Across the world, most firms are controlled by either wealthy families or by the state.

The Chinese government, for instance, controls almost a quarter of all listed firms, and these families maintain control using a mix of cross -share holdings, dual -class shares, and pyramids.

Pyramids are the most complex way to maintain control without owning a majority of the cash flow rights.

Can you walk us through how a pyramid works?

It's a multi -layered holding company structure.

Control is maintained through a sequence of holding companies that in turn control operating companies at the very bottom.

The example of LVMH illustrates this perfectly.

Bernard Arnault and his family control LVMH with a 61 .5 % voting stake, but they do so indirectly, through multiple layers of holding companies, including one called financier Jean Gougeon and another, Christian Dior.

So in these concentrated ownership systems, the original agency problem, the separation of manager and owner, often disappears if the dominant shareholder is also the manager.

But this introduces a new and maybe more dangerous agency problem.

It shifts the risk, exactly.

Instead of the manager exploiting the dispersed shareholders, the risk becomes the exploitation of minority shareholders by the dominant majority shareholder.

With fewer checks on that dominant owner, they can misuse their position.

And this exploitation has a name, tunneling.

Right.

The majority owner effectively tunnels cash or assets out of the firm and into their own pocket at the direct expense of the minority owners.

There's a Russian example in the sources that is just a master class in corporate malice.

It's incredible.

A majority shareholder used a reverse stock split, combining old shares into a smaller number of new shares, to basically loop the company.

They proposed a ratio of one new share for every 136 ,000 old shares.

Why that specific number?

Because the two minority shareholders in the company owned less than 136 ,000 shares each.

The structure was specifically designed to squeeze them out, leaving them with no right to any of the new shares.

They were paid only the low par value of their old shares, and the majority shareholder ended up owning the entire company.

That is just.

Yeah.

It's malice distilled down to a mathematical fraction.

That level of exploitation would be impossible under the shareholder protection laws of the US or UK, which really highlights the core difference in governance risk between these systems.

Okay, so we've established two fundamentally different systems.

The flexible market -based system built on transparency, and the stable concentrated system built on relationships.

The central question for any financial manager is, which system is actually better for maximizing long -term value?

And there's no single better system.

There are only trade -offs.

The long -standing debate is really centered on the criticism that market -based systems suffer from public market myopia.

The idea being that because dispersed, small shareholders rely so heavily on short -term earnings, the system forces managers to inflate profits and abandon good long -term investments.

Right.

And the evidence here is complex.

Some studies do suggest that publicly held firms invest less and are less responsive to opportunities than their private counterparts.

Others find the opposite.

The historical context is pretty telling.

Back in the 1980s, when Japan's bank -based system was surging, US commentators were advocating that we should adopt their system.

Since then, market -based systems have outperformed, and Japan suffered its loss 20 years.

So views tend to be relative to recent performance.

And the distinction might be less about public versus private and more about dispersed versus concentrated.

As we discussed, public companies that have large blockholders have someone with the incentive to do the research and understand long -term strategy, which mitigates that short -term pressure.

If we compare strengths, market -based systems are fantastic at fostering innovative, brand -new industries.

Things like railways in 19th century Britain or biotech and the internet in 21st century America.

Financial markets can accommodate a huge diversity of opinion, which allows risky young companies to find like -minded investors.

That's very hard to do when your financing depends on a few major conservative banks.

On the other hand, bank -based systems have historically sustained very strong competitive advantages in established industries, like the German chemical industry or the Japanese auto sector.

They favor stability.

But the market -based system's greatest and most ruthless advantage is its efficiency in capital reallocation.

A falling stock price sends an immediate clear and painful signal that a firm is not earning its cost of capital.

And that forces corrective action, a management change, or a takeover.

And this mechanism prevents the kind of structural stagnation that can plague concentrated systems.

Precisely.

In bank -based systems, uneconomic firms are often bailed out by their main bank or their kuretsu partners just to maintain stability, which just delays the inevitable collapse.

This creates zombie firms, companies that are economically dead, but are kept alive by continuous lending.

We saw this all over Japan in the 1990s, where banks were lending to massive failures like the retailer Sogo, which accrued nearly 2 trillion yen in debt before it finally failed.

Market systems are just far more effective at forcing capital out of declining sectors and into growing ones.

And the ability of a system to tolerate that kind of financial discipline really comes down to one final variable.

Transparency.

Market systems rely entirely on it.

Outside investors have to be able to see the true profitability of a company to impose that discipline.

Opacity lets troubled companies hide from the market.

Bank -based systems, on the other hand, can handle opacity better because the bank has a long -standing, close, private monitoring relationship with the firm.

They see the underlying reality regardless of the public reports, which allows for private intervention before a public collapse.

So ultimately, both systems are prone to their own kinds of meltdowns when their fundamental requirements break down.

A lack of transparency in the market system or a lack of discipline from the central bank or the concentrated owner.

This whole deep dive has really highlighted that constant tension between self -interest and value creation.

The core challenge of modern corporate finance is, and remains, the agency problem, which leads to those measurable agency costs and lost value and monitoring expenses.

And we fight this using a blend of strategies.

Monitoring is the first line of defense through independent boards, activist shareholders, auditors, and the ever -present threat of a takeover.

For boards, structure really matters.

Independence, small size, and annual elections are the key goals.

The second pillar is incentive compensation.

And while high pay may be partly driven by market scalability, its structure is what's truly paramount.

Effective compensation requires alignment through equity, specifically restricted stock that has to be held even after the CEO retires.

That's what ensures a focus on long -term health and succession planning.

And finally, we saw that global governance systems are a complex trade -off.

Market -based systems, like in the US, specialize in flexibility and fostering new growth, but they risk myopia.

Concentrated systems favor stability, but they risk tunneling and supporting those uneconomic zombie firms.

The goal of financial management at the end of the day is to take all positive NPV projects, and by doing so, maximize shareholder value.

And we've spent today defining the structures that are designed to enable that simple goal.

But considering how powerfully different governance rules can either help or sabotage that fundamental objective, affecting everything from the effort put into a project to the risks that are taken, what if the most critical corporate decision isn't the financial decision itself, but the organizational one?

Which set of rules will you adopt to ensure the people choosing the projects are actually looking out for you, the owner?

That choice of governance may be the biggest value driver of all.