Executive Remuneration as a Corporate …

1 1 Executive Remuneration as a Corporate governance Problem By Christina Ionela Neokleous, PhD student in accounting , University of Essex, UK (Also holds BA accounting and Finance and MRes in accounting from University of Essex, UK and MSc International accounting and Finance from Cass Business School, City University London, UK) Introduction For many years, Executive compensation was a highly controversial subject that has attracted the attention of regulators, media and academics (Clarke and Branson, 2012, ). Their criticisms took many forms of concerns relating the level of Executive pay, its relationship with company performance and the failure of Executive pay setting ( board of directors, compensation committees) to stop this managerial excess (Clarke and Branson, 2012, ).

2 It became popular research topic in Corporate governance area due to the variety of criteria given in the context. Some kind of curiosity about the pay packages top executives are receiving is developing worldwide. In addition, it is considered as a motivation by those who take offense at the very large rewards to voice their dissatisfaction. For example, Guardian reflects the discontent regarding the Remuneration of bankers during financial crisis period presenting California representative Henry Waxman who reports to Lehman Brothers Chief Executive Richard Fuld that Your Company is bankrupt, you keep $480m. Is that fair? (Clark and Schor, 2008). Moreover, public interest on Corporate governance naturally grows due to the high profile Corporate failures, especially those that have devastating impacts.

3 Although Executive Remuneration as a mechanism of Corporate governance has been used to solve agency problems, it has evolved into a Corporate governance problem of its own. Through this essay, a brief description of Executive Remuneration s history will be given including its components and theoretical perspectives. The relationship between Executive compensation and company performance will be provided. Furthermore, whether Executive Remuneration is considered as a problematic mechanism or a solution will be discussed by assessing related case studies. Lastly, some key points will be reflected. Agency Theory and Executive Remuneration In a large firm, agency problems are likely to exist where a separation of ownership and control takes place (see Jensen and Meckling, 1976) between three parties: the shareholders/owners, the board of directors and executives/managers of the company.

4 The shareholders own the company, the board of directors have the responsibility to control the decision-making process on behalf of the shareholders/owners and the executives are responsible to check the daily decision making process. However, there is a possibility that managers can use the company s assets to enhance their own lifestyles. In other words, they take advantage of their control power to satisfy their personal needs such as living a luxury life with expensive cars and personal trips while leaving the cost to fall on the shareholders (Kim et al, 2010, ). Thus, 2 principal-agent theory is considered as the cornerstone of Executive compensation and Corporate governance practices.

5 Executive compensation could take various forms: base salary, bonus, stock options, restricted share plans (stock grants), pension and other benefits (car, healthcare etc.). Base salary is the standard Remuneration that an Executive receives in terms of his/her contract with the company and it is not related to company s or executives performance (Mallin, 2010, ). In addition, executives can receive bonus which are paid annually and are usually linked to accounting -based performance measures (Mallin, 2010, ; Kim et al, 2010, ). Furthermore, additional benefits through long-term incentive contracts in terms of stock options and restricted share plans (stock grants) can be provided to executives (Mallin, 2010).

6 In stock options, directors have the right to purchase shares (stock) at a specified exercise price over a specified time period (ibid, ). As contracts, if their price rises above the exercise price, the Executive will achieve profits taken from the related difference of the two prices. In the category of equity incentives, restricted share plans were added which Kim et al (2010, ) state that their advantage over stock options is that its value does not go to zero when the stock price falls without having the asymmetric incentives that options cause . Moreover, performance shares can be included as relating to company s stock given to executives only if certain performance criteria are met, such as earnings per share targets (ibid, ).

7 In the case of company s stock price increase, these performance shares are more valuable to the executives when they receive them. Additional Executive remunerations that executives receive are loans and compensation schemes after their retirement. When a CEO retires and leaves the firm, he/she receives any performance shares owed him and he/she can sell any options or restricted stock accumulated and this is referred to as a golden parachute (ibid, ). Executives can obtain a company loan with extremely low interest rates and sometimes even interest free (ibid, ). Executive pay as positive perspective From the first years of its implementation as a Corporate governance mechanism, it was believed that Executive pay could solve the agency problems.

8 Donaldson et al (2009, ) argued that optimal contracts may induce the self-interested manager to adopt investment policies that may increase the shareholders wealth linking Executive compensation with firm s share prices and performance using earnings per share (EPS) or return on capital employed (ROCE). Murphy (1998, ) pointed out that these formal contracts typically last five years and specify minimum base salaries, target bonus payments and severance arrangements in the event of separation or change in Corporate control . Jensen and Murphy (1990b, ) stated that the most powerful link between shareholder wealth and Executive wealth is direct ownership of shares by the CEO . According to Loderer and Martin (1997, ), Tom Theobald as Chairman of Continental Bank Corp.

9 Of Chicago stated that the benefits of aligning the interests of owners and managers are well documented in numerous industries . Loderer and Martin (1997, ) also added that researchers have found that the simplest way to resolve this conundrum is to have a significant ownership commitment from Corporate managers . Williams and Rao (2006) report that executives are naturally risk averse by including stock options in compensation 3 rewards, positive effect will be shown resulting in incentive for executives to take risky projects and to achieve increased rates of return in the company. Hall and Murphy (2002, ) have presented that during the fiscal year 199, 94% of S&P 500 companies granted options to their executives, compared to 82% in 1992 , confirming the accuracy and the success of Executive compensations to bridge the principal-agent gap and to reduce the agency costs.

10 Through these results, it can be considered to motivate, reward and to discipline executives who had poor performance. In order to achieve legitimacy of Executive Remuneration and to avoid any conflict of interest, Bender (2003, ) states that it is neither the responsibility of Remuneration committee nor of executives to set the executives pay, but the one of external providers such as consultants who act independently during their work . An article related to the speech by SEC Staff about Executive Remuneration written by Spatt (2004) mentions that high compensation is necessary to attract talented individuals, who typically possess outstanding alternative opportunities.