Introduction
This essay answers the questions of executive incentives are reducing agency concerns, therefore, adding value to its shareholders, or if the they only reward executives with no value added to its shareholders. After the proper research was made the conclusion was that incentives reduced drastically the agency problems, however, without proper monitoring, such as, board of directors, it would not work most of the time.
First, an explanation of its theoretical perspective is given, specifically about the agency theory. Secondly, issues related to executive incentives are mentioned, however, not in detail. Furthermore, an explanation about the executive incentives is given and how they can be manipulated to the agent own interest. Lastly, examples are mentioned so the reader can understand with real life examples what is discussed here.
Theoretical Perspective
Adam Smith (1776), Berle and Means (1932) started addressing separation of ownership and control in a large corporations’ concerns. However, Jensen and Meckling (1976) first introduced a theory, called agency theory, that would formally address those concerns. Agency theory is the relationship between an agent and a principal. An agent has the duty to act in behalf of the principal, i.e. following the principal’s interests. However, it has been proved that, often, agents act in their own self-interest other than the principal’s. This theory has come to acknowledge this problem and it has the purpose to reduce this conflict of interests.
According to Eisenhardt (1989) the theory main assumptions can be divided into three categories, human, organizational and information. Self-interest is one of the main assumptions of the theory and it is classified as a human assumption. Risk aversion and bounded rationality are also human assumptions. Agency theory assumes agents are self-interest driven, i.e., they follow their own interest other than the principal’s. Bounded rationality is when the decision-maker, in this case the agent, seek for a satisfactory solution rather than an optimal one. Finally, risk aversion is when the agent does not take risks as its principal would prefer, for example, if an executive is getting massively paid why take risks and lose his job? Organizational assumptions include goals conflict among its participants and information asymmetry. Conflicts of goals is when executives and shareholders have different goals toward what they think is best for the company. This is often caused due to the information asymmetry that exists between agents and principals, i.e., executives have more information to decide than principals, however, is the decision the correct one? Lastly, there is the information assumption, that states information is a commodity that can be purchased (Eisenhardt, 1989).
According to Jensen and Meckling (1976), to reduce such assumptions mentioned previously, solutions have been raised such as, monitoring and incentives. This incurred costs to the principal, which are formally called agency costs. Boards of directors were created as a form of monitoring the executives of the companies, to verify that executives were complying with their contract, i.e., follow shareholders’ interests (Bosse and Phillips (2016)). Non-executive directors (NEDs), i.e., directors that have been implemented in the boards of directors so they could give an exterior perspective to the company (Donaldson, 2016). Incentives were given to executives to further reduce the assumptions discussed previously, that will be evaluated in more detail further below.
Issues related to Executive incentives
Directors’ Remuneration Report (1995), most known by the Greenbury Report, chaired by Sir Richard Greenbury established that all public companies need a remuneration committee or should explain the alternatives chosen, that would decide all the remuneration the companies’ executives will receive by comparing it to other related companies’ remunerations (Hughes, 1996). After the financial crisis, the Walker Review (2009), also stated that remuneration committee should oversee executive pay with more attention. The Report also stated that should be an increase in executive remuneration disclosure to the public.
Different types of executive incentives
A current executive can receive various types of compensations for the company’s performance. Base salary and bonus are received every year and salaries are measured by the median of other CEOs companies. Therefore, most new appointed CEOs have a salary above average increasing it with time, consequently, salaries are bigger and bigger. Bonus are calculated commonly by the earnings per share (EPS) ratio. According to Rappaport (1978), that will make companies’ CEOs to focus on the short-term goals other than long term. R&D expenditure and capital expenditure are low due to its negative impact in EPS, prejudicing the company on the long-term run. Companies prefer to give bonus other than large raise because by giving bonus the executive is being awarded for his previous performance while raises are or the unknown future performance (Kim et al, 2010).
