The rise of the large public corporation in the early part of the twentieth century introduced an unprecedented challenge: How can widely dispersed owners (principals) ensure that the individu- als charged with running their firms (agents) act in the owners’
best interests? Berle and Means (1932), among the first to ad- dress this issue in detail, characterized the modern corporation as
“ownership of wealth without appreciable control and control of wealth without appreciable ownership” (69).
Eventually, this dilemma was accommodated if not resolved, by a form of governance widely described as “managerial capitalism”, (e. g., Marris 1964; McEachern 1975; Williamson 1964) in which professional managers, who generally had abundant firm-specific expertise but little ownership stake, led America’s large enterpris- es (Useem 1996). These professional managers took satisfaction in balancing the needs of various stakeholders. In his landmark description of the post-World War II modern corporation, econo- mist Carl Kaysen (1957, 314) wrote:
[T]here is no display of greed or graspingness; there is no attempt to push off onto the workers or the community at large part of the social costs of the enterprise. The modern corporation is a soulful corporation.
This model prevailed for roughly the period 1950 to 1980, ac- companied by increased size and influence of major corporations.
as Khurana (2002, 53) noted:
The steady, visible hand of the professionally trained man- ager guiding the corporation toward stability and long-term growth was seen as superior to that of the jumpy manager continually reacting to the unpredictable and fickle “invisible”
hand of the market.
By the late 1970s however, skepticism about managerial capi- talism mounted. America’s manufacturing sector was in steep decline, lagging international competitors in both efficiency and quality. (This section draws heavily from Ghoshal 2005; Ham- brick 2005; Hambrick et al. 2005; Khurana 2002; Useem 1996 and Ward 1997). Many companies had diversified into far-flung activities, yielding benefits for no one except their top execu- tives. Indeed, during the latter period of managerial capitalism, roughly 1970 through 1980, corporate profitability (measured as return on assets) dropped steadily. There was an increasing belief that America’s CEOs—and their boards—were not serving owners or the overall economy very well.
It was around 1980 that the corporate milieu at least in the United States, began a tectonic shift. Corporate executives were allowed, indeed encouraged, to become much more aggressive in
their marketplace dealings. They were simultaneously subjected to much harsher penalties for their shortfalls and more abundant payoffs for their successes. What had been polite jousting became gladiatorial combat.
The election of Ronald Reagan as U.S. President in 1980 ush- ered in a new era of unfettered markets and shareholder pri- macy. Known for his fervent free-market views, Reagan followed the experiments of President Jimmy Carter in eagerly deregulat- ing numerous industries. Moreover, the competitive successes of Japanese companies in several important sectors (including auto- mobiles, computers and steel) prompted Reagan to sharply cur- tail antitrust enforcement. Big mergers were permitted; market shares were allowed to advance; cozy oligopolies gave way to vigor- ous competition.
Not only was Reagan pro-competition but he was also pro- shareholder. An unabashed booster of supply-side economics, Reagan quickly lowered tax rates for businesses (as well as indi- viduals), under the logic that the existing rates were excessive to the point of decreasing government revenue—an idea illustrated in the well-known Laffer curve. Reagan’s overall economic plat- form, famously dubbed “Reaganomics,” was framed as a return to free-enterprise principles and empowerment of the private sector.
One cannot begin to consider Reagan’s policies without also acknowledging the influence of the prominent economist Milton Friedman on the president’s beliefs. A staunch advocate for share- holder wealth maximization, Friedman decided to take aim at the post-war “soulful corporation” and its accompanying emphasis on balancing various stakeholders’ interests (Friedman 1970):
In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while con- forming to the basic rules of the society…
During his eight years as president, Reagan closely adhered to Friedman’s economic principles, even using variations of Fried-
man’s own language in spelling out his policies.1 Documenting the similarities between Reagan’s annual Economic Reports and Friedman’s earlier writings, Elton Rayack (1986) wrote: “So close- ly do the Reports adhere to Friedman’s free-market ideological framework, even with respect to rethoric, it is almost as if they were ghostwritten by Friedman himself.” (198)
At the same time that corporate executives were being encour- aged to increase their companies’ profits, they were also being subjected to new forms of heightened scrutiny and discipline.
The shares of major American corporations were increasingly held by large institutional shareholders (notably pension funds, mutual funds and insurance companies), which had much more power to sanction corporate executives than did the small indi- vidual investors who had previously been prevalent (Gompers and Metrick 2001). The invention of junk bonds allowed hostile takeovers of corporations of almost any size. If a raider thought he could improve the performance of a company or saw an op- portunity to break it up and sell the pieces for more than he paid, there was now little to stop him—no matter how big the target (Davis, Diekmann and Tinsley 1994; Holmstrom and Ka- plan 2003).
And then of course, there was the rise of agency theory. This theoretical perspective, developed and promulgated by several influential economists from the University of Chicago (Fama and Jensen 1983; Jensen and Meckling 1976), quickly gained visibility and adherents both in academia and on Wall Street.
According to agency theory, corporate executives who are not the company’s owners have ample opportunity and motive to serve their own interests rather than the owners’ interests (for a recent review of agency theory, see Gómez-Mejía, Berrone and Franco-Santos 2010). They can shirk, steal or take actions that promote their prestige, security and other pet agendas instead of shareholders’ wealth. In turn, there are two major ways that owners can resolve the “agency problem.” They can appoint a
1 The two were also friends going back to 1970, when Friedman met then- Governor Reagan while serving a visiting professorship at the University of California (Los Angeles). Reagan went on to write a “highly laudatory blurb for the dust jacket of Friedman’s (1980) best seller, Free to Choose”. (Rayack 1986, 2).
vigilant board to closely monitor the CEO, carefully watching for missteps or misdeeds, and they can install financial incen- tives that align the executive’s interests with those of the owners (Zajac and Westphal 1994).
