Is Executive Compensation Expensive - Essay Example

Introduction With the advent of modern corporate, the aim and objectives of the organizations have changed also. Since most of the companies are public in nature with large number of shareholders therefore it is very imperative that the mechanism should be in place to safeguard the investments of the shareholders and since the ownership and management of the companies are two separate and distinct entities therefore there arise a question of whether the management should engage into practices where they can help create value for the shareholders and maximize it. Financial Management of the company is one such domain where the management of the company can maximize the value for its shareholders by adopting various practices and policies which can help achieve them their highest goal. However there are also theoretical frameworks i.e. Agency theory which suggest otherwise that the managers and shareholders can conflict with each other when pursuing their individual goals and that the managers can engage into practices where they may take actions which may not help maximizing the shareholders value and rather work in their own benefits. Executive compensation is one such domain where modern executives are largely being criticized for taking high compensations mostly on the pretext that money spent on their compensation could have been utilized for creating value for the shareholders. This essay will look into how the financial management theories and practice can help managers to maximize the value for the shareholders and how it is achieved in practice besides providing a brief outline of how the managers may not, in practice, do things which can help maximize the value for the shareholders. Executive Compensation The issue of executive compensation needs to be viewed in the historical context of the way modern businesses developed. The era during 1990s saw a slow and steady increase in the overall median compensation of the CEOs from 1992 to 2000 increased from USD 2.335(m) to USD 6.549(m)- a general increase of 180%1 suggesting the direction of the overall increase in the executive compensation. (Murphy). Similarly, despite the overall decline in the performance of financial sector due to subprime crisis, Goldman Sachs CEO Lloyd Blankfein has been able to gross up a bonus of $70million which is 30% more than what he got in previous year. However these growths in the overall compensation of the executives have mostly been in the domain of increase in stock options of the executives. The research conducted on the executive compensation subtly points towards the fact the executives exercise substantially degree of power over the board besides showing the attitude of grabbing opportunities at will. They not only exercise significant influence over their pay within the organizations however they also influence the boards of their respective organizations to provide them necessary backing to legalize their actions and further legitimize the whole process of executive compensation. Thus many view that the executives through their sheet managerial powers in the organization try to manipulate the situation in their favor. However, the hypothesis of managerial power is based on two facts: 1) CEOs prefer more compensation than less. 2) CEOs and their top managers are able to influence the structure and level of their pay. Based on these facts, it is therefore argued that the through sheer managerial power, executives tend to exercise their powers over the organizations to derive benefits in their own favor. One of the most important aspects which must be noted that executive compensation is best analyzed through agency theory Agency Theory Jensen and Meckling were the pioneers of this theory who proposed this theory based on the conflict between agents and principals. Jensen and Meckling defined agency relationships as a contract under which one party engages another party to perform some work on their behalf. (McColgan)2 and because of that principals usually leave most of the decision making to the agents. Agency theory basically explains as to how organize the relationships between the principal and agent where the principal determines the work and the agent undertakes that work. This problem mostly arises due to the incomplete information and uncertainty prevalent in most business settings. (Shane)3. Further as McColgan discussed that “the agency theory problems arise because of the impossibility of perfectly contracting for every possible action of an agent whose decisions affect both his own welfare and welfare of the principal also”. (McColgan). It is because of this that problem arise which gives rise to the fact that managers may not take value maximizing decisions if their own welfare is not being cared of by the principals. This theory further argues that due to this, two agency problems arise for any firm. Adverse Selection and Moral Hazard. (Shane). Adverse selection is the condition under which the principal cannot ascertain if the agent accurately represents his ability to do the work for which he is being paid. Moral hazard is the condition under which the principal cannot be sure if the agent has put forth maximal effort (Eisenhardt)4. “There are two main branches of agency theory. One, called positivist agency theory, focuses on the broad problem of separation of ownership from control and emphasizes how managers are disciplined by incentive schemes, external labor markets and capital markets. The second branch called the principal-agent research takes the ownership and allocation of firms as a given and concentrates on the design of ex-ante employment contracts and information systems” (Nilakant and Rao)5. The basic premise of the theory is that if both parties to the relationship are utility maximisers there is good reason to believe that the agent will not always act in the best interests of the principal Because of this problem between the agents and the principles, it was suggested that the adequate compensation can solve this problem to some extent however; Jensen and Meckling argued that the fixed wage contracts are not always the optimal solution to organize the relationships between the agents and the principals since his perception about producing quality work will not change because of the fact that no matter how hard he works there will hardly be any difference in wage between his and those others which may not be as efficient and effective managers. As discussed above that the welfare issue of both the principal and agent depend upon how the managers or directors within the company decide. Further to this, the very core of financial management within the organization suggest that Financial Management function in the organization are one of the most critical functions in any organization because all organizations ultimately translate their policies of value maximizing through the financial management perspective and success and failure of the policies are finally measured against the financial results achieved by the company. It deals with the financial aspects of the corporate enterprise including the strategies adapted right from the formation of the organization to its various stages during its life cycle. Financial Management includes strategies for financial planning, capital formation etc. (Rai)6. Effectively therefore, the financial management within the organization has two main or core responsibilities to perform: 1) Profit Maximization 2) Wealth Maximization Wealth Maximization is also called value maximization and implies the maximization of the stock prices of the firm since shareholders are not directly involved in the process of management and are compensated traditionally as managers of the firms are therefore they recoup their investments through the appreciation in their share prices and dividends. With the help of financial management, managers achieve the value maximization for their shareholders mainly through following: 1) By making capital expenditures which can substantially increase the production and service generating capabilities of these organizations. 