June 30, 2013
By Christina Ionela Neokleous
For many years, executive compensation, with the forms of base salary, bonus, stock options, restricted share plans (stock grants), pension and other benefits (car, healthcare etc.), was a highly controversial subject that has attracted the attention of regulators, media and academics. Their criticisms took many forms of concerns relating the level of executive pay, its relationship with company performance and the failure of executive pay setting (e.g. board of directors, compensation committees) to stop this managerial excess. It became popular research topic in corporate governance area due to the variety of criteria given in the context. Some kind of curiosity about the pay packages top executives are receiving is developing worldwide. In addition, it is considered as a motivation by those who take offense at the very large rewards to voice their dissatisfaction. For example, Guardian reflects the discontent regarding the remuneration of bankers during financial crisis period presenting California representative Henry Waxman who reports to Lehman Brothers Chief Executive Richard Fuld that “Your Company is bankrupt, you keep $480m. Is that fair?”. Moreover, public interest on corporate governance naturally grows due to the high profile corporate failures, especially those that have devastating impacts. Although executive remuneration as a mechanism of corporate governance has been used to solve agency problems, it has evolved into a corporate governance problem of its own.
In a large firm, agency problems are likely to exist where a separation of ownership and control takes place between three parties: the shareholders/owners, the board of directors and executives/managers of the company. The shareholders own the company, the board of directors have the responsibility to control the decision-making process on behalf of the shareholders/owners and the executives are responsible to check the daily decision making process. However, there is a possibility that managers can use the company’s assets to enhance their own lifestyles. In other words, they take advantage of their control power to satisfy their personal needs such as living a luxury life with expensive cars and personal trips while leaving the cost to fall on the shareholders.
During the fiscal year 1999, 94% of S&P 500 companies granted options to their executives, compared to 82% in 1992, confirming the accuracy and the success of executive compensations to bridge the principal-agent gap and to reduce the agency costs. Through these results, it was considered to motivate, reward and to discipline executives who had poor performance. In addition, an article related to the speech by SEC Staff about executive remuneration mentions that high compensation is necessary to attract talented individuals, who typically possess outstanding alternative opportunities. From the first years of its implementation as a corporate governance mechanism, it was believed that executive pay could solve the agency problems by influencing the self-interested manager to adopt investment policies that may increase the shareholders’ wealth. It was also believed that executive pay was the rescue from agency problems hoping for a better economy with more honest and trustworthy relations between executives, shareholders and general public.
The most executive compensation packages include some requirements regarding the company performance and its relationship with the amount of executive pay received by company’s executives. Several research studies took place to demonstrate if there is actually a relationship between company performance and executive pay, if this relationship is positive or negative and how this affects the company as an economic entity and its viability in the current market. In general terms, performance is measured using a variety of indicators such as return on assets (ROA), market-to-book ratio, earnings per share (EPS) and return on capital employed (ROCE). However, negative relationships between executive pay and company performance are taken place ascertaining agency problems and the fact that executives continue to take advantage of their position and act fraudulently to achieve high executive compensations. Additionally, a spate of unexpected company failures, financial scandals and examples of ‘corporate excesses’, such as high pay awards to the executives of poorly performing companies threatened to undermine investor confidence.
Accounting scandals of well-known companies, such as Enron, WorldCom, Fannie Mae, General Electric (GE), Royal Bank of Scotland (RBS), revealed the problematic side of executive remuneration. Lessons have been taken regarding the shareholders as principals and executives as agents where there is no alignment between their interests and as a result, the performance-based pay for executives exacerbates the agency problems instead of decreasing them. Executive remuneration increases the focus of executives only on their personal interests, ignoring the shareholders’ interests, resulting vast turmoil on the viability of the company and the general economy. The use of executive pay schemes as a solution to align agent-principal’s interests was ‘an illusion’. Additionally, executive compensation is viewed not only as a potential instrument for addressing the agency problem but also as part of the agency problem itself.
