New York, Sept 25: Most large companies today are run by managers who typically own only a small fraction of their company. This can lead to agency problems i.e. the possibility that managers may take decisions in their own interest and not in the interest of the shareholders.Recognising the potential for this divorce of interests, modern-day finance has prescribed that companies offer employment contracts, which include stock options and performance bonuses to align managerial interests with those of shareholders. The conventional view is that before the growth of options and incentive contracts for managers in the late 20th century, companies were unaware of and unable to control agency problems.
The most well-known proponent of the conventional view was Adam Smith, the father of economics. Adam Smith in his famous book, The Wealth of Nations, noted that the early joint stock companies generated mismanagement, allowed managerial negligence and faced agency problems, which the companies wereunable to control.
A recent academic study by Arun Khanna, a Ph D candidate in finance at Purdue University, overturns the conventional view. Khanna's study provides evidence that shareholders even in the early 17th century were savvy and aware of the potential for agency problems. Khanna's study tells the economic story of employee compensation contracts used by the first joint stock company in history, the East India Company, which was established on December 31, 1599, by a royal decree of Queen Elizabeth I of England.
Khanna examined historical documents, including the minutes of the board of directors meetings of the East India Company from the early 17th century, and has found evidence of the East India Company using a wide variety of employee compensation contracts, including share ownership, quasi-stock options and performance based bonus plans.
Interestingly, the company actually used a wider variety of employment contracts in its earlier years when it had a peculiar joint stock similar to alimited term partnership.
In later years, it shifted to a mix of salary and performance based compensation schemes, which were uncannily similar to modern day compensation plans. Khanna notes, "The East India Company's historical records show that more than three centuries ago, the company used a surprising wide array of employment contracts designed to reduce agency problems. While it would be premature to conclude that the company could control agency problems, it is clear that the contracts were designed to minimise agency problems."
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