Introduction becoming larger and larger, the way companies

Introduction

 Corporate governance can be defined as ‘the
control and direction of companies by ownership, boards, incentives, company
law and other mechanisms’ (Thomsen & Conyon, 2012, p.4) This
essay aims to critically evaluate the role of the significant mechanism within
corporate governance which is executive incentives. Critically assessing how
useful this mechanism is and its importance within a company via the Agency
theory which most represents a framework for this specific mechanism. This will
be done by firstly looking at the agency theory and the agency problem and its
relevance within executive incentives. Looking into the difficulties with the
mechanism and its implementation.

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Theoretical
Framework – Agency Theory

Over the years
different frameworks have been developed in an attempt to analyze and break
down corporate governance, such as agency theory, stewardship and stakeholder theory.
Agency theory will be focused on in order to break down the effectiveness of
executive incentives and the roles of the mechanism within corporations. These
different theories have been developed with a different perspective based on
factors such as economics, politics and phycology. Looking into not only on
corporate governance but companies and individuals.

Agency theory
focuses on the relationship between management and shareholders. It characterizes
the firm as a tie of contracts between principles and agents (Jensen and Meckling 1976).
Berle and means (1932) discussed the relationship and how it led to the
separation of ownership and control. There are a number of features within the
principle agent relationship. As companies are becoming larger and larger, the
way companies are run has changed, management act on behalf of shareholders who
finance the business. ‘(The principal(s)) engage another person (the agent) to
perform some service on their behalf which involves delegating some decision
making authority to the agent.’  (Jensen
and Meckling, 1976, P.308). This is where a separation of ownership and
control is established. This separation is one of the major features of the
principal-agent relationship.

The principal
being shareholders and the agent being management of a company. If shareholders
are unable to monitor actions of the management, management turn to use company
assets to feed their own interests at the expense of the shareholders. (Kim, Nofsinger, Derek, 2010)
.This is where the famous agency problem arises. The problem is focused on the
conflict of interest between the two parties, the argument lands that agents
may not prioritise the principal’s welfare in line with theirs, the main
assumption within agency theory being that this separation causes a conflict of
interest. (Solomon, 2013, P.9)

An example where
there was a conflict of interest between management and shareholders can be
seen within the fall of the large energy company Enron, the fall that led to
their bankruptcy. Enron’s management had puffed up the price of stocks to their
own financial gain disregarding the interest of the principal. (Paul M. Healy and Krishna G. Palepu, p14,
2003). As a result of this the share value of the company dropped
radically which led to principles losing millions, from this we can derive that
the management had no duty of care towards the investors interests rather they
were more concerned with profitability of their own. A major issue with this is
that it causes a sense of division between the principle and agent. This can
have a negative effect on firm performance.

As the principal-agent
problem has many features, another feature that should be discussed is the lack
of communication and trust, this feature looks into how principles may lose
trust in agents when a project becomes difficult, principles will begin to
question the performance of agents and the processes they take in certain
situations. A lack of communication between the two can bring about this loss
in trust. (Muller and Turner, 2005
p.400-401). Another key characteristic within the agency problem is
utility maximization, this feature puts some emphases on how managers behave.

One route
corporations can take in order to tackle the agency problem is through executive
incentives and monitoring techniques, by offering certain incentives the aim is
to align the interest of principles with agents. As agents are delegated a
large amount of decision making in the day to day running of the company. Its
aim is to make these decisions more optimal in the shareholders interest.
Another technique is monitoring management through meetings and AGM’s with the
aim of solving the agency problem. Through these meetings principles will have
the chance to express any concerns they have with the present performance of
the firm and the approaches management intends to implement principles
objectives.

These incentives
and monitoring put in place by the principle will incur costs, these costs are
known as agency cost, agency cost can be defined as the ‘costs as the sum of
contracting, monitoring and bonding costs undertaken to reduce the costs due to
conflict of interest.’ (C. Jensen,
2005, P.6). These costs are incurred due to the conflict of interest
between management and shareholders.

As mentioned
corporate governance is examined in many different perspective with different
theoretical frameworks, stewardship theory stems from psychology and sociology,
it looks into the manager’s behavior under certain situations. Its main assumption
is that a steward’s behavior (agent) ‘will not depart from the interest of his
or her organization’ (Davis,
Schoorman, Donaldson, 1997, P.24). In comparison to agency theory which
claims under the principle-agent problem that managers will act in their own
best interest unless incentivized to do otherwise.

Executive
Incentives

Executive
incentives falls under one of the categories to solve the agency problem, the
aim is to align interest of agents and principles. It’s impossible for
principles to observe the actions of management entirely, management may then
be tempted pursue their own agendas. Risk averse managers may be tempted to
pick projects which are easy to manage with lower returns due to the fear of
being terminated, because a more risky project could potentially fail. CEO’s
may also take advantage of company perks at the expense of the shareholders, in
some extreme instances CEO’s may also turn to fraud and theft by embezzling
shareholder funds As seen previously in many scandals such as Enron or Tesco
plc. (Thomsen & Conyon, 2012,
P.179).  In an attempt to tackle
this executives are stimulated to prioritise shareholder interests through
contacts where a part of their wealth is dependent on shareholder wealth, the
idea is to drive them to think and act as owners rather than agents. (Conyon and Schwalbach, 2000).  The aim is to design the most
efficient compensation packages possible in order to attract retain and
motivate CEO’s. (Conyon, 2006, P.25)   Some of these contracts include bonuses,
stock options and long term incentive programs.

