Corporate Governance and the Role of Executive Incentives - Essay Example

Running Head: assignment Corporate Governance and the Role of Executive Incentives of the of the of the Professor] [Course] Introduction Governance has gained strict implications and meanings when used in corporate parlance. Increased competition and influence of regulatory bodies has made maintenance of order, compliance and value based performance essential for businesses and organizations to function. Corporate governance as such has grown manifold in its research based abilities and controlling the corporate behavior of entities involved. With numerous mechanisms working under the aegis of corporate governance, executive incentive attracts the greatest attention owing to its significance and recent upheavals due to fraud and non-complaint cases by some of the major organizations. The paper seeks to determine the role and effectiveness of executive incentives in corporate governance drive of an organization and draws the conclusions from various research findings to anchor the understanding of the concept. Inclusion of real life cases assists the application of theories in practical sense. Corporate governance and various mechanisms Separating management and ownership is one problem that has always posed serious challenges for corporate form of an organization. The fundamental problem of conflict of interests where managers focusing on personal gains overlooking shareholder’s interest gets severe in loosely governed organization. Corporate governance is a tool which aims to align the interest of all parties and stakeholders in the organization and provides a strategic direction to the performance and control functions by ensuring order and decision making process are done effectively. In this regard, areas where most of the conflicts arise within an organization are related to recruitment and compensation of CEOs and top level management. Based on the above conflicts a detailed theory has been developed which is known as Agency-theory (Jensen and Meckling 1976). The theory describes various types of costs which are incurred owing to the different type of conflicts between shareholders, managers and debt owners. Agency cost is defined as the sum of monitoring cost, bonding costs and residual loss. Other two types of costs are agency cost of equity and agency costs of debt where former arise due to conflict of interests between managers and shareholders whereas latter arises due to conflict between shareholders and debt holders. Corporate governance is a system that brings more transparency and control in the organization. The approach involves setting accountabilities and linking management’s compensation with shareholder’s value. Mechanisms operational There are many mechanisms that can be applied to deal with the problems in affecting good corporate governance. There are various mechanisms of Corporate governance which can be classified as Executive Incentives, transparency and reliability of financial accounting information, legal Protections, ownership structure, corporate leverage, role of board of directors, and dividend policy (Haque, Arun & Kirkpatrick n.d). While exercising corporate governance, there are various internal and external pressures which an organization is exposed to and hence, mechanisms also fall into internal governance and external governance mechanisms. In corporate governance, categorization of various mechanisms takes place as under: Internal governance mechanisms Ownership concentration relies on large block shareholders who hold greater percentage of shares and are in a position to control managerial decisions. However, small number of such shareholders, diversified business lines and propensity to maximize shareholder value makes this mechanism weak in its application. Board of directors constitute candidates elected unanimously by the shareholders to accomplish the tasks of taking decisions, maximizing shareholders’ wealth and controlling the overall affairs of the organization. However, here also, probability of opportunism and favouritism cannot be denied which mars the relevance of this mechanism as a corporate governance tool. Executive incentives, by far, handle the agency problem to the greatest extent. As per the agency problem, shareholders (or principals) appoint managers (decision makers or agents) to take decisions on their behalf and pay compensation to them for their risk bearing activities. However, issues crop up when either the goals of both these entities clash or shareholders are not able to verify as to whether the action of the agent was appropriate or not. This gave rise to executive incentive mechanism where principals now pay the agents (or managers) for their performance and as such, managers are also careful of their actions and decisions because the pay, bonus, compensation and incentive will now be dependent upon the outcome of their decision. External governance mechanisms Market for corporate control is the only mechanism under this category which is resorted to by organizations when the internal governance mechanisms fail to deliver results. Under this, takeover of the corporation by external firms and individuals takes place which leads to the formation of new divisions and diversifications in the existing business. Most explicit framework for executive incentive mechanism Corporate values/culture/vision explicitly communicates the values of the organization. The key to the effective management of executive rewards lies in balancing the internal and external pressures which have direct effect on business performance of an organization. All such pressures can be represented diagrammatically (Figure 1) with executive reward package lying in the core of the network. Figure 1: Executive reward package at the centre of network of Internal and external pressures The above network suggests that not only shareholder’s interests but also the pressure from labour market has to be considered while deciding on the appropriate reward package. Rest of the drivers is present in almost all types of compensation structure for executives. It is very unlikely that business performance would not be enhanced if executives reward package is linked with the performance by any of the corporate governance mechanisms. Haque, Arun & Kirkpatrick (n.d) opine that corporate governance mechanism in an organization is dependent upon a number of factors, both internal and external. In this light, the executive reward package should be well matched with the cultural setting of the