Chapter 9 Agency Conflicts and Corporate Governance

Learning Objectives
 Explain how overconfidence prevents corporate boards from putting compensation
systems in place that align the interests of managers and shareholders.
 Explain the role of prospect theory casino effects in aligning the interests of
shareholders and managers.
 Describe how aversion to a sure loss can interfere with the alignment of the interests
of investors and the interests of auditors engaged to provide opinions primarily about
firms’ financial statements, and relatedly firms’ internal controls.
 Analyze how, because of aversion to a sure loss and overconfidence, stock option–
based compensation can exacerbate agency conflicts.
Traditional Approach
Rational principals offer contracts to rational agents that combine positive rewards
and penalties, so called carrots and sticks, with three goals in mind.
1. Participation: offer the agent a contract that is attractive enough.
2. Incentive compatibility: Set the carrot-stick differential to induce the agent to
represent the interests of the principal.
3. Don’t overpay the agent.
Risk and Agency Conflicts
 In the traditional approach, incentive compatibility typically prevents managers from
diversifying away all the unique risk of their firms, especially career risk.
 Managers who bear such risk might react by behaving in too risk averse a
fashion, to the detriment of investors.
 In theory, managerial risk aversion can be countered by using stock options.
 Options reward managers for favorable outcomes, but do not penalize them for
unfavorable outcomes.
Paying for Performance in Practice
 Most influential academic studies on executive compensation conclude that CEO pay
varies far too little to be consistent with traditional theory.
 These studies, published in 1990, indicate that most corporate boards do not structure
salaries, bonuses, and stock options so as to provide either large rewards for superior
performance or large penalties for poor performance.
Carrot-Stick Differential
 Executive pay has featured too narrow a carrot-stick differential, resulting in low
variability in respect to corporate performance.
 The frequency with which CEOs are dismissed for poor results is low.
 Corporate stock options do not appear to play a major role in aligning the interests of
executives and investors.
 Some evidence points to the relative strength of shareholder rights as being key.
Low Variability
 For the median CEO in the 250 largest companies, a $1,000 change in corporate value
corresponded to a change of just 6.7 cents in salary and bonus over two years.
 A $1,000 change in corporate value corresponded to a change in CEO compensation
of just $2.59.
 Accounting for all monetary sources of CEO incentives—salary and bonus,
stock options, shares owned, and the changing likelihood of dismissal.
Changing Attitudes and Perceptions About Risk
 In this regard, the value of shares owned by the median CEO changed by 66 cents for
every $1,000 increase in corporate value.
 At the median, stock options added another 58 cents worth of incentives.
Stock Options
 Compensation consultants point out that during the 1990s CEO pay increased by
between 400 and 600%, mostly driven by the granting of stock options.
 At the beginning of the 1990s, for the typical company, the value of stock options was
approximately 5% of the value of stock outstanding, a figure which over the course of
10 years increased to 15%.
 Notably, by the end of the 1990s, stock options comprised approximately 98% of
executives’ long-term incentives.
Mixed Evidence
 There is mixed evidence about whether firms offering stock options to their
employees perform better than those that do not.
 A study suggests that executive and employee stock options do lead to increased firm
value, principally because they aid in employee retention and serve as a substitute for
cash compensation in cash-strapped firms.
 Less clear is whether stock options serve to align the incentives of executives and
employees with those of shareholders.
Pay Slice
 CEOs increased their proportion of overall executives’ compensation, and by 2010 the
average CEO’s “pay slice,” meaning their share of the total compensation paid to the
top five executives, was approximately 35%.
 Evidence suggests that higher values for CEO pay slice are detrimental to shareholder
interests.
Differing Views
 Some academics suggest that CEO compensation is excessive and reflects board
members exhibiting undue loyalty to CEOs.
 However, not all agree with this view.
 A study of executive compensation and governance in U.S. firms, which was
published in 2014, argued that average executive pay has been positively correlated
with firm performance and firm size.
From Mouths of Directors
 Overconfident directors underestimate the extent of both traditional agency conflicts,
and behavioral biases on the part of executives.
 Overconfident directors are inclined to think that they do a better job of addressing
agency conflicts than they actually do.
 Overconfident directors are prone to approve compensation that feature insufficient
pay for performance, and overpayment.
Stock Options and Psychology
 There are two important behavioral phenomena associated with stock options being
used to compensate employees, especially executives.
1. Excessively optimistic, overconfident employees overvalue the stock options they are
granted.
2. “Casino effect.”
They say, “You can fiddle with my bonus, but don’t cut out my options”--because they know
there’s the big casino waiting out there.
Risk Aversion and Impatience
 The behavioral approach distinguishes between mild versions and extreme versions of
psychological phenomena such as excessive optimism and overconfidence.
 Risk-averse managers who exhibit mild versions require less performance-based
compensation (eg stock options) to overcome their innate aversion to risk.
 However, managers with extreme versions prefer greater performance-based
compensation.
Impatience
 Executive stock options tend to have expiration times that are 10 years from the time
the options are first granted.
 Theoretically, all else being the same, executives who are very impatient will demand
a high return to defer gains.
 They are therefore much more likely to be compensated with a proportionately
smaller performance component in the form of stock or stock options or bonus.
Relative Incomes
 People are competitive creatures, who care where they place in social pecking orders.
 Survey evidence documenting levels of happiness find that for the most part, it is
relative income that determines happiness, not absolute income.
 Evidence suggests that how a firm’s employees view their own salaries depends to a
great extent on what they think other people in the firm are earning.
 Perceptions of relative position have large effects on morale, having to do with
feelings about status and respect.
Catering By Managing Earnings
  Managers appear to use heuristics involving a prioritized list of threshold reference
points, namely positive earnings, past reported earnings, and analysts’ expectations.
 Wherever possible, managers use discretionary items to meet or exceed the highest
possible threshold.
 Evidence indicates that firms in which the composition of CEOs’ compensation
feature a high proportion of stock and options are more likely than others to manage
earnings.
Auditing: Agency Conflicts
 Managers, as agents, release financial statements in order to report the financial
results of their firms to the owners.
 How do the principals monitor managers?
 The conventional way is to hire the services of a professional auditor.
 Auditors are vulnerable to being “bribed” by unscrupulous firms in order to issue
clean opinions.
 The traditional view holds that auditing firms have reputations to protect for their
integrity
Behavioral Pitfalls Box
 What behavioral phenomena come to mind as you read its contents?

