Concerns about the relationship
between corporate governance and
executive compensation are not new.
In fact, in “The Wealth of Nations” (1776),
Adam Smith writes that individuals hired
to manage companies in favor of shareholders may instead pursue their own self-interest. The Enron, Tyco and WorldCom
fiascos of the early 21st century are the
more recent examples of the problems
noted by Smith.
“A combination of the changes in the
ways in which executives are compensated and, in some cases, the lapse of oversight by boards has led to many instances
of the gross mismanagement by some and
the over-compensation of executives, especially as it relates to overall company performance,” says Dr. Asghar Zardkoohi,
Department of Management at Mays
Business School.
Smart Business talked with Zardkoohi to
find out what can be done to provide a balance between governance, compensation
and stockholder interests.
How has executive compensation changed
over the years?
Prior to 1985, U.S. executives received
almost all of their compensation in cash, as
salary. In 1985, only 1 percent of the median CEO compensation was in some form
of equity, like shares of stock or stock
options. That number has gone up steadily
ever since and reached 66 percent by 2001.
The median cash compensation has gone
from just under $1 million in 1980 to about
$2.5 million in 2001 while the total median
CEO compensation has increased to more
than $7 million.
Companies started relying more on stock
options to tie compensation to performance beginning in 1993 when Congress
made any amounts paid to a CEO above $1
million per year a nondeductible business
expense unless it was tied to performance.
Has the significant increase in executive
compensation been tied to performance?
Some of the increase in compensation is
tied to increased performance. Another factor is increase in corporate size. The
larger the company, the more difficult it is
to manage; thus, managers ‘deserve’ higher
compensation. Also, the industry mix of
the corporation is a factor. Corporations
that enter different industries are harder to
manage than those that focus in one industry only.
Still, compensation has far outpaced performance.
What are the explanations for this?
There are several. In about 80 percent of
corporations, the CEO serves as the board
chair. Since the board determines the compensation of the CEO, and in most cases
the CEO is influential in determining who
will serve on the board, the board favors
the CEO over the stockholders in determining the CEO’s pay.
Second, the board generally hires compensation consultants to help determine
the CEO’s pay. In general, consultants,
knowing the average compensation of
CEOs in the market for comparable firms
in the industry, will suggest compensation
above the market average. No consultant
will suggest compensation that is below
the market average. The game of beating the average tends to ratchet up the average
over time.
Last, but not least, is the influence of
fraudulent performance signals that some
firms send to financial markets.
What mechanisms might be used to motivate
efficient management and less fraudulent
behavior?
One effective set of corrections is to
allow only a fraction of stock options to be
exercised at any given point in time; the
time between any two exercise events be
specified; the fraction of the exercised
option be replaced by the same fraction of
stock options; and that the options that are
exercised be replaced with new stock
options.
For example, allow only 10 percent of
stock options to be exercised at any given
point with at least three months between
any two exercise events. And stipulate that
the exercised options are replaced with
new ones at the current price of the stock.
This correction has the effect that — at any
given point in time — the executive will
have a significant number of options unexercised, in this case 90 percent. This may
effectively deter any incentive to engage in
fraudulent reporting of financial statements because the stock price takes a beating if and when the market learns about the
fraud. The executive will be punished
based on 90 percent, while benefiting from
only 10 percent of the stock options. The
three-month lapse between any two exercise events allows the market to learn
about any fraudulent activities that may
have caused price change of the stock.
A second correction would be to index
the price of the stock based on the average
stock price of different stocks from the
same industry. If the stock price does not
beat the average, then the manager should
not be rewarded for performing below
average.
DR. ASGHAR ZARDKOOHI is the T.J. Barlow Professor of
Management for the Mays Business School at Texas A&M
University. Reach him at [email protected] or (979) 845-2043.