Question

The Chief Executive Officer (CEO) is a top corporate manager whose primary job is to lead the day-to-day running of the corporation and whose primary goal is to maximize shareholder value. To incentivize CEOs, many large corporations have been compensating CEOs with various forms of pay-for-performance in addition to a fixed annual salary. According to some estimates, over the last two decades CEO compensation in the United States has on average increased by 600%, with a disproportionate increase in equity-based compensation (e.g. stock options). These increases in executive compensation, particularly stock options, have generated enormous controversy. The recent high-profile corporate scandals and financial market tsunami have led some observers to argue that the excessive focus on shareholder value maximization in general, and inadequately designed executive compensation in particular, have led to managerial gross misbehavior as well as short-termism. Some argue that rapid increases in executive compensation represent unmerited transfers of shareholder wealth to top executives with limited if any incentive effects, and at times have led to outright frauds. The problem is exacerbated when the CEO is also the chairman of the board of directors. The adverse effects of excessive CEO compensation are particularly severe in countries where institutional checks such as shareholder protection and shareholder activism are weak.

Required：

Identify any potential conflicts of interest and suggest possible solutions.

Answer 1

Potential Conflicts of Interest

The following are the reasons for a potential conflict of interest when the CEO's pay includes a high proportion of stock options :

1. CEO grows with the company

Advantage

When shares go up in value, executives can make a fortune from options.

Disadvantage

When share prices fall, investors lose out while executives are no worse off.

2. The interest of shareholder and the CEO aligned :

Advantage

The CEO will be motivated to focus more on; his work, given there is a direct correlation between his pay at the company and the stock price.

Disadvantage

The incentive to keep share price high the CEO. will be encouraged to focus exclusively on the next quarter and ignore shareholders' longer-term interests

3. Cash Availability

Advantage

Higher cash availability/cash richness since most of the CEO compensation is associated with stock options.

Disadvantage

Less cash availability in case the CEOs is paid higher amounts in cash. The company would need to generate cash for day to day operations.

Is the 600% increase justified?

• Higher instances of the wage gap between top executives and workers will lead to distress and labor strikes.
• Impact on the overall economy given that a few individuals will make money rather than consumers having more to spend increasing income inequality.

Possible Solutions

1. Giving stock ownership instead of stock options.

2. Salaries, bonuses and stock options can be structured to highly incentivize for good performance and penalize for poor performance.

3. The threat of sacking or dismissing in case of poor performance.

4. Increase with respect to pay for performance and not