The Prime Directive
Robert K. Rasmussen
University of Southern California Gould School of Law
Douglas G. Baird
University of Chicago Law School
September 15, 2006
Vanderbilt Law and Economics Research Paper No. 06-19
Vanderbilt Public Law Research Paper No. 06-18
U of Chicago Law & Economics, Olin Working Paper No. 339
Agency costs dominate academic thinking about corporate governance. The central challenge is to devise legal rules to align the interests of the managers (the agents) with those of the shareholders (the principals). This preoccupation is misplaced. Whether it is finding a baby-sitter or a dean, the challenge of hiring the right person dwarfs the challenge of aligning that person's incentives. The central task for corporate governance - its Prime Directive - is to ensure that the right person is running the business. In this essay, we suggest that the challenge of aligning the managers' incentives has been drastically overstated and the way in which legal rules affect hiring (and firing) decisions has been too often ignored.
Putting the emphasis on agency costs may lead to rules that slight what matters most. The current preoccupation with executive compensation runs the risk of inducing the board to worry more about the details of the employment contract rather than selecting the best person in the first instance. More important, the law can play an important role ensuring bad managers are fired. Once hired, all managers need to be mentored, monitored and, when necessary, replaced. There is little to suggest that a single entity is well-situated to perform all three. There is tension between the roles of confidant and policeman. Here, debt contracts play a crucial and largely neglected role. Covenants in debt contracts can insure that underperforming managers are called to task. Private debt holders' role in monitoring a business and ensuring that underperforming managers are replaced may be as important as the market for corporate control.
Number of Pages in PDF File: 22
Date posted: September 18, 2006