Signaling
 A firm that seeks to communicate that its financial statements are clean might engage
the services of an auditor with a high reputation who also charges high fees.
 Signaling theory stipulates that firms who face accounting problems would not use
such an auditor.
 Therefore the choice of auditor in and of itself sends a strong signal to investors.
Reference Point Issues?
 Did 2X shift Andersen’s auditors from perceiving themselves to be in the domain of
gains to perceiving themselves to be in the domain of losses?
 Does attitude towards risk depend upon whether a person perceives him- or herself to
be in the domain of losses as opposed to the domain of gains?
Sarbanes-Oxley
  Since 2000, a succession of corporate scandals with varying degrees of fraud made
clear that compensation in the form of stock and stock options could not be counted
upon to align the interests of investors and managers.
 Among the firms involved in fraudulent activities were Coca-Cola, IBM, Sunbeam,
Cendant, Xerox, Lernout & Hauspie, Parmalat, Enron, WorldCom and Healthsouth.
 Under Sarbane-Oxley Act, SEC requires that the CEO and CFO of every publicly
traded firm certify, under oath, the veracity of their firm’s financial statements.
SOX and the Board
 Sarbanes-Oxley increased the number of independent directors on corporate boards.
 Independent directors neither work for nor do business with a corporation or
its executives.
 Board audit committees are required to include at least one financial expert.
 Every quarter, after the CEO and CFO have certified the firm’s financial statements,
the full panel must review those statements.
Behavioral Pitfalls Box
 What behavioral phenomena come to mind as you read its contents?

HealthSouth
 HealthSouth was founded in 1984.
 At year-end 2001, HealthSouth was the largest U.S. provider of outpatient surgery,
diagnostic imaging and rehabilitation services.
 In 2002 HealthSouth was investigated for an accounting fraud that prosecutors
suspect began as early as 1986.
Overstated Income and Insider Trading
 Between 1999 and the second quarter of 2002, HealthSouth overstated its income by
$1.4 billion.
 The SEC accused HealthSouth executives of having engaged in insider trading by
selling substantial amounts of HealthSouth stock while they knew that the firm’s
financial statements grossly misstated its earnings and assets.
 As part of their compensation, HealthSouth’s executives received options on 3.6
million shares of HealthSouth stock.
Richard Scrushy
 HealthSouth’s founder and CEO was Richard Scrushy.
 Specifically, the SEC alleged that Scrushy induced HealthSouth executives to
manipulate the firm’s stock price until he could sell off large blocks of stock worth
$25 million.
 The SEC claimed that since 1991 Scrushy sold “at least 13.8 million shares for
proceeds in excess of $170 million.”
Ernst & Young
 HealthSouth’s auditor was a top tier accounting firm, E&Y.
 HealthSouth appears to have engaged in numerous practices that were intended to
deceive their auditors.
 In 2001 HealthSouth paid Ernst & Young $1.16 million in auditing fees.
 It also paid an additional $2.39 million in “audit-related fees” for what HealthSouth
called “pristine audits.”
Stock Price Driven by Financials
 A comparison of the two graphs suggests that Healthsouth’s stock price was largely
driven by its reported financials.
Ethics and Cheating
 Incidents of student cheating have increased over time.
 Students even cheat in courses about ethics.
 Students are the executives of the future.
 Two-thirds of young males and half of young women believe that “in the real world,
successful people do what they have to do to win, even if others consider it cheating.”
Self-Image
 Although some people are simply unethical at their core, most people like to view
themselves as good and decent.
 Most people who cheat do not think of themselves as “cheaters,” and instead deal
with cognitive dissonance by limiting the degree to which they cheat.
 How to overcome (nudge)? Ask people to reflect on how being caught would
embarrass their loved ones, lead them to lose social standing, and damage their
careers.
Summary
 Incentive-based compensation lies at the heart of good corporate governance.
 In practice, executive compensation displays too little variability in respect to pay for
performance, insufficient dismissal, and excessive payment for executives.
 Managers who behave in accordance with prospect theory might find the risk
characteristics of stock options attractive because of its casino effect.
 The combination of aspiration-based risk taking and overconfidence can also induce
ambitious, unethical managers to manipulate accounting information in order to
exercise their stock options when the stock is overpriced.