Stock options being
one of the most popular incentives is essentially a contract that gives the
holder the right to purchase any underlying stock at a fixed price in the
future. (Thomsen & Conyon, 2012).
The worth of the option increases as the market price increases above fixed
price executives are offered. The difference between the market price and the fixed
price if greater than the market price will act as a profit for the executives.
‘Sustained growth in the market price of a share over a number of years has the
capacity to generate significant returns to the recipient of the associated
option.’ (Keasey, Thompson, Wright,
1997, P.87). The use of stock options highlights the conflict of
interest because it effects a close connection between the two groups and links
their interests financially. This will make agents more inclined to take
actions that increase firm performance in an attempt to drive share value up,
this can also be a problem as some managers may sacrifice growing dividends to
utilize the money to increase stock price as that will enhance their stock
option.

One way of testing
whether incentives works is looking at the direct link between firm performance
and incentives. Chris Roebuck states in an interview that the ‘differential
between FTSE 100 CEO pay and the average pay of everyone else has grown by
double, are we saying that every single FTSE has improved its performance by
double?’ He then goes onto say that it hasn’t and the link between organizational
performance and CEO pay isn’t directly linked and that there may be other
factors. He explains that some of these factors include that remuneration
committees ‘roll over’ when powerful CEO’s who aren’t performing ask for more
cash. However emphasizes that in order for companies to attract potential CEO’s
who are talented then incentives should be implemented, he states that CEO
performance should be down to whether CEOs beat the market. (Bloomberg Global News). Another
factor within incentives is that it may not only be there to align the
interests of both principle and agent but to maintain a competitive advantage
for talent within other companies.

Executive
incentives have proven to be a rather controversial mechanism. However, this
may not be the case for all corporations. An example where financial incentives
was used to achieve a common goal between agents and principles can be seen in
Hillcorp Energy where they had offered staff $100,000 bonus given they met a
certain goal. ‘It would appear that Hilcorp employees have fulfilled these
goals because the firm just issued the bonuses.’  (Fortune,
2015). Employees who are given the ability to impact their financial
wealth through incentives are more driven to meet targets to benefit
themselves, this common goal between the two clearly benefits both principle
and agent. There was no conflict of interest and it not only has a short term
effect on performance of staff but possibly long term , ‘ I don’t think that myself
along with everyone is not going to give less than 100% every day,”
receptionist Amanda Thompson told the TV station. (Fortune 2015). By creating a common goal and aligning the interest
of principle and agent through these incentives, the principle agent problem is
solved and a more unified work force is apparent in meeting objectives set.

Furthermore over
the years there have been attempts to regulate executive incentives as some
managers may abuse their power for their own financial gain. As seen in the
Maxwell affair in 1991 where an agent stole from the company’s pension fund
resulting in loses for the principles. The well-known Cadbury report (1992) was
published as a result of this in order to shed some light on executive incentives.

The Greenbury
report (1995) followed after the ‘fat cat’ spectacle. It was the Greenbury
report that focused on issues relating to directors pay. (Solomon, 2013, P.98). The report was targeted at finding
the connection between the salaries of agents and firm performance. The
Greenbury report highlighted that remuneration packages should be enough to
‘attract, retain and motivate directors and managers of the highest quality’. (Greenbury Report 1995).  Following big scandals the Directors remuneration
report was established. This gave shareholders the ability to vote at annual
general meetings and be proactive in the regulations relating to incentive
packages. This report was then revisited in 2013. The well-known Higgs report
(2003) that was as a direct consequence of the fall of Enron gave insight into
the roles of non-executive directors and how effective they can be.

Section D, the
remuneration aspect within the corporate governance code emphasizes on how
companies should set out their incentive schemes and to focus on designing
schemes of performance-related remuneration for executive directors. (UK CGC, 2016, P.20). The aim is
to ensure that the remuneration comities avoid rewarding poor performance
amongst other elements.

 

Conclusion

In conclusion, executive
incentives play a major role within big corporations and can be very valuable

incentives are
beneficial and play a major role within corporations. This is because once the
wealth of the principle is contingent with the agents wealth, agents will be
more dedicated to top firm performance in an attempt to receive the incentive,
this forms the bases of a common goal between owners and management, as seen in
the case of Hilcorp, staff were more motivated to meet objectives following the
incentive pay out, in a way it dissolves the separation between agents and
owners. However we mustn’t ignore that some agents may even take advantage of
this and fraudulently portray firm performance to profit from the incentive.
The various documents and reports constructed throughout time aim to solve of
these issues, further more reports such as Greenbury and Cadbury aim to link
rewards with performance measures to tackle the agency problem. Through heavy
monitoring and regulation incentives should be kept but only paid when the
performance is contributing to the long term objectives of the firm.