Corporate Governance & Executive Compensation

Managers are agents of Shareholders. Often there is a lack of congruence in the objective of the shareholders (principals) and managers (agents). This leads to agency costs which represents a loss in the value of the firm. The aim of this course is to reduce such agency costs.

Divergence of Interest
Institutional imperative: divergence between the goals of shareholders and managers. Decision Mgmt ShHolders Performance CF Sh ROR Sources of Fin RE Debt Debt RE Equity Equity

Devices for Containing Agency Costs -Internal Devices.

Internal monitoring: Performance monitoring and responsibility accounting.Worker>Low Level Mgr> Middle Level Mgr>Top Level Mgr>Board of Directors. Incentive Compensation Contracts. To make interests more congruent, managerial compensation may be linked to shareholders returns. Stock Option, performance bonuses (sometimes) reduce agency costs.

External Devices.

Market for Corporate Control: when internal control do not work, the market for corporate control may act as a deterrent on managerial behavior that dissipates shareholder value. Also referred to as the takeover market, it is a market in which the right to control represented by a chunk of equity holding that is sufficient to wield control- is traded. Proponents of takeover argue that an active market for control is a good external disciplining device. Helps in rescuing hapless shareholders from the clutches of inept management.

Managerial Labour Market: Reputation and track record of a manager. Market can make a manager pay a price for self-serving behavior. However it is difficult to isolate the effect of managerial action from other influences which shape a firms performance.

Corporate Governance in Industrially Developed World

Anglo-american Model
Individual and Institutional Investors. Professional Managers who have negligible stake.Typical executive considers himself John Wayne (Seathji), wielding complete control. Myopic outlook of institutional investors builds pressure on management to report good earnings performance in the short run.

A small and growing number of investors are playing an active role in corporate governance. Tight disclosure norms, insider trading laws, stiff penalties for price manipulation. Active market for corporate control providing credible threat of take over.

German-Japanese Model
Banks and financial institutions have substantial stakes in the equity capital of the companies. They play an active role in the management of the firms. Disclosure norms are not too stringent. Checks on insider trading is not too high, impairing on the efficiency of the capital markets.

Corporate Governance in India

Management by chromosomes. Entrenched System In the public sector

Transient system with key players, viz, politicians, bureaucrats, and mangers taking a myopic view of things.

Reforming Corporate Governance

Strengthen the hands of Institutional Investors. Separate Management from Control

Management Initiation Implementation under Chairman

Control Ratification Monitoring Under MD

Expand the Role of Non-executive Directors. Limit the Size of the Board. Ensure that the board is Informationally well equipped. Link Managerial compensation to performance. Enhance Contestability. Cumulative Voting system Improve Corporate Accounting and Reporting Practices.

Goldman Sachs Group, Inc

Introduction:effective functioning of the Board and its committees, to promote the interests of stockholders, and to ensure a common set of expectations as to how the Board, its various committees, individual directors and management should perform their functions.

Assignment

Read the handout pay special attention to VI. The Committees of the Board

Legal Provisions v/s CII code

Companies Act 1956

Limited co must have at least 3 directors Board must meet at lease once in a quarter No person can be a director of more than 20 cos. BoD have power to a)borrow,lend,invest b)declare dividends c) Appoint MD Total remuneration of the directors is subject to a ceiling of 11% of net profits.Sitting fees subject to some limits. BOD has a duty to present the Annual Report to the members. BOD punishable for breach of trust, dishonesty and fraud.

CII Code

In an attempt to improve the quality of corporate governance, CII has suggested a code for its members.

Executive Compensation
Key elements of Executive compensation in India are salary, benefits and incentive compensation. Benefits include furnished accommodation, pension and gratuity benefits, chauffer driven car, medical reimbursement, club membership, LTA and so on. Incentive compensation is typically in the form of an annual bonus which is linked to performance measured commonly in terms of certain accounting numbers. Occasionally it is In the form of stock options or reward of shares.

Conflict of Interest
Excess perquisites hurt the interests of the shareholders. Differential risk attitudes: Sh holders are willing to accept more firm specific risks as they can wash them away through diversification in the capital market. Managers, on the other hand are not inclined to accept high firm- specific risks as they have greater concern about the security of their job and growth prospects with the firm. Varying time horizon s: Managers-short term results shareholders are interested in long term creation of value.

Failure of Executive Compensation Plans to Promote Value Creation. Linkage between size and pay. Emphasis on short term performance. Reliance on accounting measures which are poor proxies for value creation.

Designing an Incentive Compensation Plan

A well conceived incentive compensation plan goes a long way in aligning the interests of managers and shareholders.
Integrate the Incentive plan into the total compensation Architecture. Choose the Appropriate Level of Risk Posture and Time Focus. Use Objective criteria Select the right set of performance measures. Reward relative measures.

Discourage parochial behavior. Abandon attempts to measure what executives control. Lengthen the Decision making Horizon of the Executives. Employ Stock Options Judiciously. Ensure tax Efficiency.

ESOP

Eligibility
Not a promoter, not a director who holds more than 10% of the outstanding Equity Shares. Compensation committee consisting of a majority of independent directors, for advice and supervision of the ESO scheme. No ESOS unless shareholders pass a special resolution. Pricing Lock in period and rights of the option holder.