Corporate Governance and Executive Remuneration, Essay Example

Introduction

Rent seeking practices require that an organization or an individual in a high level of power seek to increase their own wealth without contributing to the enhancement of wealth at the system level. As a consequence, there are many theories as to whether the level of executive pay would reflect rent seeking by managers. Ultimately, there is no straight answer to this question. While rent seeking practices would help compensate for a low level of executive pay, it is unlikely that a highly paid executive would withdraw from the rent-seeking practice purely due to this increased wealth. Therefore, it is necessary to assess the financial conditions by which the level of executive pay would impact rent seeking practices.

According to current, research, executive pay has increased significantly in the years between 1993 and 2003. Researchers claim that the growth could be explained by either the arm’s length-bargaining model of executive compensation or the managerial-power model (Bebchuk & Grinstein, 2005). However, it is plausible to assume that rent seeking practices are an important component of this formula. Additional studies demonstrate that “director independence is associated with improved decisions with respect to some specific types of decisions”, including executive pay (Bebchuk & Weisbach, 2010). Thus, it is evident that many different variables, including financial conditions during specific time periods in history and the system of corporate governance utilized.

One variable that appears to play a role in the relationship between the level of executive pay and rent seeking practices appears to be the degree to which executives are provided with incentives for their work (Bebchuk & Fried, 2003). In addition, the use of compensation consultants to determine the pay of executives is an important aspect of this formula (Crystal, 1991). Executives use compensation consultants to justify their income in a manner that appears to be legitimate to individuals that keep track of an organization’s financial records. A third factor that impacts the use of rent seeking practices is the type of corporate governance system implemented within an institution (Denis & McConnell, 2003). Overall, it is necessary to gain an understanding of these three factors to determine whether the implementation of rent seeking practices is related to the level of executive income. Based on previous research, it appears that this is a complicated relationship that will require consideration of a variety of factors to reach a reasonable conclusion.

Executive Incentives and Compensation Arrangements

Bebchuk and Fried argue that rent seeking practices are likely to have an impact on the creation and implementation of compensation arrangements (2013). Because executives tend to wield power over their own payment, many company heads take action to alter the reported profitability of their organizations to turn an additional profit. Therefore, it is important to consider that executives are most likely to take advantage of rent seeking practices if they do not believe that providing themselves with a direct raise will be supported by shareholders. In most instances, shareholders are unconcerned with the profitability of the executives, provided that the company remains profitable. Thus, rent seeking practices directly contrast the interests of shareholders, but executives are unable to control their own income in a more direct manner.

According to a study conducted by Stacey R. Kole, a cross-sectional study of compensation arrangements demonstrates that “the terms of stock option and restricted stock plans, and the flexibility afforded the board of directions in negotiating with managers, vary systematically with the characteristics of the assets being managed” (Kole, 1997). It is important, therefore, to consider the relationship between the executive and the accounts being managed. All such factors contribute to the understanding of compensation arrangements both on the executive and employee level. Kole demonstrates that in many cases, the compensation arrangements made are independent of the profitability of the organization and the value of the company’s stock (1997). Therefore, it is important to consider that rent seeking practices may be incentivized in a manner that will allow executives to ensure that their salaries will continue on an upwards trend.

According to the federal government of the United States, “Risk-taking incentives provided by incentive compensation arrangements in the financial services industry were a contributing factor to the financial crisis that began in 2007” (Board of Governors of the Federal Reserve System, 2011). To prevent future financial problems, the Federal Reserve proposed guidance on financial compensation in 2009 in an attempt to limit these practices. However, while this code is currently in place, it serves as a form of recommendation rather than stringent requirements. As a consequence, it is not able to sufficiently resolve the problems that it intended to rectify. While risk-taking incentives provided by incentive compensation arrangements were not the pure cause of the 2007 financial crisis in the United States, it is an important factor that could have been more readily avoided compared to the other contributing causes. Therefore, while the federal government now has a more comprehensive understanding of the relationship between rent seeking practices by executives and the economic status of the nation, the country has little ability to prevent the financial practices from damaging the economic standing of the United States. It is therefore necessary for the government to determine more effective ways to regulate compensation arrangements.

In 2011, the U.S. Securities and Exchange Commissions proposed regulations that would require the disclosure of incentive-based compensation arrangements at financial institutions in the United States (U.S. Securities and Exchange Commissions, 2011). While these guidelines were constructed to implement several requirements, the most beneficial regulation states that the SEC will “Prohibit incentive-based compensation arrangements that encourage inappropriate risk-taking by providing excessive compensation or that could lead to material financial loss to the firm” (U.S. Securities and Exchange Commissions, 2011). However, it is important to consider that prior to the implementation of this code, it was generally expected that these practices should not occur. After the implementation of the code, the United States government is more clearly stating that this law should not be breached. While it is unlikely that the code itself will prevent these unethical business practices, the white collar law enforcement agencies will be able to convict individuals that breach this code with more clarity and using more severe punishment, typically in the form of associated fines.

