Abstract 5 Section 2: The difficulties with Efficient

Abstract

 

The
following paper addresses one of the major issues within the pay distribution
matter – executive compensation. Firstly, one will acknowledge, three main
theories, the CEO’s importance and the impact of its performance/ attributes on
the firm. The
second section of the paper depicts theoretical explanations for the rise in
top earners’ payment and provides one with factors which influence the increase
in executives’ compensation. The third section focuses its attention on the CEO
compensation as subject of efficient contracting. However, in order to offer a
broader view on the argued problem and its issues, the managerial power
approach is presented as well. The paper concludes with a brief summary of the
above mentioned sections.

Table of contents:
 
Abstract 2
Introduction. 4
Section 1: CEO’s importance. 5
Section 2: The difficulties with Efficient Contracting. 6
Section 3:  The
Efficient Contracting view and Managerial Power approach. 7
Conclusion. 11
References. 12
 

 

 

Introduction

 

During the past 40 years there has been
noticed a rapid rise in executive payment. However, few are aware of the fact
that this
process started far before.
According to Murphy (2012), between 1895 and 1904 thousands of small American
firms emerged to form 157 new large corporations which by 1928 already offered
bonuses to their executives’ payment. In addition, the booming post-
II-WW-economy benefited American firms to internationalize, and thus, contributed
to the phenomenon of increased executives’ compensation. Consequently, many
disputes and academic researches appeared regarding this topic, arguing the
reasons and forms of payment through which it has occurred and the link between
executive’s characteristics and firm’s value. The most relevant and suitable explanations
in this sense arise though the optimal contracting and managerial power view.
The first one explains the process of establishing an optimal pay package by examining
the ‘shareholder-board of directors’ relationship while the latter provides a
descriptive overview of the ‘CEO-board of directors’ relationship. These frameworks
are important due to the fact that they provide a clear explanation about a
phenomenon that affects each workers’ life in a direct or indirect way. The top
earners ‘compensation issue is relevant across all industries around the globe,
a thus only an adequate understanding of the problem will provide suitable
solutions.

 

 

Section
1: CEO’s importance

 

“I think as a
company, if you can get those two things right — having a clear direction on
what you are trying to do and bringing in great people who can execute on the
stuff — then you can do pretty well.”  (Mark Zuckerberg,
CEO of Facebook)

 

CEOs’ compensation is a topic of great
relevance in today’s age of financial globalization. Daily, companies strive to
adopt different techniques, methods and strategies which would yield the best performance
on the national or global market. However, one of the major factors which
contribute to the realization of a firm’s core objectives as: profitability,
productivity, growth and other, is a qualified CEO.

According to Gabaix and Landier (2007) CEOs’
are matched to firms competitively according to their managerial talent. Hence,
one can deduct the importance of executives in a firm’s management and their substantial
link to a company’s performance. CEO employment requires participation of three
parts of a company’s: shareholders, board of directors and the potential
executive. The responsibility to successfully manage the negotiation process of
the CEO’s payment is assigned to the board of directors, who must go through a thorough
process of employment in order to meet the company’s and shareholders’
interests. Additionally, to corporate governance and CEO characteristics, other
factors must be taken into account. Thus, the consequences of executives’
performance were analysed by Hermano and Martin-Cruz (2016) through three perspectives:
agency costs, upper echelon theory and organisational behaviours theory.
According to agency costs theory CEOs’ (managers’) goals should be aligned to
the firm’s aims for a better performance. The executive is closely connected to
the firm’s performance. This fact leads the board of directors to advantage the
potential CEOs during negotiations rather that act in the shareholders’
interests (Gümbel, 2006). In other cases, it determines them to adequately
compensate the managerial talent while optimizing the firm’s value (Murphy, 2013).
Echelon theory states that top management’s characteristic is reflected in the
firm outcomes. Thus, CEOs’ attributes have a significant role in a company’s
good overall performance (Stanford Graduate School of Business, n.d.) that
require an optimal contracting during employment negotiations. The
organisational behaviour theory deals with how executives’ leadership behaviours
impact firm’s performance. However, there are certain disputes which question
the present, and above mentioned theories due to additional external factors of
impact. Analysing the above mentioned theories one may conclude the importance
of a suitable CEO to be employed in a company and adequately compensate for its
talent. As a result, the question of which factors determine the appropriate
amount and forms of payment arises.