market, access to financial assets and the overall performance of the firm. This is so because corporate governance rests on the premise of impartial and independent decision making by the members which is a behavioural phenomenon and factors like objectives, externalities, interests of other entities and individual motivation guide this behavioural phenomenon (refer to case below). Case in action- Enron Corporation This case has been responsible to emphasize the need of corporate governance that acted as an alarm bell for all the organizations around the world. Whole economics of corporate governance revolves around the findings from the detailed study of this case (Munzig 2003). Enron Corporation, an energy company based at Houston, Texas figured in the headlines when its Auditor- Arthur Anderson supplied misleading accounting and financial details of the organization and directed the company towards bankruptcy because of mammoth debts and crucial information hidden from stakeholders. Primarily counted into breach of accounting ethics, Enron case unveils some of the major flaws in the corporate governance and the principal-agent problem in particular. Superficially, the case revolves around bending of accounting principles and ethics by the top executives of Enron in their favour when they diversified into the energy broking business. Concealed from outside investors and stakeholders, the executives dealt separately with energy contractors and benefitted from the difference in the buying and selling of energy commodities. Arthur Anderson accomplice the fraud by misreporting actual figures which were later on discovered running into millions dollars of debt. Delving deep into the issue, serious loopholes in the corporate structure and conflicts of interest between parties come into picture. One of the solutions to the principal-agent problem, namely aligning the interests of management and shareholders by way of stock options spelled demise for Enron when its executives became equity owners in the organization and got the freedom to receive huge incentives for self-dealings. The opinion of Shleifer & Vishny (1996) turned real when managers at Enron manipulated the financial details and their earnings to heighten their pay and receive significant incentives. With stock options, they served both as principals and agents and thus their accountability did not realize any limit or boundaries because of which they undertook unnecessary risks through hedged partnerships. Background behind executive incentive mechanism Executive incentives are crucial in deciding the proper alignment between executive’s and owners financial interests. Similarly the structure of these rewards is equally important to avoid ‘alignment effect’ or ‘entrenchment effect’. The major components of rewards can be classified under salary, bonuses (related to performance), option of shares and long term benefits. Various findings suggest that there is positive and direct correlation between executive incentive and increase in shareholder’s value (Appendix 1). The ideal structure of these incentives would motivate the managers to give their best in order to gain maximum reward. However it cannot be said that these incentives have any effect on the behavior of the executives. This would also help in bringing down the various costs that have been discussed earlier as the main focus of managers would be on making optimum choice. Similarly the option of purchase of shares induces a degree of ownership in the managers which is always a positive indication for an organization (Fama & Miller 1972). Specifically, empirical findings of Florackis & Ozkan (2009) suggest that managing executive incentives in the context of corporate governance results in minimizing the agency costs arising from conflicts of interests and creating leverage for the business by means of increased access to external debts and finance. This happens because of the reliable and trustworthy image of the company made in the eyes of stakeholders which grants it greater access to finances and capital formation. Roles and effectiveness of executive incentive mechanism The base salary component of the executive’s reward package is not sensitive to business performance, but still it is important to ensure a degree of financial security for the managers. No executive in the world is likely to accept a total performance based reward package. Most of the annual bonuses are based upon short term goals being met. This carries a serious risk that could adversely affect shareholder’s interests. Executive incentives linked with performance Normally speaking, financial incentives have always been linked to enhanced motivation and performance. In the case of corporate governance mechanisms, it gains higher prominence due to the responsibility owned by the executives involved in decision making as equity based reward makes them stick to the purpose of their functioning. Research findings by Beer (n.d) assert that incentives are now being attached to performance and outcomes. A survey of 205 executives disclosed the perceptions of executives that bonuses and increased compensation motivated them to work better and synchronise their activities with the corporate goals. Till now, device of executive incentives and other monetary perks has been used in the context of attracting and retaining employees but recent scams by top-notch organizations and their non-complaint behavior has raised stark questions as to whether incentives are meant solely for retention or for altering the corporate behavior of managers and executives. The research concludes that executive incentives do alter the behavior and performance of executives and managers by attaching expectancy and outcome based pay to their compensation package and making them more responsible towards their duty for shareholders. Executive incentives linked with accounting fraud Erickson, Hanlon & Maydew (2006) in their research compared 50 firms alleged as accounting fraud firms by the Securities and Exchange Commission (SEC) against firms which were not accused of any fraud. Though the findings revealed that stock option selling and accounting fraud was not higher in the case of fraud firms as compared to the non-fraud firms, yet it was concluded that managers at fraud firms were found to have been engaged in more of selling activities than the non-fraud counterparts. Results of the above research do not support any solid linkage between accounting fraud and executive incentives but executives in the drive to meet short term