Furthermore, stock options are issued. Stock options are contracts between the company and the executives that allow them to buy stocks at a fixed price, called strike price. If the stock goes down that price the option is invalidated. However, if the stock price goes up executives can sell and profit the difference. Stock options have an expiring date, most commonly 10 years, after that period they become invalidated. Almost never an executive issue its stock options with the intention to keep it (Spector, 2016). However, underwater option, term called when a share price goes lower than the strike price of the option, has a value of zero. Often, CEOs options are deeply underwater and a recovery is unlikely. Thus, executives find themselves without any motivation. To re-motivate executives, boards have lowered the strike price of the previously issued option. However, that will lead to a greater risk approach from the executive because if all go wrong, boards will further reduce the strike price again and again (Wharton, 2003).
After the 2000s corporate crashes, there was a perception that stock options played an important role into it. Alternative forms of long-term incentive compensation like stock grants came into place. Stock grants can either be restricted stock or performance shares. Restricted stocks are common stocks with restrictions. A certain length of time needs to pass or a certain goal should be accomplished for the CEO to be able to sell them. It has the advantage of not being asymmetric because if the share price falls it does not go to zero like the options. Performance shares are attributed to CEO only if certain performance criteria are met. For example, a certain EPS. Similarities are seen with bonuses (Erickson et al, 2006).
Real-life Examples
As agency theory assume, this measures can always be manipulated by CEOs and board of directors. The scandal of Brocade’s CEO Gregory Reyes that backdated options by a month in 2001. As stated before stock options are granted at a certain strike price which is usually its market share price. However, CEOs and directors have taken advantage of this by changing the date of such option, since it is never known the specific ate at which options are granted. By changing the date to one that had a lower share price executives are lowering its strike price and, therefore, lowering the standard and profiting with it. Gregory Reyes was granted stock options at a strike price of $26, it is believed. However, by backdating a month, Reyes managed to get the strike price at $13. Consequently, by the time the share price was $26 instead of breaking even, Reyes, was already 100pc over its strike price on the options (Wall Street Journal, 20102). The same can be done by forwarding the option other than backdating. In a review made in the
end of 2006, it was discovered that over 130 companies have been backdating options (Fried, 2008). Golden parachute, other type of incentive given to executives, is a compensation given to an executive that is dismissed from its services due to a merger or acquisition. Former CEO of FleetBoston, Terrence Murray has a retirement of $5.8 million yearly. In addition, Murray could use the company’s corporate jets for 150 hours a year. According to Bloomberg (2016), that published a ranking of golden parachutes in the S&P 500, Wynn Resorts’ CEO, Steven Wynn leads the ranking with an astonishing $358 million. Executives have other benefits, for example, loans at little interest or no interest at all. For instance, WorldCom’s CEO, Bernard Ebbers, has borrowed a total of $341 million by 2002, at almost no interest, when the company went bankrupt (Wall Street Journal, 2002). Frequently, these loans are never repaid. Sarbanes-Oxley Act 2002, has prohibited any loans made from companies to its executives or directors for personal use (Hostak et al, 2013). The fall of Enron in 2001, executives were selling their shares at higher prices due to creative accounting, also known as fraudulent accounting. In this case executives followed their own interest, a main assumption of the agency theory, with no concern to its shareholders. Another example is Tesco, that in 2014, also with creative accounting, has overstated profits by £250 million, also related to the self-interest assumption to exercise their options, with no regards to their shareholders (Financial Times, 2014).
Executive incentives have come a long way since it was inserted in companies. Agency costs were reduced drastically. However, they still exist and, as is stated before, there is still a lot of issues to attend. With link of compensation to share price and company’s performance the agent (executives) have aligned its own self-interests with the principal (shareholders). Nevertheless, it was necessary to introduce executive monitoring together with incentives, which is not focused here. Focus should be to monitor executive incentives more carefully; a greater disclosure requirements should be put in place, so executives have less temptation to follow their own interest and as is its purpose follow shareholders’ interests.
References
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