All told, these various forces had massive effects on corporate America and its CEOs—again, beginning in the 1980s and contin- ueing through today. Starting in the mid-1980s, a number of icon- ic corporations, including Disney and Gillette, were targeted by takeover raiders. Even though these companies were profitable, the raiders thought that they could make them even more profit- able. The message to CEOs was abundantly clear: “Satisfying is no longer sufficient. If you are not maximizing the economic returns from your company’s assets, we will take your company over and throw you out”.2
At the same time, newly-dominant institutional investors ex- erted more pressure for financial performance. They cajoled managers, put underperforming companies on public “watch lists” and engineered CEO ousters. Indeed, CEOs became much more vulnerable to dismissal, a trend that became exceedingly evident when 13 CEOs of Fortune 500 firms were fired in the short span of April 1992 through August 1993 (Ward 1997).
Between 1980 and 1999, CEO dismissal rates tripled (Charan and Colvin 1999). And recent data suggests that, over the pe- riod 1998 to 2005, CEO turnover increased yet more and be- came more tightly linked with (poor) firm performance than in earlier periods (Kaplan and Minton 2008). In short, CEOs were held to higher standards of performance and they were much less secure in their jobs.
In line with the prescriptions of agency theorists, the use of the stick as a motivational device was supplemented by the use of the carrot. CEOs were increasingly given large baskets of stock and stock options (mostly the latter) to align their interests with those of shareholders (Murphy 1999). In 1980, equity-based in- centives (stock and option grants) made up around 13 percent of
2 Eventually, some companies adopted a variety of anti-takeover protections, abetted by varying state-level anti-takeover laws, but the new emphasis on maximizing shareholder returns was here to stay.
total CEO pay (Mehran 1995); in 2006, it was 58 percent (Mercer Human Resource Consulting 2007), a proportion that remains roughly the same today.
In a well-documented trend, the aggregate size of CEO pay packages increased markedly (Bebchuk and Grinstein 2005; Fryd- man and Saks 2010; Gabaix and Landier 2008). For instance, the ratio of CEO pay to average worker pay increased from around 25:1 in 1970 to almost 500:1 in 2000 (Murphy and Zabojnik 2004).
This meteoric rise has directly contributed to the public atten- tion (often scorn) heaped upon today’s CEOs, as well as upon the boards whose job it is to select, reward and discipline these CEOs.
Indeed, with institutional investors nearly doubling their share of the stock market from 1980 to 1996 (Gompers and Metrick 2001), boards themselves were subjected to considerably in- creased scrutiny and reform. The composition of boards shifted from a relatively even mix of company executives and outsiders to a much higher proportion of the latter, who were increasing- ly expected to be totally “independent” (i. e., with no business ties to the firm or its managers). Instead of being hand-picked by the CEO, new directors were to be selected by a nominating committee consisting only of independent directors. Directors were increasingly compensated with company stock and stock op- tions instead of cash alone, further strengthening their focus on maximizing shareholder value (Holmstrom and Kaplan 2003).
More recently, following the fall of Enron and the passage of the Sarbanes-Oxley Act in 2002, every board was admonished to have either a separate chair (other than the CEO) or a “lead director”, a prominent outside director who can marshal the board in the event of any concerns about the CEO’s actions or performance.
In short, if America’s CEOs once had cozy relationships with their boards, that is less the case today.
The involvement of boards in CEO appointments also changed.
Before 1980, boards played relatively passive roles in the CEO selection process, typically ratifying the anointment of internal candidates who were hand-picked by incumbent CEOs. Khurana (2002) highlighted the example of Jack Welch, who famously emerged victorious in the “horse race” to replace Reginald Jones
(“Reg”) as CEO of General Electric in 1980. Welch recounted this experience in his autobiography, making clear who held the pow- er in the succession process:
On that wintry Monday, Reg told me that he had recom- mended me for the job and the board unanimously supported it… Reg had given the board a month’s time to… raise any is- sues they wanted after the vote. There were none. (Welch and Byrne 2001, 87).
As part of the shift in governance norms (especially after the late 1980s), boards were expected to be much more systematic and comprehensive in selecting new CEOs. Instead of bowing to incumbents’ suggestions of insider successors, boards were now expected to look far and wide for ideal candidates; additionally, boards were now expected to engage executive search firms to help with this process. As Khurana (2002) documented, boards were expected to place extra-heavy emphasis on charismatic qualities—energy, eloquence, irreverence for the status quo, and splash—in their selection process. In seeking candidates with these attributes, boards were increasingly inclined to look outside their firms; indeed, the proportion of external CEO appointments rose from 15 percent in the 1970s to more than 26 percent during the 1990s (Murphy and Zabojnik 2004).
In short, the milieu surrounding CEOs and boards has under- gone a quantum change since the 1980s. The process by which CEOs are selected, the manner in which they are paid and the heightened rate of CEO turnover have all contributed to more of a high-stakes game, where the potential rewards—and career risks—are much greater than in the era before agency theory.
Moreover, these trends have spread beyond the United States, with recent research suggesting a move toward more shareholder- oriented policies in other countries, including Germany (e. g., Fiss and Zajac 2004; Sanders and Tuschke 2007), Japan (e. g., Jack- son 2009) and China (e. g., Xu and Wang 1999). By any measure, agency theory has been a wild success in the marketplace for ideas, both within the scholarly and business communities. Indeed, it is perhaps the most influential theory developed within the business disciplines in the last 30 years.