Executive Compensation Schemes Issues - Essay Example

Investment banks are known to pay exorbitant executive compensation schemes are which are not properly disclosed in company accounts.The current structure of disclosure of executive compensation does not provide a complete picture about the nature and magnitude of executive compensation. A company's audited financial statements and the corresponding supporting disclosures provide a firm-specific information set which is made available to investors and regulators. When this information is not properly disclosed, this will lead to future problems on the part of the company owners. A promising action to address this problem is to develop frameworks for employee stock options valuation that will enhance the quality of compensation disclosure. This lack of information also does not help shareholders determine the company's long term prospects. The debate on executive compensation continues to acquire a national scope with the string of investment bank failures. Many business analysts put forward corporate reforms that try to construct payment schemes that will really induce CEOs to pursue the shareholder interest. Introduction When Nike paid William Perez US $18.2 million dollars in 2006, it made him the highest-paid chief executive. However, it was during Perez' one-year tenure that Nike's stock price dropped by more than $7 per share and the Swoosh lost US $2 billion dollars in market value. Nike's board asked the underperforming Perez to leave the following year. A US government official acknowledged the exorbitant executive pay in large American companies. Christopher Cox, chairman of the US Securities and Exchange Commission had admitted that executive compensation had changed but the SEC's disclosure rules have not been able to keep up with the pace. Company disclosure obfuscates rather than provides the clarity regarding executive compensation. (Seattle Times, July 9, 2006) US President Barack Obama had implemented restrictions on pay for executives at investment banks bailed out by taxpayers so as to curb Wall Street excesses and reign in public anger before the White House requests for federal funds to bail out the financial sector. Obama described Wall Street bonuses as "shameful" and expressed "disgust" at executives who reward themselves for failure (Financial Times, February 4, 2009). Obama further said that America does not disparage wealth but what gets people upset are executives who reward themselves for failure, particularly when those rewards are subsidized by US taxpayers. He pegged the compensation of executives of companies that receive assistance from the government at US $500,000 ('345,000) a year. Executives can obtain restricted stock, which could not be sold before the government had been repaid. (Financial Times, February 4, 2009). A Chief Executive Officer of a Standard & Poor's 500 company received US $14.2 million dollars in total compensation annually in 2007, according to the Corporate Library, a corporate governance research firm. The median compensation package that executives had earned was US $8.8 million dollars. In addition, the AFL-CIO labor union recognized that a fair compensation system for executives and workers is essential to the establishment of a long-term corporate value. The chief executive officers of large U.S. companies averaged US $10.8 million dollars in total compensation in 2006, more than 364 times the pay of the average U.S. worker. (Financial Week, 2007) Options constitute an important portion of executive compensation. An aspect of these programs is the discreteness of vesting dates and option exercise dates. The option grants occur infrequently. Investment banks and executive compensation The business of an investment bank is doing huge deals. This deal making usually involves raising capital either debt or equity for clients and advising on merger and aquisition transactions. In addition, investment banks sell securities to institutional investors. They also trade for their own account. Investment banks are involved in managing third-party asset. A company investor and owners depend on executives, who own a small portion of the companies they manage, to make major investment and expenditure decisions. An executive whose personal financial stake remains unaffected by the value of the company he or she manages may decide on actions that decreases the value of the investors' claims. The articles are similar in that the authors think that investment banks, its executives and board members need to be regulated and monitored by government officials, government regulators, the stakeholders and the general public. Board members despite their good reputation, still needs to be monitored closely. (Ramirez et. al. 2004). Agency theory is a critique of managerialism. (Fama and Jensen, 1983). Jensen and Meckling distanced themselves from the rejection of the profit maximization assumption. They admitted that executives have motives that differ from those of owners. The issue is to align incentives whereby the executive's interests will correspond with those of owners. This involves the means by which owners can provide effective monitoring mechanisms.One mechanism they proposed was the provision of equity to management. When managers