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.

Discuss what the relative strengths and weakness of the corporate governance system are. What respective roles can lawmakers, board of directors, top managers, shareholders, financial intermediaries and the financial media play to ensure a well-functioning financial market? Identify any potential conflicts of interest and suggest possible solutions.

Answer 1

A CEO who is also the chairman of the board of directors can influence voting in favor of matters which might be in the personal interest of the CEO but not in the personal interest of the corporation. Take for instance the banking industry. To rapidly grow the bottom line of the P&L and the asset side of the B/S, the CEO might pass large ticket loans, to riskier organizations or enter into derivative transactions not suitable for the bank. By showing higher net profit growth in short term, the CEO might ask for high salary compensation & ESOPs. The CEO is on the board can also subdue the risk committee of the board to vote in favor of the CEO's plans. Such a short term & personal motive can cause long term asset quality problems in the banks and might even raise solvency concerns. Hence the board of directors must play a very independent role in the appraisal of the decisions being made by the CEO.

Lawmakers can ensure that proper reporting & scrutiny of the financials of the organization is being done. They can ensure that the board has independent members who are not just proxy signatories. They must have a good understanding of the business & must have an ethical track record. Lawmakers must also ensure that the members of the board are not related parties.

Shareholders can play a very vital role by actively participating in the voting process of the company. Small shareholders must form a representative body to make a combined vote of large proportion.

Financial media must maintain its autonomy & not just be a paid promotion advertisers by the management of the company.