Constraints on managerial discretion
The degree of discretion that senior executive managers have in setting objectives is limited by both external and internal constraints. External constraints arise from the active market in company shares while internal constraints arise from the role of nonexecutive board members and stakeholders, trying to align the managers’ and the owners’ interests by the rules shaping corporate governance.
External constraints
There are five sources of external constraint on managerial behaviour in any system of corporate control. Those who potentially hold this power are:
1.Holders of large blocks of shares who use or threaten to use their voting power to change management or their policies if they become dissatisfied.
2.Acquirers of blocks of shares sold by existing shareholders unhappy with the performance of management.
3.Bidders in the takeover process who promise to buy all the voting shares of the enterprise.
4. Debtors/Investors, particularly in times of financial distress, who act to protect their interests in the company.
5. External regulators and auditors.
In outsider systems, external control is exercised mainly through the workings of the stock market rather than voting. In the stock market, shares are continuously tradedand the price re£ects the relative numbers of buyers and sellers and their willingness to buy or sell. The influence of the workings of the stock market on managerial discretion assumes that a fall in the share price will make management more vulnerable to shareholder activism either in selling shares or in voting at shareholder meetings.
In outsider systems, shareholders are inclined to sell under performing shares to maintain a balance in their diversified share portfolios. In insider systems the selling of shares is more difficult and, therefore, shareholders are more likely to use their voting power to influence management. In outsider systems the working of the stock market makes it feasible to acquire blocks of shares by purchase and to make a bid for all the equity of a company, thereby threatening the tenure of the existing management. Other external constraints on managerial behaviour are the need to comply with company law, independent auditing of accounts and the lodging of company accounts with the regulators. The annual accounts of a company are designed to present a reasonable picture of the company’s activities and its ¢nancial health in terms of profit and debt levels to actual and potential shareholders. On occasions, audited accountshave been found to have presented an inaccurate picture, in that a company has gone bankrupt after the accounts appeared to show a healthy financial situation. The bankruptcy of Enron in the USA in 2001 was a notable example.
Internal constraints
Within the organizational structure of the company, there are groups who may be able to influence management to change policies. The first of these are the non-executive directors, who are appointed to the boards of UK companies to oversee the behaviour of the executive directors. However, they are normally appointed by the executive managers and, therefore, may not be independent in their actions or effective in constraining executive directors. They are often few in number and can be outvoted by executive directors. One of the objectives of corporate governance reform in the UK is to make non-executives more effective. In the German system the supervisory board plays this role by influencing the management board, but its membership is more wide-ranging.
The second of these groups are the owners or shareholders, who can exercise their authority at meetings of the company or informally with management. Directors are elected at the annual general meeting of the company. Dissatisfied shareholders can vote against the re-election of existing executive directors or seek to get nominees elected. They can also vote against resolutions proposed by the executive of the company, such as those relating to executive remuneration. In the past this has rarely happened as shareholders have been passive rather than active in company affairs and sell underperforming shares. However, in the UK institutional shareholders have become more active in organizing coalitions to either influence management behind the scenes or forcing votes at annual general meetings.
A third group that can influence executive managers are the stakeholders within the company. These include employees of the firm as well as customers, suppliers, lenders and the local community. They may do this by expressing their criticisms concerns either directly to the executives or indirectly by informing shareholders, the media and outside experts or commentators. Investment banks and stockbrokers offer advice to shareholders on the potential future earnings of the company, and such comments may help to influence attitudes toward incumbent managers.
Aligning the interests of managers and shareholders
It has been argued that the discretion executive managers exercise can be limited by the development of incentive mechanisms to ensure that the interests of managers and owners are more closely aligned. If we assume that shareholders wish to maximize profits, then managers may be encouraged to do so by the payment of profit-related bonuses in addition to their basic salary and/or by rewarding successful performance with share options in the company.
Critics of such schemes argue that senior managers may be motivated by nonmonetary rewards and that it is difficult to devise incentive schemes that only reward superior performance. A survey by Gregg et al. (1993) explored the relationship between the direct remuneration (pay plus bonuses) of the highest paid director and the performance of around 300 companies in the 1980s and early 1990s. They found that almost all large UK companies had bonus schemes for top executives but that rewards were weakly linked to corporate performance on the stock market. The authors concluded that the results called into question the current system of determining rewards and that the incentive schemes did not successfully align managerial interests with those of the shareholders
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