own a stock in the firm, they share interests in its performance with other owners. Another mechanism is to provide direct monitoring through the appointment of a board of directors who are limited to operating in the stockholders' interest. A third monitor is the market, both in terms of its effect on the firm's stock price and the related market for corporate control. This separation of ownership and control has been seen as the root of corporate governance problems. Berle and Means (1932) had raised the alarm regarding the concentration of economic power brought about by the rise of the large corporation and the emergence of a powerful class of executives who are insulated from the pressure of stockholders and of the larger public. Some company owners resolved this issue by tying management incentives to the stock price. This strategy may have the adversarial effect of enabling managers to exploit their discretion in reporting earnings with the goal of manipulating the stock prices of their companies so that they get higher pay and bonuses. Investment banks are known to have fixed and high fees as they keep expensive management consultants in their roster. The investment banking industry only has a few dominant banks whose market shares appear not to have changed much given the ten-fold growth of the industry since the 1970s. Investment banks price strategically and collude to keep management fees above average costs. The authors agree on a few points. Investment banks tend to use the latitude in accounting rules to manage their reported earnings. Healy and Wahlen (1999) stated that the evidence is consistent with earnings management to window dress financial statements prior to public securities offerings, to increase corporate managers' compensation and job security, to prevent violation of lending contracts, and to decrease regulatory costs. Cohen, Dey, and Lys (2005) concur with Healy and Wahlen in that earnings management peaked from 1997 until 2002, and options and stock-based compensation was a predictor of aggressive accounting behavior. However, a study indicated that executive earnings can be limited by corporate governance arrangements (Klein, 2002). A study proved that the use of discretionary accruals to manipulate reported earnings is more pronounced at firms where the CEO's potential total compensation is tied to the value of stock and option holdings. During the years of high accruals, CEOs exercise unusually large numbers of options and CEOs and other insiders sell large quantities of shares. (Bergestresser and Philippon, 2006) The study of executive compensation dwells on the opportunity cost to the company of the stock and performance-based aspects. The cost to the company is the foregone resources. If the executive adopts a wealth maximizing strategy, then the cost of the call option does not go higher than the cost of creating the hedge portfolio that offsets the cash flows of the executive's option portfolio. The binomial approximation to the riskless hedge provides an estimate of this cost. Interest rate and dividend yield variation are not priced by the hedge portfolio. Stock options reward stock price appreciation regardless of the performance of the economy. If the exercise price can be linked to measures like the S&P 500, or a similar index of close product-market competitors, then executives are rewarded for gains in stock price. Another option is to give executives a portfolio of stock options with exercise prices linked to external criteria such as the performance of the S&P 500), and some with exercise prices linked to internal criteria such as division profits or specific executive goals) would provide a direct share price incentives, relative performance incentives and individual incentives. (Abowd and Kaplan, 1998) Bebchuk and Fried (2004) explained that management should run the corporation in the interest of corporate ownership. The compensation scheme must induce management, particularly the CEO and the CEO's allies, to manage the corporation for the benefit of its owners. Bebchuk and Fried gathered a wide range of empirical evidence to show that many CEO pay schemes are paying CEOs lavishly whether or not they are effective in management. The authors argued in favor of further corporate reforms that try to construct payment schemes that will really induce CEOs to pursue the shareholder interest. A. The current problems in the financial markets, and the reasons why some investment banks have failed. Most investment banks have failed due to their executives' corporate greed, rampant insider trading, investments in failed assets and unacceptable accounting standards. If insiders trade legally without relying on privileged information, then the reputation of an investment bank should not be linked to the trading activities of its insiders. If the disclosure requirements set by the US Securities and Exchange Commission (SEC) were effective in prohibiting insiders from trading on privileged information, there should be no difference between insider trading and outsider trading. Seyhun and Bradley (1997) examined reported insider transactions and compiled sales by the insiders of firms filing for bankruptcy petitions prior to the filing date. The literature did not have points on which they disagreed