Some weaknesses are reflected through accounting-based incentives where accounting profits are used as performance indicator. First, executives can increase the research and development into higher costs in order to make the company look more profitable in the future than in the present aiming to an increase on accounting profits. Furthermore, the possibility of earnings manipulation by executives, specifically CFOs, plays a significant role in the ‘true and fair view’ of company’s financial statements. By so-called cooking the books, executives change the numbers of financial statements in terms of their own preferences to show higher profits and at the end, to get higher executive compensation. Additionally, having less transparency and more complicated bonus schemes, it leads to higher bonus for the executives but such complexity of shareholder value is not been associated with. In some cases, they do not provide any disclosed detailed information relating the bonus performance targets in the annual report and doubts were appeared in the context questioning if it was related to transparency or camouflage issue.
In addition, stock options have faced difficulties on the alignment of managerial incentives with shareholders goals. Due to the combination of stock price appreciation and dividends on shareholder returns, CEO increases dividends in favour of using the cash aiming to increase the stock price. By increasing the stock price, CEO gains higher share of dividends at the end of the year. In the case of risky investments, there is a higher possibility to raise stock price by using stock options, rewards CEO. Thus, CEO tends to take risky projects and follow risk business strategy in the company to have higher chances to get stock options award. In this case, CEO takes advantage of his/her position by acting and taking decisions without thinking the possible consequences. Moreover, a manipulation of earnings may occur by executives to increase profits for one specific year and to make the stock price more favourable for exercising options. However, this may have dramatic consequences in the company leading into bankruptcy.
In general, stock prices are affected by company performance and also by external factors as world economy. When there is prosperity in the economy, the stock prices increase. All companies, regardless of their financial condition and success, take the advantage of stock price increase. Therefore, executives of poorly run companies are being enhanced by receiving richly compensation when they do not deserve them. On the other hand, when there are economic difficulties in the company due to stock price fall, executives should be awarded but they are not, due to decreased options. Moreover, the performance-based pay was criticized negatively arguing that the problem of executive remuneration was not the high levels of compensations received by CEOs but the fact that their compensation was not related to companies’ performance. In addition, after their retirement, executives receive a compensation, characterized as ‘Gratuitous Goodbye Payments’ where they can live a luxury life receiving retirement packages with huge amount of money and free access to corporate jets, apartments and other benefits. In this case, executives may inflate firm’s earnings in order to increase the level of executive compensation and to secure their future bonuses and other rewards using fraudulent actions. There is not a relationship between executive pay and company performance characterizing it with the term ‘camouflage’ where executives hide the total amounts of their retirement rewards and there was no sign of transparency. The strong desire to camouflage may result to inefficient compensation structures that affect negatively the managerial incentives and company’s performance. Thus, weaknesses of pay arrangements show the necessity of reforms in current compensation practices.
A significant interest in executive compensation and corporate governance can be observed due to the prevailing financial climate, the financial collapses of well-known firms and the accusation of rewards for failure and a lack of accountability. Criticisms from different backgrounds reflect the problematic side of executive remuneration as it cannot fully be handled to the related practices as a corporate governance mechanism. Viewing the ‘two sides of coin’, it can be argued that if it is used appropriately without any excess or fraudulent actions, executive compensation can bond executives to owners so as to enhance shareholder wealth. On the other hand, the misused or dysfunction of this corporate governance mechanism can impoverish managerial entrenchment and moral hazard. The huge amounts of executive pays drive the corporate governance to erosion sending the message that boards of directors spend shareholders’ money lavishly and without the appropriate supervision. Therefore, calls for immediate legislations and reforms have been presented through these years in order to find out the possible solution that may stop this devastating situation with executive pay. In the beginning, executive pay seems to be the oasis in the desert where suddenly disappears and the consequences are followed one by one.
Christina Ionela Neokleous
BA Accounting and Finance, University of Essex, UK
MSc International Accounting and Finance, City University London, UK
PhD Accounting, University of Essex, UK