Agency Theory and Executive Copensation

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Agency Theory and Executive Compensation

Agency theory essentially involves the costs of resolving conflicts between the principals and agents and aligning interests of the two groups. In this case, agency theory focuses on the on the link between executive compensation and firm performance. Executive compensation can be used to create shareholder value by improvement of a firm's performance. Management's role as an agency and their relationship with shareholders often results in a conflict of interest in the area of executive compensation. While management is focused on developing the company through its qualified CEOs, shareholders are interested only in their returns. As a result, differing interests may exist where investment cash flows, financial management and reporting are concerned. These mechanisms are considered to be the lifeblood of an organization yet have often been subjected to agency issues.

Agency costs refer to the reductions in benefits to owners stemming from contracts governing the separation of ownership and control. Examples of agency costs include legal expenses in drawing contracts to control managers' salaries and the cost of producing annual reports. Managerial expense preference is a special kind of agency cost associated with the tendency of some managers to enhance the benefits received from their institution. (Hannan 180) Some examples include, hiring larger staff, enjoying large travel and expense accounts, and enjoying lavish furnishings. Managers make decisions according to criteria based on whether they receive net benefits from the proposed action. They set asset/liability objectives and owners protect their interests by setting appropriate constraints.

The study of firm governance mechanisms deals with two connected problems that of creating an optimal contract and that of the mode of control between the parties in a situation of exchange. Agency theory focuses on the mechanisms which facilitate the management of conflicts of interest between shareholders (the principal) and top executives (the agent). It is based on three postulates (1) the first is that there is a potential divergence of interest between shareholders and the CEO; () the second is the existence of an information asymmetry which makes it difficult for the shareholders to monitor the activities of the CEO; () the third is that the CEO, as a rational agent, seeks to maximize his or her utility and at the same time has an aversion to risk (Eisenhardt, 18).

Given the divergence of interest, the principal and the agent can pursue conflicting objectives. Shareholders seek to increase their wealth and the value of the firm, while the CEO can take advantage of his or her position as decision-maker for self-serving purposes even if this is to the detriment of the shareholders' interest. It is the CEO who decides and takes action. This action not only influences his or her utility, but also that of the shareholders. The problems of information asymmetry are all the more important in situations of dispersal of capital and complexity of the CEO's activities (Eisenhardt, 18). The shareholders have a limited amount of information concerning both the decisions and actions of the executive and his or her personal traits in terms of capacities, preferences and intentions. By delegating the power of decision to the CEO, shareholders take the risk of adverse selection (a bad choice of CEO) and also take a moral risk (possibility of opportunism on the part of the agent). The control of the agent's actions therefore becomes the fundamental worry of the principal. To confront this problem, shareholders have recourse to two solutions, or often to a complex balance between the two (1) develop a system of supervision to ensure that the actions of the CEO are not in conflict with the interests of the shareholders; () adopt compensation programs based on measures of performance which safeguard the shareholders' wealth (Gomez-Mejia & Wiseman, 17). However, supervision of the CEO's behavior is all the more costly and difficult in situations where his or her activities are non-programmable and the information asymmetry is extensive (Eisenhardt, 18). Developing compensation systems which permit a better alignment of the shareholders' interests with those of the CEO becomes the most viable control mechanism because it induces a form of "self-control" by the agent (Bloom & Milkovich, 18). According to the normative agency theory, the choice of an optimal compensation program consists in creating a balance between the basic pay linked to behavior and incentive pay linked to performance. The focus of this balance is to provide the appropriate incentives to the agent and optimal risk-sharing between the principal and the agent. This balance is complex because one has to arrive at a combination which permits the incentive pay to align the shareholders' interests with those of the CEO, without transferring too much risk through the variability of the compensation paid to the CEO (Jensen & Murphy, 10). In order to ensure an effective control of the executive, agency theory presumes that it is necessary to make executive compensation contingent upon the firm reaching its performance objectives, and consequently increasing the shareholders' wealth. Several choices are therefore made between the components of executive compensation in terms of fixed and variable pay, short and long-term pay, and between the different indicators of performance (share value, profits, and profitability indicators) in order to closely link compensation with the success of the firm (Gomez-Mejia & Wiseman, 17). Linking the compensation of the agent with the interests of the principal supposes (1) splitting the compensation into fixed pay (basic salary) and variable pay (incentive and performance-contingent pay); () having recourse to different forms of short-term incentives, such as bonuses, and long-term incentives, such as stock options; () fixing performance objectives which determine the attribution of incentives; (4) choosing measures of performance (Gomez-Mejia & Balkin, 1). The control which shareholders exert by means of compensation presumes that performance contingent, variable, at risk and long-term pay permit the alignment of shareholders' interests with those of the CEO. Performance-contingent pay is based on a reinforcement of the link between compensation and performance; this link is called "pay-performance sensitivity" (Gomez-Mejia & Wiseman, 17). A strong link between the evolution of compensation and the evolution of a firm's performance makes it possible to both control payroll costs and ensure the reversibility of compensation. Since performance can never be guaranteed on account of the potential divergence of interest and information asymmetry, it is therefore essential not to guarantee the level of the CEO's compensation. Variable pay reinforces contingency with performance and at the same time diversifies short-term and long-term incentives which could motivate the CEO to act in the interests of the shareholders (Bloom & Milkovich, 18). It also permits part of the risk to be transferred to the CEO's charge in order to favor a mutual adjustment between the interests of the principal and the agent, to make the CEO take responsibility for the consequences of his or her actions and to minimize the decisions which maximize the welfare of an executive having an aversion to risk to the detriment of the enrichment of shareholders (Gomez-Mejia & Wiseman, 17). Having recourse to long-term incentives such as stock options reinforces the identification of the CEO with the firm and its durability, limits opportunistic behavior and the non optimal use of resources, reinforces the elements of uncertainty in the compensation, and strengthens the links between the CEO's interests and those of the shareholders (Jensen & Meckling, 176).