on other areas regarding investment banking. Most of the studies presented their arguments using theoretical frameworks rather than surveys. The articles show that academic opinion with respect to investment banking and executive compensation do change over time. In the 1990s, the laizzez faire economy was heralded as the promising path. The corporations were given the power to hire and pay the best wages to their executives. They were free to maximize profits and expand operations. Hence, the state and the labor union did not interfere with the operations of large corporations and the exectuives. In the 21st century, President Obama, the Senate and the Congress are actively interfering in corporate decisions and have limited the levels of executive compensation. The collapse of many corporations and investment banks underscore the importance of strict regulation and monitoring of large private companies. Hermalin and Wallace (1997 ) used an alternative specification that revealed that in the savings and loan industry there is a strong pay performance relationship accounting for the inter-firm heterogeneity. John and Narayanan (1997) revealed that the disclosure regulations of SEC create incentives for informed insiders to manipulate the market. These studies suggest that even the ex-post reporting requirements imposed by SEC do not eliminate the possibility that insiders trade on their privileged information. Members of the investment banking commmunity earn abnormal profits. If insiders trade on their privileged information, then the reputation of an investment bank would have an impact on insider trading. Ramirez, et. al., (2000) showed that investment bankers may have traded on privileged information. These bankers voluntarily or involuntarily refrain from exploiting their information advantage during the aftermarket period immediately after the IPO. Insiders' information happens at different stages in the history of a corporation. One point at which insiders possess a significant information advantage is when a firm goes public. The investment banking sector presents a special situation to study the behavioral aspect of insiders because investment banks also underwrite their own security offerings. This situation rules out the possibility that the underpricing of an Initial Public Offering (IPO) is due to information asymmetry between issuer and underwriter. This situation rules out the possibility of an information leak to the public. The self-underwritten IPOs of investment banks represent a situation in which the information asymmetry occurs only between the IPO issuing firm and the investors. It will be highly unusual insiders not to take advantage of their information advantage. If reputation of an investment bank is important (Hayes 1971), it would be a shock to observe insiders taking advantage of their superior information in the long run. Hence, there is less insider trading in this industry because of voluntary restraint. The short-run insider trading immediately after the IPO represents a case for examining the insiders' struggle between keeping firm integrity and exploring the information advantage. Theories about the use and reporting of executive compensation schemes, with investment banks as an example. Corporate governance literature presents somestudies on the relationship of earnings manipulation and corporate governance structure. Klein (2002) stated that abnormal accruals are negatively associated with both audit committee independence and board independence. Xie, et al (2003) studied a sample of firms from the S & P 500 and find that earnings manipulation is less likely for those firms whose boards have more outside directors. Studying sample of United Kingdom firms between 1993 and 1996, Peasnell et. al. (2005) reveals a negative relation between the likelihood of managers making income-increasing abnormal accruals to avoid reporting losses and earnings reductions, and the proportion of outsiders on the board. Murphy (1985) assessed the incentives provided to executives by using a panel of firms. He noted that compensation equations estimated on cross-sectional data are different from those that controlled for fixed firm effects. Large firms tend to pay lower rates of return but they pay their executives more. He showed that firm performance is positively correlated with managerial remuneration. Deckop (1988) documented that CEO compensation is positively related to firm profits as a percentage of sales. Jensen and Murphy (1990) reported a weak alignment between shareholder interests and managerial incentives. They estimated that CEO wealth changes $3.25 for every $1,000 change in shareholder wealth, due to the fact that the median value for CEO stock holdings as a fraction of shares outstanding was 0.0025 in 1987, the only year for which they collected stock-holdings data. Stock held by family members and shares held as options exercisable within 60 days were equivalent to shares owned by the CEO. C. How investment banks use and report executive compensation schemes Burns (2006) stated the negative effect of CEO compensation contracts on misreporting. They found out that the sensitivity of the CEO's option portfolio to stock price is significantly positively related to the propensity to misreport. Relative