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Yet more on fiduciary obligation

July 31st, 2008

I’m planning a further post about the notion of ‘creative capitalism’, but before I get on to it, I thought it might be useful to clear up some of the confusion surrounding the alternative view, that managers have a ‘fiduciary obligation’ to act solely in the interests of shareholders, reflected in debate here, at Crooked Timber (including this great post by Dsquared) and at the Creative Capitalism blog.

A surprising number of people seemed to want to argue that, even in the absence of any legal enforceable obligation, and therefore any reasonable ex ante expectation on the part of investors, managers are morally obliged to put the interests of shareholders before their own, and before the interests of any other stakeholders. This ethical absolutism is particularly odd when it is combined with a willingess to endorse breaches of implicit contracts with workers and, as in Richard Posner’s post, hypocritical pretences of corporate altruism.

This kind of claim about the moral responsibility of managers as agents runs against the whole body of literature on principal-agent relationships, which takes a starting point the assumption that agents will pursue their own objectives within the constraints of their contractual relationship with the principal. It’s up to the principal to design the contract in a way that aligns the interests of principal and agent (this is called incentive-compatibility).

The other point raised by Daniel is that the concept of maximizing profits is too ill-defined to act as a real constraint on managers. Hence, if fiduciary obligation is to made an implementable policy, it must be tied to something more concrete.

There is one coherent version of fiduciary obligation that satisfies the incentive compatibility requirement. This is the view that managers are obligated to seek the maximum possible increase in the stock price (after taking account of dividend payments), and that they should be motivated to do so by being paid largely or wholly in stocks or options. This is consistent with fiduciary obligation if the shareholders are taken to be the specific group who hold shares when the manager is appointed, and whose interests are therefore aligned with the manager’s. Finally, stockholders can use lawsuits to protect themselves against opportunistic manipulation of stock prices.

This approach was highly popular during the 1990s, but the dotcom boom in particular showed its weaknesses. On the one hand, it turned out that stock price manipulation was easy to do and hard to prove, while the remedy of stockholder lawsuits came to be seen as a cure worse than the disease. On the other hand, as the principal-agent literature predicts, risk-averse managers don’t want their entire return tied to the vagaries of a stock price. So, they’ve not only sought to write contracts that guarantee them a large risk-free income, but they rewritten those contracts ex post when the terms called for them to share the losses of stockholders.

So, the idea of managers as agents who share the interests of stockholder-principals is problematic, and the idea of managers as capitalist saints who subordinate their own interests and objectives to those of an abstract body of stockholders is nonsensical. That doesn’t provide a positive basis for any alternative corporate objective to the pursuit of profit (including rents captured by managers) in some form or another. I’ll come to this point, I hope, in my next post.

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  1. July 31st, 2008 at 19:54 | #1

    In my roles as a director (and manager at times)of not-for profit and for-profit I have always interpreted ‘fiduciary obligation’ as toward the entity or firm. The shareholders are one large part of that, often the major part, but not the only part by any interpretation.

  2. Bingo Bango Boingo
    August 1st, 2008 at 11:22 | #2

    FXH, I’d focus more on your Corps Act obligation to act in the best interests of the corporation as a whole. The courts have consistently applied this rule as meaning acting in the best interests of shareholders as a whole (or creditors in a failure scenario), where necessary against the interests of employees, customers, everyone else.

    John: “This kind of claim about the moral responsibility of managers as agents runs against the whole body of literature on principal-agent relationships, which takes a starting point the assumption that agents will pursue their own objectives within the constraints of their contractual relationship with the principal.” Aren’t you really mixing up the positive with the normative here?

    BBB

  3. Ian Gould
    August 1st, 2008 at 11:54 | #3

    Actually, the idea of “managers as agents” seems to be used ainly to justify ignoring the wishes of particular groups of shareholders on the basis that’s there’s a “silent majority” of other shareholders who support management’s position.

    When the beneficial owners of most shares are actually super fund members who exercise no control over how their shares are voted, this seems to be a handy excuse for management sdoing whatever the hell it wants provided it keeps the fund managers on side.

  4. Bingo Bango Boingo
    August 1st, 2008 at 12:09 | #4

    Ian, fund managers are usually the ones telling management to get nicked. They are far more active, in terms of scrutinising management, than your average direct investor who votes their own shares at AGMs, etc. Read the AFR some time. Half of it is about some fund getting stuck into some CEO and/or board for screwing things up, or for some proposed course of action that will screw things up.

    BBB

  5. Ian Gould
    August 1st, 2008 at 12:36 | #5

    BBB, yes fund managers have their own priorities – but those priorities don’t necessarily reflect the priorities of their clients.

  6. August 1st, 2008 at 12:50 | #6

    bbb – yes when the crunch comes the legal path is clear but not all decisions are crunch and other legit issues can be weighed into decisions without transgressing the Corp Act.

  7. Bingo Bango Boingo
    August 1st, 2008 at 13:19 | #7

    Fair points all.

    BBB

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