Agency costs dominate academic thinking about corporate governance. The central challenge is to devise legal rules to align the interests of the managers (the agents) with those of the shareholders (the principals). This preoccupation is misplaced. Whether it is finding a baby-sitter or a dean, the challenge of hiring the right person dwarfs the challenge of aligning that person’s incentives. The central task for corporate governance—its Prime Directive—.0is to ensure that the right person is running the business. In this essay, we suggest that the challenge of aligning the managers' incentives has been drastically overstated and the way in which legal rules affect hiring (and firing) decisions has been too often ignored. The current preoccupation with executive compensation runs the risk of inducing the board to worry more about the details of the employment contract rather than selecting the best person in the first instance. More important, the law can play an important role ensuring bad managers are fired. The market for corporate control does this, but debt contracts also play a crucial role, one that has been largely neglected. Covenants in debt contracts can insure that underperforming managers are called to task. Indeed, they may be as important as the market for corporate control.
Robert K. Rasmussen & Douglas G. Baird, "The Prime Directive" (John M. Olin Program in Law and Economics Working Paper No. 339, 2007).