The basic problem of corporate governance, of course, is that of agency costs. Agency costs are defined as the sum of the monitoring and bonding costs, plus any residual loss, incurred to prevent shirking by agents. In turn, shirking is defined to include as any action by a member of a production team that diverges from the interests of the team as a whole. As such, shirking includes not only culpable cheating, but also negligence, oversight, incapacity, and even honest mistakes. In other words, shirking is simply the inevitable consequence of bounded rationality and opportunism within agency relationships.
A sole proprietorship with no agents will internalize all costs of shirking, because the proprietor's optimal trade-off between labor and leisure is, by definition, the same as the firm's optimal trade-off. Agents of a firm, however, will not internalize all of the costs of shirking: the principal reaps part of the value of hard work by the agent, but the agent receives all of the value of shirking. Alchian and Demsetz offered the useful example of two workers who jointly lift heavy boxes into a truck. The marginal productivity of each worker is very difficult to measure and their joint output cannot be easily separated into individual components. In such situations, obtaining information about a team member's productivity and appropriately rewarding each team member are very difficult and costly. In the absence of such information, however, the disutility of labor gives each team member an incentive to shirk because the individual's reward is unlikely to be closely related to conscientiousness.
In any team organization, one therefore must have some ultimate monitor who has sufficient incentives to ensure firm productivity without himself having to be monitored. Otherwise, one ends up with a never ending series of monitors monitoring lower level monitors. Economists Armen Alchian and Harold Demsetz solved this dilemma by consolidating the roles of ultimate monitor and residual claimant. According to Alchian and Demsetz, if the constituent entitled to the firm’s residual income is given final monitoring authority, he is encouraged to detect and punish shirking by the firm’s other inputs because his reward will vary exactly with his success as a monitor.
Unfortunately, this elegant theory breaks down precisely where it would be most useful. Because of the separation of ownership and control, it simply does not describe the modern publicly-held corporation. As the corporation's residual claimants, the shareholders should act as the firm's ultimate monitors. But while the law provides shareholders with some enforcement and electoral rights, these are reserved for fairly extraordinary situations. In general, shareholders of public corporation have neither the legal right, the practical ability, nor the desire to exercise the kind of control necessary for meaningful monitoring of the corporation's agents.
Who then watches the watchers?
Economist Eugene Fama contends that lower level managers monitor more senior managers. Agency Problems and the Theory of the Firm, 88 J. Pol. Econ. 288, 293 (1980). Such up-stream monitoring, however, does not take full advantage of specialization. Fama and Michael Jensen elsewhere point out that one response to agency costs is to separate “decision management”—initiating and implementing decisions—from “decision control”—ratifying and monitoring decisions. Separation of Ownership and Control, 26 J. L. & Econ. 301, 315 (1983). Such separation is a defining characteristic of the central office typical of M-form corporations. The M-form corporation replaces the simple pyramidal hierarchy with a more complex structure in which the central office has certain tasks and the operating units have others, which allows for more effective monitoring through specialization, sharper definition of purpose, and savings in informational costs. In particular, the central office’s key decision makers—the board of directors and top management—specialize in decision control. Because low and mid-level managers specialize in decision management, expecting them to monitor more senior managers thus calls on the former to perform a task for which they are poorly suited.
I was reminded of all this by Francis Pileggi's post on a recent Delaware case, Hampshire Group, Limited v. Kuttner, C.A. No. 3607-VCS (Del. Ch. July 12, 2010). Francis explains that:
This case began with an investigation by the board of the founder and CEO of a publicly held company based on accusations of lavish spending and self-dealing. Claims were brought against the CEO and key officers. Although the CEO settled for a substantial sum, this opinion addresses the claims that proceeded against the modestly paid CFO and Accounting Officer who were left “holding the bag” for transgressions at issue.
Their breach of fiduciary duties was the result of, in essence, “failing to say no” to the CEO when they approved various expenses incurred by the CEO.
He then summarizes the court's statement of the fiduciary duties of directors:
This is one of the few decisions in Delaware that thoroughly examines the fiduciary duties of officers (as compared to directors only) in the context of specific actions taken at the request of a CEO/director, and perhaps is the first that fully examines that duty after the Delaware Supreme Court decision of Gantler v. Stephens. ...
As key employees of the Hampshire Group, the Court emphasized the truism that the officers, Clayton and Clark, “owed certain fiduciary duties to the company and its stockholders.” The Court observed that, like directors, Clayton and Clark “were expected to pursue the best interests of the company in good faith (i.e., to fulfill their duty of loyalty) and to use the amount of care that a reasonably prudent person would use in similar circumstances (i.e., to fulfill their duty of care).” See footnote 76. The foregoing is perhaps one of the more pithy statements of the fiduciary duty of an officer or director that has been stated in recent Delaware decisions. ...
The Court made the important point that where, as in this case, the defendant officers were not accused of self-dealing, but rather facilitating wrongful action by another (in this case the CEO), the Court was required to examine the state of mind of the officers “to determine whether they acted in bad faith for a purpose other than advancing the best interests of the corporation.” See footnote 81.
In this situation when the Court is examining whether the officers breached their duty by performing disloyal acts at the behest of their CEO, the Court is required: “To make a difficult, but necessary, judgment of whether the subordinates acted loyally by trying to do their job for proper corporate purposes and good faith, or acted disloyally in bad faith by putting the self-interest of their superiors ahead of the corporation’s best interest."
I have no particular objection to the legal rules announced here. Yet, I would caution the Delaware courts to be mindful of First Corinthians 10:13, which in the NRSV reads, “God is faithful, and he will not let you be tested beyond your strength."
The economic reality is that subordinates are poorly positioned to monitor their supervisors. Expecting them to act as a meaningful constraint on those superiors risks unfairly testing them beyond their strength, especially given the more draconian sanctions faced by officers. Imposing anything remotely resembling Caremark-like oversight and monitoring duties on subordinate officers viz-a-viz superiors thus should be out of bounds.
Hence, I would encourage courts to distinguish between active and willing participation by subordinates (for which liability is appropriate) and passive acquiescence or looking the other way or failing to monitor superiors (for which liability is inappropriate).
