Paper outline:
What does “agency problem” mean?
What are the remedies for the agency problem?
The Sarbanes-Oxley Act?
Solution to Parmalat’s case
Describe the dominant compensation philosophy nowadays.
What is the link between company size and executive pay?
What are the limitations to equity incentives?
Why cash incentives be a solution for the pay-performance problem
Big Bath
How to Create an Owner-Employee Contract to Share Value Creation
Corporate Governance
What does “agency problem” mean?
Agency problems are behaviors issues that arise out of the formal separation of management and ownership of a professionally managed company such that they form they key determinant of the capital structure and the distribution of policy decision. In this case, shareholders are twisted by the management who fill their pockets at the shareholders expense. Agency problems are present because of the separation that is created by directors and fiduciaries that make decisions based on their shares in a company rather than the rational interest of the actual shareholder. On the other hand, company management in annual board meetings interact with these directors and fiduciaries rather than the actual shareholders and are therefore not truly answerable to them. This provision, removes that guilt of greedy behaviors by management of public companies (Schroy, n.d.).
What are the remedies for the agency problem?
There are several solutions to the agency problem and more than one solution may be incorporated in a new company structure. Company shareholders can elect a board of directors that is independent of the management thus serving as a mechanism against management insensitivity attributed to the agency problem. Another way is to have executive stock options that align the interests of the owners with that of the managers. Having a small pool of shareholders is also another solution; therefore shareholding of public companies should be concentrated. In some case overseas listing of the company shares serves as a barrier against agency problems for companies located in countries having a weak investor protection policy. Compliance with the Sarbanes-Oxley Act is another way of reducing agency problems (Madura, 2008).
The Sarbanes-Oxley Act
The Sarbanes-Oxley Act was enacted in 2002 to enhance the standards for public boards and their management as well as their accounting firms so that major scandals witnessed in the same period concerning loss of asset value as a result of financial book manipulation. The act ensures that there is a reliable financial reporting which maintains investors’ confidence in the company as well as the integrity of the securities exchange. The act introduced a public company accounting board. The act stipulates that management has to have a sound internal control structure to ensure there is proper financial reporting and sound effective governance. In addition, auditors have a role to access and report the relevancy of management’s assessment on the financial health of the company. The act strengthens the discipline and structure of organization and instills ethical values by emphasizing on the correct procedures that the whole organization has to follow and to ensure its obedience, the act comes with severe penalties provisions (Wagner & Dittmar, 2006).
Solution to Parmalat’s case
Parmalat’s case is an example of a company’s failure at corporate governance; the company is an Italian food group that collapsed after its management failed to follow Italian corporate governance standards. These include having an independent director board and the correct composition of the internal control committee. The company’s external auditor also failed to offer an early warning and a solution to fix the financial problems of the company.
A solution to the Parmalat case would be to employ the various remedies of agency management in the company as outlined above. New regulation should be enacted by the government with clear provisions aimed at stopping fraud because fraud is the key influencer of bad governance. Ineffective accounting standards have to be corrected and strengthened so that the financial health performance of companies is readily reflected to shareholders. On the other hand, shareholders should ensure that the company management has multi-year focus for running the company as a way to prevent any future mistakes associated with stop gap measures to financial control out of the desperation to meet monthly and quarterly goals (Clarke, 2007).
The problem at Parmalat was attributed to the failure of the gatekeepers composed of the senior leadership and auditors, to act on the tale signs of impending collapse. This highlights the failure of a rule based strategy at controlling company health status. Therefore to remedy this problem, the correct solution has to be based on the creation of a culture of ethics. Management and stakeholders need to adopt mechanisms that promote the development of an ethical and responsible corporate culture and one way to do this is to have supervisory agencies that are powerful enough to enforce regulations of corporate governance (International Commercial Crime Services, 2005).
Describe the dominant compensation philosophy nowadays.
