978-1259278211 Chapter 9 Solution Manual Part 3

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3. Managerial Rewards and Incentives

From a corporate governance perspective, one of the most critical roles of the board of

directors is to create incentives that align the interests of the CEO and top executives with the

However, CEO pay appears to be somewhat out of control, with CEO pay escalating over

time and with the average CEO pay in S&P 500 firms being 330 times the pay of an average

 Extra Example: Copy Cat Compensation Policies Lead to Pay Inflation

David Larcker, who directs Stanford University’s corporate governance program, says companies can measure

performance one of three ways: by stock price gains (with or without dividends added), by accounting measures

(like profit gains) and by non-financial indexes like customer satisfaction and employee turnover. “A company ought

to pick performance indicators for bonus schemes that are consistent with its corporate strategy,” Larcker says.

Although corporate governance pundits have been parroting such truisms for years, there is little evidence that major

corporations actually use such guidelines. Rather than pay for performance, 86 percent of S&P 500 companies

consider what groups of peer corporations pay their bosses. GM’s board was not dissuaded merely by a plunging

stock price from paying Wagoner millions and instead based his pay in part on how much IBM, Altria and other,

mostly more successful, firms paid their bosses.

The result is a Lake Wobegon effect: everyone struggling to be paid above average. The result of peer comparisons

is that chief executive pay grew from 40 times average worker pay in 1980 to 330 times in 2013. Finally the recent

recession took pay down, but only a little. Median pay in 2008 fell 10 percent from the year before among 148 large

corporations, but this drop was a lot less than the 37 percent drop in stock prices (and shareholder wealth) for firms

in the S&P 500.

Source: Lambert, E. 2009. The right way to pay. Forbes, May 11: 78–80.

Discussion Question 38: It could be argued that since top corporations have to compete

for top talent, it is okay to, in essence, “out-bid” the competition by offering larger

compensation packages to attract the best talent. Do you agree? Why or why not?

There must be an effective combination of three basic policies to create the right financial

incentives for CEOs to maximize the value of their companies:

1. Boards can require that the CEOs become substantial owners of company stock.

2. Salaries, bonuses, and stock options can be structured so as to provide rewards for

The SUPPLEMENT below points out that executive compensation, which is supposed to

align the interests of stockholders and managers, can lead to managers to pay too much attention

to short-term performance.

 Extra Example: Bonuses and Stock Grants Can Lead to a Short-Term Focus

Commentators regularly lament the short-term focus of managers of corporations. This problem is often attributed to

activist investors pushing for quick performance improvements and day traders punishing firms for momentary

missteps, but the empirical evidence indicates that activist investors have a longer-term focus and that day traders

have little influence on the strategic actions of firms.

So, what leads managers to take such a short-term focus? It may be the structure of top managers’ compensation.

Firms often grant top executives’ bonuses based on a single years’ performance. With this timeframe, it is not

surprising that top executives manage the firm to perform well in the short term. Options they grant typically vest in

three years and are instantly exercisable by managers. Thus, managers have an incentive to goose up the firm’s stock

price as much as possible right around the options’ vesting date, at which point they quickly cash out.

What are possible solutions? It may be as simple as using three- to five-year windows of performance for bonuses.

Additionally, rather than allowing managers to immediately cash out their options, firms could require managers to

hold a proportion of their vested stock options for an additional three to five years before selling them to generate a

longer-term perspective.

Source: Pozen, R. 2014. The Misdirected War on Corporate Short-Termism. wsj.com. May 19: np.

We address some figures on the tremendous pay packages that top executives of publicly-

owned corporations have earned in recent years.

Teaching Tip: You can spur a lot of debate by asking if the amount of executive pay in

recent years has become excessive. Some students will claim that it helps to attract top

talent and that, if tied to corporate performance, any level is justified. Others may feel

Much of the wealth that CEOs and other top executives have created for themselves is

Discussion Question 39: What resistance do you foresee to the implementation of some

of the actions recommended in this exhibit?

Discussion Question 40: Would requiring executives to invest a year’s salary in the

company turn away potentially good candidates, and thus limit the company’s options for

top leaders?

