Corporate Governance Goals in Australia - Example

Corporate Governance Name: Instructor: Institution: Course: Date: Corporate Governance Introduction In recent times, corporate governance has dominated the corporate world, although its definition remains elusive. In a broader perspective, corporate governance entails various organizational, economic, legal, and social initiatives aimed at ensuring transparency, accountability, and performance in the corporate world. Its wider acceptance came after increased financial scandals that engulfed corporations in the 20th century. Many corporate governance strategies have relied heavily on managerial compensation, in form of equity-based remunerations, as the most effective way to make them more transparent and accountable in a bid to improve performance of the organizations. This type of compensation involves linking employment earnings of top executives to the value of the shares of the company. Most of them take the form of share options – share plans that allow employees to purchase a particular amount of an organization’s stocks for a given price, popularly referred as strike or exercise price – and stocks. The programs have been associated with various objectives, including giving the employees sense of ownership, aligning their interests with those of investors, making them select decisions that maximize investors’ wealth, and others. However, despite being key elements of governance in the corporate world, the schemes may encourage the wrong type of behavior among the executives. According to Larcker and Tayan (2011), most of the scandals witnessed in America’s corporate environment were caused by managers’ unethical behaviors influenced by the overreliance on performance-based schemes. Among others, the schemes may encourage executives to engage in backdating of the stock options, manipulating the prices of shares to gain short-term benefits, and unwarranted retaining of earnings. Despite parity in the use of equity-based remunerations across various nations, Australia seems to lag behind other countries such as Canada and USA in accepting the schemes. Only an insignificant number of listed companies in Australia utilize the schemes to improve managerial performance. Among the most significant reason for this lag regards taxation of the stock options - this has not been the case in other nations like USA until 2006. The current essay explores usage of performance-based compensation in Australia, as well as some of the corporate governance goals and chief executive officers’ behavior related to these schemes. Equity-Based Remuneration in Australia Despite equity-based plans in Australia sharing various attributes with plans in other countries such as Canada and USA, companies in Australia show less use of the plans compared to companies in the other nations. From the Australian Stock Exchange (ASX), only a small proportion (less than 5%) of the listed companies that show implementation of stock options and shares. One of the reasons for this low extent of usage of the plans includes existence of tax legislations that seem to require taxation of the stock options just as any other form of earnings. As a result, many companies have been unwilling to use them anticipating that they will increase their expenses and reduce their earnings accordingly because they have to report the options in their income statements. Regarding the nature of the options, tax legislation in Australia treats equity-based remunerations as qualified or non-qualified. Qualified plans include those options that allow employees to the have the earnings of the plans taken as long-range capital profits. On the other hand, nonqualified plans remains one of the widely used by companies because their flexibility. Employees can exercise them only after vesting for the required period, normally set at the time of grant. Although earlier tax laws allowed employees to choose when to pay taxes for the options, current modifications have integrated various changes. In the existing tax code, nonqualified plans are taxed during granting, according to the existing market price of the shares. In contrast, some qualified schemes can be exempted from taxation they satisfy various requirements, including the granting of the schemes was done as a share option. In such circumstances, the employees can delay payment of taxes until that time when they will exercise their rights. The Australian Accounting Standards Board (AASB) does not require companies to report stock options’ value in income statements. Instead, it requires them to disclose them as employment earnings in the statements, using the date of vesting as the reporting date (Pasula 2009). Objectives of Equity-Based Compensations Today, many organizations agree that equity-based remuneration, including share options and shares, present the most effective way to align the interests of workers with those of employers. Therefore, many forms of governance guidelines across the globe support the use of these schemes in employee remuneration packages. According to Fernando (2009), one of the most significant objectives of such systems is to address economic issues of agency costs, in which the interests of chief executive officers may differ from the best goals of investors. Equity-based compensation presents a powerful means to encourage executives, as reasonable optimizers of their individual wealth, to pursue wealth of investors. In Australia, governance in many firms is dominated by segregation of control and ownership between managers and shareholders. This may give rise to conflicts of interest between the investors who own the firms and the chief