05/04/2011 05:02 pm ET Updated Jul 04, 2011

CEOs Do Make Better Decisions When Their Interests Align With the Stockholders

In a recent book and accompanying op-eds, Roger Martin, the dean of the University of Toronto's Rottman School of Business argues that a much-cited article written by two of our Simon School's former faculty members, Mike Jensen and Bill Meckling, "fixed" (in a bad way) the financial game and thereby led to a greater likelihood of economic bubbles and crashes. The Jensen-Meckling article, published in 1976, spelled out the problem of imperfect monitoring in the corporate arena and the resultant agency costs. It noted that manager-agents should have sufficient "skin in the game" to ensure that they more appropriately represent stockholder-principal interests. It is such "skin in the game", in the form of option and stock grants, which Martin holds responsible for recent major economic downturns because it has incentivized managers to focus too much on the "expectations market" at the expense of the "real market".

In an op-ed in the Toronto Globe and Mail, Martin states "historically, professional managers played entirely within a single market; they were in charge of performance in the real market and were paid for performance in that real market. That is, they were in charge of earning real profits for their company and they were typically paid a base salary and bonus for meeting real market performance targets."

Martin misses the point that performance and profits in the so-called "real market" that managers should focus on doesn't just involve today's "reality" but it also involves future "realities". Stockholder-principals care not just about how the company is doing today. The value of their assets also hinges critically on how the company will do in the future and the price of a stock is precisely the measure of expected real performance and profits in the future. Thus, to argue that managers shouldn't also be rewarded on the expectations of future real performance and profits and that only today's reality should matter is, simply put, ludicrous. It's akin to arguing that the only realities we should care about in terms of our homes and cars are the real values they deliver to us in the present and not at all the real, expected values they will provide us in the future.

Now, admittedly, expectations do not always prove to be accurate. The business world involves having to make a lot of educated guesses about the future and basing one's operating decisions in the present on those risky, educated guesses. Bad guesses generally lead to adverse consequences for stockholders-principals and their manager-agents, especially when those agents own a piece of the assets. Think about the over $1 billion in personal holdings that former CEO of Lehman, Dick Fuld, saw evaporate when the firm he was the lead decision-maker for tanked.

Underlying Martin's argument is also the assumption that implicitly accuses savvy investors of being subject to potential manipulation by flash-in-the-pan managers. He ignores the possibility that a CEO might greatly enhance their reputations by evaluating growth opportunities prudently, making investments only when they appear good bets and, for sensible competitive reasons, revealing little private information about the strategies underlying those bets.

Apparently, Martin believes investors and analysts are incapable of differentiating between prudent allocators of capital and those who regularly promise more than they deliver. Jensen and Meckling had more respect for analysts. Like Lou Gerstner, they too would argue that the market is a "brutally honest" measure of performance. Investors quickly learn to discount the projections of those who think they can manipulate expectations.

If anything, the recent economic downturn has taught us how much we have yet to learn from Jensen and Meckling's seminal paper. In particular, much greater attention is now starting to be given to exactly how manager-agents should be compensated through ownership stakes. If the managers take risks on behalf of stockholders, risks that affect a company's performance over a multi-year time horizon, to what extent should their compensation be immediate (stock that can be sold or options that may be exercised right away) versus involve a longer vesting period so that managers better take into account the longer-run risks associated with their corporate decision making?

More broadly, think about all the reasons why we ended up in the recent economic mess precisely because relevant agents didn't have sufficient skin in the game. In addition to the bankers who created and sold mortgage-backed securities but who didn't have vested interests in how their actions would affect their firms' longer-run performance, there were: homeowners who could get mortgages without having to put any money down; policymakers who promoted low interest rates and encouraged greater home-ownership through funding for vehicles such as Fannie Mae and Freddie Mac but have remained largely immune from the repercussions of their actions; and rating agencies who are legally precluded from having a direct interest in the assets whose credit-worthiness they evaluate for others.

Jensen and Meckling's fundamental point is that agents make more appropriate decisions on behalf of the stockholders they represent when their own interests align with those of stockholders. Anyone who would like to argue the validity of this point would be just as hard pressed to explain why we are more likely to wash a car and change its oil when we own the vehicle than when we rent it.