The Prime Directive

32 Pages Posted: 9 Apr 2007

See all articles by Douglas G. Baird

Douglas G. Baird

University of Chicago Law School

Robert K. Rasmussen

University of Southern California Gould School of Law

Multiple version iconThere are 2 versions of this paper


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 babysitter 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.

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. The market for corporate control does this, but debt contracts also play a crucial role, one that has been largely neglected. Covenants in debt contracts can insure that underperforming managers are called to task. Indeed, they may be as important as the market for corporate control.

Keywords: corporate law, corporate governance, separation of ownership and control, management incentives, executive compensation, corporate control

Suggested Citation

Baird, Douglas G. and Rasmussen, Robert K., The Prime Directive. University of Cincinnati Law Review, 2007, U of Chicago Law & Economics, Olin Working Paper No. 339, Vanderbilt Law and Economics Research Paper No. 06-19, Vanderbilt Public Law Research Paper No. 06-18, Available at SSRN:

Douglas G. Baird (Contact Author)

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Robert K. Rasmussen

University of Southern California Gould School of Law ( email )

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