All modern organizations have one common feature that forms the major distinguishing factor between the management and the shareholders. In the developed countries, large corporations are actually composed of a distinct structure made up of the shareholders and management. In fact, the separation of management and ownership seems to have gained immense popularity during the start of twentieth century. As a result of the separation of corporate ownership and management, the corporate world has experienced unprecedented growth. On the other hand, separation of ownership and management has created an increase in conflict between the shareholders and the management. As a matter of fact, many academics and players in the world of business have been attracted to the conflict and even made attempts to propose diverse mechanisms of resolving them. The conflicting interest between the shareholders and the management has been commonly referred to as the agency problem.
Executive compensation is among the multivariate propositions made by different academics and people in the business world as a possible solution to the agency problem. As a tool for the resolution of agency problems, executive compensation embraces the creation of incentives to the management. Creation of incentives to the management is seen as a move towards motivating the management to act in favor of the shareholders. Moreover, the management has the mandate to undertake diverse decisions that greatly affect the financial position of the organization. As such, motivating the management is viewed as a way of ensuring that the interests of the shareholders are considered supreme by the management whenever decisions are being evaluated.
The approach to executive compensation
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Most companies whose shares are traded publicly do not have shareholders who are also in the management. Therefore, there is a separation between ownership from management. In such companies where the shareholders are not involved in management, managers possess substantial power and determine the course that the companies take. Means and Berle (1933) observed that when directors are in the office, they possess an almost discretion in their management. In modern finance, discretion and the power of management has been defined to as agency problem (Balsam, 2002).
The fear that the management may opt to use their managerial discretion to pursue selfish gains is the major reason for engaging in executive compensation. There are a number of activities into which the management may get involved into whose end results do not benefit the shareholders. For instance, empire building is an activity that has an impact of benefiting the managers' pursuit of fame. Similarly, it is possible for some managers to hold excess cash instead of distributing it during the times when profitable investments are lacking. Moreover, some managers ensure that they strongly entrench their positions such that ousting them out of their offices is almost impossible. This is particularly when the performance of such managers is extremely poor (Bebchuk & Fried, 2003).
In consideration of executive compensation, fundamental conflicts of interest between the shareholders and the management are considered inexistent. Therefore, two major views have been considered in the process of resolving agency problems through executive compensation: approach on optimal power and approach on managerial power. Most of the financial economists believe that executive compensation should be viewed through the approach on optimal contracts. According to the financial economists who subscribe to this approach, the arrangements yield partial solution to the inherent agency problem. In the approach, the board sets schemes through which the executive is compensated with the main goal of availing executive incentive towards maximization of shareholders wealth. Nevertheless, a number of flaws have been identified with the approach. In fact, the major problem has been identified as that there are inherent political limitations on the extent to which executives can be treated generously. Therefore, such schemes on compensation do not seem high powered in an adequate manner (Jensen & Murphy, 1990).
The approach on managerial power is another way towards executive compensation. The approach focuses on how the agency problem and executive compensation can be linked together to yield better results in the maximization of shareholders' wealth. The proponents of this approach are of the view that executive compensation does not only solve the agency problem but also that it is itself an agency problem. Through various research works, it has been realized that sometimes executive compensation does not result to the intended goal of providing incentives to the management. On the contrary, the compensational attempts have been seen to promote rent seeking by the management. In consideration of the pros and cons associated executive compensation, there is intense influence from managers on executive compensation.
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The design of an executive compensation package is highly influenced by the power possessed by the management (Balsam, 2002). Proponents of the contracting approach are particularly concerned with the extent to which the power of management determines executive compensation. Additionally, the power of management has been seen as likely to cause substantial pressure on the shareholders in terms of costs of executive compensation. The extra pay earned by the executives has an impact of distracting the intended incentive creation on the management and actually diluting it entirely. As such, the costs only affect the performance of the corporation without any positive change on the agency problem.
