Executive compensation scheme

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INTRODUCTION

Executive compensation is cash and bonuses given to the executives (Hajazi and Bhatti, 2007) [Online]. Besides that, it also include a large variety of payment which received by the top executives within the company. Therefore, corporate governance serves as a vital mechanism to stringent disclosure rules to improve control over executive compensation (Bahar, 2005) [Online].

Executive Compensation Schemes (ECS) in practice, consists of a variety of components that is monetary and non-monetary form. The common components which are mainly in monetary form basically include fixed salary which is the most common and it is the foundation for all ECS. Besides that, bonuses are rewards paid to executives for their achievement of objectives during a fiscal year and it consists of short-term or annual bonuses. Furthermore, long term incentives which include restricted share, share options, or both of it is granted to encourage executives for their achievement of goals that beyond a single fiscal year (Heisler, 2007) [Online].

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Additionally, the other forms of compensation and benefits in non-monetary form that many executives are entitled to which is Supplemental Executive Retirement Plans (SERPs) which consists of two basic SERPs that are 'Restoration' or 'ERISA Excess' plan and it permits executives to earn additional retirement funds based on their total salary. Furthermore, deferred compensation is basically an account to be paid by the employer, who incurs a liability payment for future services that have been provided by the executives. Change-in-Control (CIC) agreement serves to protect the company and its executives in the case of a buyout or takeover by another company. Finally, a variety of perquisites which include special benefit and privileges, are given to executives such as company cars, financial planning, personal use of corporate helicopter, and other similar benefits (Heisler, 2007) [Online].

The agency theory concept holds that directors and shareholders have different objectives, and therefore ECS is to align directors' interest with shareholders and company's stakeholders (Bender, 2004; Sapp, 2008) [Online]. Besides that, it does have a great significance for its activities which includes increasing the firm's value, retaining its key management and focusing the direction of the company as well as creating shareholders' value (Lee, 2009; Hajazi and Bhatti, 2007) [Online]. Furthermore, ECS also plays a role of motivator to the executives (Bender, 2004) [Online]. Therefore, the company is willing to pay more compensation in order to maintain higher salary level for executives (Hajazi and Bhatti, 2007) [Online].

Whereby, in practice there was the failure of executive compensation in recent crisis in the United Stated and which affected the world economies, such as the credit market freeze, collapse of Enron, Lehman Brothers bankruptcy, and the near failure of American International Group (AIG) (Schneider, 2009) [Online]. It indicated that ECS are inherently flawed and that there may be insufficient requirements to disclose the level of executive compensation in the annual report (Heisler, 2007) [Online]. Therefore, the issue of ECS had become the focus of increasing attention to public scrutiny, stakeholders, as well as the interest of academic researchers (Bender, 2004) [Online].

EXECUTIVE COMPENSATION SCHEMES

Design of ECS

The main objective for a well-designed of ECS is to provide fairness between various parties because ECS is an important signal of the values, morals, and welfare where the company operates (Bender and Moir, 2006) [Online]. Consequently, the company need to be fair between different employees in the same company, so that high-performance executives receives a higher rewards in order to differentiate the contributions (Bender and Moir, 2006; Bender, 2004) [Online]. Another aspect of the fairness is between director and his peers in comparable companies. Bender (2004) [Online] argued that director should have the equal opportunity to obtain an amount equivalent to their peers because they will make a comparison of their role and contributions, and their pay with their peers. After the comparison was made, they will be satisfied if the compensations are about the same (Bender and Moir, 2006) [Online]. The final aspect of fairness is ECS must be fair to both executives and also to the shareholders to whom the company owns residual profits (Bender and Moir, 2006) [Online]. As a result, the objective of this aspect is to avoid executives paying large amount but shareholder suffer loss in the fiscal year (Bender, 2004) [Online].

