Re-thinking the Firm: Agent Capitalism

Barry M. Mitnick, Ph.D.

Professor of Business Administration

Katz Graduate School of Business

University of Pittsburgh

The theory of the firm is wrong.

The theory says that when liberal incentives like stock options are used to morph managers into owners, we get motivated managers loyal to the firm.

Instead, we get a new class of predatory owners who seek private profit rather than true corporate value. They do this by shifting risk to others, free-riding their way to outrageous returns.

In the new model of firm governance that must emerge, such skimming gives way to an ethic of full-cost management. Risks and costs must be pushed back to where they belong.

The roles of owners and managers are separate, and must be kept so: Firms perform best when managers serve as agents of the firm and not as surrogate owners.

Thus recent events suggest that we are entering the third age in the evolution of the relationship of owners and managers: Entrepreneurial and managerial capitalism are giving way to agent capitalism.

Seventy years ago, Berle and Means warned of a threat to corporate control. As the founding owner-entrepreneurs of American corporations departed, ownership was dispersed among many, distant shareholders. The new class of professional managers would then steer the firm’s resources to their own private benefit. The returns to investment that had spawned entrepreneurial capitalism would be diverted and diluted.

Over decades, the solutions included mechanisms to align the interests of managers and owners. Thus, in managerial capitalism, the rewards of managers were tied to measures of bottom-line success, such as stock options and performance bonuses.

The theory of the firm never worked out exactly how the alignment of interests would be transmitted to the firm and become improved performance; theories in finance and economics did not need to deal with such mundane issues as long as the incentives were right. The firm itself was little more than a mysterious black box that responded when the incentives of managers were tweaked to match those of the owners.

Though institutional economists worried about intervening transaction costs, in fact few agonized over the details of exercising authority and managing real, complex, conflictful, layered organizational systems. Even “behavioral” economists who recognized that goals could be manipulated dealt only with modifications in the managerial decision calculus.

In the current crisis, the public has been treated to a parade of chief executives who profess to be ignorant of what was done on their watch. There may be the bare kernel of truth to that: Under managerial capitalism, top managers really don’t take their role to be management; they are merely surrogate owners whose actions are focused on enhancing the short-term, paper value of the firm.

One can hear Charlie Brown: Good grief! Doesn’t somebody have to run this place?

But the conditions that led to the fearful warnings of Berle and Means had not changed. Most investors were indeed distant and ill-informed. Managers influenced the selection of the Board; the Board awarded managers not only performance incentives, but golden cushions to soften their departure from the corporation. These rewards were explained as part of the incentive to attract scarce managerial talent; in practice they merely absorbed the natural risks of management.

Indeed, the more that managers received the rewards that entrepreneurs had received, the more that they behaved like them: They sought to expand their personal benefits and to control the risks that threatened those benefits. Like the entrepreneurs of the late nineteenth century, they extracted great wealth from the corporation, engineered stability-producing arrangements that removed competition, used government regulation as a means to control external threats, and shifted costs to sectors that lacked the information and market power to oppose them.

This was indeed a managerial capitalism, as the dire predictions of Berle and Means came true, but in an even more perverse fashion. Instead of subverting ownership control, managers found themselves blessed by the owners’ representatives. The Board now came to serve not the owners, but the pleasure of the managers. Far from being incentivized to run the firm efficiently, managers used their new discretion to milk both the firm and the distant shareholders.

It is no surprise that among the losers in Enron-like disasters are small investors, pension holders, employees, and members of the local community. In short, the corporate leaders of managerial capitalism became little different from the robber barons of a century ago.

What has brought this modern crisis of the corporation to a head is its scale: As the economy enjoyed a run-up virtually unsurpassed in economic memory, the natural constraints of business failure receded. New technology, such as internet start-ups, generated paper wealth, so that it became costless to give managers the risk protections they demanded. The prudent alignment of managerial with investor interests became a raindance in which top management became indistinguishable from ownership. And like the robber barons of old, they went after the gold.

The market’s hard line would have it that what we see in Enron and the others is merely a calling to accounts; risky business is risky, after all, and failures, even big ones, occur as a normal part of market business. The problem is that not all participants elected to bear the risks as a part of the chance of earning the benefits. This wasn’t a case of risk badly managed, but of a risky ripping-off. Poorly-informed stakeholders were left holding a very empty corporate bag, whose contents had been dumped in the managers’ pockets.