 

Section
2: The difficulties with Efficient Contracting

 

Gabaix and Landier (2007) state and explain
in their paper several arguments for the rise in executive compensation phenomenon.
One is the increased risk within the business sector which determines a higher
level of payment as a result of efficient contracting. CEOs’ require/are
offered higher incentives for the responsibility they must take. However, this
aspect includes factors as the presence of executive’s risk aversion,
diversification and limited liability which influences the level of incentives.
It is stated (Murphy, 2012) that different forms of compensation imply
different risk level the executives bear, which certainly may decrease the high
level of payment/incentives. Another argument to the increase of pay is the
rise in stock-based compensation. This payment option is often used as a tool
suitable for corporate governance which aligns the shareholders’ and executives’
aims. Nonetheless, it can considerably rise the level of CEO’S compensation
contributing to a lower level of firm’s value and economic performance (Senbet,
2011). The rise in managerial entrenchment is another factor that favours the
CEO to get higher incentives and payment. In such a case executives have
excessive power which harms shareholders’ goals and affects negatively the objective
of maximizing the firm value. Usually, it happens by managing businesses that
return a negative net value, but still, bring a higher level of utility to the
executive (Weisbach, 1988). It does it by changing outrage costs and
constraints or implementing hidden forms of bonuses (Gabaix & Landier,
2007). Another point of view to analyse is – benchmarking. There is a tendency
for firms to choose their CEO’s payment program based on other higher-paying
companies. This is due to difficulties the board of directors meet while
establishing an appropriate level of compensation based on CEO’s abilities or/and
in order to offer a more competitive payment package. As a result, a small
change in compensation, caused by few companies, determines a big increase in aggregate
CEO payment (Laschever, 2013). Daily, technological advances also play a role
in the increase of top earners’ compensation. Although, it is not in
‘plane-sight’, such factor can be explained by the fact that it modifies CEOs’ activities
within the firm. Today’s new technological era determined executives’ tasks to
change, causing outside options. This in turn, determines an efficient
contracting, which results in high level of payment (Gabaix & Landier,
2007). Firm’s size plays as well a major role in the establishment of an
adequate CEO pay. By presenting empirical evidence, Conyon, Fernandes et.al.
(2011) affirm that “the total level of compensation increases monotonically
with firm size”. Hence, as the company is getting larger, the amount of
compensation CEOs receive is increasing as well. Of major importance is the
corporate governance, which certainly has a significant influence over the pay
packages. In dependence of governance strategy, and its possible
inefficiencies, the degree of relative CEO’s performance changes, and thus, the
level of required compensation (Gümbel, 2006; Gabaix & Landier, 2007).

All of the above mentioned factors, in
addition to numerous other important ones, construct the framework for
executives’ compensation program. Two of such frameworks are going to be
evaluated further in the present paper by analysing in detail the managerial
entrenchment argument.

 

Section
3:  The Efficient Contracting view and
Managerial Power approach

 

Within the
executive compensation problem academics differ two major approaches: the
optimal contracting and managerial power. Several difficulties were presented
in the section above regarding the establishment of an optimal executive pay,
however the managerial entrenchment perspective comprises the most
inefficiencies in both frameworks, efficient contracting and managerial power model.
Therefore, the present section focuses its attention on the characteristics of
the entrenchment theory, as it depicts its particularities through the above
mentioned executive compensation frameworks.

 According to Bebchuck and Fried (2004) the
optimal contracting view is a more normative approach rather than descriptive,
as opposed to managerial power view. Thus, it is more suitable to present the
first principal-agent model through the managerial entrenchment view, presented
in the section 2 of this paper. An optimal contracting is a reaction to the
contracting environment (Weisbach, 2006). Hence, in the efficient contracting
model negotiations between executive and board of directors are occurring as a
matter of shareholders’ aim of profit maximization, subject to certain
constraints (Gümbel, 2006). Such constraints are proven to loosen the concept
of arm’s-length contracting approach and ‘encourage’ the board of directors to
favour CEOs while contracting, and pursue their own interests within the firm
(Gümbel, 2006; Bebchuck & Fried, 2004). One of these constrains,
behavioural, determines the link between incentive payment and subsequent CEO’s
performance. The second constraint is tax issues and regulatory requirements
which may not restrict top earners’ payment as much as it is needed. The third
constraint is the bargaining power of the counter party, which in case of
executive compensation, is higher for CEOs due to their skills, abilities and
potential contribution to the firm profit. As a consequence, many CEOs are being paid,
according to their performance, through stock option plans. In the efficient contracting view such method is
difficult to implement since there is a tendency to reward executives on absolute
performance (rather than relative). In addition, stock options favours
rent-seeking (Hall & Murphy, 2003) and their exercise price can be re-set
in case of poor manager’s performance, which certainly advantages CEOs. Furthermore,
numerous companies offer their CEOs other forms of incentive payment as well, such
forms of payment as retirement perks, ‘golden hand-shakes’ and parachutes which
come in contradiction to shareholders’ interests. Another inefficiency of arm’s
–length optimal contracting is that although regulations require full
disclosure on CEOs payment packages, there is still room for improvement
regarding how it actually occurs in practice (Gümbel, 2006). In this sense it
is also worth to mention that the ‘free-rider’ problem is as well a matter of
inefficiencies in optimal contracting framework. In majority of cases,
shareholders possess just a small fraction of the firm which cannot assure
disciplinary measures to be taken. They are also unable to reject some proposed
contracts, to take some actions when being expropriated and exercise their vote
regarding the executive option plans due to possible “potential crisis” that
may consequently appear (Gümbel, 2006). In an opposite case, when there is a
large shareholder, there is more incentive to “monitor management and invest
effort in reducing managerial opportunism” (Bebchuk & Fried, 2004). This
then results in better arrangements for shareholders. However, a set of
barriers are usually imposed by corporate governance that limit shareholders’
direct regulatory activity within the firm. Within shareholders and board of
directors’ agency- problem, a possible conflict of interests might determine
shareholders to be reluctant in rejecting a proposed executive (Gümbel, 2006).

