Managerial Incentives and Corporate Governance
Corporate governance involves different checks and balances with the ability to influence the incentives and monitoring of a firm’s management. Sound corporate governance is predominantly essential when a firm’s management is different from its ownership. Randall (2009) argued that in the absence of appropriate corporate governance, managers who are separate from a company’s ownership may not be incentivized to work hard towards achieving shareholders’ goal of maximizing profits. Instead, non-owner managers might end up lavishly spending money and other resources in ways that directly benefits themselves, for example on perks, and living an expensive life. Surprisingly, some other managers may be tempted to spend firm’s money to accumulate personal wealth through frauds or theft (Randall, 2009).
Essentially, when a firm’s ownership is separate from its management, there is a likelihood of differences in goals between the two parties. The difference between the management’s goals and those of the owners is referred to as agency problem (Thomas & Shughart II, 2013). The main challenge of corporate governance is aligning the manager’s incentives to ensure they act in the interest of owners rather than working to achieve their goals.
However, past researches have led to the conclusion that the separation of a firm’s management and ownership is unfriendly to the foundation on which the economic protocol used over the past three decades was based on. Such separation is swiftly increasing, and it seems to be a foreseeable development in the modern corporate work (Dixon, Guariglia & Vijayakumaran, 2013). Various contemporary scholars have also maintained the same stance. However, it has been argued that this predicament lies in capitalism. Hence, the dilemma maintained that factors such as regulations, antitrust policies, tax incentives and political demands to implement antitakeover statutes have led to development of focused managers (Randall, 2009).
Conversely, recent research has indicated that there has been no significant increase in separation of management from ownership since 1930. As a matter of fact, ownership of public traded firms by management has significantly increased rather than decreasing. As opposed to the past, directors of a firm and officers have scooped a greater percentage of the company’s ownership, a situation that has made managers owners of big stakes in the firms (Dixon, Guariglia & Vijayakumaran, 2013).
Nevertheless, Managerial ownership is just one among the many devices that can help in ensuring alignment of the enticements of managers and owners. Firms adopt various internal control and incentive strategies to eradicate the agency problem. Apparently, incentives such as bonuses, ownership stakes, and stock options have been confirmed to binding factor between managers’ rewards and the firm’s performance (Tirole, 2010). With its power to hire and fire top executives, the independent board of directors can continuously monitor and punish managers. The incentive-alignment is particularly good for the firms that cannot be easily monitored by the outsiders.
Moreover, external market forces can be helpful in restraining agency costs. For example, in a competitive market, well-managed firms can kick out of business firms that are poorly managed. However, while market competition for the firm’s products is recommended, it may lag behind in trying to guarantee incentive configuration and protection of shareholders’ interests. The Market for Corporate control is another well-known market force whereby outsiders are free to take over mismanaged firms, thereby replacing the managers as well as the corporate governance system inherent in the firm. Although the threats inherent in taking over a firm necessitates an important monitoring on the management, it is not a sure way that the agency cost would be minimized, especially with the prevalent of laws and regulations that discourage takeover in markets. Consequently, the legal environment actively influences the disciplinary impact, both from internal incentive alignment and market forces strategies. Apparently, pitiable alignment between management’s incentives and firm owners increases the risks that shareholders face.
In a more precise way, Dixon, Guariglia, & Vijayakumaran (2013) pointed out that if the wealth of managers is tied in a non-diversifiable investment of human capital within the firm, there is a tendency that the managers would tend to risk-averse. On the other hand, shareholders are mainly risk-neutral since they can diversify their investment across different capital markets with the aim of spreading risks. Alternatively, according to the agency theory, managers would tend to enhance their short-term consumption and use corporate resources to build upon their personal utility, hence disadvantaging shareholders. As stated by Dixon, Guariglia, & Vijayakumaran (2013), managers will be reluctant to invest in risky opportunities. Consequently, their incentives to take risks will largely depend on the extent to which their interests are aligned to those of shareholders, to maximize share value.
Dixon, Guariglia, & Vijayakumaran (2013) stated that in such a situation where managers’ actions cannot be easily tracked, the contracting against choices of a managerial policy will be incomplete. Their suggestion to solve this problem is to offer to managers incentives that take the form of equity shares in the firm. This is considered one of the ways of solving the moral hazards problems faced by management. On the same note, other scholars argued that the holding of a firm’s common stock by managers serves to reduce problems attached to management’s incentives by motivating to make investment decisions that increase variance. Separate researchers offer evidence that holding of a firm’s equity shares by managers offer managers with an enticement to adopt riskier policies and invest heavily in R&D, a catalyst for an organization’s growth and business expansion. In a report by Dixon, Guariglia, & Vijayakumaran (2013) it was revealed that the degree of a firm’s efficiency positively correlates to the managers’ ownership in a firm.
