The separation of security ownership and control differentiates a modern public company from a classical model company, in which an entrepreneur single-mindedly operates the firm to maximise its profits. In a modern public company, entrepreneur is no longer responsible for the key decisions and tasks within the organisation, instead, it is the manager who controls the operational & financial decisions but does not own the company and has little resemblance to the classical “economic man.” Thus, came the need to address the incentive problems that arise when decision making in a firm is the province of managers who are not the firm’s security holders.3
One way to address these incentive problems in the agency conflict was by aligning the manager-agent’s and owner-shareholder’s interests through performance based pay i.e. by compensating the managers based on their performance for they should continue to conduct business in a way that maximises the economic returns of shareholders.
The speech called “Growing fast in slow-growth economy” delivered by Jack Welch in August 1981, is considered as the dawn of obsession with shareholder value. Over the last three decades, the ideology of shareholder value has been fortified as a principle of corporate governance in companies situated on both side of the Atlantic. Yet the idea that corporate managers should make maximising shareholder value their goal—and that boards should ensure that they do—is relatively recent.5
But does the implementation of this principle of maximising shareholder value improve the competitive performance of corporate enterprises?
Lately, the term has been incorrectly associate with maximising the short term earnings to boost current stock price. However, proper understanding suggests that maximising shareholder value means retaining the talent and reinvesting in growth and development of the company to increase its long-term cash flow. As an example, let’s look at the Harvard journal released by Lucian A. Bebchuk and Holger Spamann on “Regulating Bankers’ Pay”. Excessively risky investments in the financial sector was one of the major causes for subprime crisis of 2007-2008. It wouldn’t be completely inappropriate to believe that performance based executive compensation encouraged this excessive risk-taking and that fixing these arrangements will be important for safeguarding the future. The analysis of banks’ compensation arrangement in the early 2000s shows that the paycheques of bank executives were greatly aligned to the banks’ assets. Gains from the risky investments benefit the holders of shares and options, on the other hand, losses affect the shareholders, bondholders, and depositors. Therefore, the executives have incentives to engage in precarious business without considering the consequences that these risks have on shareholders in the bank. Another recent example explaining the concept of shareholder value and agency problem in the financial industry comes from the rapid growth of marketplace lending (MPL). Initially, MPL or peer-to-peer (P2P) provided a platform for retail borrowers and investors to contact each other directly, which was pretty much straight forward. Major competitive advantages of MPL platforms include: extremely low operating model; the ability to offer loans to some customers who may have been turned down for loans by established banks; superior customer experience driven by speed and convenience; and an ability to use public data to (safely) overcome incumbents’ data advantage in scoring risk, potentially going on to achieve better risk-pricing by taking a more agile ‘Big Data’-based approach.12 More recently, these platforms struggled to find enough cash from retail investors to meet with the rampant demand for easy credit. Thus, these platforms turned to financial institutional investors, such as hedge funds, private equity firms and banks, that would repackage loan portfolios in the form of securitisation , prompting the sector to be named more accurately as ‘marketplace lending’.4 Although, these MPL platforms are well equipped with technology to evaluate risk associated with each of the borrowers, they have little reason to care whether the borrowers can repay – because these platforms have no skin in the game. In May 2016, the founder and CEO Renaud Laplanche and several other executives of the Lending Club (largest MPL platform in the United States) resigned amid an ethics controversy. This spring Lending Club sold a number of loans to Jefferies, an investment bank, which planned to package them into bonds and sell them on to other investors. Like the individual lenders who use the site, Jefferies specified the types of loans it was willing to buy. But $22 million of the loans didn’t meet the criteria Jefferies asked for, and the company said at least some of its executives were aware of the flaws and let Jefferies buy them anyway.7 The parallels with subprime crisis suggest that investment in such excessively risky portfolios by managers is a direct result of the relation between their compensation arrangement and company’s assets.
Such examples demand an immediate need for regulations in executive pay in the financial industry, the pay arrangements should be designed to advance executives’ and not only shareholders’ interests. Constraints should be placed on the compensation structures that shape how executives choose the actions to be performed under these regulations. The focus should be on the structure of the compensation – not the amount – with the aim of avoiding incentives for excessive risk taking. Executive bonus compensation should be based on the metrics that reflect the interests of preferred shareholders and bondholders. Such changes in the compensation structure would induce executives to take into account the effect of their decisions on the owner-shareholders, and consequently, would curtail incentives to take excessive risks.2