EXECUTIVE

COMPENSATION:
An Introduction
Executive Compensation

A well-designed executive compensation plan is

important because it rewards both executives
and shareholders, whereas a poorly designed
one wastes corporate resources without
motivating the executive.
OWNER-MANAGER CONFLICT:
AGENCY THEORY
Sidebar 13.1: Applying a Good Governance Model
to Compensation

“The fox is guarding the henhouse”. Crediting issues, gaming

opportunities, pay inflation, and extra expense can be interwoven
so tightly in the final compensation plan that it is almost impossible
to address and resolve them after the fact. On top of this,
shareholders and Congress impact the process through Sarbanes-
Oxley. Now, the CEO and CFO can go to prison if errors that are
deemed unethical occur in the compensation plans and it is found
that there was knowledge of these errors or “inadequate controls.”
That fact alone has driven management to exert increased control
and governance over compensation.
terms and conditions (T&Cs) have always been a
fundamental element of a well-designed compensation
plan, they focus primarily on explaining various
administrative and employment aspects and are often
not enough by themselves to support governance.
Governance implies that a system for authoritative
control is in place related to the program. While some
executives may perceive governance as excessive
control.
Compensation Governance

Board governance is essentially the checks, balances, and

due diligence necessary to ensure that C-level (CEO, COO,
CFO, CXO, etc.) executives do not make short-sighted
decisions that benefit themselves at the expense of
shareholder value. Because of the complex legal,
accounting, and reporting issues that must be considered,
the compensation committee of the board of directors
typically handles executive compensation packages for
top executives.
Communication and Process Gaps

1. The gap between senior management and front-line

managers.
• Communication
• Alignment
2. The gap between functions (such as HR, Sales, and
Finance).
3. The gap between business units (BUs) with distinct
profit & loss (P&L) responsibility.
4. The gap between geographies that may or may not
have different laws and subsidiaries (legal entities).
Demystifying Sarbanes-Oxley

In 2002, Congress passed the Sarbanes-Oxley Act as a

response to scandals at Enron, Tyco, and other public
companies. The act is intended to “protect investors by
improving the accuracy and reliability of corporate
disclosures.”
Figure 13.1 Contents of Sarbanes-Oxley act.

Title I—Public Company Accounting Oversight Board

Title II—Auditor Independence
Title III—Corporate Responsibility
Title IV—Enhanced Financial
Title V—Analyst Conflict of Interest
Title VI—Commission Resources and Authority
Title VII—Studies and Reports
Title VIII—Corporate and Criminal Fraud Accountability
Title IX—White Collar Crime Penalty Enhancements
Title X—Corporate Tax Returns
Title XI—Corporate Fraud and Accountability
Section 302, Corporate Responsibility for Financial Reports:
This section states that the CEO and CFO must certify each
annual or quarterly report.

Section 401, Disclosures in Periodic Reports:

This section states that a company must disclose off-balance
sheet transactions that have a “material current or future
effect on financial condition.”

Section 404, Management Assessment of Internal Controls:

This section is very similar to Section 302,but adds the
responsibility for “adequate” internal controls and
management’s responsibility for assessing and reporting on
the controls’ adequacy.
A Detailed Governance Model

A more detailed outline of “adequate controls” is

necessary, primarily because (as with most government
legislation) it isn’t spelled out for the concerned
executive anywhere else.

Accountability: This accountability should be reinforced by the

organizational structure, performance metrics, performance
evaluation, and compensation plans themselves.
Alignment: The processes and systems required to support them
must align with those objectives. Where necessary, explicit
decision support tools should supplement the processes.

Accuracy: There should be a paper trail to support auditing of

that data. Rules and regulations should be accurately
communicated and enforcement and penalties accurately
applied. Performance evaluation must be based on an accurate
picture of that performance and payout formulas accurately
applied and calculated.
Leadership

•Have some experience with the motivational power and

potential complexity of compensation.
• Be able to influence and marshal resources from other
departments.
• Represent decisions made by the compensation team and
outline the supporting arguments for those decisions to
outsiders.
• Have the authority to restructure the composition of the
compensation team as deemed necessary to execute the
company’s strategy and governance model.
Central versus Local Control

The presence or absence of regional leaders who share a strong

sense of accountability, alignment, and value of accuracy will
further complicate these questions. The most successful
companies typically have structured a framework that explicitly
retains certain decision rights for central corporate resources
while empowering local resources to make other specific
decisions to suit their unique business environment and
strategies. These decision rights should be documented in both
the governance framework and the compensation T&Cs.
Centralized: Market benchmark percentile, role eligibility,
performance measures, some formula mechanics, quota-
setting process, most crediting rules , key policies concerning
employment status, pay administration.

