Organizational Design 613businesspeople or top managers of other firms) provide general
oversight of the corporation. Given the limited compensation paid,
outside directors are far less entrenched in their roles than inside
directors. Accordingly, monitoring by outside directors can mitigate
principal-agent problems.
As an example, consider a hostile takeover in which both inside
and outside directors stand to lose their jobs. For the inside directors,
this loss can be enormous, including surrender of an executive
position and the large income, important responsibilities, and
prestige that go with it. For the outside director, all that is lost is a very
part-time job and a very part-time salary. Thus, the inside director
might strongly oppose the tender offer, whereas the outside director,
largely free from a conflict of interest, would act more objectively.
As critics point out, strong outside directors often cannot rein in top
management. Outside directors are typically chosen by inside directors,
and their continued employment depends on getting along with the
insiders. In addition, inside directors typically control the flow of
information to outsiders. Corporate governance reform proposals aim at
increasing the independence and influence of outside directors. Reform
plans often include one or more of the following proposals: increasing
the number of outside directors (most proposals specify a majority of
outside directors); removing inside directors from nominating new
directors and from setting directorial compensation; requiring
companies to include competing slates in their proxy solicitation
materials; allowing shareholders to initiate changes in the corporate
charter; setting mandatory retirement ages or term limits for directors;
and prohibiting interlocking directorships (where inside directors of
one company are outside directors of another and vice versa).FINANCIAL INCENTIVES As noted in the previous section, incentive contracts
can mitigate principal-agent problems. The same reasoning applies to a com-
pany’s top management. By crafting pay-for-performance compensation plans,
the organization can give managers greater incentives to maximize share
value.^26 This mechanism serves to reduce the costs associated with the separa-
tion of ownership and control.
Consider a corporation, whose stock is currently trading at a price of $100
per share. Now compare three possible executive compensation schemes. At
year end, executive 1 receives a flat bonus of $200,000 cash. Executive 2 receives
$100,000 cash plus $100,000 worth of restricted shares (that is, 1,000 shares).(^26) There is a lively debate on the causes of large executive salaries and perks. See L. Bebchuk and
J. Fried, Pay without Performance: The Unfulfilled Promise of Executive Compensation(Cambridge, MA:
Harvard University Press, 2006); D. Owen, “The Pay Problem,” The New Yorker, October 12, 2009,
pp. 58–63; and J. Gordon, “Executive Compensation: If There’s a Problem, What’s the Remedy?
The Case for “Compensation Discussion and Analysis,” Journal of Corporation Law (Summer 2006).
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