A Review of the Greed Cycle by John Cassidy Essay Sample
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A Review of the Greed Cycle by John Cassidy Essay Sample
From the introduction of the first public company by Francis Cabot Lowell in 1814, the principal – agent conflict between stockholders and managers has existed. The Greed Cycle offers an exploration and analysis of the agency problems that exist between stockholders and managers as well as some of the mechanisms that have been used to reduce these problems. The following review will highlight the changing nature of the goal of the corporation, the relationship between agency problems and the goal of shareholder wealth maximization, successful and unsuccessful ways in which agency problems between managers and owners have been addressed, the relationship between agency conflicts and options given to managers, and thoughts regarding the ultimate goal of the corporation.
Into the early 1900s, most managers seemed content to work toward maximizing shareholder wealth in return for large salaries. However, by the 1920s, this accord had changed drastically. Insider trading, stock price manipulation and diversion of corporate funds for personal use was rampant. The goal of the organization had shifted to maximizing the interests of management. Recognizing these abuses and a need for change, Congress enacted the Securities Act of 1933, which, among other restrictions, outlawed insider trading and other attempts to manipulate the market. This act and the establishment of the SEC in 1934 helped to reduce the agency conflict between owners and managers.
During the 1960s and 1970s, senior management compensation was more typically tied to the size of the firm: the bigger the firm, the bigger the salary. This ushered in a new goal for the corporation, at least from management’s perspective, to seek rapid expansion of the firm with little concern for risk, profitability, cost, or stock price. During this time, managers spent lavishly on themselves even when their companies were in financial trouble. The 1980s saw another shift with the beginning of the shareholder value movement. It was during this time that CEOs became to be viewed more widely as agents of the company’s shareholders. The prevailing goal became then as it is now: to maximize the value of the firm as measured through the market price of its stock.
While conflict may be inherent in the principal – agent relationship between stockholders and managers, a number of mechanisms have been developed over the years to help reduce these conflicts, some successful and unsuccessful. Stockholders will always wield the power to join together to force out managers whose interests aren’t aligned with those of the shareholders. However, this isn’t a practical solution for addressing agency problems, because it’s too costly and time-consuming. It was thought that corporate competition would spark managers to do the best they could for their companies by cutting costs and increasing profits as much as possible. Through the work of financial economists Michael Jensen and William Meckling, we learn that managers will not automatically work to maximize shareholder value in the face of competition. Government regulation and corporate governance can be effective tools for curbing some unethical agent behaviors, such as insider trading, but are not enough to eliminate agency problems. In his article, Cassidy discusses the leveraged buyout (LBO) as an example of another mechanism for keeping management focused on shareholder wealth: the threat of takeover. Managers have incentive to maximize stockholder wealth, because keeping stock prices high was an effective deterrent to takeover. While the threat of takeover may still be an effective mechanism, LBOs largely fell out of favor during the recession of the early 1990s.
The introduction of the stock option as a component of executive compensation offered yet another mechanism for addressing the conflict between stockholders and management. Stock options provided executives with a great incentive for maximizing the firm’s stock price: the opportunity to reap enormous personal profits! Unfortunately, it wasn’t long before stock options were being abused. Over time, stock options became an incentive for some company managers to use accounting tricks to mislead investors about the firm’s value in order to increase the value of their own options. While some of these methods even produced short-term gains for the firm, they were often harmful to a firm’s long-term health and profitability. It’s Cassidy’s opinion that stock options aren’t a good measure of management’s contribution to the firm, because the value of the stock is mostly out of their control. Investors, not managers, determine a company’s stock price. Because of the temptation to abuse stock options for personal gain, economists such as Paul Volcker now conclude that stock options should be eliminated.
The most widely accepted goal for the public firm is maximizing its shareholders wealth as measure through the market price of its stock. However, the inherent conflict of interest between stockholders and managers can make it difficult for management to stay focused on this goal. A number of mechanisms exist to reduce these agency conflicts. Some have been more successful than others. New mechanisms for reducing agency problems will continue to be developed and with them new opportunities for abuse will be discovered. While management is ultimately accountable to the owners of the company, investors should understand the risks and conflicts inherent in the relationship.