The Use of Compensation Consultants

Typically, organizations in the United States make use of compensation consultants to ensure that executive salaries are decided as a consequence of fair practices. In essence, these individuals are expected to work as unbiased third party members to make decisions that reflect the balanced interests of executives, shareholders, and the organization as a whole (Bizjack et al., 2000). However, these individuals are typically considered to be directly supervised by the executive team. As a result, there is a clear conflict of interest between the two parties. Compensation consultants are therefore frequently used to help the executives justify the large salaries they earn (Hall, 1999). Based on this understanding, it is not important for executives with high level salaries to participate in the act of rent seeking because they are able to justify their income in a more ethical manner.

Jensen and Murphy demonstrated that CEOs are often paid independently of their performance rankings (1998). Therefore, if an executive wants a pay increase, it is likely that he or she will obtain it even if it contradicts the progress that the company has made within a fiscal year. This is an important understanding because it provides room for rent seeking practices to come into play. Since it would be believed a widely unpopular move for an executive’s salary to increase if the value of the company’s stock decreases, compensation consultants can be used to help the executive find ways to increase the salary without the public noticing to a significant extent. However, it is important to note that overall, CEO compensation is becoming worse over time (Jensen & Murphy, 1998). Compensation for executives compared to lower level employees was found to be more than ten times higher for executives who worked in the 1930s compared to executives who work today. This raises an important question as to why this is the case.

In this current economic climate, it is essential for executives to appeal to shareholders so people will continue to invest in their organization. Ultimately, this reflects the wealth of the company and allows it to look like it is performing well in the eyes of the public. Because of this effect, executives are unable to give themselves raises without earning concern from the shareholders. Therefore, a majority of executives forgo additional salary raises and instead compensate this lack of payment with bonuses and incentives (Jensen et al., 1990). Furthermore, rent seeking practices are not out of question. The compensation consultant can act as a counsellor to help guide the executive and determine what steps should be taken to acquire the most desirable income.

Ultimately, it can be said that compensation consultants are a tool that are used to sufficiently camouflage unpopular rent seeking practices that executives regularly engage in. For example, Hank Paulson was a Goldman Sachs executive who regularly dealt in rent seeking practices (Wray, 2013). During his time as an executive, he benefitted from a bailout by AIG. Overall, it can be said that the company was not profiting significantly due to rent seeking practices, but Paulson covered his trail by using compensation consultants and accountants to justify the budget and pay level expenses.

Type of Corporate Governance System

It is important to consider that individual organizational culture can contribute to executive benefits and whether or not their payment will be considered legitimate. Several studies suggest that the location of the organization will play a major role in the type of governance system that is implemented. In the United States in particular, a regulatory system is in place “that emphasizes the protection of shareholders and requires that each firm transparently disclose material information about its finances and its contracts” (Core et al., 2003). Therefore, it is reasonable that an executive would feel more pressured to utilize rent seeking practices in the United States than if the individual were in a different country. Since unethical business practices are commonplace among many executives in the country, it is not surprising that rent seeking practices would also be more common among this population as well.

According to current media outlets, this appears to be a major problem plaguing the United States. In particular, economists are worried that rent seeking executives are reducing the amount of innovation that their companies typically see, hindering the growth of these organizations in addition to economic growth overall (Wray, 2013). As a consequence, it seems apparent that executives in the United States would be willing to engage in these practices because there is little oversight. If the actions of high level company employees are not being regulated by a stringent corporate governance system, compensation consultants, or shareholders, it is reasonable that they will engage in whichever financial activities that they deem fit. Often, these actions will not be in the best interest of the organization as a whole.

Even in countries in which corporate governance codes are followed on the regular, it is important to consider that a major problem that organizations face is that the established codes are not often backed by science or research (Thomsen, 2007). Therefore, executives do not believe they need to follow these codes to a significant extent because essentially, the outcome of this governance system is unknown. Specifically, in the United Kingdom, the Cadbury Code was released in 1992, entitled Financial Aspects of Corporate Governance and published by the “Committee on the Financial Aspects of Corporate Governance” under the supervision of the chair, Adrian Cadbury. These codes were established to enable corporations to gain an understanding of how to resolve corporate governance risks and failures (The Committee on the Financial Aspects of Corporate Governance, 1992).

