In the wake of various corporate scandals, the issue of corporate governance has been pushed to the forefront. Never before has such scrutiny been placed upon corporations. Corporations of late have flouted the laws in place regulating corporations. This has not only happened in the United States, but also around the world. With the rise of these scandals and the subsequent fall from grace of these corporations, people and shareholders alike are demanding their governments enact new laws governing corporations. Now faced with a difficult situation, governments must decide how best to regulate corporations. In the process of making these decisions, the governments have been dealt a challenging issue- what is the best method of corporate governance?
Before one can begin to debate the pros and cons of the various forms of corporate governance, one needs to understand what a corporation is and how it developed. The firm, or corporation according to Coase, developed because of the high cost associated with the market mechanism and it was the second best alternative when the market was too expensive or imperfect. The modern corporation first developed in the United States as a result of the growth of mass production and mass consumption. The new technologies rapidly increased production and that needed to be monitored along with every aspect of the business.
Managers were needed to handle the sudden increase in demand and production and bureaucracy grew as a result. A hierarchy was created from the top down in order to streamline the process. Orders came from the top, and each level was assigned its respective tasks. Managers are responsible for delegating the individual tasks to the workers at the lowest level and making sure the workers completed the tasks assigned satisfactorily. According to Alfred Chandler,
These new high-volume technologies could not be effectively exploited unless the massive flows of materials were guided through the process of both production and distribution y teams of salaried managers… These administrative hierarchies grew to a still much greater size in industrial enterprises that, again on the basis of modern transportation and communication, integrated mass production and mass distribution within a single business enterprise (133). Corporations as we know them today grew out of the need to manage technology and labor. As they developed, different forms emerged. The most common were family owned or had shareholders. Each type had its advantages and disadvantages.
Family owned corporations were prevalent in Europe in the mid-nineteenth century and some exist today. Today, the major stakeholder is either from a family or may be from a bank or another corporation. According to Roe, "Firms in continental Europe are owned less by diffuse stock markets and more by concentrated block holders than in the United States, with the blocks usually owned by families" (16).
A family owned corporation faced many more internal issues, as families often bicker over small details, which can hamper the progress of a corporation. Also, families fight over who actually controls the policies and makes decisions within the corporation. This constant struggle creates arbitrariness, which is opposite of what the corporation needs. There need to be strict protocols for every aspect of the business to follow in order to be calculable. In addition to internal squabbles, the family owned corporation often had constraints upon the amount of capital they could raise without issuing stock to sell to outsiders. Often, the corporation outgrew the family's ability to support it and families were forced to look outside relatives for financial and other forms of assistance.
As corporations outgrew their respective family owners, they evolved into the large multi-divisional corporations that we are so familiar with today. Most corporations have a separation between ownership and control. According to Mark Roe, The large, publicly held, diffusely owned firm dominates business in the United States despite its infirmities, namely the frequently fragile relations between stockholders and managers. Managers' agendas can differ from shareholders' and tying managers' actions tightly to shareholders' goals has been central to American corporate governance. The stockholders own the corporation, but do not often participate in the control. (1)
The managers control the decision making processes, other than electing the board of directors which is done by the shareholders. To put stockholders and managers in principal-agent terms, the stockholders are the principals while the managers are the agents. The agents do the bidding of the principals. Placing the responsibility of running the corporation in others' hands is where the problem lies. It is human nature to look out for oneself before the good of another, much less the good of the corporation. Managers are entrusted with the "peoples' capitalism" and must act in order to benefit the corporation. They are the trustees of the stockholder's property. Roe also describes the three major groups within the corporation as,
Owners, usually from the richest strata in the society, cannot been seen to have acquired their wealth too unjustly; otherwise neither managers nor employees will work well for the owners. Managers must be motivated to do their jobs. They cannot run their firms into the ground or divert its wealth to themselves; otherwise owners will not invest and employees will be too uncertain of long-term prospects to work hard for the firm that would soon be run into the ground. And employees must be motivated to work and be unable to appropriate owners' investments; otherwise owners will not invest. Nor can the employees be positioned to prevent managers from running the firm; otherwise managers cannot effectively induce the firm to produce.
These three groups are integral to the ability of the corporation to continue doing business. Without one of the three, the corporation would quickly fail. Managers are highly necessary to the success of a corporation with their role in between the owners and the workers. While acting as trustees for the stockholder's property, managers are faced with making decisions that can affect the corporation either in the short or long term.
What's best in the short term may not help the corporation in the future. Equilibrium must be reached so the corporation is solvent and comfortably running. "Managers must have discretion in the diffusely-owned public firm and how they use that discretion is crucial to stockholders" (Roe 2). Managers need to be able to devise processes that every aspect of the business can follow. In order for the corporation to be most efficient, arbitrariness needs to be removed- everything must be uniform. Also having a set of policies clearly defined allows the management to place blame on a certain person or area of the business if something goes wrong or deviates from the set plan.
In an effort to have managers follow their wishes, stockholders have given stock options and other incentives. Roe remarks, "Powerful incentive pay goes to American managers, directors are often outsiders, and takeovers and proxy fights occur often enough that they affect managerial motivation" (17). Stock options increase the manager's stake in the company by making them shareholders. However, this program can entice managers to focus solely on increasing profits, thereby increasing dividends, which makes the managers wealthier. Again, this just helps the company in the short term, but may actually harm the company in the long term.
Stock options give the major stockholders greater assurances that managers are acting in the best interests of the corporation, but the pitfalls are large. The temptation for managers to line their own pockets is huge. Stock options again raise the central issue with principal-agent concept. Will the managers simply look out for themselves or will they work in the best interest of the corporation, managing the short term and long term prospects? Stockholders need to be able to closely monitor the actions of its managers and be aware of what is happening within the corporation. This is true for both the closely-held corporation and the diffusely-owned, manager-controlled corporation.