Due to the problems, which arise from the Agency Theory, it leads to the creation of the executive incentive mechanism. Executive incentives are incentives offered by business in order to reward and retain their most productive workforce. This is can be defined as: "an executive incentive has been regarded as an internal mechanism to alleviate the agency problems between executives and shareholders" (Meyer et al, 2000) Due to the levels of competition, businesses are being forced to offer more lucrative incentives. Incentives result in an increase in market efficiency, as they result, more sales.
There is usually the idea that 'who works receives the appreciation and who does not work, lacks behind'. As a result of this public attention is attracted because of the bias involved. This has in turn lead to the rise in the number of financial scandals. The most notable was the collapse of Enron, an American energy company. Only months before it collapse it was regarded as one of the most innovative, best-managed businesses in America. Enron's reported growth from under $10 billion to $101 billiion in 2000 was seen as outstanding success. There were many causes of the collapse.
Although the major cause was the lack of attention shown by the shareholders of the business and the lack of truthfulness from its managers. Therefore with Enron being regarded as a success they had to cover up its failures. As a result shareholders lost $74 billion due to the amounts that it owed in liabilities. Due to the financial implications that it had on America's economy, several meeting were held to discuss the issue. This lead to the formation of the Sarbanes- Oxley Act in 2002. The Act is said to be a point for point explanation into the company's perceived failings.
It introduced mandatory provisions to enhance corporate governance mechanise so fraud can be easily detected. Before the Act, auditing firms undertook in financial transactions with the business, although that has since been eliminated. Previously it was held as a mode of good faith and loyalty to have the shareholders interest in high regard, although the Act now requires senior officers to check the accuracy of financial statements. The Act also requires that any conflict of interest be disclosed in order to limit the risk of bias.
Another regulation that was brought about after the collapse of Enron, was the New York Stock exchange proposal where it was announced the all firms must have a majority of independent directors and in addition to regular meeting, the board of directors should have sessions without the management. This resulted in a number of benefits in governance controls. The main benefit is that instead of suggesting laws, they can enforce them. This in turn minimises financial loopholes available to fraudsters. Another benefit is that they maintain confidence within the financial market.
This is due to the fact the it has become mandatory to question management, therefore shareholders can pay closer attention to what's happening, therefore all parties involved will be safe. Evaluation There are many types of incentives in place that executives of business can be remunerated with. Especially due to enormous financial pressures being faced by businesses, they now have to work harder to retain their executives. Although, not all executives are motivated solely by compensation packages, it plays are major role in business.
Many of the top business executives receive their salary plus cash bonuses. These can be In the form of both short term and long tem bonuses. Usually bonuses which are seen to be performance related are said to be short term because its directly related to output, i. e. executives will receive cash bonuses related to the performance of the firm over the past year. There are occasions where they are awarded share bonuses where they will be subject to invest, representing longer periods usually more than 1 year. This has both its advantages, as well as disadvantages.
The main advantage is that it motivates employees, therefore as a result increasing productivity. Most importantly shareholding wealth is increased, therefore minimising the effects of the agent-principal problem. This was further investigated by Mathis and Jackson: "Organizations may establish variable pay plans for teams or groups to improve productivity, tie pay to team performance, improve customer service or production quality, and increase employee retention" (Mathis and Jackson, 2000) Although on the other hand, it has disadvantages, which are tax related.
Due to its inclusion within the executive compensation package, any bonuses earned will be taxed like their income. Therefore arises the problem of striking a bonus which is reasonable for both parties. Another incentive which is often used is the Stock Option. They are contracts that allow executives to buy certain number of stock at a price which is fixed, later on in the future. The main benefit of this type of incentive is that it allows company's to share ownership with its employees. Therefore resulting in the agent-principle relationship to improve because of the minimisation in conflicts of interest.
This has been further enforced by the introduction of the Hampel Report 1998 which was a follow on from the Cadbury and Greenbury Reports: " … We would wish to see the balance corrected. Public companies are now among the most accountable organisations in society… But the emphasis on accountability has tended to obscure a board's first responsibility- to enhance the prosperity of the business over time. " (Hampel Report, 1998) The Hampel Report clearly needed to redress the balance which was apparent between parties, shareholders and managers.