However, there are some companies in practice whose ECS is not well-designed and lead to inherent flawed. For example the collapse of Tyco, they received widespread attention because of its Chief Executive Officer (CEO) purchased goods that is unrelated to business practices amounted over $2 million (Heisler, 2007) [Online]. Therefore, Iyengar (2000) [Online] argued that at the level of CEO, cash compensation is directly linked to the level of operating cash flows generated by the company, yet is unrelated to the accounting or the company performance.

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Another example is the collapse of Enron, employees were prohibited from selling shares in their limit of four hundred and one thousand program during a collapse period, while executives were selling individual shares without restraints and this action was harmful to thousands of employees who saw that their retirement funds had suddenly declined and they were unable to take any preventative action. These two cases highlight the need to reflect fairness and respect for other stakeholders as it had also significantly affected profitability and the performance of the company. So, these problems had brought into question the fairness of ECS (Heisler, 2007) [Online].

Furthermore, the objective of a well planned ECS is to provide the proper aligning of principal and agent objectives where shareholder act as principal, executives act as an agent (Chaudhri, 2003) [Online]. In practice, most of the company's executives are assumed to purse actions which maximize their own expected utility without maximization of shareholders' wealth. Therefore, shareholders are unable to directly observe executives' decision-making and they do not have sufficient incentive to incur higher cost to monitoring top executive's behavior (Matsumura and Shin, 2005; Lee, 2009) [Online]. Bruce, et al. (2007) [Online] agreed that executive compensation serves executives at the expense of shareholders. As a result, Bahar (2005) [Online] suggested that incentives could be used to overcome this problem as ECS is designed to be used to align the interest of the executives with the shareholders (Kakabadse, et al., 2004) [Online]. Whereas, those companies which are facing significant problems with regard to company performance are those who paid less attention in designing executive compensation schemes (Hajazi and Bhatti, 2007) [Online].

In spite of that, there have been some issues arising on the ECS in which there are many companies who had failed to design schemes that provide direct correlation among the company performance and shareholder wealth creation (Clieaf and Kelly, 2005) [Online]. The important point is that the market for corporate control fails to exert straight constraints on ECS. For example, AIG had paid an amount of $165 million in retention bonus payment to its employees which are including those who were no longer working in the company and the compensations paid to the top executives were given (on a non-monetary basis) shares worth $42.4 million but it did not maximize the company performance and shareholders' wealth yet resulted in an almost complete meltdown of the entire company's financial system with reckless credit in order to cover mortgage-based securities of the company. In the case of AIG, the executives had acted selfishly rather than focusing on maximizing shareholders' wealth which resulted in the company's near collapse (Bender and Moir, 2006) [Online].

Brick, et al. (2006) [Online] agreed that a higher ECS may have compromised their objectivity on behalf of shareholders to monitor management. For example, Enron had the seventh highest compensation schemes in the United States (U.S.) as reported by The New York Times in 2001 yet it collapsed due to excessive ECS that their executives received compensations which amounted to $380,000 annually compared with the average executive compensation in U.S. corporations was $152,626 (Bebchuk and Fried, 2003) [Online]. Therefore, excessive ECS may affect the executives' control of the company and result in an ineffective monitoring to the company performance (Brick, et al., 2006) [Online]. Furthermore, it may also be related to a serious problem where they might create opportunities for management self-dealing, especially if these schemes are negotiated with the boards of directors with an improper motive, as well as CEO duality and director shareholding that could have significant adverse impact on the company's performance (Lee, 2009) [Online].

In addition, the third objective of a well-designed ECS is to motivate executives to work harder and result in better outcomes for the company (Bender, 2004) [Online]. Financial incentives could motivate top executives appropriately. However, executives are not solely motivated by money in terms of their relationship with the company, or money is not the best mechanism to attract executives interest (McConvill, 2005) [Online]. Bender (2004) [Online] argued that none of the executives worked harder just because he/she was offered an incentive. Therefore, Bahar (2005) [Online] suggests that focus on other sources of incentives (non-monetary form) would better serve as a motivator in order to increase the executives' utility such as long-term incentives, stock option. In the event of stock options, these basically make up the largest segment of the ESC (Heisler, 2007) [Online]. However, many of the executives were using this right for holding restricted stock and made profit from the share market. Thus, it would affect the share price of the company (Heisler, 2007) [Online]. In addition, the company planned to be high powered ECS and it would risky for the company as the executives can crowd out such sources of motivation like self-centered profit seeking individual (Bahar, 2005) [Online].