While these regulations were published, it is necessary to emphasize that they were simply regulations that should be followed to ensure that ethical and productive practice would occur. A publication by the National Computing Centre found that because no one individual has the ability to make decisions at the executive level, a majority of these governance recommendations will not be followed in practice (NCC, 2010). In addition, the Cadbury Code was drafted by several non-executives. Therefore, the information provided in these recommendations are not fully reflective of the needs of executives across the board. It would be reasonable to redraft such a document after recruiting the involvement of company executives to determine a corporate governance protocol that would prove to be maximally effective.

“Since the publication of the Cadbury Code (1992), there has been a rapid international diffusion of corporate governance codes containing recommendations on boards, executive pay, disclosure and investor relations” (Thomsen, 2007). The author of this study proposed that the reasons for the international diffusion of corporate governance codes and its associated consequences cannot be explained by market failures, but instead due to a desire to bargain with stakeholders, including investment banks, auditing firms, incumbent owners, managers and employees. This results in the implementation of rent seeking practices. The author also claims that the corporate governance codes that are currently in existence are designed in a manner that allows for these practices. When studies are conducted that compare these codes, most are found to be strikingly similar. Therefore, instead of regulating business practice, corporate governance codes have been contributed in a manner that promote rent seeking practices because these processes ensure profitability on the behalf of the executive. Furthermore, executives appears to have collaborated either directly or indirectly to determine which information should be contained within their corporate governance codes to allow these rent seeking practices to continue.

It is apparent that the corporate governance systems in place in the United States and the United Kingdom are not sufficient to ensure progress. It is also important to note that corporations in Asia are facing the same difficulty. A survey indicated that while Asian firms are considered to be well run, they do not experience the degree of profitability that is expected for their level of growth (Claessens & Fan, 2002). Therefore, it is important to consider that corporate governance as it pertains to rent seeking practices is an issue that most first world nations are currently experiencing and that it is reasonable to tackle these troubles as a world financial problem.

Conclusion

While it appears that executives have direct control over their own income, they must balance the income they report with income generated from rent seeking practices. Ultimately, a large profit for executives would not look favourable to shareholders, so it is important for these individuals to find additional ways to earn a profit. It appears that these practices are relatively independent of the level of income that these individuals own. There is a constant drive to earn more profit in spite of the levels earned and many executives believe that pursuing rent seeking opportunities is the most effective manner in which they could accomplish these goals. Furthermore, it appears that corporate governance policies are not adequately designed to control the rent seeking practices that executives engage in. Since this problem exists in the United States, the United Kingdom, and Asia, it is reasonable to assume that this is an issue shared by the first world. As a result, it is important for these regions to collaborate to determine how to improve the profitability of corporation in spite of these detrimental business practices.

It is important to consider that governments around the world have attempted to reduce the incidence of rent seeking practices among the executive members of corporations. However, it appears that the regulations put in place do not actively discourage unethical practices. Instead, if an executive level employee is imposed a fine for committing financial actions that breach these codes, they are more likely to conduct this same behaviour again, but in a manner that will allow them to accomplish their goal in a more secretive manner. Executives are typically caught engaging in rent seeking practices because they move too much money at once or do not adequately cover their steps. However, many executives employ the assistance of compensation consultants and other accountants to help them accomplish this. Therefore, they are aware that at the end of the day, they will break even in spite of their losses from fines and associated legal fees.

Due to the existing evidence, it does not appear that executives will engage in rent seeking practices based on their current level of pay. Since they have no oversight, they will engage in these practices independently of their earnings. Overall, rent seeking practices are detrimental to the economic well-being of the nation in which the corporation is based. Due to existing statistical information, high level executives received more base pay in the 1930s – 1950s proportionally to average worker income than they do today. Therefore, the pay of the executive is more likely to be tied to the economic standing of the nation; they are able to justify higher salaries if their company is profitable. However, since this is not the case of many corporations around the world today, executives are willing to engage in under the table transactions to earn the pay they think they deserve; this will always be the case independently of the starting salaries they receive. To put an end to rent seeking practices, it is therefore necessary to ensure a greater level of governmental and regulatory oversight. This is necessary to ensure that the economies of first world countries are not negatively impacted as a consequence of the behaviours of their executives. Since it does not appear that current regulations are effective to contribute to this cause, it is necessary for the governments from different industrialized countries to collaborate and establish an international code that would be mutually beneficial for all parties involved. In this manner, if it is shown that trade will be impacted by failure to comply with the codes and regulations that are established, the shareholders will become aware of the ethical problems that are occurring at their company and reform could reasonably occur.

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