Executive compensational arrangements can be influenced by the prevailing forces in market directed towards maximization of value as well as power of management. As a result, the executive compensational arrangements depart from favoring the managers only. However, the power of management approach holds that the extent of deviation from the maximization of value is extensive making executive compensation inadequate means of incentive creation. The view in the approach towards optimal contract is that reasonable extent of suffering is experienced by managers in regard to agency problem. Consequently, managers do not always act in such a way as to maximize the value of the shareholders (Jensen & Murphy, 1990). This fact prompts the application diverse mechanism through which incentives can be created to the managers.
The view on optimal contract endears the board to act in the interest of the shareholders by providing cost effective incentives to the managers through executive compensation. In this case, compensational packages, optimal in nature and done under arm's length form of bargaining involving the executives and the board. Similarly, optimal contracts can be derived from the factors in the market that oblige the parties involved to adopt them. Nevertheless, the two approaches do not seem to have effective results in constraining departure from the outcomes regarded to be done at arm's length.
There is no explanation in assuming the management's automatic intention to maximize shareholders' wealth. In the same manner, it should not be expected that directors will automatically seek to uphold the wealth of the shareholders. Interestingly, when the circumstances and incentives of the directors are analyzed, it is evident that their behavior is not immune of agency problem (Bebchuk & Fried, 2003). Consequently, the existence of agency problem associated with directors limits the possibility of effective redress of agency problems between shareholders and the management. For instance, directors are motivated by the desire for a re-appointment into the board.
There are various limitations as to the application of executive compensation as a way of incentive creation to the management. Besides the influence that managers have on the implementation of executive compensation arrangements and the existent of agency problem caused by the directors, it has been realized that sometimes the market forces do not provide sufficient assurance that the outcome of embracing optimal contracts will lead to successful management motivation into observing shareholders' interests. Theoretically, it is hoped that different structures of the market have the ability to impose constraints between the decisions of the directors and the needs of the management (Jensen & Murphy, 1990). In fact, most of the markets impose less stringent measures such that substantial deviations are experienced. For instance, in the case of takeovers, many firms seem somewhat hostile towards the acquirer. As a result, the acquirer faces immense challenges from the incumbent management who often limits his full control of the firm. The hostility is to the detriment of the shareholders as the new acquirer provides better bids to the shareholder. As a result, shareholders lose substantial wealth.
Overcoming incumbent hostility and virtually other forms of negative influence of executive compensation require cleverly crafted solutions (Balsam, 2002). For instance, financial economists are of the view that the resolution of negative impacts of executive compensation can be greatly reduced if the designers adopt compensational arrangements that are transparent and salient. In fact, the decisions of the designers are highly dependent on the perception that many people from outside the organization have towards executive compensation. Bearing in mind that shareholders incur massive costs of compensating the executive, it is imperative to develop measures that tend to reduce such negative impacts. Additionally, the power of managers to influence their compensation causes bad incentives (Bebchuk & Fried, 2003). As a result, executive compensational arrangements may be adopted eventually leading to the erosion of shareholders' value.
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In an attempt to reduce the executive influence of their compensations, some measures may be put in place. To start with, it is important for corporations to adopt performance based compensation. As a result, managers who do not perform should be completely prevented from creating own compensations. Secondly, options compensation should be managed with extreme caution. The main concern with the options compensational arrangement is the fact that managers can make huge profits by disposing their options although the firm may be making losses. As such, it is important to adopt other compensational arrangements that are related to market rise or rise of the sector. In addition, it is suggested that stock option compensation should be optimally designed as opposed to the "at-the-money" arrangements that are often used. The options provide managers, risk averse in nature, with incentives to make decisions that maximize shareholders' value.
The fact that incentives do not always result to the maximization of shareholders' value calls for the application of other ways of resolving the agency problem. For instance, a combination of constraints, punishments and incentives may yield better results. Constraints are meant to reduce the management power and applying a check on their actions. As such, certain guidelines are put in place on how managers need to act. Similarly, firms can apply punishments whereby poorly performing managers are punished through various ways such as reduced perquisites. Interplay of the three forces can yield successful results in the resolution of agency problem.