The Debate on Executive Compensation - Essay Example

?The Debate on Executive Compensation The debate over companies’ executive compensation in the recent past has been run in the highest possible tone.This is following the incommensurate pay they receive in the company’s overall performance. The executives’ pay has been discussed for a long time with the recent financial crunch just rekindling the debate. It has been a worrying moment for the certain economist why the executives’ pay maintains an exponential trend even at times that the companies are facing serious financial challenges. The logics behind this reasoning are that the executives’ pay should reflect their performance to the company rather than being a constant that is not moved by the financial constraints of the companies (Bertrand and Mullainathan 2001, p.62). Instead of the inverse proportionality of their pay to the performance of the firm, it should be such that the relationship is directly proportional to each other. Usually, the executive pay is a combination of the salary, extra bonuses, reimbursements, and shares on the company stocks. The compensation is given a stringent configuration to comply with the necessary legal requirement, which includes tax law, regulations of the government, the desires of the company as stipulated by the executives and the organization itself, and of course the reward and performance. Most important is the fact that the executive pay is always a subject of approval from the board of directors and meanings that the salary is predetermined before the actual performance of the executives is noticed (Bertrand and Mullainathan 2001, p.62). Different schools of thoughts have thus arisen over the executive pay by hypothesising on the motivating factor for the increasingly rising pay for the CEOs and two schools of thoughts have been brought forth. Some believe that the pay increment is natural and beneficial and it is necessitated by the scarcity of the required business talent that is able to propel the companies to the desired levels. Therefore, they bring a competition of retaining the best business mind in the various companies by increasing their pay to avoid poaching by other companies (Chen, Zhang and Li 2011, p.51). This scarce talent is believed to be capable of greatly adding to the value of the stockholder in the company. The other thought process perception is rather opposed to the compensation level and asserts that it is a socially unaccepted phenomenon that is largely fuelled by the social and political order that allows the executives to self-determine their own pay and have absolute control over it (Chen, Liu and Li 2010, p.54). Thus, the payment of the executives is not a covert that is whimsically decided by the CEOs themselves but is also approved by the board of directors who also determine and give consent to the figures. Despite this, the economists are not persuaded by this and therefore maintain that the executives’ pay must be aligned to the performance of the company, without which it is irrational and unjustified (Bruce, Buck and Main 2005, p.41). In reference to the objective brought by the economist over the hefty pays that go to the executives even during the period of economic crunch, this paper critically examines the agency theory and explains why it is impossible to explain the compensation of the executives with the provision of the theory. Besides that, the paper also gives comparative approach of evaluation from other theoretical sources that consider the relationship between the principal and the agents apart from the agency theory. The Agency Theory This theory shows the connection that exists between the principals and the negotiators in a business scenario through managing the business affairs to the best interest of each. The principals in the case companies are the shareholders while agents are the executives; in this relation, the agency theory tackles any problem that may arise between the principal and the agent in the course of running the business. Thus, the agency theory is known to be instrumental in solving two major differences that are often witnessed in a business scenario; the principal and the agent have divergent goals and desires creating a conflict with the principal unable to examine actions of the agent. The second problem is the different attitudes towards taking the risks occasioned by different tolerance capacity of the two, situations similar to this always lead to the principal and the agents taking contrasting actions (Shleifer and Vishny 1997, p.37). Concisely, the agency theory explains the association between the principal and the negotiator where the principal delegates power of agents in making decision. These decisions deemed beneficial to the company, and as a representative of the principal to the third party in a transaction, in this regard, the agent is hired by the principal to act on his behalf (Holmstrom 1979, p. 91). This necessitates problems arising if there are inefficiencies and lack of information because of the responsibilities given to the agent. Principal-Agent Problem It is widely acknowledged that the executives’ compensation is deeply rooted in the provision of agency theory to which the principal-agent problem is borne. Drawn from the discipline of political science and