Executive compensation is
an ongoing controversial topic in the corporate finance world. The controversy resides in the agency problem
inherent when a CEO is expected to act in the best interests of the
shareholders. Degrees of risk tolerance
vary between corporate management and shareholders. Management is often more inclined to take on
more operating, financial, or investing risk while shareholders are usually
conservative. In an effort to reduce
agency problems, many companies have adopted compensation structures and
incentives that seek to align the interest of CEOs with that of the
corporation. Popular methods of inducing
a CEO to act in this manner are stock-based employee compensations in the form
of stock options, restricted stock, and performance shares.
compensation plans can mitigate agency problems as they provide a direct
connection between executive compensation and company performance. Stock options give employees the right to buy
a share of stock at a predetermined price.
Restricted stocks are shares of a company that transfers to a person
only after certain conditions are attained.
Performance shares are also company stock but they are only given to
management if certain company-wide performance targets are met. Companies utilize these sorts of compensation
because of the idea that CEO interest is more in line with shareholders when
both parties share the risk and rewards of performance. Shared risk may prevent executives from acting
on ill-advised risky activities. Furthermore,
an optimal equity compensation strategy can motivate less risky CEOs to make
bold decisions to generate greater returns.
Stock options are cost effective incentives that influence CEOs to make
value maximizing decisions without direct cash compensation. The potential future economic potential of
ownership shares may also be enticing enough to attract talent to a
company. Other than being cost
effective, “options are typically structured so that only employees who remain
with the firm can benefit from them, thus also providing retention incentives”
(Hall,Murphy,49). While equity based
compensation may seem like an attractive strategy to cut agency problems, they
are not without their faults.
based award plans are an integral part of many corporations’ compensations
programs. Takeaways from major
accounting scandals such as WorldCom and Enron are that sometimes companies and
executives can have an excessive fixation on stock prices and that it can lead
to accounting manipulation. Decreasing
share prices may motivate a CEO, who has a high level of ownership shares, to
participate in fraudulent activity as an act of self-preservation. Thusly, corporations and shareholders are
exposed to the risk of an executive’s fraudulent behavior which has proven to
be detrimental. In 2007, Brocade
Communications Systems, Inc was involved in an accounting scandal relating to
the backdating of employee stock options.
Former CEO Gregory Reyes and other executive management were charged
with allegations of backdating stock options between the years 2000 and 2004
and concealing millions of dollars in executive compensation from
investors. This ultimately resulted in
“materially understated employee compensation expenses and overstated operating
income and company performance” (Alexander, Alexander,Scholz). As
exemplified in the Brocade case, executive stock based compensation plans do
not eliminate greedy nature and can be still be manipulated.
Equity based compensation plans are
enticing strategies to consider as cost efficient methods of attracting,
retaining, and motivating CEOs. Along
with this advantage comes the risk that is seemingly related to all incentive
programs, susceptibility to manipulation.
In order to incorporate equity based compensation and mitigate agency
problems governance must be applied.
Restricted stock and performance shares should be considered as
potential compensation to a CEO prior to stock options. While there are increased regulations to
stock options post Brocade, restricted stock and performance shares allow the
board of directors to set benchmarks and limits by creating desired
conditions. A condition for a restricted
stock may be to require a CEO to hold the company stock for a period which promotes stability independent of the stock price. To keep the integrity of a stock based award
programs it may be best that independent directors first approve of such
awards. Managing expectations from
within the company and establishing fixed compensation plans distances CEOs
away from excessive market pressures and high risk situations.