C. CEO Duality: Is it Good or Bad?

Duality, where one person is both CEO and Chairman of the Board of Directors, is one of

There has been a great deal of pressure to separate these roles, and a number of firms did

so in response to pressure they received in recent years. We discuss research suggesting that the

Discussion Question 41: Under what conditions is duality advisable? Why?

D. External Governance Control Mechanisms

Thus far, our discussion has been on internal governance mechanisms. However, internal

controls do not always ensure good governance. The separation of ownership and control that is

1. The Market for Corporate Control

If a company’s internal control mechanisms are failing—that is, the board is not

effectively monitoring managers and shareholders are largely indifferent, there is a strong

likelihood that managers will behave opportunistically. Such behavior can take many forms,

The market for corporate control is one external mechanism that provides a potential

solution to the problems above. Rather than “fight,” shareholders will eventually sell their shares,

The first thing a “successful” corporate raider may do upon gaining control of the

corporation is to fire the management and replace it with its own appointed leaders. The risk of

In recent years, the threat of the takeover constraint has become less effective as the

2. Auditors

Despite stringent disclosure requirements, there is no guarantee that the information

disclosed by a firm will be accurate. Managers may purposely disclose false information or

However, these audits often fail to catch accounting problems. A recent study found that

big accounting firms were deficient in their audits of 20 to 45 percent of audits they conducted.

3. Banks and Analysts

Financial institutions and stock analysts are two external groups that monitor publicly-

held firms. Commercial and investment banks have a vested interest because they lend money to

In practice, analyst recommendations have been more optimistic than warranted by the

facts. “Sell” recommendations are very infrequent, in part, because most analysts work for firms

4. Regulatory Bodies

All corporations are subject to some regulation by the government and the extent of

regulation is largely a function of the industry within which they compete. Industries such as

banks, utilities, and pharmaceuticals are subject to more regulatory oversight because of their

The failure of a variety of external control mechanisms led the U.S. Congress to pass the

Sarbanes-Oxley Act in 2002. This act calls for stringent measures to ensure better governance of

Although the financial regulation of corporations by the Securities and Exchange

Commission and the Internal Revenue Service are often the most visible government regulators,

 Extra Example: The NLRB Takes on Boeing’s Expansion

For years, Boeing has had a contentious relationship with unions at its main production facilities in the state of

Washington. When Boeing faced growing demand for its planes, and it needed to expand its operations, it decided to

open a new plant in South Carolina. Boeing hoped it would have better relationships with workers in North

Carolina, which tends to have weaker unions and more favorable labor rates than Washington.

Even though Boeing did not plan to cut any jobs to its unionized workforce in Washington, the National Labor

Relations Board (NLRB), the federal agency that regulates labor and union rules, charged Boeing with retaliating

against its unionized workers in Washington by opening the new plant in South Carolina. The NLRB threatened to

block the opening of the South Carolina plant. The NLRB pressed its case for months, but it dropped the case after

the International Association of Machinists (IAM), the main union in its Washington plants, asked the NLRB to drop

the case. Why did the union ask the NLRB to drop the case? It only did so after Boeing guaranteed that a new plane,

the 737 Max, would be manufactured in Washington and offered the unionized workers raises and bonuses.

Critics have looked at this deal and concluded that the NLRB acted not as an independent, neutral regulator but,

instead, as an agent for the IAM, insuring that the union was able to squeeze Boeing to offer it a sweetened union

contract. Others have argued that the NLRB was only acting to ensure that Boeing didn’t harm its unionized workers

in Washington by moving production to South Carolina.

Source: Anonymous. 2011. Boeing bullied. The Economist. December 17: 115.

Such a highly partisan perspective should generate some spirited discussion. Ask:

Discussion Question 42: Do you think the NLRB acted fairly in this case?

Discussion Question 43: How should Boeing have handled this situation?

5. Media and Public Activists

Although the press is not typically recognized as an external control mechanism in the

corporate governance literature, it would be hard not to argue that the financial press and media

play an important role in monitoring the management of public corporations. In the United

Consumer groups and activists can also play a very visible role by crusading against what

they perceive as corporate malfeasance. We briefly describe a few of Ralph Nader’s 30 watchdog

Discussion Question 44: Do you feel that Ralph Nader’s groups constitute an effective

external governance mechanism for corporations? Why? Why not?