economics, the problem of principal and the agent is all about the challenges of giving motivation to one party and in this case the agent so that it can act to the best interest of the other, in this case the principal at the expense of his/her interest (Eisenhardt 1989, p.55). It can be clearly construed from the statement that the compensation of the executives is meant to allow them putting the interests of the shareholders first in any situation that will require to make a choice. It should be remembered that the agents are given the decision making powers by the principal, so without their interests taken care of in terms of the compensation rate, their decision is likely to be biased against the principal (shareholders) (Bebchuk and Fried 2003, p.64). Principal-agent problem is a common phenomenon when their interests differ, coupled with the problems of asymmetrical information to the two parties where one party-principal has a feeling that the agent has more information that they have and is probably not working in their interest. The problem becomes even more palpable when the activities proposed by the principal are costly to the agent and vice versa. Here, the situation culminates into moral hazard as well as conflict of interest (Bebchuk and Fried 2003, p.71). This situation might be of interest to the principal, especially when they think that the agent is likely to benefit; then they will be leading to revocation of the contract. This situation is analogous to that of the dentist and the patient, the dentist being the agent and the patient being the principal in this case. A dentist may recommend an expensive treatment for the patient because the situation genuinely calls for that, while the patient, on the other hand, is left doubting whether the recommendation is genuine or just for making more money for the dentist. Therefore, it is apparent that the executive’s compensation is determined in such a way that it makes them put the interest of the principal before any other interest. This situation in the agency theory also gives rise to moral hazard and conflict of interest, as stated in the principal-agent problem The Principle of Moral Hazard and Conflict of Interest In the economics theory, moral hazard is witnessed in a situation where one is not directly liable for the cost that could be incurred in the event that the risk taken does not become productive ultimately. Moral hazard is said to have occurred when the actions considered by one party finally become detrimental to the other party following a financial transaction done on their behalf by the agents. Moral hazard is witnessed because individuals or parties given the responsibility to make decisions do so with less caution and care than they would have done it if they would also be a part of the consequences of their decision (Bebchuk and Fried 2005, p.88). Because the agents are not always liable for the consequences of their decision, they take certain risks without full evaluation of their efficacy leaving the shareholders with the burden of their actions. Economists have suggested that moral hazard does happen, given the fact that there is asymmetrical information where the agent harbours more information than the principal. For this reason, the agent can be coerced through incentives to act inappropriately considering the principal viewpoint if their interests are not carefully aligned (Bebchuk and Fried 2005, p.91). With regard to the conflicts of interest, it is a possibility given to the nature of the relationship between the agent and the principal; the agent, in most cases, has more information than the principal, and mostly makes major decisions in the firm in accordance with the primary interest of the firm. Notwithstanding, there is also a set of secondary interest that will also present themselves and that will make the agent make otherwise decision that would further the primary interest. The competing primary and the secondary interests are referred to as conflicts of interest (Devers, Cannella, Reilly and Yoder 2007, p.78). It is always because of corrupting the motives of action to favour another; this puts the agents at a pivotal role in making informed choices for the business. Inability of Agency Theory to Explain Executive Compensation In whichever way one would like to look at it, the agency theory is highly incapable of addressing the issue of executive’s compensations given that there are no clear relationships defined so that the compensation can be universally determined. In the whole theory, there is nowhere the compensation of the executives is discussed, if anything, the theory only asserts that the executive compensation should be such that it makes the executive have the interest of the principal before any other interest. This recipe of giving the executives hefty pays is opposed by the economists. The other issue is the nature of the agents the principal as acknowledged in the theory, it concedes that the agents retain more information about the business than the principal does. This is more or less an indication that administratively, it has more influence than the principal; because of this factor the theory pre-empts that the principal is always not at ease with the agent over the decision they take-whether they are principal focused or not. With this