Executive Compensation and Company Performance - Coursework Example

Executive Compensation and Company Performance This paper discusses the ment: "Of all the lies out there, the one that corporate executives' payis linked to the performance of their companies takes the prize." The discussion has three parts. The first part lays down the theoretical aspects of the relationship between owners and managers, the role of executives in a company, and how they are compensated or paid for their work. The second contains actual evidence and recent examples of executive compensation and efforts to link pay with company performance. The third relates the evidence with the theory to determine whether or not executive pay is linked to company performance. Executives: What They Do and How They Get Paid A business corporation is a complex human organization that serves several needs and interests and where owners-shareholders (also called principals) invested saved or borrowed funds in expectation of decent returns. For the business to be viable, it has to turn out products or services that are profitably sold to meet the needs of customers. The principals in turn may (or may not) hire managers to run the business and generate the expected profits. These hired managers (agents or executives as they are now called because they carry out or execute the plans of principals) have their own interests, the main of which is to receive adequate levels of compensation or pay to convince them to work for the principal and in such a work environment. Principals and agents therefore each have their own interests. While principals want the highest return for funds invested, agents want the highest pay they can get for their work. Their interests converge in a common desire to keep the business viable so that both continue to enjoy the rewards of their work. It is therefore to their advantage to align their respective self-interests and desires. In practice, however, this has not always been the case, as shown by events in early 20th century America when agents (managers) of railroad companies got paid well even as they mismanaged their companies, resulting in principals suffering heavy losses on their investments. Recent examples (Enron and WorldCom) show this to be still a problem. The study of the relationship between principals (owners represented by the board of directors) and agents (managers or executives) was pioneered by Berle and Means (1932), who pointed out that the interests of the owner and the manager may diverge because of the separation of ownership and control and the absence of a system of checks and balances in the exercise of power within the organization. Unlike in a business where the owner is also the manager who works to earn the maximum profit under acceptable levels of risk, Berle and Means concluded that hired managers if these are not the same as owners tend to work with the limited aim of running the company only for their (the agent's) own profit. The experiences of modern business corporations in the last century contain numerous examples of divergence between the interests of agents and principals, with disastrous results (mainly to the principals). This led to debates by economics and finance academics as to whether an ideal ownership structure exists that would prevent the failure of a business. This issue touches the core of why businesses exist in the first place, which is to maximize profits for its owners' investments, and attempts to explain a related set of problems: why and how firms previously managed successfully by their owners eventually fail when under hired managers. Economists used to assume without question that everyone - owners, managers, employees, and lenders - act together for the good of the firm because "each one is bound by formal and informal contracts to ensure that shareholder value is maximized" (Brealey and Myers 991). After all, biting the hand that feeds them would seem unwise and against common sense for intelligent managers to do, but through the years this continued to happen as well-paid managers continue to run their companies to the ground. Since the 1970s, academics have been studying the principal-agent conflict in business firms. Williamson (1975) argued that the agent acts out of self-interest and guile in pursuing his own goals, a mode of behaviour marked by opportunism arising from asymmetric information within the firm as agents with better information than their principals proved capable of doing anything for their own profit, for example by submitting false financial reports (Erickson et al. 2002) as Enron did (McGill et al., 2003). Another reason was proposed by Jensen and Meckling (1976), who studied the ownership structure of corporations and defined the principal-agent relationship as a contract under which a principal engages an agent to perform some service on the principal's behalf in exchange for delegating some decision-making authority to the agent. This relationship brings about what they called the agency problem: while the agent has to make decisions that affect both his own welfare and that of the principal, the agent bears the entire cost of failing to pursue their own goals but captures only a fraction of the benefits of their decisions. This is why agents make decisions that minimize risks while maximizing their benefits, leading to inefficiency that decreases shareholder value in the form of benefits due to the principal. Such inefficiency due to agency costs is measured by financial markets and represents a loss of shareholder value arising from the divergence of interests between principals and agents. They