Components of Success

Corporate Governance Controls

The market based corporate governance system solution to this problem employs the full arsenal of internal, external and market techniques. In general, the solution is to employ mechanisms that align the interests of managers and shareholders. If these mechanisms are unsuccessful, other techniques must be used. However, with the introduction of management entrenchment devices such as poison pills and altered board structures or increases in the debt component in capital structures that serve the same purpose, all solutions to the principal agent problem are blunted.

On the internal side there are a number of ways to improve managerial behaviour. The first is the use of compensation contracts related to the performance of the company. These contracts include stock options or similar contracts that pay off to managers when the firm's share price increases above some threshold value. These contracts are costly to shareholders but the expectation is that with an improved alignment of interests, the expected benefits exceed costs. Of course there are problems with the asymmetric payoff associated with stock options-there is no cost for poor performance except in the extreme cases where management is fired; in addition there is the possibility of excessive risk taking by management intended to increase the value of their stock options. In the latter scenario, the incentive to take riskier projects is a counter-weight to the tendency to take less risky projects due to their undiversified human capital. However, Board oversight and internal controls are essential to control excesses in this direction. Bonus pool schemes have been introduced to penalize negative managerial performance.