Essay on Corporate Governance and the Agency Problem
The Agency Problem and Business Ethics
Responsibility's like a string we can only see the middle of. Both ends are out of sight.
At the bottom of enmity between strangers lies indifference.
Economists describe an 'agency problem' in which there is a twisting of investors' rational intentions by agents and other interlopers. A simple example is the hired manager who fills his pockets at shareholders' expense.
The 'agency problem' is as old as capitalism. Niall Ferguson, in his book “Empire –The Rise and Demise of the British World Order and the Lessons for Global Power”(1), gives an excellent eighteenth-century example of this problem.
Ferguson recounts how one of the world's first corporations, the East India Company, did business in Asia while far-away shareholders on Leadenhall Street in London tried to exercise their legal prerogative of control.
A ship would take six months to carry messages from the owners to agents in Calcutta and another six months to bring a reply. Supervision of executives abroad was tenuous, with a one-year delay in communications.
Expatriate agents of the East India Company, without close oversight, ran private businesses in competition with shareholders. Some managers became fabulously rich, remitting boxes of diamonds to England for their private estates and giving the English language a new word – nabob – to reflect their luxurious lifestyles
In 1767, with war and famine in India, prices of shares of the East India Company began a long slide that lasted eighteen years. Managers were blamed for the bad times. The company accumulated debt, slashed dividends, and drew negative remarks from the father of modern economics, Adam Smith, in his new book, Wealth of Nations.
Finally, an exasperated Parliament impeached Governor-General Warren Hastings. The accusations, quoted by Ferguson, were similar to complaints of shareholders against the modern nabobs of Enron. Warren Hastings, forced to resign, was charged with:
[A] wanton and unjust and pernicious exercise of his powers and the great situation of trust which he occupied … extending an undue influence by conniving extravagant contracts and appointing inordinate salaries … receiving money against the orders of the Company, and his own sacred engagements; and applying the money to purposes totally improper and unauthorized … with enormous extravagances and bribery in various contracts, and a view to enrich his dependants and favorites.
A show trial dragged on for seven years, but Hastings was cleared on all accounts. The management of the East India Company was reformed, and the stock price recovered.
Dividends and Distance
The East India Company had only a few thousand shareholders – most of whom attended meetings and took an active interest in company affairs. The shareholders demanded and received high cash returns on their investment, despite their loose control over self-serving, freebooting agents, far from London.
Indeed, the 'agency problem' of the eighteenth century, stemming from a twelve-month delay in communications, was mild compared to its modern version.
In today's capital markets, most shareholders never come together and have scant knowledge of company business. Companies stop paying dividends and investors don't care.
They are unaware when executives help themselves to vast amounts of corporate money, while squandering capital to temporarily boost stock prices. Many do not even know they are owners.
For investors living under 'democratic capitalism', there are more formidable barriers to control of company management than the perilous six-month voyage through raging oceans that separated the gentlemen adventurers of the East India Company in London from their agents in far-off Bengal.
With respect to equity markets, the 'agency problem' is the most cogent explanation for investors' apparent irrational behavior that led to the Great Bubble.
It is the reason why the Efficient Market Hypothesis is nonsense. It is a practical proof of the Irrationality Axiom of capital flow analysis.
Boeing and the Agency Problem
The Boeing Company (see Essay: The Boeing Buyback) provides a useful example of the 'agency problem' in today's capital market. At the millennium, Boeing had over one-hundred-thirty-thousand shareholders.
Less than two percent of these were institutional intermediaries that held almost two-thirds of the voting rights and controlled the company.
How many people actually had beneficial interests in the Boeing Company is unknown, because there are no accurate reports of indirect interests through mutual funds and pension plans.
A reasonable estimate might be that there were in excess of twenty million souls with such interests. Possibly over ten million of these beneficial owners held 401(k) retirement plans sponsored by the companies where they worked.
It is likely that the largest portion of Boeing shareholders were represented by indirect investments held through 401(k) and other retirement plans.
There would have been at least five interlopers between a typical investor in a 401(k) plan and the executives of Boeing.
In tracing the path of ownership, we see how the distance between American investors and corporate managers was so much greater in the late twentieth century than the long perilous maritime voyage that separated shareholders in London from their agents in distant Calcutta, two hundred fifty years before.
The Typical Shareholder
Directors of public companies pay lip-service to the interests of their shareholders. However, they are usually referring not to the actual owners of the company, but rather to fund managers and fiduciaries who vote the shares.
