The Hindu Business Line : Needed better, not more, regulation

Adam Smith’s famous discussion of the organisation of production in a pin factory articulated the advantages of division of labour and the economic gains from large-scale production. But Smith expressed considerable scepticism about the relative efficiency of that particular form of business organisation we now call the corporation in which management and ownership are separated.

His observation on the corporation reads thus: “The directors of such companies being managers of other people’s money than their own cannot be expected that they watch over it with the same anxious vigilance with which the partners in private co-partnerships frequently watch over their own.” (The Wealth of Nations.)

Managers as agents

One way to think of managers in large corporations is as ‘agents’ paid by the shareholders. The principals or owners employ the agents to act as stewards on their behalf. Agents, however, do not share the same interests as the principals who employ them. They may, for example, seek to use the company’s assets for their own private benefit.

So the corporation has developed instruments to mitigate these “agency costs”. Managers agree with owners to submit themselves to auditors, to answer to boards and to take part of their pay in the form of bonuses.

All these things help, but still do not eliminate the principal agent problem in the corporation.

Boards are often the creatures of management. Disclosure is limited to what is required by law and shareholders are a diverse and disjointed group and usually find it difficult to take any action. Free to spend other people’s money, managers and directors squander it.

Alan Blinder, a professor of Economics at Princeton University, once likened managers to mountain climbers since they invest the money or excess cash flow just because “it is there.”

In early 2008, following an extensive survey, The Economist found that instead of returning cash to shareholders, managers typically spend too much money on favourite projects, reckless diversification, and extravagant indulgences.

L’ affaire Satyam

The recent Satyam episode in which a family that controls India’s fourth largest software services company with a 8.6 per cent stake, worth $275 million, decided to spend $1.8 billion of reserves and fresh borrowings to acquire two sister companies in the realty and infrastructure businesses is probably just the tip of the iceberg.

In Satyam’s case, shareholders responded angrily and the management had to withdraw the deal, but not before significant shareholder value had been destroyed. This is not the first time that corporate governance has come under attack in India for its laxity.

Another frequently cited manifestation of the failure of corporate governance is the huge compensation given to top executives compared to the average pay packet. And the disparity has been growing.

Regulating executive pay is perhaps out of the question, since it represents the price of attracting and retaining talent. Self-regulation also does not seem to be working and is unlikely to.

Therefore pushing for more transparent disclosure requirements for all forms of executive compensation — stock options, pension benefits, use of company assets such as airplanes and severance allowances, including golden handshake payments, disclosing the ratio between the highest and the lowest paid employee and so on, may be a possible way out. Shareholders ought to know why a senior manager is getting such fancy sums.

Perverse incentives

Consider what happened during the recent financial crisis in the US. The system prevalent on Wall Street rewards managers for “appearance of profits”, rather than on accounting performance, thereby creating perverse incentives for those who are managing other people’s money. When the dubious investments turned toxic, the investors lost, but the managers kept their bonuses. These ill-gotten gains — money for nothing — are in small part a result of lack of proper oversight, but in large part a result of greed. While greed can’t be immediately dealt with in any convincing manner, a short step can be taken to improve the level of corporate governance, especially the quality of boardroom decisions.

One fallout of the financial crisis has been the general acceptance of increased regulation, even in a laissez faire economy such as the US.

Regulation is no longer being reckoned as an irrelevant intrusion, but is considered necessary to help achieve development goals. Economy after economy has agreed to bail out struggling corporations and injected much needed fiscal stimulus in their economies. This is bailout season.

Prescriptions at the macro level should however be matched with strengthened micro foundations, such as improved corporate governance. Where mis-governance has distorted pay and decision making in the boardroom, it should be put right. Warren Buffet has repeatedly claimed that “collegiality trumps independence” in the boardroom. How prophetic these words have been in the Satyam case.

In judging whether corporate India is serious about reforming itself, CEO pay and performance of independent directors remain the acid tests. India’s notorious past with respect to regulation does not inspire confidence in how this will be done. But one thing is clear: we need to regulate better and, at the same time, ensure that regulation does not degenerate into control.

(The author is Professor, ICRIER, New Delhi. blfeedback@thehindu.co.in)

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