Two academics based in the U.S. — Oliver Hart and Bengt Holmstrom — were named co-winners of the 2016 Nobel prize in economics for their separate research on contract theory. Their pioneering work includes influencing corporate governance and shedding light on the setting of performance-based pay for CEOs. Holstrom’s work, in particular, supported the use of remuneration linked to measures of relative total shareholder return.
Their evolutionary thinking on shareholders, creditors, managers, workers, customers, suppliers and others as different stakeholders has led us to consider corporate governance through the design of contracts between those stakeholders. Hart and Holmström laid the foundations that enable us to do this.
In the late 1970s, Bengt Holmström demonstrated how a principal (e.g., a company’s shareholders) should design an optimal contract for an agent (the company’s CEO), whose action is partly unobserved by the principal. Holmström’s informativeness principle stated precisely how this contract should link the agent’s pay to performance-relevant information. Using the basic principal-agent model, he showed how the optimal contract carefully weighs risks against incentives. In later work, Holmström generalised these results to more realistic settings, namely: when employees are not only rewarded with pay, but also with potential promotion; when agents expend effort on many tasks, while principals observe only some dimensions of performance; and when individual members of a team can free-ride on the efforts of others.
While contracts are commonplace, they are generally not simple. They might be designed at times when the objectives of stakeholders differ (the so-called “agency problem”). For example, shareholders may want to maximise a company’s profits, while managers may want to build an empire through mergers and acquisitions.
There is also “asymmetric information” where the actions of one set of stakeholders are not visible to other stakeholders in the company. Everyone can read the financial statements, but shareholders cannot directly see how much effort the managers put in to drive profits.
The Nobel citation for Holmström (see HERE) credited him with demonstrating how shareholders should design an optimal contract for a CEO whose actions they are not able to fully monitor.
Contracts can also be incomplete. It is either not possible or too expensive to write contracts that take all possible outcomes and circumstances into account. It is precisely the incompleteness of contracts that provides a rationale for governance in research by Hart.
Consider, for example, a simple executive pay scheme in a company where shareholders own the company but control lies with management. This relationship presents both an agency problem and asymmetric information. In an attempt to deal with these issues, the shareholders link the managers’ remuneration to an observable outcome such as revenue or profit. Profits, however, can be affected by factors outside of a manager’s control, and a contract that covers all combinations of managerial effort and external factors is impractical.
Managers generally act in groups and, so, it may also prove difficult to assign an outcome to one person. You can, of course, write contracts that penalise the group if a product fails, or a plant proves inefficient. However, Holmström argued that uncertainty about the causes of such failures means monitoring would be necessary with a consequential higher cost.
An alternative approach to determine remuneration would be to judge the performance of managers against that of their peers. This approach, however, would only work if you can successfully remove the influence of common external factors affecting how managers perform.
So, where did they land?
Since simple contracts may not be easy to design or enforce, a better mechanism to protect the interests of non-managerial stakeholders is needed. Corporate governance emerged as the panacea for the protection of these interests and has continued to become an even stronger influence in the design of executive pay arrangements.
Hart and Grossman also examined how control is exerted by voting rights.
Holmström and Hart do not provide all the answers to resolve the problems associated with weak corporate governance. They do, however, induce us to think about a firm as a microcosm of the society in which we live, where stakeholders with different objectives compete for power and control.
Despite proxy advisers and other governance stakeholders at times trying to go the other way, their work has enabled us to move away from the one-size-fits-all rules about things like financial structures and pay. Holmstrom and Hart have led us to focus on making contracts and mechanisms that work which has been a transforming contribution to corporate governance research.
So, did their theories work? Holmström was on the board of Nokia. In a recent interview he said that Nokia’s executive compensation became too complex, despite having independent directors.
Nokia did not do so well, allowing it to be acquired by Microsoft.© Guerdon Associates 2022 Back to all articles