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In a perfect morally conscious world, one can assume that CEO's have fiduciary duties towards shareholders. This means that they place the shareholders' interest ahead of their own with regard to the administration of the firms' assets. With these obligations also comes a moral fiduciary duty. This implies that CEO's make moral decisions on how to manage the firm to maximize its values, but also how much compensation he can accept (Moriarty, 2009). This principle however is not common as a basis to determine a CEO compensation package in the 'real world'. The principal-agent theory on the other hand, gives a more commonly used perspective on CEO compensation issues in which managers and executives are seen as opportunistic individuals (Goshal). The assumption is that executives are solely willing to act in the shareholders' best interest, if they too can benefit from these actions as a shareholder (Matsumura & Shin, 2005). Offering stock option as a form of compensation has increased in the recent years in an effort to control agency problems. It functions as a control system that can maximize a CEO's own financial wealth, and at the same time protects the livelihood of the firm and interests of shareholders (Nichols & Subramaniam, 2001).
Link agency- theory ethics
When is executive compensation fair?
Attracting a CEO is not any different from attracting goods and services in a liberal market economy, where the price is established by supply and demand. So if in this case the CEO labor market shows that the demand for competent CEO's surpasses the number of available CEO's it will therefore create the necessity for a larger compensation package as it would happen in a liberal market economy, because that is how the system works (Perel, 2003). Another argument is that a skilled and experienced CEO can significantly contribute to a firms' value, growth and, success (Nichols & Subramaniam, 2001). But, to attract the best CEO that fits the firm and will create deliver successes, the Board of Directors have to be willing to pay a salary that is equal to a CEO salary in the same industry at a minimum. Offering less will consequentially compromise in the quality of CEO candidates and thus compromises the ability to maximize the firm's value for shareholders (Perel, 2003). A final argument in favor of a high level of CEO compensation is that it is commonly accepted that salaries of employees differ depending on their position in an organization. A CEO earns more than a floor manager and a floor manager earns more than an office clerk. The difference in salaries between a CEO and an average employee can be rightfully justified on the bases that a CEO carries a far greater weight in his position, in terms of responsibility towards the firm but also in terms of the complexity of the position. To run a successful firm in a global and extremely competitive environment that is constantly submitted to change requires great amount of skills, talent and effort.
When is CEO compensation inappropriate?
Even though there are some arguments that justify high compensation packages, high CEO pay can also cross ethical boundaries, in which CEO's and Board of Directors play a crucial role. Ultimately, the Board of Directors has the last say in the composition of compensation packages, which according to Perel (2003) compiles nearly 60%-70% of stock options. The problem with large stock grants is that CEO salaries can be extremely compromised, when stock value declines below the exercise price. It can put a CEO in a position where in he is tempted to use unethical tactics to falsely keep stock prices high consequentially harming the firm's value.
According to Shivdasani and Yermack (Nichols & Subramaniam, 2001) more than 80% of CEO's are also Chairman of the Board. This will create conflict of interest issues if the chairman also nominates the members of the Board of Directors. Graef Crystal, compensation expert, states that CEO's tend to nominate friends that are not skilled to make sound decisions about compensation matters. The CEO keeps them content and well paid in return of a favor, when the board has to negotiate the compensation plan. What also make boards sensitive to unethical behavior is that 75% of directors that are attracted outside of the firm are CEO's as well. An outside director can very well be seen as an asset because he is objective and impartial. However, at the same time an outside board member/ CEO can also be empathetic to a CEO when it comes to authorizing a compensation package with the underlying thought: I will do a favor for you and you do a favor for me (Nichols & Subramaniam, 2001).
There is a significant amount of pitfalls in composing a fair and ethically sound compensation package. It has to high enough to compensate for the invested skills, talent, and effort of a CEO but not too high to avoid unethical actions that can harm the firms' livelihood.
In regard to the literature review, it can be concluded that the arguments in favor of a high level of CEO compensation do not overrule the fact that high CEO packages can lead to unethical situations.
Basing CEO pay on ethics principally has to start by creating governance where the Board of Directors compose of members that have relevant knowledge to make CEO compensation decisions, and that are nominated independently without the interference of the CEO. It is also fundamental that shareholders have a more active role in the CEO compensation process (Perel, 2003). A select group of shareholders for instance could function as a sounding board for the Board of Directors about setting regulations and limitations on CEO packages. Further study could focus on how to determine an ethically fair compensation package for large firms.