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Saturday, July 31, 2004

Commitment and Self-Interest

Cross-posted from System Viability and Corporate Governance blog

Standard investment advice is to diversify. Among other things, this means that it's not a good idea to hold significant quantities of shares in your own company, since you are doubly exposed if the company fails. (Think Enron.)

Meanwhile, it is widely supposed that the company's interests are served if the directors and employees have an investment stake in the company as well as an employment stake. This is supposed to align the personal interests of the directors and employees with the interests of the company. There is personal commitment to the success of the company, with an inflated cost of exit.

Furthermore, by having large personal shareholdings, company directors demonstrate their confidence in the company's present state and future prospects, and their belief that the share price undervalues the true worth of the company.

There is therefore a structural conflict of interest between company (external shareholders) and employees (especially directors). How is this resolved?

Either the individual directors take an irrational stance in respect of their personal investments, accepting an unbalanced portfolio with a sub-optimal risk/reward ratio. However, we should not expect true alignment between the interests of a director with an unbalanced investment portfolio, and the majority of shareholders whose investments are (of course) properly balanced and diversified.

Or the directors cheat. For example, holding derivatives that hedge against the excess exposure to the failure of the company. For example, manipulating information. And as a privileged class, the directors hedge against failure by awarding themselves massive termination payments. (While not illegal, this is a morally corrupt practice.)

According to this argument, directors are driven by the system towards either madness or badness. (Some manage both at once.) The answer is not to recruit a new cadre of morally upright and selfless leaders, but to change the system.

Click here for Trevor's reply

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