After Honeywell disclosed the other day that dismissed chief executive Michael Bonsignore would be getting a severance package of nearly $10 million, a friend called me to ask how economists could justify big severance packages for executives who have failed.
Words escaped me. I commiserated with him on the performance of his household’s small stake in Honeywell. However, I couldn’t give him a good explanation. My sarcastic response was that it’s a complicated economic phenomenon called “dumping on shareholders.”
Many owners of Honeywell stock and former employees may agree. During the last three years, Honeywell and AlliedSignal shareholders have lost billions of dollars in value—a subject I’ve heard plenty about because my son works for AlliedSignal, the firm that took over Honeywell and assumed its name in 1998.
Bonsignore’s golden handshake has emerged as a classic illustration of how, in free markets, corporate governance can break down to the detriment of stockholders and employees. Early economic theory, though, didn’t allow for this.
Today, research is focusing on a whole new category of market failure called “principal-agent problems.”
It helps explains why corporate directors make such payments when they have no legal obligation to do so, and when it’s clearly contrary to the interests of the shareholders they theoretically represent.
For decades, economists explained businesses’ behavior with the “profit-maximizing firm” theory. They assumed that in large firms, all employees were loyal and worked only to increase the wealth of the owners. And they figured that in publicly traded corporations, the board of directors would faithfully carry out its fiduciary responsibility to shareholders.
In such a setting, high executive pay is the result of an efficient market. Thus, every $10-million-dollar-a-year executive must be worth that to stock owners.
This was theory, of course. But at times, it was ludicrously at odds with human behavior.
Some employees worked as little as possible. Others cottoned up to bosses even when it ran counter to the interests of the firm. Managers even worked to boost short-term earnings and win bonuses before bailing out to another firm.
Directors, far from zealously representing the shareholders, often formed cozy relationships with key managers. Corporate boards frequently became self-perpetuating cliques, with elections at annual meetings a mere rubber stamp for decisions already made.
The failure of accepted economic theory was too glaring to ignore.
Younger scholars identified a new way in which free markets can fail and called it the “principal-agent problem.”
Stock owners are the principals in a firm. Managers and directors are their hired agents. But human agents do not necessarily work in the best interests of the principals they represent.
My uncle, who never studied past grade school, could have told you that. But economists are still struggling to construct models of all the possible outcomes when there is a principal-agent problem.
The Bonsignore severance package is clearly one such situation.
One interpretation of this specific incident is that the Honeywell board was split between a faction that wanted to oust Bonsignore and another that wanted him to stay.
A decent severance package for Bonsignore may have been the price his defenders exacted for agreeing to his ouster. Some Ph.D. student in economics is probably modeling this in a number of lengthy equations right now.
The problem has existed elsewhere in the economy, but adjustments have been made. For example, putting salespeople on commission rather than straight salary, piecework wages in factories, stock options and bonuses are all measures that firms have used to keep agents’ incentives aligned with principals’ interests. And the Securities and Exchange Commission has instituted rules requiring publicly traded firms to have “outside” directors to avoid corporate boards that are “captives” of management.
Nevertheless, principal-agent problems remain common and difficult to solve.
For people who hold shares in Honeywell or other firms with similar management, one lesson is that you need to complain. Call the directors. Send them forceful letters. Write your mutual fund or 401(k) plan managers and tell them how you feel.
Agents, such as directors, will represent you well only if they feel some heat when they do badly.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.