The walls that separate the millions of beneficial owners from corporate executives are many-layered, soundly built of ignorance, misinformation, failed fiduciary responsibility, delayed accountability, and legal disclaimers.
The haughty MBAs who run American public corporations perceive the 'little people' that own the company as remote and distant strangers. Professional executives, many times removed from the ultimate owners, are profoundly indifferent and unconcerned about the needs of those whom they profess to serve.
Thanks to a study by the Investment Company Institute (ICI), released in the spring of 2000 (2), we have research on the average 401(k) plan owner and, therefore, a notion as to the motivation of the majority of beneficial owners of Boeing shares.
According to the ICI study, the median holder of a 401(k) plan in 1996 was male, married, 41-years old, a high-school graduate, and seven years in his current job.
He had an annual household income of $50,000, with $45,000 in financial assets, of which $30,000 was invested in employer-sponsored retirement plans.
Of the financial assets invested in 401(k) plans, seventy-two percent were applied in equities, with half in stock mutual funds, and the rest in shares issued by the investor's employer.
In other words, the typical 401(k) owner held about $25,000 in diversified stock portfolios, and, therefore, probably owned, indirectly, less than $250 in stock of the Boeing Company.
Since the stock was administered through mutual funds, it is unlikely that our investor would know that he had holdings in Boeing.
Mutual funds do not reveal stocks currently held in portfolio, and the SEC requires investment managers only to disclose an out-of-date list of portfolio composition upon request.
Saving for Retirement
Since the typical plan participant had thirty-five years until retirement, and since his annual contribution was about $3,000 (of which $1,500 was invested in stock mutual funds), it is unlikely that his plan would grow sufficiently to afford a high degree of financial security.
The $250 which the investor might have indirectly held in Boeing stock would pay an annual dividend of about three dollars – hardly enough to elicit interest about the doings of Boeing executives.
Extreme diversification and lack of awareness of ownership were the first and most important barriers between beneficial owners and Boeing executives.
Each 401(k) plan is different. Although savings in these plans often were insufficient to afford a comfortable retirement, investors still had strong reasons to participate.
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First, people were aware of the dubious future of social security and were concerned about their retirement income.
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Second, many companies contributed matching funds to the investor's savings, offering an opportunity to accumulate assets at a discount.
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Third, the government, within limits, did not tax payroll savings that were put into a 401(k) account.
Investors could save and accumulate profits, tax-free, until retirement when the tax rate would presumably be lower. Finally, savings were automatic and convenient through payroll deduction.
Sparse Disclosure, Poor Advice
According to the ICI study, a typical 401(k) plan gave the investor a choice of five investment funds (a variety that investors considered satisfactory), plus the opportunity to invest in stock of the employer.
The company would provide little help in choosing which funds to include in a plan, other than a succinct description of performance, risk, and investment objectives of each fund.
The investor would have a multiple choice between Growth Fund A with a return of, say, 20% over the last five years, Value Fund B with a return of 15%, and Balanced Fund C, returning 10%.
The investor had no easy access to information as to how much of this 'return' was made up of dividends and how much was unrealized market profits, subject to being wiped away should the Great Bubble burst.
The investor had no data on the average price-earnings ratio or underlying dividend yield of the components of each fund.
He might not even understand such information, if available. The investor naively presumed that the Investment Committee of the plan administrator would offer investment alternatives that were appropriate for the purpose of safeguarding his life savings.
The plan prospectus would be loaded with caveats, warnings, and admonitions that absolved the employer, fund managers, and trustees of the plan from any responsibility, should the investor lose his entire retirement fund.
To avoid liability and violation of SEC rules, employers usually would profess to not give investment advice, although the selection of funds, in itself, was a tacit recommendation.
Plan administrators would suggest that employees consult financial advisors, accountants, and other specialists – if they were able to afford these high-priced professional services.
Most 401(k) investors base decisions on popular magazines, TV commentators, and opinions of family, co-workers, and friends.
Except for executives, most investors' would choose their plans based on recommendation of TV commentators, popular magazines, and the opinions of family, co-workers, and friends.
The fact that about one-quarter of 401(k) investments were invested in the employer's own stock – an egregious lack of diversification that should be unacceptable to a professional retirement planner – indicated not only the lack of understanding of risk on the part of investors, but also a disregard for employees' interests on the part of plan administrators.