Localized: Pay level, pay mix, upside, weightings of

performance measures, some formula mechanics, pay
frequency, individual quotas, supplemental policies.
Meetings, Voting, Notes, Documentation

scheduled or ad hoc meetings to confirm plan issues from the

assessment, plan change objectives, expense budgets, system
capabilities and testing requirements, communication strategies, mid-
period plan (or quota or territory) changes, and emergent issue
resolutions. vote of the team members should be explicitly stated as
requiring a single authority to approve, a majority to approve, a super-
majority (67 percent), or full consensus. The results of any votes should
be documented in meeting minutes and the minutes should be filed
(electronic and paper copies) for future reference and auditability.
Situations:

First, there are individuals with preexisting businesses

who either do not have the desire and/or skills required
to manage the business.

In the second, there are individuals with good

ideas/products that may not have the funds necessary to
bring those products to market and/or sustain
themselves through the startup period and thus must
seek outside investors.
Public capital markets include domestic and
international, stock and bond markets (e.g., the New York
and Tokyo Stock Exchanges).

Private capital markets include venture capitalists,

banks, friends, neighbors, and relatives.
A more likely scenario is that executives, while not stealing the
assets, may not manage them in a value-maximizing way. That is,
they might pass up profitable investments because taking those
investments would require increased effort on their part. They
might also overconsume the perquisites of their position, for
example, purchase a corporate jet rather than fly commercial
airlines.

Academics refer to the costs arising from the separation of

the ownership from the management of the corporation as
agency costs (see Jensen and Meckling 1976).
• Monitoring by large shareholders and the board of
directors.
• Equity ownership by executives.
• The market for corporate control.
• The managerial labor market.
• Compensation contracts that provide incentives to
increase shareholder value
Other Theories that explain and influence
Executive Compensation

Class hegemony theory

Gomez-Mejia (1994) notes “board input is primarily used to
legitimize high executive pay, reflecting a shared commitment
to protect the privileges and wealth of the managerial class.”

Efficiency wage theory (Prendergast 1999) suggests that

executives are paid a premium to provide them with the
incentive to exert effort to avoid being fired. This premium
leads them to put forth effort, because of the consequences of
being fired (i.e., having to accept another position at a lower
wage).
Figurehead Theory
Ungson and Steers (1984) argue that the CEO, unlike an
operational manager, should not be paid based upon operating
results, but rather for his or her role as leader or political
figurehead (figurehead theory).

Human Capital Theory

Agarwal (1981, p. 39) explains the logic behind human
capital theory:
The amount of human capital a worker possesses influences his
productivity, which in turn influences his earnings. The same
general reason should hold for executives as well. Other things
being equal, an executive with a greater amount of human
capital would be better able to perform his job and thus be paid
more.

Managerialism theory argues “that the separation of

ownership and control in modern corporations gives top
managers almost absolute power to use the firm to pursue their
personal objectives” (Gomez-Mejia 1994).
marginal productivity theory
Gomez-Mejia (1994) defines this as the “observed performance of
the firm minus what performance would be if the next best
alternative executive was at the helm, plus the pay that would be
necessary to acquire the latter’s services.”

prospect theory focuses on the executive’s loss aversion

(Wiseman and Gomez-Mejia 1998). That is, in certain circumstances,
for example, to avoid losses or missing goals and/or targets, the
executive is actually willing to take risks.
social comparison theory, board members use their own
pay as a reference point when setting pay of executives
(O’Reilly, Main, and Crystal 1988).

tournament theory (Lazear and Rosen 1981; Rosen 1986),

executive compensation is set to provide incentives, not to the
executives themselves, but rather to their subordinates.