On the contrary, according to Dixon, Guariglia, & Vijayakumaran (2013), if the wealth of managers is tied up in a firm, managers may act risk-aversely, giving up on those investments that can initiate growth within the organization. Tirole (2010) argued that managers may go for investment opportunities that are risk free, and forego risky investments that can contribute to organizational growth. The higher the personal gains, the more the management would tend to avoid risky projects.
Tirole (2010) asserted that monitoring by capital markets keeps a check on management conduct, especially if such monitoring is carried out by a large institutional investor, will restrain managerial control. Knowledge of management that their actions are being monitored induces them to involve in business undertakings that result into organizational growth rather than those investments that increase their personal gains.
However, managerial incentives to contribute to organizational growth go beyond solving the agency problem. As Tirole (2010) argues, professions such as consultants, psychologists, and personnel officers would definitely consider the economist’s portrayal of managerial incentives as shortsighted. In his view, other factors such as intrinsic motivation, corporate culture, trust, social responsibility, essence of self-esteem, and love for their job, also play an important role in motivating managers to work hard to improve their contribution to organizational growth.
As stated by Tirole (2010), managers and top executive receive remuneration in the form of salary, stock options, and bonus. A manager’s Salary is a fixed amount paid at the end of a specified period, either monthly or annually. Bonuses and stock options reimbursements constitute the incentive component of the monetary compensation that are said to be efficient in inducing managers to internalize the interests of shareholders. Stocks options are being highly used by firms in different parts of the world as management incentives to improve their contribution to organizational growth. According to Williams (2015), in the year 2011, as many as 30,000 various stock options were offered to managers in the United States. In his remarks, Williams (2015) noted that stocks options are currently offered not only to top executives within an organization but also to subordinates to motivate them to maximize shareholder value.
The underlying idea is that managers would work hard to increase the value of a company’s shares to make a profit out of the deal. In the process, shareholders also benefit from the high value of shares. The Stock option has been found to an effective incentive to encourage management to perform exceptionally and hence improve their contribution to organizational growth.
The stock-based incentives which constitute the major part of the incentive have been widely used in the United States to incentivize managers. A dramatic increase in equity-based pay, mainly stock options has been reported in Japan and Germany (Tirole, 2010). Stock-based incentives are considered capable of incentivizing managers to concentrate on maximizing share value (Tirole, 2010).
While there is an increased agreement in support of the link between pay and performance, it is also well known that performance measurement is not done perfectly. The plans of paying bonuses to managers are mainly based on accounting data that can be manipulated. Bonuses have been reported to be incentives of major frauds in the accounting realm (Randall, 2009), the case of Enron being a good example. It has been hypothesized that bonuses and stock options cannot substitute each other since their serve different objectives incentivizing management to improve an organization’s growth.
On one hand, a compensation package based on bonus serves as a managerial incentive to choose short term over long term. As a result, a manager would tend to swap long term and short term profits when conducting business. It has been reported that when bonuses are increased, managers are encouraged to increase an organization’s current profit. Contrary, an increase in stock option as a managerial compensation plan will encourage managers to be focused in achieving an organization’s long-term objectives Tirole (2010).
The stock options mode of managerial compensation may take the form of gain sharing, incentive plans designed to promote enhanced corporate culture participation and partnership. According to Williams (2010), Gainsharing has been reported to be highly efficient in helping managers achieve increased operational performance as well as nurturing a positive attitude at the place of work (Williams, 2015).
Financial rewards can be used in conjunction with the sanctions to promote management’s performance. In a review report by Organization for Economic Cooperation and Development, governments can utilize performance results to perk up organizational performance. By rewarding and punishing individuals responsible for management of government agencies. It is stated that more than 20% of the OECD countries, agency heads a negative pay when they fail to meet the performance targets of their organization. For example, in countries such as Korea, Denmark and the United Kingdom, an agency’s COE is partly determined by how the agency is successful in meeting its performance goals (Organization for Economic Cooperation and Development, 2009).
However, the issue of linking management’s performance to pay is complex. Considering the case of Irish, the prevailing system encourages performance improvement with sanctions tied to underperformance rather than rewards for food performance. Although organizational performance may not be directly related to management pay, it is used as a part of appraisal strategy with a capability to influence performance in an organization (Organization for Economic Cooperation and Development, 2009). As Organization for Economic Cooperation and Development argued, tying management’s performance to the organization’s objectives can help strengthen performance culture and create incentives for high performance. Managers’ performance incentives do not end with financial rewards. Increasing flexibility can serve as a direct incentive to managers to improve their contribution to organizational growth.