As stated above, compensation programs should
have as a goal “shareholder maximization, subject to a variety of constraints
“, however, often it is not the case. The managerial power view sets a number
of major constraints, in addition to ones of efficient contracting approach.
Still, as managerial entrenchment theory depicts, in practice those constrains
do not fulfil their designation completely. Consequently, CEOs often use their
attributes to increase their bargaining power and inquire high compensation
programmes. Bebchuck and Fried (2004) denote the idea that bargaining power is
in fact an agreement between the board of directors and executives which harms
shareholders’ interests. This comes as a result of directors having financial
and non-financial incentives to benefit CEOs’ interests, being so, the later
have a major influence over the board. The power the executives gain while contracting determines them
to extract “rents”, to “camouflage” some of their bonuses (under retirement
benefits for example) and try to decouple the pay-for-performance way of
compensation (Bebchuck & Friend, 2004). It is done so in order for
executives to bear less risk, put less effort and pursue strategies that would
serve themselves rather than shareholders. For the reason that the managerial
power
framework offers such a descriptive overview it is hard to provide normative
statements in this sense. Hence, academics more frequently present analysed
examples of inefficient compensation, as previously mentioned, through agency-problem
approach (Bebchuck & Fried, 2004; Murphy, 2012). One of
such inefficiencies is caused by the reluctance of board of directors to
develop individual payment models. “Directors lack adequate time and information
for investigation of alternative, efficient compensation arrangements” (Bebchuck & Fried, 2004), and
therefore, frequently
firms choose to conform to executive compensation plans similar to other firms.
As a result, the evolution of efficient compensation models is slowed down and
the unequal pay distribution problem persists (Bebchuck & Fried, 2004).
Human error (also called “honest stupidity” or “the perceived cost view”) is
another inefficiency. It occurs in the optimal contracting view in which human
imperfections may cause inefficient payment packages which favour managerial
power. The exercise price of the options paid to CEOs is another aspect of
executive compensation that must be reviewed. It is argued that linking the
stock exercise price to a stock market or industry (rather than the firm’s own
stock price) will help to establish an optimal level of executive payment and
reduce the ‘flaws’ caused by managerial approach (Bebchuck & Fried, 2004). Executive
loans under favourable conditions or even loan forgiveness are another
consequence of increased managerial power that harms the CEO compensation
issue. Retirement benefits, camouflaged bonuses and deferred compensation are
inefficiencies that provide once again that efficient contracting approach does
not depict all the aspects of an optimal executive pay package and certainly is
not a measurement to the argued problem.

 

Conclusion

 

The present paper asserts the problem of CEO
compensation by introducing two approaches: the efficient contracting and
managerial power view. For a better understanding of the topic it is important,
firstly, to acknowledge the reasons executives play such a major role in firm’s
performance. Hence, the first section presents the agency costs, upper echelon
and organisational behaviours theories. These theories depict the importance of
shareholders’ and CEO’s interest alignment, the impact of CEO’s attributes on
firm’s overall performance and the significance of CEO’s leadership behaviour
on the company’s outcomes. In order to understand the core of the problem, the
second section provides a broad overview over the theoretical explanations for
the increase of CEO payment. One is provided with an analysis of several
arguments as: increased risk, managerial entrenchment, stock-based
compensation, benchmarking, firm’s size, corporate governance and technological
advances. The enumerated reasons provide a clarification for the increase in
top earners’ payment distribution and establish the ‘ground’ for the optimal
contracting and managerial power approaches. Section three of the paper
describes the efficient contracting view as a normative approach which depicts
the shareholders’ relationship with the board of directors in the process of
CEO’s appointment. The second agency-problem, managerial approach, offers a
descriptive frame of the problem. It analyses the inefficiencies that arise
within the managerial power model and provide the subsequent consequences.