Ethics of Executive Compensation Abstract Executive compensation has been a target for criticism by stakeholders and academics over the past several years. Corporate executives have been receiving immense compensation packages specifically in the form of stock options. The purpose of the incentives is to align the goals of executives and stakeholders. Although theory encourages desirable behaviour, many a time executives take advantage of their governing position and engage in fraudulent activity to increase personal wealth at the expense of the corporations’ shareholders.
This paper will analyze the ethics behind executive compensation. The first section provides an explanation as to why compensation has reached such high levels, followed by a discussion of possible prevailing ethical viewpoints embraced by corporate executives, and how these view points set the stage for unethical conduct with respect to compensation. The subsequent section provides an analysis of three empirical studies that attempted to find a correlation between executives’ incentives and corporate social responsibility. Lastly, proposed solutions to these problems are presented along with concluding thoughts.
Current Compensation Levels Executive compensation has risen dramatically in past decade. In a survey conducted by Business Week, excluding stock options, executives received a 39% increase in compensation in 1996 while the salary of the average worker increased by only 3% (Nichols & Subramaniam, 2001). In another study of the compensation levels for S&P 500 firms, Bebchuk & Grinstein (2005) discovered that CEO compensation increased a dramatic 146% for the period of 1993-2003. In addition, the compensation levels of the top...
five executives of S&P 500 firms increased 125% in the same period.
These increases are difficult to comprehend considering profits and stock prices of the S&P 500 only increased by 11% and 23% respectively (Nichols & Subramaniam, 2001). Although the increase in market value created an environment for increasing compensation without much criticism from outsiders, are these levels justifiable? Academics have studied compensation policies of numerous firms in search of an answer. The economic principle of supply and demand offers an explanation of the compensation market equilibrium. A job has economic value to the employer that created the position.
The price to fill the position is determined by the forces of supply and demand (Perel, 2003). As with all other commodities, when the demand for a particular service increases, the price rises. If the supply of the commodity increases, the value of the service declines due to the abundance and competitive pricing. The position of an executive is not one that can be easily filled as it requires a certain degree of skill, experience, and knowledge of the industry resulting in a low level of supply. The latter half of the 1990’s brought with it the internet bubble, an era of internet based services which was deemed to be the new economy.
During this period, executives of public companies were being drawn to new technologies and start up companies, creating an imbalance in supply and demand (Bebchuk & Grinstein, 2005). As demand for executives began to rise, firms increased their compensation packages in an attempt to keep talent within their firm. Although the internet bubble burst, the compensation 2 increases made the executive population financially
secure. This increased wealth has escalated the reservation price of executives, specifically the older generation.
As a result firms have to offer more in order to induce these individuals to work (Bebchuk & Grinstein, 2005). In the last decade, long term compensation packages including stock options have accounted for the majority of compensation increases (Bebchuk & Grinstein, 2005). Equity based compensation packages of the early 1990’s were low in comparison to other incentives. In theory, equity based compensation will align the goals of the executives and shareholders. Executives will receive the greatest payoff if the value of the firm increases over time.
Therefore by rewarding executives based on future firm value, the goals of executives and shareholders would be placed on the same path. Institutional investors have large ownerships in publicly traded companies and many a times act as advocates for shareholder interests by negotiating with management, publicly addressing corporations in the media, and by presenting shareholder proposals at the annual shareholder meetings (Matsumura & Shin, 2005). Institutional investor acceptance of the goal alignment theory resulted in equity based compensation to become widely ccepted in the late 1990s, however the costs shareholders would bear as a result were not considered, nor were salary levels decreased. In the perspective of board members these compensation plans involved no initial cash outflow, and the option value did not have to be expensed resulting in a greater reported income (Bebchuk & Grinstein, 2005). In an attempt to correct for this “costless” compensation illusion, the Financial Accounting Standards Board (FASB) proposed that the compensation expense recorded on the company’s income statement include the market value of the stock option presented to executives.
However due to the outcry received from the accounting profession, business community, and congress, the FASB withdrew their proposal (Nichols & Subramaniam, 2001). Recently, the Securities Exchange Commission (SEC) made amendments to the disclosure requirements pertaining to executive compensation. The new rules require public companies to disclose the compensation packages of their top five executives in notes to financial statements (SEC, 2006). The expectation of this amendment was that the disclosure of such sensitive information would instill a compensation policy that was morally and ethically sound.
The increased disclosure would benefit the firm by improving corporate governance, and by decreasing informational asymmetry between investors and executives, ultimately resulting in a lower cost of capital (Matsumura & Shin, 2005). On the other hand, disclosure of compensation may result in a “beauty contest” between firms (Matsumura & Shin, 2005). Companies might participate in the executive compensation version of an “arms race” as each firm strives to offer their executives top dollars. By developing a reputation for high level of pay, firms will attract the largest pool of talent to their organization.
The reputation of a CEO based on past performance directly correlates to compensation (Perel, 2003). For example, before his downfall, Al Dunlap, also know as “Chainsaw Al” had the reputation of bringing a company in financial distress back on its feet, by making drastic changes in the company including massive layoffs, discontinuation of operations, and corporate restructuring. History shows that when Chainsaw Al was announced the CEO of a
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