Motivating Managers: Executive Compensation One way to encourage management to act in shareholders’ best inter-

Motivating Managers: Executive Compensation One way to encourage management to act in shareholders’ best inter-

ests, and so minimize agency problems and costs, is through executive compensation—how top management is paid. There are several differ- ent ways to compensate executives, including:

Salary. The direct payment of cash of a fixed amount per period. Bonus. A cash reward based on some performance measure, say earn-

ings of a division or the company. Stock appreciation right. A cash payment based on the amount by which the value of a specified number of shares has increased over

a specified period of time (supposedly due to the efforts of manage- ment). Performance shares. Shares of stock given the employees, in an amount based on some measure of operating performance, such as earnings per share.

Stock option. The right to buy a specified number of shares of stock in the company at a stated price—referred to as an exercise price at some time in the future. The exercise price may be above, at, or below the current market price of the stock.

Restricted stock grant. The grant of shares of stock to the employee at low or no cost, conditional on the shares not being sold for a spec- ified time.

The salary portion of the compensation—the minimum cash pay- ment an executive receives—must be enough to attract talented execu- tives. But a bonus should be based on some measure of performance that is in the best interests of shareholders—not just on the past year’s accounting earnings. For example, a bonus could be based on gains in market share. Recently, several companies have adopted programs that base compensation, at least in part, on value added by managers as mea- sured by economic profits.

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The basic idea behind stock options and restricted stock grants is to make managers owners, since the incentive to consume excessive perks and to shirk are reduced if managers are also owners. As owners, man- agers not only share the costs of perks and shirks, but they also benefit financially when their decisions maximize the wealth of owners. Hence, the key to motivation through stock is not really the value of the stock, but rather ownership of the stock. For this reason, stock appreciation rights and performance shares, which do not involve an investment on the part of recipients, are not effective motivators.

Stock options do work to motivate performance if they require owning the shares over a long time period; are exercisable at a price above the current market price of the shares, thus encouraging manag- ers to get the share price up, and require managers to tie up their own wealth in the shares.

Currently, there is a great deal of concern in some corporations because executive compensation is not linked to performance. In recent years, many U.S. companies have downsized, restructured, and laid off many employees and allowed the wages of employees who survive the cuts to stagnate. At the same time, corporations have increased the pay of top executives through both salary and lucrative stock options. If these changes lead to better value for shareholders, shouldn’t the top executives be rewarded?

There are two issues here. First, such a situation results in anger and disenchantment among both surviving employees and former employ- ees. Second, the downsizing, restructuring, and lay-offs may not result in immediate (or even, eventual) increased profitability. Consider AT&T in 1995: In a year in which the company restructured, barely made a profit, eliminated 40,000 jobs, and its stock had lackluster returns, the chief executive officer (CEO) received salary and bonuses of $5.2 mil- lion and options valued at $11 million. If the restructuring pays off in the long-run, the CEO’s pay may be justified, but meanwhile, there may

be some unhappy AT&T shareholders: The average annual return on AT&T stock over the period 1996–2001 was –23.19%. 6 Another problem is that compensation packages for top manage- ment are designed by the board of directors, which often includes top management. Moreover, reports disclosing these compensation packages to shareholders (the proxy statements) are often confusing. Both prob- lems can be avoided by adequate and understandable disclosure of exec- utive compensation to shareholders, and with compensation packages determined by board members who are not executives of the firm.

6 Joann S. Lublin, “AT&T Board Faces Protest Over CEO Pay,” Wall Street Journal (April 16, 1996), pp. A3, A6.

Introduction to Financial Management and Analysis

Owners have one more tool with which to motivate management— the threat of firing. As long as owners can fire managers, managers will

be encouraged to act in the owners’ interest. However, if the owners are divided or apathetic—as they often are in large corporations—or if they fail to monitor management’s performance and the reaction of directors to that performance, the threat may not be credible. The removal of a few poor managers can, however, make this threat palpable.

Shareholder Wealth Maximization and Accounting “Irregularities” Recently, there have been a number of scandals and allegations regard- ing the financial information that is being reported to shareholders and the market. Financial results reported in the income statements and bal- ance sheets of some companies indicated much better performance than the true performance or much better financial condition than actual. Examples include Xerox, which was forced to restate earnings for sev- eral years because it had inflated pre-tax profits by $1.4 billion, Enron, which is accused of inflating earnings and hiding substantial debt, and Worldcom, which failed to properly account for $3.8 billion of expenses. Along with these financial reporting issues, the independence of the auditors and the role of financial analysts have been brought to the forefront. 7

It is unclear at this time the extent to which these scandals and problems were the result of simply bad decisions or due to corruption. The eagerness of managers to present favorable results to shareholders and the market appears to be a factor in several instances. And personal enrichment at the expense of shareholders seems to explain some cases. Whatever the motivation, chief executive officers (CEOs), chief financial officers (CFOs), and board members are being held directly accountable for financial disclosures. For example, in 2002, the Securities and Exchange Commission ordered sworn statements attesting to the accu- racy of financial statements. The first deadline for such statements resulted in several companies restating financial results.

The accounting scandals are creating an awareness of the impor- tance of corporate governance, the importance of the independence of the public accounting auditing function, the role of financial analysts, and the responsibilities of CEOs and CFOs.

7 For example, the public accounting firm of Arthur Andersen was found guilty of obstruction of justice in 2002 for their role in the shredding of documents relating to

Enron. As an example of the problems associated with financial analysts, the securi- ties firm of Merrill Lynch paid a $100 million fine for their role in hyping stocks to help win investment-banking business.

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