Adam Smith’s dark fear Featured

8:00pm EDT March 26, 2007
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 Zardkoohi@tamu.edu or (979) 845-2043.