So, why be public? this is a question more and more companies have been asking. Many of the traditional advantages of being public are no longer valid, and the mounting costs all the more obvious.

• Author: Fuller, Joseph
• Position: Corporate Reorganization

IT HAS BEEN over two years since the Enron scandal broke and well over a year since Congress passed its sweeping reform legislation, the Sarbanes-Oxley Act. Enough time, perhaps, to gain some perspective on a series of scandals that continue to shock the senses of even the most jaded business observer.

Look carefully at the recent accounting scandals, and you will see a pattern writ large. A faltering company is unable to meet earnings targets fully endorsed by management and set to fulfill analysts' expectations. Staring down the barrel of an earnings gun they locked and loaded, management sets out to meet those targets using every means possible--including, at the extreme, resorting to fraudulent accounting methods. And, while pundits have written much about the causes and consequences of infamous cases such as Enron and WorldCom, one thing stands out. They all involved a fundamental breakdown in what economists call agency--the persistent, inherent problem all corporations face in aligning the interests of those who manage the company (executives) with those who own the company (shareholders).

Once considered primarily an academic issue, agency costs arose prominently in the aforementioned cases when the interests of managers and the interests of the shareholders diverged dramatically. While the dry ruminations of academics are of little interest to board members, mastering agency costs must stand at the top of any board's agenda. As the duly elected representatives of a dispersed and varied group of shareholders, directors must arbitrate between the shareholders' interest and the very real market constraints executives contend with daily. Indeed, boards sit at the intersection of this historic conflict. Managing--or, at the very least, understanding and accounting for--agency costs, then, becomes a priority for all boards.

The origins of agency costs

The public corporation, almost by definition, carries a fragmented set of owners. This continues to be one of its great advantages as well as an unavoidable, structural weakness. Public ownership spreads the entrepreneurial risk inherent in any particular venture. And it allows shareholders to diversify their portfolio efficiently and tailor that mix to reflect their appetite for different types of risk at different points in time.

However, a dispersed shareholder group brings with it its own inherent risks. In all but the rarest circumstances, no individual shareholder possesses the stature to command management's attention. Moreover, none has the incentive to invest substantially in a detailed understanding of any individual company's risk profile. (See sidebar, "Erosion of the Power of Large Shareholders.") Indeed, the evolution of the public accounting industry and the criticality attached to the integrity of corporate financial reporting reflects the supposition that most shareholders require a limited amount of accurate data to inform them in making investment choices.

As Andrew Carnegie once said, "Anybody's business can become nobody's business" with public ownership. Today even sophisticated institutional share-holders find themselves at a loss to explain the apparent ineptitude or even criminality of once lionized executives and the evaporation of value in once feted companies. Why? Because large corporations are so complex, the transactions they consummate so sophisticated, and the markets in which they compete so vast as to bewilder even sitting board members. As a result, even the best-equipped investor cannot possibly hope to understand much of what goes on inside a company beyond a superficial level.

Uninformed owners, deceptive metrics

That complexity not only affords desperate executives and fraudsters the opportunity to obscure reality for extended periods, but also undermines the flexibility of the best-intentioned managers. The lack of informed owners can restrict management's ability to act on the owners' long-term behalf. Uninformed owners prefer easily understood, often deceptive metrics of corporate success, such as sales growth or earnings per share growth rates. Their capacity and willingness to invest in their understanding of the vagaries of markets and the nuances of risks inherent in any strategy is limited. Take the example of a pharmaceuticals company in the late 1980s, struggling to overcome a weak product pipeline. It staunchly refused to cut its research and development budget in favor of short-term earnings, as the capital markets feted its rivals. While things ultimately turned out well for the company in question--Pfizer, the darling of today's industry--it had to overcome the market's predilection for the immediate and observable.

Few management teams or boards demonstrate that constancy of purpose; therefore, their vulnerability remains great. Andrew Carnegie and John D. Rockefeller had both the means and the opportunity to understand fully the companies they owned, just as Warren Buffett and Charlie Munger have done in recent years. John Q. Public has no such opportunity, most likely lacks the necessary technical skill, and will likely exercise no such patience.

So because shareholders cannot, will not, or simply do not police managers, boards have become more and more responsible for doing the work that owners once did routinely. That is, they must act as watchdogs ensuring that a company reflects the shareholders' interests as it makes strategic decisions and incurs business risks.

Board's role in principal/agent problems

For any board, the fundamental issue in resolving the principal/agent dilemma revolves around how to prevent the careerism and innate self-interest of executives from expressing themselves at the expense of shareholders. The recent heated debates over compensation reflect the public reemergence of that issue. It is, however, far from new.

As far back as 1932, Berle and Means explored agency costs and noted their centrality in the design of the modern corporation. "The management of a corporation was thought of as a set of agents running a business for a set of owners." Managers are not owners, and developing mechanisms that cause them to act like...