As a result it has set benchmark for corporate governance in the U. K. ( Solomon, 2007) Another benefit which it has over bonuses is that there is no charge on earnings, therefore allowing executive higher earning potentials. Stock options also help align the interest of shareholders and managers. Although in the case of Disney this did not prove effective. Micheal Eisner, CEO of Disney was given stock options worth $100million. He then earned substantial value, were the stock price more than doubled. Micheal Eisner benefitted greatly from this. As a result Disney's profits plummeted.
In 2001 they lost more than a $150million. However, as we know in economic theory, stock prices can fall as well as rise. Therefore if this was to happen, it can lead to a fall in levels of motivation for employers. Therefore as a result conflicts will arise between the two parties, making it difficult for governance controls to be implemented. Another major disadvantage is the possible overstatement of a companies operating income. This is because of the fact that companies can claim for tax which is not included in their income figures. This was evident in The Barings Case 1995.
This case involved a young trader, Nick Leeson, who destroyed a company by losing more than $1 billion. He decided to gamble on the stock market, although he was not using his own funds. As a result he made major losses in the company's balances, although this was covered up by speculative profits. The clearly highlighted the lack of control in banking monitoring principles. There was also a lack of supervision present by senior management and inefficiencies in auditing controls. As a result the Turnbull committee published a report in 1999 enforcing these issues.
( Turnbull Report 1999) Pension schemes have recently started to become popular due to the financial uncertainty being faced by many businesses. Although pension schemes help with the retaining of employees and aiding in motivation. Its also has major links to the cause of fraud. This was evident from the Maxwell Affair in 1991. Robert Maxwell abused his power by stealing more than 727 million from the company's pension fund. As a result the company took on too much debt to survive. This was due to the lack of monitoring by the board in regards to Maxwell's financial dealings.
The Department of Trade & Industry concluded that ' notwithstanding Mr. Maxwell's acknowledged abilities and energy, he is not in our opinion a person that can be relied on to exercise proper stewardship of a publicly quoted company'. This lead to the sharpening up in the companies functions by the introduction of the Smith and Higgs Report, 2003. They both aimed to improve the role and effectiveness of company controls. Another incentive used is the Golden Parachute. Which is an agreement between a company and employee to receive certain benefits after employment is terminated.
This usually makes it easier for a company to hire and retain executives, especially in industries prone to mergers. Therefore executive will remain objective to company aims throughout its term. Although as we know, dismissal is risk with any business, therefore if this was to happen, executives are already well compensated. Therefore making the use of other incentives less applicable. Recommendations From the previous sections we can see that all mechanisms have their benefits, as well as its limitations.
In order to examine the efficiency of incentives we have to take into account two issues. Whether there is a positive relation between a firm's performance and executive pay? (ex post evidence). Whether those firms that imposed these mechanisms subsequently experienced superior performance? ( ex ante performance) In order to answer these questions we have to be able to analyse the relationship between incentives and the firm's performance. Cheffins, 2003 argues that 'a strong relationship between pay and performance could reduce the cots associated with shareholder monitoring' .
Therefore as result it will not put off shareholders to implement control measures, due to agency costs not being affected as much. Although a negative association was found between remuneration and corporate operating and share price performance. ( Core at al, 1999) Due to this in my opinion there could be possible solutions in order to improve its effectiveness. I would recommend that tighter regulations are put in place to reduce the uncertainty and loop holes which are evident in the market.
This could either be in the form of a reduction in the amount of options executive receive, resulting in an overall reduction in their total compensation. Another option that can be exercised is the maximum wage barrier that will limit the chance of fraud within the business. As a result perks and incentives will not be taken advantage of, and shareholder interest will be held in high regard. Conclusion The key points that I understood from carrying out reasearch for the coursework was that Corporate Governance needed to be discussed broadly due its vast number of definitions.
Although we concluded that its made up of processes for supervision for a business. I also realised that there are a number of frameworks in place , each enabling the discussion and analysis of Corporate Governance. We also highlighted the extent to which they overlap. I found out that mechanisms cannot prevent unethical trading within businesses but it can at least help detect this behaviour. All in all, cooperate governance has a sound base but there is always room for improvement.