goals might compromise on the creation of shareholder’s value which is generally of long term orientation. This might also lead to the manipulation where management could attempt to earn more by boosting current gains. Moreover there can be attempt of concealment of negative information in greed of securing bonuses (Refer to case below). Case in action- Satyam Computers B. Ramlinga Raju, founder and CEO of Satyam computers, is the best available example in the domain of corporate governance where management’s greed led to the concealment of negative information and manipulation of accounting data (Knowledge @ Wharton 2009). Satyam Computers is an IT and consulting services company based in India with the recognition of being the 4th largest IT company. The founder of the company, Ramlinga Raju and the board of independent directors inflated the figures of revenues and profits to entice shareholders and manipulated the real assets, liabilities and reserve position to be able to establish deals with other major stake holding firms. Ideally, independent directors are required to exercise independent judgment when corporate performance and decisions are at stake. However, in the case of Satyam, most of the independent directors were appointed by Ramlinga Raju and his family members also acted in the capacity of directors. As such, they overlooked the company benefit and in order to maximize their personal gains, the directors resorted to misleading financial reporting and accounting practices. The audit committee established also failed to provide a clear picture of the financials of Satyam which revealed serious shortcomings in the corporate governance structure and adherence to greater transparency and accountability in dealings by promoter-cum-shareholders of organizations. Recent happenings Recently, executive incentive mechanism has been started to be associated with senior management innovation and a separate class of innovation based executive incentive is emerging keeping in mind the sustainability and competitive edge requirements of the organization (Dongxia n.d). This is so because executive incentive is one tool which keeps the interest of executives intact with that of organization’s interests and guarantees the growth of company. An exemplary incident is from Chinese publicly listed companies where they divide the executive incentives in three phases and provide stock listings for its employees’ short term and long term career planning (Yimin n.d). This arrangement serves dual purposes of value maximization for the company and encouraging the executive-cum-shareholders to work for the long term development of their interests and company as well. Recommendations Accounting based performance measurement could be replaced by equity based reward package that offers purchase of stocks and shares to the executives. This will offer long term incentive to the managers and would rule out the possibility of desperate measures to reflect manipulative short term performance. Provisions of severance pay could compel executives to restrain from sharing valuable knowledge about the company with the competitor. Such pays also assist in gaining their agreement while considering takeovers and mergers that could enhance value for the parent organization. In absence of severance pay, a CEO is more likely to oppose any such initiative. Additionally, while setting the compensation and incentive package of executives, committee of independent directors should be established who are free of favouritism, partiality and dependence and also not having any professional links with the board members to avoid any conflict of interests (QFinance n.d). Breach of corporate governance starts with manipulation of accounting and financial details which makes transparent reporting practices the first and the foremost priority. In this realm, disclosure of executive remuneration and incentives should be made available to the public in the annual reports of the company to establish actual accountability and responsibility of executives in the eyes of general public and outside world (QFinance n.d). Conclusion Executive incentive is a strong mechanism for good Corporate Governance. Firms have been using this mechanism since the birth of the corporate form of organization, but in the last decades, it has invited serious attention. Despite of various efforts there have been incidents of financial data manipulation in the recent past where managers have compromised with shareholder’s interest for their personal benefits. By deciding appropriate mix of the compensation package, efficient corporate governance can be established by alignment of the shareholder’s and executive’s interests. Appendix References Beer, M. (n.d). Do incentives work? The perceptions of a worldwide sample of senior executives. Human Resource Planning. Dongxia, G. (n.d). Research on impact of the senior executive incentive mechanism to financial performance. Proceedings of the 7th International Conference on Innovation & Management. Erickson, M, Hanlon, M & Maydew, E.L. (2006). Is there a link between executive equity incentives and accounting fraud? Journal of Accounting Research, 44, 1, p. 113-143. Fama, E. F. and Miller, M. H. (1972) The Theory of Finance. New York: Holt, Rinehart, and Winston. Florackis, C & Ozkan, A. (2009). Managerial incentives and corporate leverage: evidence from the United Kingdom. Accounting and Finance, 49, pp. 531-553. Haque, F, Arun, T & Kirkpatrick, C. (n.d). Corporate governance and capital markets: a conceptual framework [online] available from [accessed 6 Jan, 2010] Jensen, M.C. and Meckling, W. (1976). Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure. Journal of Financial Economics, 3 (4), pp. 305-360. Knowledge @ Wharton. (2009). Scandal at Satyam: Truth, Lies and Corporate Governance [online] available from [accessed 6 Jan, 2010] Munzig, P.G. (2003). Enron and the economics of corporate governance [online] available from < http://economics.stanford.edu/files/Theses/Theses_2003/Munzig.pdf> [accessed 6 Jan, 2010] Schleifer, A & Vishny, R.W. (1997). A survey of Corporate Governance. Journal of Finance, 52, (2), pp. 737-83. Yimin, X. (n.d). Research on the stock incentive mechanism of Top management of listed company. Proceedings of the 7th International Conference on Innovation & Management. QFinance. (n.d). The Board’s role in executive compensation [online] available from < http://www.qfinance.com/corporate-governance-checklists/the-boards-role-in-executive-compensation> [accessed 6 Jan, 2010] Read More