executives to whom the investors have given the authority to manage the firms – agency conflicts, where the investors serve as principals and chief executives as agents. In this context, share and stock options have the ability to limit occurrence of corporate agency costs characteristic of segregated governance structures by facilitating creation of value in the long- and short-term. Organizations also use the plans to instill some sense of possession among the managers in order to make them willing to improve their productivity for the benefit of the company. This reflects the principle that individuals feel motivated to work hard if they believe that will be something beneficial out of the work. Therefore, by giving the executives some part of ownership of the company, the schemes discourage managers from managing existing investments in ways that satisfy their individual interests at the expense of organization’s financial gains. The schemes also intend to encourage managers to take decisions that will optimize investments of shareholders (Fernando 2009, p.208). Equity-based compensation links executive compensation packages to investors’ wealth through share prices as measures of performance. This implies that the higher the price of a company’s stocks in the market in any given financial period, their higher the compensation for the executives. As such, managers will be motivated, at all times, to make decisions that sacrifice their personal aims in order to manage investors’ wealth effectively for better performance in any given period. Another potential objective of stocks and stock options as a way to remunerate executives regards countering the issue of managers being extremely risk-averse. In many occasions, shareholders blame the managers for underperformance of the organization, yet they do not compensate them for good performance of the organization. In such circumstances, managers develop a tendency to pursue only those investments that present minimal risks to the organization. They usually show reluctance to take necessary risks because of the perception that whether the company performs well or not, they will not earn any individual gains (Fernando 2009). At times, they even fail to make decisions that although they may present high-leveled risks, they have potential to generate high returns for the company. Equity-based remunerations come in to solve this problem by offering an incentive to the managers to take the appropriate risks for better performance of the company. As they are tied to performance of the company, managers will be willing to take appropriate risks for investments that have potential of exceptional returns. In this way, they will be able to maximize their equity earnings and at the same time, maximize investments of shareholders. Some forms of equity-based compensations act as strategies by corporations to retain top executives for long period and reduce employee turnover rates. Such schemes, usually referred to as unvested stock options, are designed to ensure that employees can only exercise them in a future period, with the possibility of losing the exercise rights in the interim if the employees quit their responsibilities. As such, since the employees must stay in their current employment for a certain period in order to exercise the schemes, the schemes operate as tools by corporations to make sure that the workers remain in their service for at least a minimum duration. In addition, the schemes may also encourage employees to remain with their current employer because they give the workers a sense of ownership. As such, the workers will want to stay in the current job responsibilities for extended periods to effectively manage their portfolios. Behavioral Effects of Equity-Based Schemes Although equity-based remunerations present an effective way to encourage managers to align their interests with those of shareholders, in many situations managers have abused their use due to lack of effective corporate governance structures. Many firms have experienced bankruptcy cases due to unethical behaviors by managers who misuse their exercise rights to maximize their wealth at the expense of shareholders’ wealth. Although not prevalent in Australia, cases of unethical behaviors have been witnessed in other nations, such as United States, where various financial scandals occurred during 1990s and early 2000s. Implemented in the wrong way, stock options and shares encourage executives to engage in unethical behavioral effects to benefit themselves. Among the most significant behavioral effect regards the executive’s tendency to wait until when the price of the stocks declines to exercise their rights. According to Larcker and Tayan (2011), managers develop a tendency to time the implementation of the stocks or the share options cautiously to benefit from low prices of stocks. This enables them to get high amount of shares and subsequently, set for themselves the more accomplishable objectives. For instance, this attitude was reflected in many of the scandals that engulfed America’s corporate world in 1990s. Managers of various corporations, including WorldCom, Enron, and others, accomplished this by disclosing information regarding poor financial performance before and disclosing information showing good performance after the introduction of share options. While the managers may perceive such behavior as rational, the behavior is injurious from the viewpoint of shareholders. For instance, by reporting poor financial performance prior to introduction of stock options, the managers intended to get more stock options because poor financial performance implied lower prices of