to other components of compensation, stock options are associated with stronger incentives to misreport. CEOs with option portfolios that are more sensitive to the stock price are more likely to misreport. The incentives to misreport are stronger with stock options because (1) the convexity in CEO wealth by way of stock options decreases the risk on the discovery of misreporting, and (2) stock options allow CEOs to facilitate easy exit strategies. Coles (2006) provided empirical evidence of a strong causal relation between the structure of managerial compensation, and value-critical managerial decisions, particularly those dealing with investment policy and debt policy. Controlling for CEO delta, and applying modeling and econometric remedies for the endogenous feedback effects of firm risk and policy choices on the structure of compensation, Coles found higher vega implements riskier policy choices, including relatively more investment in R&D, less investment in property, plant, and equipment, greater focus on fewer lines of business, and higher leverage. This evidence supports the hypothesis that higher sensitivity to stock price volatility in the managerial compensation scheme gives executives the incentive to both invest in riskier assets and implement more aggressive debt policy. The study showed that stock price volatility is significantly positively related to R&D expenditures, firm focus, and leverage, and is negatively related to capital expenditures. Baker, et. al., (1988) discussed the importance of internal incentive structures of companies. Pay system is independent of performance. The rampant use of promotion-based incentive systems, the absence of up-front fees for jobs, the reluctance of employers to fire, and give poor performance feedback to employees reflect poor incentive systems. The structural features of the investment-banking industry resulted in incentives for misbehavior establishing a costly regulatory regime, higher costs of doing business. Many of the traditional guardians of investors' interests, the analysts and auditors, have conflicts of interest that make it unwise to entrust them with the task. Klein (2002) revealed that board characteristics such as the audit committee independence and profile of the board of directors are able to predict lower magnitudes of discretionary accruals. Warfield, Wild, and Wild (1995) noted that a high level of managerial ownership is positively linked to the power of reported earnings for stock returns. They studied the value of discretionary accruals and pointed out that accruals management is inversely related to managerial ownership. The CEOs who assume interlocking boards get paid more compared to other CEOs. Interlocking directorships provide the CEO a degree of control over his board that harms performance. (Stelzer, 2004) There appears to be a consensus on the main issues of executive compensation. Some merit-pay critics argued that financial incentive schemes improve productivity. Policymakers favor establishing pay schemes relative to a manager's performance level. This ties executive wages to the productivity level of the executive. This pay-for-performance system can be based on objective measures such as the company attaining growth and profit targets and revenue figures which encompass sales and divisional profits. This system can also take into account the subjective measures which covers the estimated value of the employee to the organization. The performance of most chief executives cannot be measured objectively because of joint production and unobservability which implies that an executive's output is not easily quantifiable (Baker, et. al., 1988) Obama's US $787 billion dollars stimulus bill which has passed the US Congress in February 13, 2009 imposed bonus restrictions on senior executive officers and the next 20 highest paid employees at companies that receive more than US $500 million from Troubled Asset Relief Program. Companies receiving between $250 million and $500 million would face restrictions on bonuses to their senior executive officers and their next 10 highest-paid workers. The restrictions would apply to the top five employees at companies receiving between $25 million and $250 million. (Bloomberg News, February 13, 2009) The cap on executive pay, the clawback restriction on executive bonuses, and the prohibition of granting bonuses to executives of companies which had availed of the bail-out plan is an excellent strategy. These moves are specific ways in which to save the money of investors and public taxpayers. The challenge of accountability and transparency of executive compensation is highlighted in the stimulus bill. The Frank reform legislation requires that the US Treasury to confirm that incentive compensation for senior executives do not encourage excessive risks that threaten the value of the financial institution. Many positive developments are making huge executive compensation a thing of the past. A shareholder research group reports that 376 first-time directors were appointed to large U.S. companies in 2002. Outside directors meet without representatives of management and headhunters are depended upon to find board members who are not beholden to the CEO. Approximately 39 of the big 200 corporations replaced their