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Organizational Design 611

prone to expand the firm’s operations far past the point of profit maximization.

As the classical economist Adam Smith so eloquently put it

The directors of such companies... , being the managers rather of

other people’s money than of their own, it cannot well be expected

that they should watch over it with the same anxious vigilance with

which the partners in a private copartnery frequently watch over their

own.... Negligence and profusion, therefore, must always prevail,

more or less, in the management of the affairs of such a company.^25

Of particular concern is the area of executive compensation. By 2005 the

ratio of CEO pay to average worker pay in the United States had risen to 475

to 1, from around 24 to 1 in 1965. Compare the 2005 ratio to Britain (22:1),

France (15:1), Germany (12:1), and Japan (11:1). The high level of executive

compensation in the United States has not resulted in better economic per-

formance relative to that of other countries. More likely, it is the sign of sig-

nificant principal-agent problems. Because of these concerns, a number of

mechanisms have arisen to mitigate the principal-agent problems inherent in

large corporations.

1.Disclosure Requirements. Justice Louis Brandeis famously said,

“Sunlight is the best disinfectant.” Federal and state securities acts have

rigorous disclosure requirements encompassing quarterly and annual

reporting and disclosures in conjunction with proxy solicitation and

tender offers. Indeed, the philosophy behind the Securities Act is

primarily one of disclosure. If investors know the facts, they will be able

to make sound financial decisions. In 2006, in response to ballooning

executive pay, the Securities and Exchange Commission mandated

greater disclosure to shareholders of executive compensation.

2.External Enforcement of Managerial Duties. In the United States,

there are two types of enforcement. The first is enforcement through

private rights of action. State and federal law give shareholders the

right to sue if directors violate duties of care or loyalty or if directors

engage in fraud, deception, or insider trading. Private attorneys have

ample incentives through attorneys’ fees to prosecute such cases on

behalf of shareholders. The second mechanism involves direct

government enforcement authorized by state and federal laws. For

example, the government may sue or prosecute executives for

deception, insider trading, or fraud.

There remain a number of open questions concerning managerial

duties. Should the law impose broad duties or narrow ones? Should the

law mandate duties, or should the corporation be able to specify duties

(^25) Adam Smith, The Wealth of Nations,Book 5, Chapter 1, Part 3, Article 1, 1776.
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