Incentive executive compensation is financial compensation to executives in the form of salary, benefits, bonuses etc, as a reward of their performance. Executive compensation is very significant when it comes to corporate governance, and is frequently resolute by board of directors of the company (Ellig, 2002).
If shareholders could directly view the firm's prospects and the executives' deeds and recognize in advance the actions that can maximize shareholder wealth then no incentives or compensations to the executive would be needed. However, because shareholders are not aware and cannot identify every act the executives take in every scenario, the shareholder should delegate most of these choices to the executives, who most likely has greater information about many of these decisions. Therefore, to motivate these executives to work in the best interests of the shareholders, compensations and incentives are paid to the executives that link their wealth to firm performance.
The principal-agent model by Murphy (1999) is the standard economic theory of executive compensation. It forecasts that firms plan efficient compensation packages to motivate executives and overcome moral hazards. According to Core et al, (2003), board place executives incentives based on the magnitude of agency problems, economic factors and monitoring difficulty that align shareholder and managerial interests. They further stated that agency theory forecast that an executive incentive has positive relationship with firm performance.
There is general belief that the executive pay structures are planned to improve risk taking and make value for shareholders but not to protect debt holders. This is common particularly in the banking industry where banks are well levered and their leverage is finance.
Also, executives get more incentives if they are able to increase shareholder interest by paying higher dividends and capital gains. Therefore, the executives would involve in a high risk ventures that will benefit the shareholder and him/her gaining higher compensation. This affects the governance system in the firm. Similar incidents occurred at USA in 2007 and bought about financial crises and its multiple effects on the world at large. Which Bindert (2008) stated that credit crisis in USA was as a result of poor executive compensation structure. However, this high risk ventures by the executives can be resolved through the use of balanced risk-taking incentives.
Narayanan (1985) said executives select projects yielding immediate profits to improve the early perception of their capability in order to receive higher incentives and compensations. This immediate benefit to executives could offset the fact that, from a long-term viewpoint, they pick assignments that does not have the maximum net present value. However, bonuses that are paid as compensation can focus executives' attention on immediate performance. To solve this problem Gaver (1992) indicates that when existing compensation agreements and primarily stock options are unable to determine incentive conflicts then we can adopt long-term performance plans such as risk preferences.
Unacceptable incentive compensation planning can compromise the freedom of executives in risk management and control roles. For example, a conflict of interest is formed if the performance measures useful to them, or the additional benefit pool from which their bonuses are taken, depend largely on the financial results of business actions that such executive supervise. Such reliance can give executive an incentive to promote risk taking that is not in agreement with the firm's risk management procedures and control structure.
In conclusion the plan of executive compensation systems is greatly important if the concerns of business executives are to be in line with shareholders and other stakeholders and with the goals of society for shared and sustainable wealth.
DQ #2: Discuss whether executives are working for themselves or for the shareholders.
Executives in capital markets seek to maximize their own efficacy at the cost of corporate shareholders. Executive have the capability to work in their own self-centeredness rather than the firm interest because executives have more information than shareholders (asymmetric information).
Greenwood (2002) mentioned that executives (agents) should work simply to enhance the interest of their shareholders (principals). However, he suggested that the morals of the market place cannot be ignored and that executives can only work for themselves. Mitchell (2001) is a leading dissenter from the conventional view that executives can flee the morals of the marketplace, but not by being fiduciaries for shareholders. Executives try to make most of the business's contracts implicit instead of explicit.
Mitchell (2001) discards the conventional assumptions that owner interests are inevitably associated with social interests or that owners may control their assets in accordance with the morals of the market place, thus without considering others interest. In his analysis he said corporate executives, however, are motivated to dump their personal moral agenda by their jobs, which drive them, instead, to a self-centeredness surplus.
Proof of self-centered executive behavior comprises the utilization of some corporate reserves in the form of privileges and the escaping of optimal risk positions, where risk-averse executives avoid lucrative opportunities in which shareholders of firms may prefer to invest. Shleifer and Vishny (1990) said executives spread at a high cost to owners and resist hostile takeovers that increase owner's wealth. Corporate executives invest in firms allied to their own experience and background, even when such investments are not beneficial for the shareholders. Therefore, executives of firms would take decisions that are not in the best interest of the shareholders.
Mitchell (2001) identified the clear come-back-that executives not accountable to shareholders would only be unanswerable, and might direct companies to favor their personal interests without considering someone else. After all, executives are totally trapped in competitive stresses not all which come from owners. The executives of firms are entrenching themselves by making it expensive for any possible substitute to step into their shoes. They benefit by gaining better job security and more independence of actions.
In most of big publicly traded corporations, executives usually own only a small fraction of the common stock which makes agency conflicts potentially quite significant. Therefore, owner wealth maximization could be secondary to a variety of other managerial objectives. For example, executives may have a primary goal of maximizing the size of the business. By so doing they increase their own status through creating a large, rapidly growing firm, opportunities for middle managers as well as job security. As a result, executives of firms may follow diversification at the cost of the owners who can simply diversify their personal portfolios just by investing in the shares other companies.
From the above, it is clear that executives work for their own interest rather than interest of the shareholders as alluded by Greenwood (2002), however, good corporate governance practices and well monitored internal control system by the board of directors of firms would help to overcome such problems by executives placing the interest of shareholders first.