The dominant compensation philosophy nowadays is to have management form part of the company ownership so that it is concerned more with improving the shareholder intrinsic value rather than reducing it. Currently, most incentives are tied to the level of performance in absolute terms rather than the value creation of a consistent performance and sustainable profitable growth. The compensation outlook is short term, focusing on the year horizon and as a result monthly and quarterly goals become exaggerated in their importance forcing the management to employ perverse habits and accountancy. In most cases the compensation strategy is a piecemeal attempt such that new plans are always added each successive year. The company ends up having more goals and measures than the total number of its employees.
What is the link between company size and executive pay?
Company size today determines the executive pay. However the executive pay is offered in form of risk, as equity in the company. Big sized companies have the ability to offer greater compensation to their executives (Gomez-Mejia, 1997). These companies enjoy a larger market share and therefore their CEO has a daunting task of maintaining or increasing the already large market share hence their high compensation. Large companies have a larger dollar value median for CEO salaries that smaller companies, moreover as their size grows these companies increase the at-risk compensation of their executives at a much higher rate that for small companies. According to Hallock (2010), CEO pay tracks have tracked the market capitalization of their respective companies historically increasing as the company grew.
What are the limitations to equity incentives?
Limitations to equity incentives include the volatility of the market which is sometimes enigmatic and demotivating and most employees are not poised to bear the compensation risk. Employees are bent on survival thus cannot make more aggressive bets when their shares are not performing well. Another limitation is market mystery because many employees and their executives have limited financial expertise of the global capital markets and cannot comprehend valuation. Thus they become prone to the sell-side analysis based on short term measures and deferral of long-term initiatives in the company. Thirdly, non-operative nature of the equity incentives make them less of a motivation compared to cash incentives that allow linkage to be made on actions and their corresponding results . Lastly, equity incentives provide a poor line of sight of the relationship between the influence on employees and the traded security of the company. In some cases stock options become end of year bonus and employees do not attribute the stock option to their performance thus defeating the logic of having equity incentives.
Why cash incentives be a solution for the pay-performance problem
Cash incentives could be the solution to pay-performance problems however without addressing the underlying problems of poor performance, a focus on compensation as a motivating factor will not succeed. Cash incentives usually come after the performance of the company has already been measured and therefore does not serves as a success in modifying the behavior necessary for good governance. In this regard, cash incentives must not be implemented alone and have to be incorporated together with equity. In addition the equity grant has to be a fixed share grant rather than a fixed value grant so that it augments the sensitivity of pay to performance. To solve the pay-performance problems, the company should have a linkage of its yearly and long-term plans with the ratio of bonus used in its grant multiplier. Finally cash incentives have to be based on the value generated in the company rather than the returns of the company so that they are linked with the shareholder interest and thus influence an increase as share sensitivity (Ittner, Lambert, & Larcker, 2003).
Big Bath
Big bath is an accounting term that refers to the practice of taking a large proportion charge out of an asset during a single year so that subsequent years show a minimal reduction in net income. The term is associated with the desire to minimize additional expenses in the following year by lumping the projected expenses the current year’s financial books. In the big bath, a company reduces significantly the value of its assets so that a marginal improvement in the later years is reflected as a net income on the same asset when they are sold (Shijun, 2004).
How to Create an Owner-Employee Contract to Share Value Creation
Owner-employee contract to share value creation is an alternative approach to remedy the persistent confines of the dominant total compensation strategy. It is possible to have an owner-employee contract however the contract has to be reached through a combination of features. These features include, a better and single measure;
By measuring the economic value added will simultaneously include profits, capital and costs of capital and this converts the present value into a flow measure thus EVA measurement directs resources efficiently to the maximization of shareholder value. Secondly, goal setting has to be value-based; this are established using the fair market value and establish the correct performance standard. Thirdly, there should be a multi-year accountability and this is achieved by having annual payments as a function of annual performance but in relation to the cumulative performance of the multiple years. This kind of contract stretches the management horizon. The owner-employee contract has to have an equity-like payoff where an unlimited downside or upside guards against short term behaviors that are damaging to the company and serves as a continuous motivation linked to the company performance that does not periodically turn off like other motivation initiatives that are switched off in exceptional years (Pettit & Ahmad, 2000).
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