doubts lingering in the minds of the principal, they are not able to object on the agents’ pays, given the fact that the agent can be swayed by incentives from the external environment to make otherwise decisions. These factors critically make the theory incapable of addressing the issue of the executive’s pay and can only allow it to go any level because it presumes the agents to have a greater influence that the principal. Again, the principal of moral hazard stated by this theory can be construed to mean that in case the agents’ pay is reduced in conformity with the economic realities facing the business, they will take risks. These risks can lead to losses, and because they are cushioned from the liabilities, they can make such several decisions that may dent the financial position of the business (Jensen and Murphy 1990, p.72). Therefore, in order to consider a theory that can address the issues of executive compensation, it will be prudent that other options are also considered and give a structured way of ensuring rational pay to the executives as opposed to the universal amorphous pay that they currently enjoy. Alternative Theories In order to determine and put the compensation of the executives under the required checks, there are some theories that can be used to determine this. In the interest of equal work and equal pay that root for commensurate remuneration for the employees, it is in order that companies use the theories other than that of agency to reach a more considerate balance. One of such theories is the performance measurement. Here the company will have to ascertain their ability to prevail through the estimation of certain parameters like investments, programs and whether acquisitions are meeting the expected results (Edmans and Gabaix 2009, p.63). Through this, the executives will be paid differently depending on what input they bring to the business depending on the standards set. Profit Sharing Apart from the performance measurement, profit sharing can also be used to guide the determination of the executive’s pay; in this case, the company offers direct or indirect payment to the agent depending on the profit realized by the company. This payment is added to the agent’s regular salary. This theory would help negate the perception that the executives are given hefty payment because it will justify the pay (Becht, Bolton and Roll 2003, p.39). The board of directors will predetermine the mode of sharing the profit with the agent such that the more the company makes profit, the more the agent earns as their pay. In this plan, the agents are always allocated some share so that sharing of the profit will be based on the shares allocated to the agents’ shares. Efficiency Wage The theory of efficiency wage proposes in simple terms the wage that is allocated for the efficiency realized in the unit labour. This dictates that the agents are paid differently owing to the fact that they demonstrate different efficiency, the presumption in this case is that when agents are efficient, they are more productive to the business than inefficient workers (Becht, Bolton and Roll 2003, p.45). This theory is also seen as bringing rationale to the payment that will be given to the executives. When they are paid more, it will be justified economically given they must have equally produced more. The provision of these alternative theories is clearer than the provision given by the agency theory over the executive compensation. Bibliography Bebchuk, L. A. & Fried, J. M. 2003. Executive compensation as an agency problem. Journal of Economics Perspectives, 17:71-92. Bebchuk, L. A. & Fried, J. M. 2005. Pay without performance: Overview of the issues. Journal of Corporation Law, 30: 647-673. Becht, M., Bolton, P., & Roll, A. 2003. Corporate governance and control. In Constantinides, Harris, & Stutz (Eds.), Handbook of the Economics of Finance. North-Holland: Elsevier. Bertrand, M. & Mullainathan, S. 2001. Are CEOs rewarded for luck? The ones without principals are. Quarterly Journal of Economics, 116: 901-932. Bruce, A., Buck, T. W., & Main, B. G. 2005. Top executive remuneration: A view from Europe. Journal of Management Studies, 42: 1493-1506. Chen, J.J., Zhang, H. and Li, W. 2011. ‘Financial Crisis and Executive Remuneration in Banking Industry - An Analysis of Five British Banks’, Applied Financial Economics, Vol.21, pp.1779-1791. Chen, J.J., Liu, X and Li, W. 2010. ‘The Effect of Insider’s Control and Global Benchmarks on Chinese Executive Compensation’, Corporate Governance: An International Review, pp.107-123, Vol.18 (2). Devers, C. E., Cannella, A. A., Reilly, G. P., & Yoder, M. E. 2007. Executive compensation: A multidisciplinary review of recent developments. Journal of Management, 33: 1016-1072. Edmans, A. & Gabaix X. 2009. Is CEO pay inefficient? A survey of new optimal contracting theories, European Financial Management, 15:486-496. Eisenhardt, K. M. 1989. Agency theory: An assessment and review. Academy of Management Review, 14: 57-74. Holmstrom, B. 1979. Moral hazard and observability. Bell Journal of Economics, 10:74-91. Jensen, M. C. & Murphy, K. J. 1990. Performance pay and top-management incentives. Journal of Political Economy, 98: 225-264. Shleifer, A. & Vishny, R. 1997. A survey of corporate governance. Journal of Finance, 52: 737-783. Read More