An article in The Wall Street Journal discusses a trend among some large U.S. corporations to base the compensation of outside members of their boards of directors partly on the performance of the corporation. “This growing practice more closely aligns the director to the company. [Some] companies link certain stock or stock-option grants for directors to improved financial performance, using a measure such as annual return on equity.”

Question

An article in The Wall Street Journal discusses a trend among some large U.S. corporations to base the compensation of outside members of their boards of directors partly on the performance of the corporation. “This growing practice more closely aligns the director to the company. [Some] companies link certain stock or stock-option grants for directors to improved financial performance, using a measure such as annual return on equity.”
How would such a linkage tend to reduce the agency problem between mangers and shareholders as a whole? Why could directors be more efficient than shareholders at improving managerial performance and changing their incentives?

Damon · Answer

If the company does better the shareholders get happier.
The directors have direct say in decisions about paths the company takes. Outside directors of course often are officers in other corporations and know how to run companies batter than most shareholders do. If you pay them more when your company does better, they will focus on your company doing better.