Shareholders – weak, stupid and impudent?

The small private shareholder is an a weak position: Unlike corporate bonds or bank credit, equity investments stay with the company. The equity investor cannot ask for his money back. He also has no contractual right on income. He has control rights, but to exercise them effectively he would need information and expertise that he is normally lacking. Giving his small share, he has also no incentive to make effective use of his right. And even if he did, he alone would have no influence.

Carl Fürstenberg, an influential banker during German industrialization, called such shareholders "dumm and frech" (stupid and impudent) - stupid because they give their money away without any guarantee, and impudent, because they even expect to be remunerated for their stupidity by receiving a dividend.

Managers – agency versus stewardship perspective

Standard economic theory analyses the control problem of outside equity investors as a principal agent relationship. The classical model is due to Tirole (Econometrica, 2001). The principal (shareholder) provides the agent (manager) with equity capital to finance a project that could otherwise not be undertaken. The project is expected to generate a return worthwhile the investment, but only when the manager exerts enough effort. Whether or not the manager works hard enough cannot directly be observed and it cannot be derived from the outcome, as this is also influenced by factors outside the control of management. How can the manager convince an outside equity investor that he will exert enough effort? 

The solution the theory perceives is a set of incentives and sanctions that will make the manager exert the right kind of effort in her/his own interest. Discussion often focuses on “incentive pay”, but there are many more ways to align the interest of outside equity investors and managers, though neither incentive pay nor any of the other instruments or mechanisms offer perfect control (see below).

The principal agent model has been criticised as overemphasising the selfishness of managers. Stewardship theory argues that many managers identify with their business and organization. If this proposition is right, the interests of managers and shareholders will be congruent and control, intervention or pecuniary incentives might not only be unnecessary, but even harm managers’ intrinsic motivation.

The difference between the agency and stewardship perspective burns down to three issues – a methodological, an empirical and a practical one. On the methodological level, the agency approach takes a pessimistic scenario as its starting point or working hypothesis and asks how productive cooperation may come about despite the fact that the interests of the parties concerned are in conflict. Stewardship defines the problem away.

The empirical question is whether managers are generally good or bad? The realistic guess is that you will find both types. The observation of “good managers” does not answer the question. Even “bad people” may behave in a good manor, if this better serves their interest.

The practical question is whether it is useful to suppose that everyone is selfish. The answer is yes and no. Yes, in order to be prepared. No, if the assumption leads us to neglect the importance of “good intentions”. The methodological assumption of agency theory might serve as a general excuse for misbehaviour. The assumption seems to suggest that we should not blame the individual for misbehaviour, but the system. The strength and value of stewardship theory is that it avoids this fallacy. It emphasises that we should appeal to the “good” in people. We should establish evaluation and selection criteria that promote “good behaviour” rather than “selfish behaviour”. Of course this does not ensure that only the “good” will make it. The “selfish” might be more strongly motivated to get to the top, and this will induce them to behave ethically along the way if respective evaluation and selection criteria are in place.

To conclude – stewardship is right in its emphasis on ethical behaviour. Such an emphasis will support those who are ethical “by nature” or through their socialization, and it will educate those who are otherwise equipped, but ambitious enough to adjust. However, we still need effective governance instruments to control those who have reached the top, because even the selfish might get there, and even those with “good intentions” can sometimes be mistaken in their judgement.