Disclosure of ECS

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Corporate scandals have highlighted the problem of understanding the way in which executives are paid (Hajazi and Bhatti, 2007) [Online]. Furthermore, ECS are becoming less transparent because corporate governance only requires the disclosure of the company's top five executives payout in its financial reports and it does not disclose all the aspect of ECS for the public as investing purposes (McConvill, 2005; Lee, 2009) [Online]. Thus, corporate governance best practice seeks to design mechanisms which align the interests of management with shareholders (McConvill, 2005) [Online]. In addition, corporate governance also play an important role of forcing companies to disclose information so that it would reduce the agency costs that are linked to executive compensation (Bahar, 2005) [Online]. Generally, a part of good corporate governance in ECS is to motivate directors to raise shareholder value (Bruce, et al., 2007) [Online].

Moreover, according to Bahar (2005) [Online], proper disclosure of the ECS would be sufficient to align executives' ECS with their performance to shareholders. Thus, corporate governance serves as a tool to encourage transparency in ECS, and to align executive behavior with the objectives of the company. Besides that, McConvill (2005) [Online] agreed that disclosure could make executives more accountable because it can be improve the governance of ECS and it could also increase the awareness to shareholders and to reduce the agency cost to analyze ECS. As a result, corporate governance can prohibit the executives from designing inappropriate compensation schemes and could act as a stronger constraint on managerial power (Bahar, 2005) [Online]. Therefore, transparency might drive positive behavior among executives if there is strict adherence to an ever-lasting range of governance regulations.

Nevertheless, transparency of ECS would still create a problem to company and increasing popular attention to ECS. Moreover, lawyers can manipulate the inappropriate ECS in order to help others in setting remuneration at an inadequate level (Bahar, 2005) [Online]. Furthermore, there are also have some problems with the governance which are company continued to increase the compensation every year but yet less to do with the company's strategic objective than with gaining legitimacy in the eyes of key shareholders (Bender and Moir, 2006) [Online].

Ward (1998) [Online] argued that shareholders are the owners of the company hence they have authority to know what they are paying their own agents. However, corporate governance does not state or suggest how the disclosure of ECS in the financial reporting. Hence, executives can package the figures among actual information or they can dress up reported values. Furthermore, they can resort to using all kinds of strategies to hold back the exact amount and structure of ECS. In spite of that, it may create problem at the company level in order to prevent outsiders from analyzing whether the ECS of the company is advisable and appropriate with direct links to pay with performance. It also may gives a difficulty for interested parties and analyst in comparison ECS at the market level (Bahar, 2005) [Online]. In practice, there had been various accounting scandals around the world even if these companies had disclosed their share option in the footnotes.

Besides that, there are lack of disclosure in ECS such as deferred compensation plans, pension plans and other long term compensation schemes in the financial reports. However, there are many companies which still remain that opt to not disclose such ECS to the investing public. Eventually, the objective of transparency in ECS is not to monitor what was paid to executives but to investigate whether it is set out appropriate incentives to the executives to perform their job (Bahar, 2005) [Online]. Practically, there are several companies which have collapsed in recent years and most of them are related to the lack of transparency of ECS such as Enron, WorldCom, AIG and so on. As a result, the lack of transparency of ECS would affect shareholders decision.