A study of the financials of Colgate-Palmolive revealed that the CEO for the company had earned a stock option worth million dollars adding to the salary and bonuses. Upon further investigation and comparison it was found that the financial revenue of the CEO for Colgate-Palmolive had actually declined in comparison to the other companies. This establishes the fact that most companies have set high compensations for CEO's yet do not in effect perform as marginally as the shareholders expect them to. (Hallows 18)

Karen Hallows, (18) mentions an investigation conducted in 8 companies to evaluate the conduct of a CEO governing each of those organizations through a time span of four years. The investigation brought out surprising facts that the annual rate of return measured up to be around 1. percent for those companies, while the CEO of these companies enjoyed an inclined rate in the wage by 8.1 percent, nearly double the annual rate of return of the company. This establishes that CEO's setup higher wage rates in their own interest against the objectives of the company and the shareholders.

It has been speculated that managers concerned should be aligned with the value of the organization. Armand Hammer founded and ran Occidental Petroleum until his death in 10 at the age of . During the last decade of his life he pursued strategies that were widely criticized and that resulted in dismal share price performance for Occidental while the stocks of other oil companies tripled in value. An example was the building of an art museum for Hammer's art collection at a cost of $10 million to shareholders. When it became known that Hammer had entered an intensive care unit, the rumor spread that the 1-year-old chairman was critically ill. Based on this rumor, the price of Occidental stock increased from $8 to $1 per share, representing a total gain in shareholder value of approximately $00 million. (Grinblatt 17) This establishes that manager's attitudes can be insensitive towards stockholder's investment.

Arguments exist against providing the management with compensation as it is believed that the compensation entitles the management to greater financial gain, introducing a great inconsistency in the organizational wage equality. Jensen and Murphy (14) believe that the wages for management has declined over a period of times when compared to that in the 10s yet their compensations have been on the rise constantly to the extent of being considered exorbitant by the investors.

The classical theory of firm behavior states that managers should concentrate on maximizing the expected benefits to owners, consistent with the risk owners are willing to assume. Managers should ignore their risk/return preferences in making firm decisions. Owners are the ones to set objectives for asset/liability management. (Aghion, 18) In contrast, agency theory is a positive view of managerial behavior. It asserts that by human nature managers, if left unmonitored, will pursue their personal risk/return preferences. Therefore, non-owner managers (agents) and owners (principals) must create contracts to control managerial behavior and align the interests of managers with those of the owners more closely.

References

Aghion, Dewatripont, Rey, (18) "Agency Costs, Firm Behavior and the Nature of Competition" Toulouse Institute

Bloom, M., Milkovich, G.T. (18), "Relationships among Risk, Incentive Pay, and Organization Performance", Academy of Management Journal, vol.41

Eisenhardt, K.M. (18), "Agency Theory An Assessment and Review", Academy of

Management Review, vol.14

Gomez-Mejia, L.R., Balkin, D.B. (1), "Compensation, Organizational Strategy, and Firm Performance", Cincinnati, OH South-Western Publishing Company.

Gomez-Mejia, L.R., Wiseman, R.M. (17), "Reframing Executive Compensation An

Assessment and Outlook", Journal of Management, vol.

Grinblatt and Titman, (17) "Financial Markets and Corporate Strategy", McGraw Hill

Hallows, Karen. (18) "Executive Cash Machine How a Pliable System Inflates Pay Levels", New York Times, November 8, 18

Hannan, Mavinga, (180) "Expense Preference and Managerial Control the Case of the Banking Firm", RAND Journal of Economics

Jensen, M.C., Murphy, K.J. (10), "Performance Pay and Top Management Incentives",

Journal of Political Economy, vol.8

Jensen, M.C., Meckling, W.H. (176), "Theory of the Firm Managerial Behavior, Agency Costs and Ownership Structure", Journal of Financial Economics

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