Society refused to accept this as merely the downside of market capitalism. Rather, it was seen as the Dark Side. In this market democracy, we don’t share market values that include exploitation. The market turns out to be free only if it is ethical. The playing field has rules that keep it level, and we accept only horizontal turf.

The issue of expensing stock options puts the basic dimensions of owners and managers in sharp relief. Kept off the books, stock options treat managers as surrogate owners. The options are not really rewards to align the separate class of managers with that of owners, but become merely another way for owners (now including the managers) to extract surreptitious ownership benefit from the firm.

By expensing and reporting options, the firm asserts that managers are only its agents, not its owners; the firm is bearing true costs in controlling its agents. This is agent capitalism, in which managers are expected to act in the firm’s interests first, internalizing and managing the full costs presented by those interests, and in their own interest only incidentally.

Managers are not to be more like owners; we let the Board worry about serving owners and other constitutional interests of the firm. Managers, like the owners’ representatives on the Board, are to be fiduciaries, but for different principals: The Board serves the owners and other societal stakeholders who exert valid claims on the corporation; the managers, on the other hand, serve the firm itself.

Managers are professional agents of the firm; their special talent is to run things, not to extract value. The owners’ representatives are there to ensure that value is produced.

When managers cease to be agents, and see the firm only as a vessel to be squeezed for a profit to be shared by them and the owners’ representatives, they are merely raiders, short-term pirates of a wealth that needs captains for the long-term.

Like other professionals, managers serve under special expectations, and we expect them to police those expectations, rather than fleece them. Although the professional codes of physicians, lawyers, and CPAs haven’t done the whole job, they are taken seriously. We need a similar code for agent-managers. At the least, we expect managers to do no harm and to reveal harm when it is discovered, as well as to serve the firm with fiduciary dedication, probity, and skill.

The firm presents a complex set of principals. Thus, agent-managers would realize the obligations created toward pension-holders, as well as protect the health and preserve the economic well-being of the firm’s employees. Rather than shift the costs of production onto the natural environment, they would internalize them. They represent and resolve the firm’s multiple interests as part of the firm’s essential task performance.

No firm can ignore what the market demands, of course, but astute management preserves its most valuable assets to ensure the long-term viability of the firm. Such managers protect the interests of both current and future holders of equity.

Nothing in this argument disputes the desirability of seeking efficiency and of maximizing value in the firm. What it does do is recast the roles, responsibilities, and objective set of the governors of the firm.

Under agent capitalism, business schools would value teaching management and ethics, as well as the skills of owners, i.e., finance. Thus modern business education must have two tracks: The training of owners, and the training of managers. We need both. That is, business schools must be conscious of the need to prepare agents who are both skilled and well-behaved in running things, not merely junior entrepreneurs. The firm houses managers, not only capitalists.

The recent reforms reflect the practice of agent capitalism only in part. They place special expectations on top managers to certify their managerial performance, elevate penalties for noncompliance, restrict loans to managers, and create some boundaries between the managerial role and the supervisory and auditing role of the Board. The Board’s auditing agents had become, like managers, creatures of the owners, and these, too, are to be returned to their agency, with supervision by a new regulatory board.

The key element of expensing stock options, or replacing them with much smaller, outright grants of stock, is, however, missing. As long as managers can appropriate the wealth of the firm without recording the cost of that appropriation, they become merely another class of owners. And the day of the professional managerial agent, who includes and not shifts costs to others, is postponed.

The exact details of new regulation are less important than its credibility, which must produce support for and belief in regulatory authority. The SEC has until now been more successful than most agencies precisely because it was in the interest of the regulated industry to guarantee that its playing field was level.

Agency has its own, unavoidable costs. Managers will never be perfect agents of the firm, but they are far from that now, anyway. If society is to receive the service it deserves from its most powerful engine of advancement, it must place the expectations of agency on that sector. Capitalism is not, after all, the ultimate end of the good life, but only one of its agents. As Berle and Means concluded, “Neither the claims of ownership nor those of control can stand against the paramount interests of the community.