On the other hand, corporate governance only require companies to disclose compensations during the year awarded their options, option for the duration and the option strike price but it does not require to provide detailed information regarding the option type granted by the executives in the financial reporting (Bahar, 2005) [Online]. However, executives who are holding in their company's share would provide a strong relationship between share price and executives' wealth (Matsumura and Shin, 2005) [Online]. Because of this, they are able to easily to cover the re-pricing of share options, although the transaction may require transfers between executives (Bahar, 2005) [Online]. In addition, there also were issues arising from executives' misconduct in the valuation of share option grant. Heisler (2007) [Online] argued that executives may receive a larger option grant which is undervalued and used backdated option so that the option share price was lower than the market price for their executives. Thus, it would lead to unjustified return for the executives as it eventually brought out a question on the fairness to the shareholders.

Furthermore, executives who are not required to disclose the options they may purchase from a financial institution in the financial report in order to protect them from the risks incurred under a share option plan or a blocked shareholding schemes. Nevertheless, the executives had treated it as management transactions. Thus, it does not designed to inform the shareholders as corporate governance requirements, and it would lead to inappropriate information for shareholders to estimate the incentive effect of the ECS. As a result of that information not being disclosed in the annual report, it could lead to shareholders being unable to properly analyze the company performance. Hence, they may believe that the ECS in the company is more performance driven than what it really is (Bahar, 2005) [Online].

Last but not least, a pension fund is one of the ECS components which have certain features that attractive to the executives and it have been use as a camouflage technique over the past few years. Furthermore, this compensation does not require to be disclosed in the annual report. Therefore, most of the company used pension funds to increase ECS because it was rarely contingent on the executives' performance (Bahar, 2005) [Online]. Moreover, the company also use this underestimated the amount of the compensation paid out or overestimation of the pay-performance correlation (Bahar, 2005) [Online]. Thus, it would significantly affect the investor decision that insufficient requirements to disclose the level of executive compensation in the financial reports.

RECOMMENDATIONS AND CONCLUSION

In recent years, there were many major corporations which have collapsed due to executive compensation schemes issues. Therefore, companies should be required to provide the complete, accurate, understandable, and timely disclosure of ECS in a more transparent manner in order to maximize shareholders' wealth (Matsumura and Shin, 2005) [Online]. For example, the company should disclose the expense share options of the time grant or exercise on the income statement for better compensation decision and it would benefit a company through have good corporate governance and eventually reduce the agency conflict. As a result, it would also reduce the cost of capital and increase shareholders' value.

Moreover, institutional investors have an important role in monitoring their portfolio company's management. Therefore, the best way to improve ECS is to increase institutional investors' involvement in the corporate governance process, which would assist in improved disclosure of the ECS because they can monitor the process of evaluating and rewarding executives' performance in order to reduce the self-dealing or attitude of selfishness of the executives. It also provides awareness to the executives that they are being monitored and it would lead to reduce agency problem and self-interest activities.

Furthermore, the company should form a compensation committee in order to reduce the problem of ECS and they must perform due diligence in investigating available market date to ensure that the accurate figures are being used to price the work which includes correct job scope, using the appropriate industry classification and so on (Heisler, 2007) [Online]. This would solve the problem of fairness in the ECS within the company as to how much executives will be paid, which will depend on the level of the executive performance that are rated by the compensation committees. Besides that, compensation committees act as an agent to ensure that share options are valued as accurately. Thus, the options which are backdated or undervalued can be eliminated by setting of option grant dates are consistent from year to year. As a result, ECS should have an alignment of interest with management as well as with shareholder value.

In addition, by involving shareholders in the process of designing of ECS, it would be more transparent to enable cost savings in obtaining information on the executive pay for shareholders as it is the way to improve accountability of executives by making shareholders vote on executive compensation. Therefore, it could bring about pressure on the executives to disapprove unjustified ECS, and awareness to the executive from designing an inappropriate ECS that did not meet the objective of aligned interest between executives and shareholders.

Last but not least, The Combined Code (United Kingdom) recommended that there should be a formal and transparent procedure for developing executive remuneration and no director be involved in deciding his or her own remuneration. Therefore, it could help to reduce the agency problem and inhibit the actions of self-centered profit seeking individual in the company and it will reflect greater fairness to the executives and other stakeholders.

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