proposed that aligning the interests of agents and principals by allowing equity ownership to agents and linking compensation to company performance, in effect motivating agents to behave like principals, would minimize agency costs and maximize shareholder value. Building on these theoretical bases, principals (owners) designed schemes of compensating executives (agents) by linking compensation to business performance. Jensen et al. (1976: 344 ff.) proposed executive compensation contracts that tied financial incentives to performance as measured by an increase in company value and reflected in the level of profits or the price of company stock at a certain target date. Other companies resorted to bonus schemes based on accounting measures of performance. Although Banker et al. (1996) showed that retail firms improved sales after doing thus, Healy (1985) observed that accounting-based executive compensation pushed managers to manipulate the company's accounting systems, favoring projects with short-term returns at the expense of long-term positive Net Present Value (NPV) investments. Weisbach (1988) and Dechow and Sloan (1991) likewise discovered that tying up compensation to accounting variables led executives to focus too much on variables such as liquidity, earnings retention, or maximizing net profits at the expense of measures that help ensure long-term profitability and growth such as R&D and capital investments. A trend that arose from these experiences was the use of stock options as part of executive compensation, in theory an effective means of tying the interests of principals to the performance of their agents. Stock options give managers the right to buy company stock at a fixed lower price at a future date, so the better the managerial performance, the higher the value of the firm and the value of the options and profits managers make when options are exercised (Agrawal et al. 1987; Mehran 1995). If the stock price does not reach the target, executives do not get their performance-based pay. A key insight of option pricing is that the value of options increases along with the risk and the expected returns from the firm's underlying assets (Black and Scholes 1973; Merton 1973). Looking at the Evidence: How Executives Really Get Paid Much has changed since principals began linking executive compensation to company or stock performance, and what was supposed to be a forthright exercise of hiring executives has turned into an opportunity for managerial abuse due to four main reasons. First, there was a change in the behavior of board directors, who are supposed represent shareholders. Bebchuk and Fried (2004) and Bratton (2005) characterized most boards as lacking in transparency when disclosing information on executive compensation and unresponsive to the needs of shareholders. He gave as a reason the surrender of control and ownership by boards over to managers in the wake of the takeover wars of the 1980s, when shareholders sued boards for neglecting their fiduciary duties. This led to hiring so-called professional directors whose token ownership of shares made them part-owners but whose loyalties were to the agents (executives) who "hired" them, creating conflicts of interest that made directors rubber stamp overly generous executive compensation contracts. This was one of the reasons why the NYSE's Richard Grasso easily secured board approval for his excessive pay in 2002-2003 ("State of New York"). Second, using empirical findings, Bebchuk and Grinstein (2005) attributed the growth in equity-based executive compensation from 1993 to 2003 to the arm's length bargaining system of compensation packages and the growth in management power that allowed managers to manipulate package sizes and stock option contracts that are grossly in their (managers') favor1. This arm's length system of CEO pay bargaining utilized consultants who get paid for their services based on a percentage of the package they negotiate. Obviously, these consultants get the highest bargain they could get, taking advantage of a subtle conflict of interest. In one case, an American pay negotiator told a CEO-candidate that he could get anything he asked for because the board's pay committee chairman with whom he negotiated knew he would soon be reporting to the CEO about to be hired (Anders 2003). The recent case of UnitedHealth's CEO McGuire is a typical example, where such abuse of managerial power led to backdated options to maximize gains (WilmerHale 2006). Third, as companies grew in size and the global business landscape became more complex, a market for superstar CEOs was created where executive compensation was not solely a function of company performance but of the law of CEO supply and demand and the effect on the stock price upon news being made public of the executive's hiring (Khurana 2002). This is the case of Bob Nardelli, whose hiring after losing the race to succeed Welch at GE raised Home Depot's market value by $10 billion (Carr 2007). Fourth, the use of stock options as part of executive compensation packages exploded in the late 1990s on the wave of empirical evidence that managers and shareholders gained from their use, motivating managers to make investment and financing decisions that increased the value of a company's assets (Benston 1985; Agrawal et al. 1987; Mehran 1995). This encouraged more boards to dispense stock options generously, resulting in changing the behavior of executives to focus on short-term, stock-price inflating news, and a tendency to hide bad news and manipulate the stock price, faults exemplified by the disgraced executives at Enron, WorldCom, and Tyco. Despite