The SUPPLEMENT below points out how a CEO can be viewed by outsiders, depending

 Extra Example: CEO Friend or Foe to the Environment?

Cypress Semiconductor CEO T.J. Rodgers certainly would qualify as a black hat to many. No friend of

environmentalists and others who disagree with his libertarian reflexes, Rodgers is as outspoken as he is blunt. For

example, Rodgers was seated between representatives from Environmental Defense and the Competitive Enterprise

Institute at a 2008 panel discussion on climate change. Likening their remarks to “two loudspeakers screaming

political slogans,” he said, in his typical manner, that he “almost would rather have been waterboarded.”

In 1996, Rodgers first gained a degree of notoriety with the socially and environmentally oriented community when

he replied to a letter from Sister Doris Gormley, a Philadelphia nun. Sister Doris expressed disappointment in the

makeup of Cypress’s board of directors, which included no women or minority members. “Get down from your high

horse,” Rodgers urged in his blistering 2,800-word letter of refutation, labeling Sister Doris’s requirements

“immoral.” He argued that he would be happy to add a woman or minority to his board—so long as they brought the

requisite talent for the job. Lost in the biting tone of the letter were the great many positives at Cypress identified by

Rodgers, from premium salaries to excellent benefits to an award-winning charity program. The letter was quickly

publicized, leading to charges that Rodgers had stooped to “nun-bashing.”

Given the ill will that this episode left behind, it is ironic that Rodgers’s SunPower is now busy manufacturing solar

cells that reduce carbon emissions and support energy independence. In the days of cheap oil, SunPower was down

to its last watt when Rodgers joined and invested in the company. His investment was part of the solution that kept

the operations going trough the thin years, until demand picked up for the company’s improving solar cells.

Source: Russo, M.V. 2010. Companies on a mission. Entrepreneurial strategies for growing sustainably,

responsibly, and profitably. Stanford, California: Stanford University Press.

Discussion Question 45: Should we celebrate T.J. Rodgers’s solar energy success story

or second-guess his business methods? Should the focus be on the CEOs’ results or on

the way they achieve them?

E. Corporate Governance: An International Perspective

In this section, we recognize that corporate governance differs among countries and

regions of the world. In the United States and the United Kingdom, corporate governance has

Such a perspective, however, seldom applies outside of the United States and United

Kingdom. This is particularly true in emerging economies and continental Europe where there is

often:

concentrated ownership

extensive family ownership and control

Thus, serious conflicts often exist between two classes of shareholders: controlling shareholders

EXHIBITS 9.8 and 9.9 address how principal-principal conflicts differ.

There must be three conditions for PP conflicts to occur. These are:

a dominant owner or group of owners who have interests that are distinct from the

a motivation for the controlling shareholders to exercise their dominant positions to

few formal (i.e., legislation or regulatory bodies) or informal constraints that

The result is that family managers, who represent (or actually are) the controlling shareholders,

Another ubiquitous feature of corporate life outside the United States and Great Britain

are business groups such as the keiretsus of Japan and the chaebols of South Korea. These are

particularly dominant in emerging economies. A business group is “a set of firms which, though

legally independent, are bound together by a constellation of formal and informal ties and are

The SUPPLEMENT below addresses an interesting issue: Is there a global standard for

governance?

 Extra Example: Is There a Global Standard for Governance?

Various ownership structures, financial market infrastructures, cultural influences, and legal systems create

alternative approaches to corporate governance structures and philosophies in countries around the world. For

example, the governance systems that exist in such markets as the United States, Germany, Japan, China and Russia

are all distinctive and reflect their own political and market economies. The United States is characterized by

dispersed ownership structures, a strong shareholder orientation, and a tradition of “outsider” governance through

independent non-executive directors. Japan and Germany are more stakeholder oriented, have a higher concentration

of ownership and corporate control, and a tradition of “insider” governance involving controlling shareholders as

well as banks or related industrial groups. Russia and China, on the other hand, are undergoing a transition to more

market-oriented economies, and have an insider/outsider mix.