CEOs in 2000, and that two-thirds of major companies replaced their chief executives at least once in 2000. It is difficult for investment banks to be transparent in their business deals due to the way they do business. The structure of an investment banking industry is influenced by the fact that : (i) the investment bank acquires a sunk set up cost to start a relationship with a firm; (ii) the firm pays the investment bank only when it finalizes a deal; and (iii) the investment bank cannot prevent other banks from free riding on the information. The industry cannot be perfectly competitive because investment banks would free ride on each other's information. Conclusion Economists show special concern about ways to monitor executive management to increase and preserve shareholder value. Investors risk their capital when they invest in a firm, and they have a right to expect that those who represent them will be responsive to their concerns. Corporate officials may not be necessarily responsive to their stakeholders. Hence, strict government regulations combined with public vigilance will force executives of corporations to assume responsibility to the larger community since their actions will seriously affect the well-being of the community. References Abowd, John and David S. Kaplan. 'Executive Compensation: Six Questions That Need Answers. US Bureau of Labor Office of Employment Research and Program Development. Working Paper 319. December 1998. Baker, George, Michael Jensen and Michael Murphy. Compensation and Incentives: Practice vs. Theory. Journal of Finance, vol. XLIII, No. 3, July 1988, pp. 593 - 616. Beattie, Alan, Edward Luce, Krishna Guha and Francesco Guerrera. "Obama gets tough on executive pay." Times Online. February 4,2009. Bebchuk, Lucian and Jesse Fried. Pay without Performance: The Unfulfilled Promise of Executive Compensation. Cambridge: Harvard University Press. 2004. Berle Adolf and Gardiner C. Means, The Modern Corporation and Private Property (New York: Harcourt, Brace & World, 1932. Bergstresser, Daniel and Thomas Philippon. CEO incentives and earnings management. Journal of Financial Economics 80 (2006) 511-529. Bowermaster, David. What the Boss Makes; Compensation by the Numbers. The Seattle Times,July 9, 2006. Burns, Natasha and Simi Kediab. "The impact of performance-based compensation on misreporting." Journal of Financial Economics 79 (2006) 35-67. Cohen, D., A. Dey, and T. Lys. "The Sarbanes Oxley Act of 2002: Implications for Compensation Structure and Risk-Taking Incentives of CEOs," University of Southern California working paper, 2004. Colesa, Jeffrey L., Naveen D. Danielb, Lalitha Naveen. Managerial incentives and risk-taking. Journal of Financial Economics 79 (2006) 431-468. Cornett, Marcia, Alan Marcus and Hassan Tehranian. Corporate governance and pay-for-performance: The impact of earnings management. Journal of Financial Economics 87 (2008) 357-373 CEO pay: Performance-based bonuses down, discretionary bonuses up in 07," Financial Week, March 28, 2008. Deckop, J.: 1988, "Determinants of Chief Executive Officer Compensation", Industrial and Labor. Relations Review 41: 215-226. Fama, Eugene and Michael C. Jensen, "Separation of Ownership and Control," Journal of Law and Economics 26 (1983): 301-325. Faler, Brian. "U.S. House Passes Obama's $787 Billion Stimulus Plan",Bloomberg News, February 13, 2009. Healy, P. M. and J. M. Wahlen. 1999. A review of the earnings management literature and its implications for standard setting. Accounting Horizons,(December): 365-383. Jensen, Michael and William H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure," Journal of Financial Economics 3 (1976): 305-360. John, Kose and Narayanan, Ranga,Market Manipulation and the Role of Insider Trading Regulations. Journal of Business, Vol. 70 No. 2, April 1997. Klein, A. 2002. "Audit committee, board of director characteristics, and earnings management," Journal of Accounting Economics, 33, 375-400. Murphy, Kevin. 'Corporate Performance and Managerial Remuneration: An Empirical Analysis'. 1985. Peasnell, K.V., P.F. Pope and S.E. Young. "Board monitoring and earnings management:do outside directors influence abnormal accruals'" Journal of Business Finance and Accounting, 32(7-8), 1311-134, 2005. Ramirez, Gabriel, Kenneth Yung and Jan Tin. "Firm Reputation and Insider Trading: The Investment Banking Industry. "Quarterly Journal of Business and Economics. Volume: 39. Issue: 3, 2000. Page 49. Seyhun, H. Nejat and Michael H. Bradley, "Corporate Bankruptcy and Insider Trading," The Journal of Business, 1997 (April), 189-216 Spatt, Chester S. Governance, the Board and Compensation. A speech given by the Chief Economist and Director of the Office of Economic Analysis of the U.S. Securities and Exchange Commission. Pittsburgh, PA. June 9, 2005. Stelzer, Irwin. The Corporate Scandals and American Capitalism. Public Interest. Issue: 154. Winter 2004. Page Number: 19. Warfield, T.D., Wild, J.J., Wild, K.L.. Managerial ownership, accounting choices, and informativeness of earnings. Journal of Accounting and Economics 20, 61-91, 1995. Xie, B. W. Davidson, and P. DaDalt. 2003. "Earnings management and corporate governance: the role of the board and the audit committee," Journal of Corporate Finance, 9, 295- 316. Read More