these seemingly negative factors that show the downside of linking executive compensation to company performance, there exists empirical evidence even in some of the examples cited that their outsized compensations were well-deserved. Take McGuire, who increased UnitedHealth's sales from $600 million to $45 billion in the 15 years he was CEO; or Nardelli, who added more than $10 billion to Home Depot's market value and whose $125 million compensation over six years including stock options look like a bargain, but he was attacked because he exercised the options just after the stock price fell 12%. Another executive recently lambasted for his $150 million compensation was James Kilts, CEO of Gillette, who turned the company around and sold it to Procter & Gamble (P&G), at great benefit to shareholders. Lorsch et al. (2005) argued that even Warren Buffet approved the way Kilts managed and sold the company and that every penny he received was well-deserved. Linking pay to performance may have been a lie in some companies, but in the light of abundant empirical evidence, this conclusion cannot be generalized. Executive Pay Linked to Performance All recent public outcries notwithstanding, empirical studies involving multiple company samples have proven that executive pay is generally linked to performance. As early as 1992, Brownstein and Panner argued that the real question is not whether executives are paid too much, but whether shareholders are getting their money's worth, concluding that in the 1980s CEOs were actually paid in line with their performance. Frydman and Saks (2006) studied the compensation of the top three executives of the fifty largest companies in America from 1936 to 2005 and concluded that as a percentage of these companies' market value and total sales, executive compensation has gone down from 1.00 in 1936 to roughly 0.40 and 0.25 in 2005 after peaks of 1.40 and 1.20 in the 1940s (Fig. 1). This means that executives at these companies have generated value for their companies at a rate higher than what they generated for themselves, consistent with Kaplan et al. (Carr, 2007) in their pay-for-performance study of top executives, hedge fund managers, and athletes (Fig. 2). Gabaix and Landier (2006) also observed that a large part of the increase in CEO compensation in the U.S. can be explained without assuming managerial entrenchment, mishandling of options, or theft, and that the six-fold increase of CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large U.S. companies. Put simply, most executives in America and other countries deserved what they got, proving false the perception that the link between pay and performance is a big lie. As pointed out by Kaplan and Minton (2006), boards that act in favor of shareholders do manage to control managerial greed and ensure executives get paid based on performance. Boards that neglected their duty as at Enron, WorldCom, and recently UnitedHealth, deserved what they got. Evidence that executive pay is tied to company performance does not, however, deny that greedy executives have abused governance gaps to exploit conflicts. These exceptions, which are not the rule, that cry out for managerial and governance reforms. Works Cited Agrawal, A. and G. Mandelker. "Managerial Incentives and Corporate Investment and Financing Decisions". Journal of Finance 42.4 (1987): 823-37. Anders, G. "Upping the Ante: As Some Decry Lavish CEO Pay, Joe Bachelder Makes It Happen", Wall Street Journal, 25 June 2003: A1. Banker, R.D., S.Y. Lee and G. Potter. "A Field Study of the Impact of a Performance-Based Incentive Plan". Journal of Accounting and Economics 21.2 (1996): 195-226. Bebchuk, L. and J. Fried. Pay without Performance: The Unfulfilled Promise of Executive Compensation. Cambridge: Harvard University Press, 2004. Bebchuk, L.A. and Y. Grinstein. "The Growth of Executive Pay". Oxford Review of Economic Policy 21 (2005): 283-303. Benston, G.J. 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"How has CEO turnover changed Increasingly Performance Sensitive Boards and Increasingly Uneasy CEOs". NBER Working Paper No. 12465 (August 2006). Kaplan, S. N. and J. D. Rauh. "Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes" 13 September 2006. CRSP Working Paper No. 615 from SSRN.com eLibrary. 6 March 2007. . Khurana, R. Searching for a Corporate Savior: The Irrational Quest for Charismatic CEOs. New Jersey: Princeton University Press, 2002. Lorsch, J.W. and A. C. Robertson. "The P&G Acquisition of Gillette." 7 March 2005. Harvard Business School Online. 7 March 2007. McGill, G.A. and E. Outslay. "Case Study: The JCT's Enron Report Sheds Light on the Book vs. Tax Debate." The Tax Adviser August (2003): 500-504. Mehran, H. "Executive Compensation Structure, Ownership and Firm Performance". Journal of Financial Economics 38.2 (1995): 163-84. Merton, R. "Theory of Rational Option Pricing". Bell Journal of Economics and Management Science 4 (1973): 141-83 "State of New York v. Richard Grasso." 24 May 2004. New York State Government. 7 March 2007. Weisbach, M.S. "Outside Directors and CEO Turnover". Journal of Financial Economics 20. 1-2 (1988): 431-60. Williamson, O. Markets and Hierarchies. New York: Free Press, 1975. WilmerHale. "United Health Report of Wilmer Cutler Pickering Hale and Dorr LLP to the Special Committee of the Board of Directors of UnitedHealth Group, Inc." United Health Group. 6 March 2007. Figure 1: Executives create more value for shareholders relative to their pay (Source: Frydman and Saks 2006, Figure 2) Figure 2: Higher-paid top executives outperform the lower-paid ones. (Source: Carr, 2007, Figure 3) Read More