the companies’ shares. Another behavioral influence includes tendency by executives to engage in unwarranted retaining of organization’s earnings. This behavior arises from the fact that governance structures, including those in Australia, does not require inclusion of the equity-based remunerations in income statement of corporations. This is to imply that the schemes are not subject to taxation because firms pay corporate tax for only the reported gross income. In addition, other firms tend to implement investment strategies that aim to decrease the amount paid to shareholders as dividends after introduction of performance-based compensations. This arises due to the fact that the schemes are dividend unprotected, implying that the price in which managers can exercise the options does not decrease in the event that the firms pay out stock returns. Consequently, this serves as a motivation for the managers to reinvest their stock returns or to carry out share buybacks. In such situation, the reinvestment boosts the prices of the shares but minimizes the total shareholder’s earnings that could have been achieved by the forfeited dividend payment. A classical example showing use of such behavior by executives involves the case in the Enron Company in USA. The firm provided executives with many share options because the accounting guidelines at that time did not require firms to report the schemes as an expense. As a result, the managers developed a tendency to reinvest their earnings into the company stocks when the shares were performing poorly in the market in addition to falsely claiming their options for deduction of taxes. This saw remuneration for company’s executives exceedingly rise above the earnings of other workers in the company, forcing the company to file for bankruptcy in 2001. Performance-based remuneration may also encourage managers to manipulate prices of stocks upward to optimize their stock earnings. As Larcker and Tayan (2011) argues, executives with considerable amount of share options may be lured to maneuver the prices of shares upward in the short range, despite knowing clearly that doing so will negatively influence the prices in the long run. For example, they may increasingly rely on accounting approaches that postpone disclosure of particular expenses to the following fiscal period, while at the same time hastening disclosure of some income. In this way, the short-range returns will appear appropriate to the shareholders, but the returns on the subsequent periods will reduce. Another behavioral effect associated with the schemes regards predisposition by executives to backdate their shares already given at an earlier time when the shares had lower market rates (Larcker & Tayan 2011, p.295). This has the negative impact of giving the managers an opportunity to exercise their rights at a lower price, which contravenes the principal objective of the schemes of encouraging executives to optimize the financial performance (market share price) of the organization. Though it presents a benefit of improving stock options’ values to the managers, backdating presents adverse effects to the investors. The behavior accordingly resets the exercise price of the options, transferring financial losses of equal value to the shareholders. For instance, Apple’s chief executive officer, Steve Jobs, managed to backdate his share options that saw him improve the value of the options to $20 million in 2007. Conclusion From the Australian Stock Exchange, only a small proportion (less than 5%) of the listed companies that show implementation of stock options and shares. One of the reasons for this low extent of usage of the plans includes existence of tax legislations that seem to require taxation of the stock options just as any other form of earnings. Despite being key elements of governance in the corporate world, the remunerations based on equities may encourage the wrong type of behavior among executives. Many organizations agree that equity-based remuneration present the most effective way to align the interests of workers with those of employers. The schemes also encourage managers to take decisions that will optimize investments of shareholders. Other forms of the programs serve as strategies by corporations to retain top executives for long period and reduce employee turnover rates. Another potential objective of stocks and stock options as a way to remunerate executives regards countering the issue of managers being extremely risk-averse. However, despite these objectives, the plans prompt some chief executive officers to develop behaviors that adversely affect the organizations. Among the most significant behavioral effect regards the executive’s tendency to wait until when the price of the stocks declines to exercise their rights. Others include manipulation of prices of stocks upward to optimize their stock earnings, engagement in unwarranted retaining of organization’s earnings, and backdating their options to improve value at expense of the other shareholders. Therefore, organizations need to implement the schemes carefully to encourage the executives to improve their productivity for benefit of the shareholders, but not in a way that provides the managers with an opportunity to amass wealth. References Fernando, AC 2009, Corporate governance: principles, policies, and practices, Pearson Education India, New Delhi. Larcker, D & Tayan, B 2011, Corporate governance matters: a closer look at organizational choices and their consequences, FT Press, Upper Saddle River, NJ. Pasula, C 2009, Changes to the taxation of employee equity arrangements in Australia, TaxTalk, viewed 24 May, 2011, Read More