2) By making acquisitions and mergers which can provide the necessary synergies within the organizations so that better results can be achieved through cost reduction, improved efficiencies and economies of scales. 3) Cost reductions 4) Increase in profits 5) Adopting optimal risk taking procedures 6) Any other activity which can have potential to create value for the shareholders through appreciation in the share prices of the firm. However, executives mostly diverted their attention from this and rather concentrated on improving upon their own compensation levels to create benefits for themselves at the cost of the shareholders. It was because of this reason that much important legislation was implemented to further reduce this and protect the interests of the shareholders. Sarbanes Oxley was part of such effort to reduce the manipulative power of executives and rationalize their role and increase their overall accountability within organizations. Sarbanes-Oxley The Sarbanes Oxley Act was promulgated after two of the biggest corporate scandals in the history of US. The Enron and World Com scandals were not only biggest in their intensity but they also exposed the existing legal framework as its ability to restrict and minimize the chances of incurring such large scale corporate frauds were not so good. As a result of those scandals, Sarbanes Oxley act was promulgated to improve upon the existing corporate laws in the country to increase and achieve more transparency and fix on responsibility on various stakeholders in the firms. The most important changes which brought in due the implementation of Sarbanes Oxley were the improved code of ethics as well as the tough corporate governance standards. Probably the biggest advantage which the act provides is the fact that it helps to strengthen the control environment within the organizations. Over the period of time, vague regulations allow organizations to promise on the control environment within the organization. With Sarbanes Oxley, organizations have to make extra disclosures in their various reports regarding the control environment in their organization besides offering more transparency in the process of reporting about the control environment. Control environments in the organization has been increased due to formation of various independent committees within the organization especially audit and ethics committees which oversea the processes in the organization and report their finding independently and are being made accountable to the board only. By making it mandatory for organizations to have good control environment, the information generation has becoming more reliable and standardized across the whole range of industries. This has not only simplified the process of regulatory follow up but also allowed firms to report information that can be trusted and relied upon not by the shareholders but also by other regulatory bodies as well. The standardization and reliability of information has further reduced the complexities of the internal businesses processes also as the firms are now faced with a uniformed set of rules against which their regulatory performance is going to be judged. This therefore has further resulted into the more effective use of the automated as well as manual control processes of the organization. There are various benefits of compliance with the SOX for the organization which are following the regulations. Various surveys suggested that the companies have reported that the implementation of SOX have potentially strengthened their internal control environment whereas most of the organizations also claimed that they would to keep the section 404 alive if they were members of the congress. In addition to this, implementation of SOX and its section 404 also creates a positive influence over investors as the implementation process greatly improves the transparency within the organization. Further it also allows more timely and accurate financial reporting thus minimizing the chances of frauds being committed in the organizations through creative accounting. Apart from benefiting from the strong internal controls and increased transparency, organizations can also improve their corporate governance process and in doing so they evolve as better citizens of the societies within which they are working. It further allows organizations to remove outdated and redundant procedures and better calibrate their IT systems and procedures with the accurate business requirements of the firm. Further since the transparency is ensured therefore accountability and on-boarding of the employees have increased too thus providing a better and more efficient working environment within the organization. Thus Sarbanes Oxley was targeted at improving the overall control environment of the organization by rebalancing the power sharing equation between the executives as well as the shareholders by increasing the overall checks on them as well as having them more accountable to the decisions they take. As discussed above that the agency theory clearly points towards the fact that there is a clear conflict of interests between the executives as well as shareholders therefore if executives get compensations which do not help increase the overall value of the firm and the shareholders than getting executive compensation as high as the current trends suggest can be potentially against the interests of the shareholders of the firms. Is Executive Compensation Excessive? It is strongly believed that the executive compensation should be driven by the ability of the management to create value for the firm however, it is being also debated that the growth in value of the firm are mostly not in line with the growth in the executive compensation. Many companies including Time Inc have rationalized there executive compensation programs to bring it in line with the strategic performance and value creation capabilities of their top management. However what is happening in reality is something different. Executive compensation in reality is not in any way in comparison with the value generating capabilities of the management for the firm. Conclusion The existing situation suggests that executives are being paid high. The agency theory rightly discussed the conflict of roles within the organization between the shareholders as well as the management of the firm. This is because of the fact most of the time, management and executives work in their own benefit. They devise plans, make investments and take decisions which have the strong potential of providing the value maximizing opportunity for their own benefit rather than for the benefit of all the shareholders as well as the firm. It was because of this reason that legal frameworks such as Sarbanes Oxley were formulated to reduce the managerial power of the executives in the organizations. Since research has suggested that executives through their managerial powers tend to manipulate the structure and level of their pay therefore such regulations were placed in order to dilute their influence over the affairs of the firm and put shareholders in more power. Through this executive compensation which is mostly being considered as excessive can be checked in. Works Cited Murphy, Kevin J. "Explaining Executive Compensation : Managerial Power Vs the Percievev Cost of Stock Options." 2002. http://www-rcf.usc.edu. 22 June 2008 . Nilakant, V and Hayagreeva Rao. "Agency theory and uncertainty in organizations: an evaluation." Organisation Studies (1994). . Read More