The incentive is for lower-level executives to work hard, win

the tournament, and be promoted, whereby they will receive
that higher level of compensation. Rosen (1986, p. 714) claims
“Payments at the top have indirect effects of increasing
productivity of competitors further down the ladder.”
External Influences on the Executive Compensation
Package
Differential Accounting Treatment: Prior to 2006, most stock options
did not reduce reported accounting income, creating an incentive for
executives to include more stock options in compensation packages.
However, after the introduction of Statement of Financial Accounting
Standards No. 123 (revised), stock options are now expensed, reducing
the incentive to issue them.
Tax Considerations: Section 162(m) of the Internal Revenue Code
limits the deductibility of executive compensation to $1 million per
individual, with exceptions for "performance-based" compensation.
This creates incentives for corporations to shift compensation from
salary to bonus and stock option plans, as these can meet the
performance-based criteria.
Political Environment: Political pressure from government regulators
and interested parties can influence executive compensation.
Government regulations like Section 162(m) and actions by non-
government regulators, such as the Financial Accounting Standards
Board, affect the after-tax cost of executive compensation. Interested
parties may criticize executive pay as excessive and unrelated to
performance, leading to pressure for compensation reform.
Disclosure Rules: New disclosure rules proposed and adopted by the
Securities and Exchange Commission (SEC) in 2006 aim to provide
investors with a clearer and more comprehensive picture of executive
compensation. These rules discourage firms from hiding
compensation and aim to improve transparency in reporting.
Sources of Data on Executive Compensation

The Securities and Exchange Commission (SEC) mandates

comprehensive disclosure of executive compensation in proxy
statements filed by publicly traded companies. These
disclosures, accessible through the Electronic Data Gathering,
Analysis, and Retrieval system (EDGAR), provide
shareholders and the public with transparency regarding
executive pay practices.
Regulation S-K, Item 402, specifies requirements for disclosing
CEO, CFO, and other top executives' compensation, including salary,
bonuses, stock and option awards, and pension changes, among
others. Introduced after 2006, a summary table must include total
compensation and pension changes. Additional tables focus on equity
compensation and director compensation. Qualitative disclosure,
including employment contracts, is now required, typically found in
the Compensation Discussion and Analysis section.
Components of Executive Compensation
The executive compensation package can, and most often does,
contain many components. These components have differing
effects on employee motivation and risk, as well as different
costs for the corporation.

• Salary.
• Bonus.
• Stock options.
• Stock grants.
• Other stock-based forms of compensation.
• Pensions.
• Benefits and perquisites.
• Severance payments.
• Change-in-control clauses.
 Making the Offer Attractive

This includes considering the executive's risk aversion, often

necessitating a premium and possibly including a severance provision
to mitigate the risk. The package's value encompasses both monetary
and non-monetary factors, such as location preference or the
perceived prestige and growth potential of the company.
Providing the Proper Incentives

Corporations design CEO compensation packages to align with

value maximization goals. While fixed salaries provide stability
and retention incentives, solely performance-based
compensation can lead to risk aversion. Therefore, packages
typically include both fixed (e.g., salary, benefits) and variable
(e.g., bonuses, stock compensation) components.

Variable components incentivize performance but may lead to

specific behaviors. For instance, bonus plans based on
accounting numbers may not always benefit shareholders, and
stock compensation ties CEO compensation to market risks.
Designing the Contract to Retain the
Executives

To minimize recruiting and training costs, and avoid the

downtime associated with an open position, corporations would
like to ensure that the executive being recruited stays with the
corporation.

The first approach would be to provide monetary incentives to

stay, for example, compensation that vests over a period of time
and hence is forfeited if the executive leaves before the end of the
vesting period. However, if the new employer is willing to
reimburse the executive for amounts forfeited when leaving the
old employer, the employment contract loses its retentive effect.
The second approach is to limit the executive’s alternative
employment opportunities with noncompete, nondisclosure,
and nonsolicitation provisions.

Restrictions

Corporations often use noncompete and nonsolicitation

provisions to restrict executives from joining rival companies or
hiring former colleagues, thereby reducing the likelihood of
them leaving. These restrictions aim to protect valuable
corporation- and industry-specific knowledge.
Minimizing Costs to the Corporations

Financial costs differ between forms of variable compensation,

such as bonuses and stock options, impacting cash flow,
accounting treatment, and tax implications. Tax deductions
under Section 162(m) of the Internal Revenue Code also affect
the after-tax cost to the corporation.

Nonfinancial costs, like equity and organizational dynamics, are

equally important. Pay discrepancies between executives can
breed resentment and damage working relationships. Similarly,
a large gap between the new CEO's compensation and that of
other executives may lead to feelings of unfairness and
potentially disrupt team cohesion.