Three-quarters of 401(k) investors admitted to having little or no comprehension of investments.
Nevertheless, in 1996 when the ICI survey was made at the height of the Great Bubble, the majority of 401(k) participants were willing to take “above-average or substantial risk” for corresponding gains.
The constant huckstering of the Common Stock Legend in the popular media influenced the investor's capacity to discern the soundness of an investment plan.
Considering that his educational attainments often only extended to high school – where he received minimal training in economic history – and the fact that past performance figures were faulty, irrelevant, and rarely covered more than ten years, the investor's perception of investment risk was certainly impaired.
Our hypothetical investor knows that saving in equities entails risk, but he interprets this to mean that, although the value of his fund might rise and fall from time to time over a long period of thirty-five years, he will still receive an annual return of nine percent or more.
This was the widely-held belief inspired by the Common Stock Legend. To think otherwise would be unpatriotic and inadvisable. It would amount to 'selling America short' – the implication being that the country was a security (represented by any stock on the NYSE) to be bought by patriots and sold by traitors.
At the turn of the century, the 401(k) investor did not know that the average price-earnings ratio of the stocks he owned was over thirty-times-earnings, and that, if the value of his portfolio were to increase at the rate he had come to expect, based on performance since 1980, this price-earnings ratio would reach one hundred times earnings by the time he retired.
Dividend yields would sink to virtually nothing. In other words, like a person who places his entire life savings in a collection of baseball cards, his financial well-being in old age would be entirely involved in a fad, dependent on the whims of others.
His belief in the future exceeded that of the CEOs of the companies in which he invested. He did not realize that the executives responsible for companies whose stock he held, had been steadily distributing assets to themselves and to short-term traders, who will have sold out entirely, many years before investors retire.
Nor did he understand that to get cash out of his funds in thirty-five years, he would compete with a massive army of Baby Boomers who would be dumping their 401(k) plans at the same time.
Time: The Ultimate Separator
In view of the intent of 401(k) plans and the incomplete information provided investors, it is apparent why eighteenth century adventurers in the East India Company had a better grasp of the performance of their investment than the typical saver in a 401(k) plan in the twentieth century.
The investors in the East India Company were seeking immediate cash dividends; each year they knew if this expectation was met. When dividends declined they could dismiss the CEO and summon him to London for trial, while he was still living.
The objective of the typical 401(k) investor, on the other hand, is to obtain retirement income thirty-five years hence. The investor perceives the current market value of his holdings but has no way of knowing what his retirement income will be in thirty-five years.
He would have been better informed by purchasing an annuity, since his quarterly investment statement might have shown that he would receive a monthly check of, say, $123.15 for life.
Instead, he sees only that his equity funds are worth $25,000 at the current market. He has no basis for comprehending what these funds might be worth in thirty-five years.
He is not even informed that the 1.5% annual dividend income on his stocks yielded only $31.25 per month, and that two-thirds of this fairly reliable indicator of cash flow was consumed by the fees of fund managers.
Directors who authorize buybacks will be long gone before investors draw their first retirement check.
In thirty-five years, most directors and executives of the companies in which he invests, if still alive, will be in their eighties and nineties by the time our typical 401(k) plan owner draws his first retirement check.
Not only will their responsibility have been infinitely diluted by diversification and multiple layers of fiduciaries, but these executives will have distanced themselves by thirty-five, memory-deleting years.
The winds of time, legal disclaimers, and statutes of limitation will have erased any trace of responsibility or even the hint of their poor judgment as fiduciaries, should our investor discover a shortfall in his retirement plan in the year 2035.
Unlike Warren Hastings in eighteenth century India, the directors that authorized the nine billion dollar buyback of Boeing stock in the late 1990s will never be called to account.
Their decision will have long been forgotten, as will their names, except by their heirs who might still be enjoying the benefits of their ancestors' tenure.
Not only would our 401(k) investor have been unaware that he owned Boeing stock and that his retirement plan was faulty, there were five layers of fiduciaries standing between him and Boeing executives, assuring that there could be no meaningful intercourse between the investor and his agents.
For practical purposes, there was no reporting up and down the line.
Compared to the 'agency problem' of the East India Company, the Boeing CEO might as well have been stationed in a parallel universe to that of our 401(k) investor.
The five layers of fiduciaries that usually separate a 401(k) investor from company directors are: the plan administrator, the plan trustees, the fund directors, the fund managers, and the company directors.
