Frequently Asked Questions about Corporate Monitoring:
1. Wouldn't a corporate monitoring firm (CMF) be just another layer of bureaucracy?
2. Wouldn't a CMF have too much power?
3. Wouldn't a CMF have incentives that diverge from the shareholders' interests?
4. What would prevent a CMF from being overly influenced by the client firm's management?
5. Isn't the CMF's job impossibly difficult? (Choosing an entire board of directors; evaluating what is done at board meetings and inside the client firm.)
6. Wouldn't it be too difficult for shareholders to choose a good CMF?
7. Aren't there simpler ways of accomplishing the same objective, without the extra corporate monitoring structure?
8. If board members are nominated by a CMF, who would chair the board?
9. How can such a corporate monitoring system get started? Who will provide the support necessary for it to happen?
1. Wouldn't a corporate monitoring firm (CMF) be just another layer of bureaucracy?
Some bureaucracy is worthwhile if it performs an important function and adds value. A corporate monitor would provide a link to enable shareowners to influence the management of their firm. The sizable premium often paid when a company gets taken over and its management overhauled gives a measure of the value this can add.
If simplifying the firm’s power structure is important enough, one bureaucratic layer could be eliminated by giving the monitor more direct control over the board of directors, as described in The Corporate Monitoring Firm. Then there would be no director elections, just monitor elections.
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2. Wouldn't a CMF have too much power?
There may be some danger of the CMF becoming too powerful. However, the annual shareholder vote for competing CMFs should be a sufficient control against abuses of that power, keeping them responsive to the owners. Alternatively, the streamlining can be foregone and the CMF can remain as merely a headhunter, choosing board nominees.
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3. Wouldn't a CMF have incentives that diverge from the shareholders' interests? For example, short-term, aggressive risk-taking instead of long-term reputation-building.
The monitors will have strong incentives to serve the owners because they can be fired annually in an openly competitive ballot, and must build their reputation to have a successful ongoing business. Incentives can be further enhanced by paying the monitor’s fee in stock that must be held for 5 years. The current trend to make directors hold stock should also be encouraged.
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4. What would prevent a CMF from being overly influenced by the client firm's management?
A pattern of inside influence detrimental to owners will eventually become known and damage the reputation of any CMF that permits it. They would then lose clients, by being voted out in the annual shareholder ballots to choose a CMF from an open field of competitors.
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5. Isn't the CMF's job impossibly difficult? (Choosing an entire board of directors; evaluating what is done at board meetings and inside the client firm.)
There is no doubt that finding a complete set of directors is a difficult undertaking. However, a corporate monitoring firm (CMF) is unlikely to replace all directors at once; that would rarely be in the owners’ interests. And in searching for the best candidates, the CMF could use all the resources deployed now, including input from shareholders, the current directors, the CEO, and executive search firms. The key contribution of the CMF would be overseeing the process to ensure the owners’ interests are being served.
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6. Wouldn't it be too difficult for shareholders to choose a good CMF?
Each CMF's public reputation will be based on impressions of various observers, including security analysts, investors, directors and employees of client firms. Monitors will be discussed and compared in the Wall Street Journal. Shareholders need only read some of these discussions to get an informed opinion on quality, and vote accordingly.
In the longer run, academics could do event studies of each monitor's average impact on client firm value. This will help validate the other sources of information on CMF quality.
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7. Aren't there simpler ways of accomplishing the same objective, without the extra corporate monitoring structure? For example, activist relational investing, incentive compensation for the CEO and the board, separating CEO and board chair roles, takeovers etc.
All these methods alleviate but do not solve the problems of diverging interests between management and shareholders. Corporate monitoring is the only solution that effectively puts control of the firm in the hands of its owners in spite of their fragmented holdings.
(a) Activist relational investing...
...suffers from a big free-rider problem: An investor holding 5 to 10 percent of the firm may organize a costly campaign to make directors set value-maximizing policies, but only reaps 5 to 10 percent of the resulting benefit. This necessarily limits such campaigns. The fact that they are undertaken at all indicates how much more benefit will result from monitoring without free-rider leakage.
While activist campaigns are undertaken on a firm-by-firm basis, corporate monitoring can be mass-marketed to all firms at once. It is a structural change that will provide ongoing benefits to any widely held firm. An activist campaign would improve management decision-making for only a few years; cronyism is likely to creep back in over time.
(b) Incentive compensation for the CEO and the board:
This clearly lessens the conflict of interests, but some divergence will always remain unless those who run the firm own 100% of the equity, which is rarely practical because they are not wealthy enough and would be taking too much risk.
(c) Separate CEO from chairperson role:
A helpful measure; but having a separate chairperson ensures neither independence from the CEO nor accountability to the owners. If a CEO can populate a board with friends, then making one of them chairperson doesn’t solve the basic problem. And even if one succeeds in creating an independent chair position with enough power to counterbalance the CEO, what prevents the chairperson from pursuing his/her own interests at the expense of shareholders?
(d) Takeovers (including LBOs):
These enforce a limit on mismanagement, but their high cost still permits a great deal of waste. Furthermore, the firm may gradually slide back into inefficiency in the years following such a restructuring. Corporate monitoring is less costly and more permanent.
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8. If board members are nominated by a CMF, who would chair the board?
A board chosen to best serve the owners would probably choose an outside director to chair the board, rather than the CEO. If the CEO somehow maintained dominance of the board and remained chairperson, the CMF could bring specific pressure to rectify that.
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9. How can such a corporate monitoring system get started? Who will provide the support necessary for it to happen? How can shareholders vote to install a monitoring entity that either doesn't exist or doesn't have a track record?
The majority of a firm's owners must be in favor for corporate monitoring to be adopted. This will require an education and marketing effort, starting with opinion leaders in the field -- business and academic specialists in corporate governance. The main question is whether investors will benefit from having more influence over who is on the board of directors. When enough large investors are willing to vote for it, the balance could be tipped in favor at a few target firms, perhaps by proponents accumulating shares.
When the idea starts gaining acceptance, corporate monitoring services will be offered by existing and/or new firms. Existing firms with relevant expertise and reputations would include those in the proxy advisory, executive search, consulting and auditing fields. A new firm could establish a reputation quickly by recruiting partners with experience in these same fields, as well as in corporate law and board service.
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