Will such distinctions prevail or will a global governance standard emerge? There is no one country model that has

proven to be ideal; all systems are vulnerable to problems. These include conflicts of interest with controlling

shareholders, ownership rights, stakeholder relations, problems of control and risk management, effectiveness and

independence of board oversight and excessive executive compensation.

In particular, ownership structure can be a key differentiator. The governance concerns of a widely-held firm can be

quite different compared to those with concentrated ownership. Thus, many of the governance practices advocated

in American might fit poorly for closely-held firms in Europe or Asia. However, this does not mean that European or

Asian companies should be passive or complacent. After all, family-owned firms around the world generally benefit

from protecting minority shareholder rights, disclosing relevant financial and non-financial information, and having

a meaningful level of independent board oversight.

What should companies do?

consider governance to be both a source of competitive advantage and a key aspect of enterprise risk

management

regularly review governance structures and practices—particularly for publicly-traded companies wanting to

maintain access to public capital markets

strive to improve transparency and disclosure standards—especially with regard to non-financial risks and

how these are communicated to various stakeholder group

Source: Dallas, G. 2005. Ensuring companies walk the talk. www.euromoneyplc.com, np.

Discussion Question 46: What are the pros and cons of establishing global standards of

governance? Is it a goal worth striving for?

IIV. Issue for Debate

How students respond to this case may be driven by their underlying values. Some

students, who consider CEO pay to be egregiously high, may focus on the inequity and

Discussion Question 47: Is it appropriate for firms to insulate their CEOs pay from bad

luck?

The instructor may wish to poll the class to see if there is a dominant view. If there is, the

instructor may wish to ask someone to express this view and then question the class to get

The key point is that there is no objectively correct answer. However, the viewpoints

expressed typically reflect an individual’s values and views on corporations. Some may argue

The instructor may wish to push the discussion to when and under what conditions it is

appropriate to insulate CEOs from bad luck. Drawing on agency theory arguments, you may

Discussion Question 48: How can firms restructure pay to ensure that the CEOs also don’t

benefit from good luck?

To make the process seem equitable, it would seem that the CEO should not benefit from

good luck if she is going to be insulated from bad luck. One way to do this is to only offer the

 V. Reflecting on Career Implications

Below, we provide some suggestions on how you can lead the discussion on the career

implications for the material in Chapter 9.

Behavioral Control: What types of behavioral control does your organization employ?

Do you find that these behavioral controls help you to do a good job or hinder you from

doing a good job? Some individuals are comfortable with and even desire rules and

Students should understand that at work there is a culture. It determines acceptable dress and

behavior. Ask students for examples of behaviors are not acceptable at their work, but which may

be acceptable in other places. Now ask how the organization enforces these norms. Usually

students will appreciate the subtle and nuanced way that organizational norms are enforced

Setting Boundaries and Constraints: Your career success depends to a great extent on

you monitoring and regulating your own behavior. Setting boundaries and constraints on

yourself can help you focus on strategic priorities, generate short-term objectives and

Personal boundaries are important for students to consider, especially when it comes to ethical

behavior. Ethical behavior directly applies to the business environment, too. Ask students what

ethical behavior they could not ever consider, regardless of the financial reward, such as

Rewards and Incentives: Is your organization’s reward structure fair and equitable? On

what criteria do you base your conclusions? How does the firm define outstanding

performance and reward it? Are these financial or nonfinancial rewards? The absence of

Students can benefit from examination of their organization’s reward structure. One way to look

at rewards is as a form of positive feedback that encourages a firm’s desired behavior. Feedback

can be pecuniary, such as salary, raises, and other compensation; or non-pecuniary, such as

“employee of the month” awards or other recognition. Ask students to list the types of rewards

Culture: Given your career goals, what type of organizational culture would provide the

best work environment? How does your organization’s culture deviate from this concept?

Does your organization have a strong and effective culture? In the long run, how likely

This topic is a continuation of the first one. It personalizes students’ responses to organizational

culture in the long term. In reality, many students will not know the extent to which they can

adapt to an organizational culture, so the goal is not to have them assess whether or not they can

survive in a specific organizational culture. A possible fruitful approach is to have students list