Trujillo kills agency theory

Well this title is not exactly correct. I would like to think that Sol Trujillo’s resignation as CEO of Telstra, his performance in the role and subsequent payment of $40m from the telco would clearly and unequivocally lay Agency Theory to rest. Take this excerpt from The Australian:

But the legacy he leaves will last far longer than his four years in
charge of the nation’s biggest telco – a testy relationship with the
federal Government, a broadband strategy in tatters, a share price near
10-year lows and a business only part-way through the five-year
“transformation” he promised on arrival in mid-2005. Telstra shares –
and its formidable core business – have held up relatively well in the
financial storm, but yesterday’s press conference announcing his
departure came with a warning that profits would fall short of
expectations in the coming year.

Unfortunately, I think agency theory is so entrenched in current economic and management thinking Sol’s resignation will either be seen as just a blip or, even worse, proof itself of the theory.

It didn’t matter much what Trujillo did at Telstra, he just had to do a lot. It didn’t matter if it was successful as long as he was making an impression. If you’re a Telstra shareholder and you think that was worth $40m, good on you. [Declaration: my partner owns a small parcel of Telstra shares.]

Who can honestly believe that Trujillo really cared about the long term outlook for Telstra? If the telco fell over in five years time, at worst his reputation is shot but he’s got $40m in the bank. More likely he would shrug his shoulders and lay the blame at the feet of his replacement while earning another $40m or so from another bunny prepared to take him on.

Agency Theory argues that the owners (ie shareholders) can only influence managers to act in their interests by offering them (largely) financial incentives.

The Spiral Path has long argued that there are two fallacies in this argument.

First, the owners of a large corporation are so diverse who can tell what their interests are and what they want. Over the last twenty years the term ‘Shareholder Value’ has come into common use. This has come to represent the sole measure of owner interests. Managers, however, are very clever. They know they can do just about anything they want as long as they say it is in the cause of Shareholder Value. Can they prove their actions are providing increased value to shareholders? No. The only way to tell would be to run the exact same scenario and take a different set of actions. Outperforming the market is often taken as a measure of shareholder value but, as we know, the market is very fickle. If Sol shaved off his moustache it would have an effect on the market. If we were to use market outperformance as a measure, we should use long term (perhaps 20 years) outperformance.

The other problem we see with Agency Theory also has to do with the cleverness of managers. If managers are going to require financial incentives to act in the interests of owners, they have learnt very quickly they can demand very very large financial incentives. And once the owners have agreed to these incentives, it is very hard not to pay them regardless of company performance. We suggest that Agency Theory rather than giving a lever to owners to encourage managers to act in their interests, has given managers a tool which allows them to act with scant regard to the interests of the owners.

What can we do about this?

First, we can take the path advocated by Australian Treasurer Wayne Swan in this article. Swan suggests that we could regulate to provide shareholders with greater control of executive remuneration.

One of my favourites is to remunerate executives based on long term performance. That is we allow them an adequate annual salary but provide most of their benefits in terms of long term bonds or shares in the company. Whichever instrument we chose the executive would only be able to convert them to cash over a period of time. Say 20% of the total amount every five years. This would encourage executives to look to the future and give them an incentive to stay with the company longer.

Of course, not all managers act against the interests of their shareholders. Many chief executives do look long term and use a whole range of measures to determine both their own performance and that of their companies.

Many executives also passionately believe in what their company does. These executives, while still being well paid, do not ask for multi million dollar salaries. Their level of self-fulfilment more than adequately compensates them for the blood sweat and tears they put into their business.

Of course, all of this begs the question of who really owns the company. Remember that Corporations Law is really only a couple of hundred years old. The Dow Jones Indexes only came into existence a little over a hundred years ago. The vast majority of historical commerce was achieved without any form of shareholding.

Perhaps we need to look to a new way for companies to raise the capital they need to operate.