Executive Compensation

1. Executive Compensation

2. Class Announcements • Assignment #8 due March 17th (today); available on-line • Assignment #9 due March 24th; available on-line • Research Paper Part #4 due April 3rd • Business Banquet - April 2nd – 5:45-8pm, Catering - Gabrieau's Bistro; Keynote Speaker - Annette Verschuren, Past President of Home Depot for Canada and Asia

3. Class Objectives • Executive Compensation as an agency contract • Elements of executive compensation contracts • Executive compensation inflation and adjustments

4. Agency Theory: Definition • “Agency theory is branch of game theory that studies the design of contracts to motivate a rational agent to act on behalf of a principal when the agent’s interest would otherwise conflict with those of the principal.”

5. Agency Theory • In agency theory, people are assumed to be rational profit maximizing individuals who will promote self interest. • Agents: • Self-Interested • Have alternative opportunities of use of their time • Choose actions that maximize own expected utility (adverse selection) • Effort-adverse (moral hazard) • Tendency to shirk (moral hazard) • Risk Adverse

6. Agency Theory: Executive Compensation • An executive compensation plan is • an agency contract between the firm and its manager • attempts to align the interests of owners and manager • details the manager’s compensation (bonus, shares, options, salary, benefits, memberships, etc.) • bases on one or more measures (net income and share price) of the manager’s effort in operating the firm.

7. Contracts Necessary: No • 1) Managerial labor market - the present value of reduced future compensation will cause managers to avoid shirking. • 2) Internal monitoring – shirking will be detected and reported by subordinate managers • 3) GAAP limits shirking – accruals reverse

8. Contracts Necessary: Yes • 1) Managing release of information – manager can disguise the effects of shirking by controlling releases of private information • 2) Internal monitoring – internal monitoring is effective if contract is based on joint contract; if the payoff is a joint effort, shirking by either manager will reduce the payoff for both • 3) Reputation – research suggests that internal and market forces (e.g. labour market) help to control not eliminate tendencies to shirk

9. Executive Compensation: Statistics • In Europe business leaders are paid 3 to 40 times the average employees salary and performance is comparable to North American Companies • The average compensation among Canada's top 100 CEOs was $7.96 million in 2012. This compared with the average annual Canadian worker's salary of $46,634. • Highest paid CEO in Canada W. Galen Weston, George Weston Ltd., $5.7-billion; #2. Gerald Schwartz, Onex Corp., $981-million • http://www.theglobeandmail.com/report-on-business/careers/management/executive-compensation/ten-canadian-ceos-with-the-most-valuable-share-holdings/article12147066/?from=12144305

10. Executive Compensation: Canada • How much Canada's top 100 CEOs got paid last year • The Globe and Mail (on-line) • Published Monday, May. 27 2013, 5:00 AM EDT • Last updated Tuesday, Jul. 23 2013, 3:44 PM EDT • http://www.theglobeandmail.com/report-on-business/careers/management/executive-compensation/executive-compensation/article12136604/?from=12145005

11. Executive Compensation: Elements • Several compensation components • Time Horizon • Mix of short term and long term incentive components – balance reward based on current year’s performance and a longer manager decision horizon • Share Ownership • Risk Profile • Risk – upper (i.e.. cap) and lower (i.e.. bogey) limits limit variation in executive compensation caused by uncontrollable events in economy or industry • Incentive • Threshold levels of performance measures – accounting and market based measures • Incentive effects - apparent and measurable • Net income and share price are compliments

12. Executive Compensation: Measures • Company Performance • Total Shareholder Return • Return On Assets • Return On Capital • Return On Equity • EPS Growth • EBITDA Growth • Net Income Growth • See http://www.theglobeandmail.com/report-on-business/careers/management/executive-compensation/bang-for-their-buck-compare-executive-pay-days-with-company-performance/article4232218/?from=4246044

13. Executive Compensation: Net Income • Net income must compete with other measures (e.g. share price) in compensation plans • The efficiency of compensation contact may be increased if it is based on two or more performance measures • Relative proportions of each measure: • a) precision – reciprocal of the variance of the performance (insensitivity to noise trading, market inefficiency, secondly-wide factors) • b) sensitivity – rate at which the expected value of the measure responds to manager effort (limiting earnings manipulation, one year time horizon)

14. Executive Compensation: Risk • Risk and return trade off - the more risk the more return compensation required • Risk avoidance –incentives to exert effort will suffer if not enough risk is imposed • Controlling compensation risk: • Limiting downside risk – too much risk may be dysfunctional and cause only “safe” strategies (bogey) • Limiting upside risk – cap excessive opportunistic risk opportunities which incur a high penalty (cap) • Relative Performance Evaluation (RPE) – reduces manager’s risk while maintaining incentives by setting incentive rewards compared with relative average performance of other firms in industry • Compensation committee

15. Executive Compensation: Politics • Compensation is unrelated to market value: • 1) Pay and performance relationship is low for large firms because of size effect • 2) Small declines in firm value would lead to excessive risk avoidance if compensation is highly tied to performance • 3) Restriction devalue stock options and stock holdings • 4) Disclosure of executive compensation allows market to assess compensation • 5) Corporate governance policies require independence of compensation committee • 6) Power theory – managers influence own compensation • 7) Shareholder activism - say on pay” votes were introduced for shareholders tow years ago

16. Executive Compensation: Inflation • Compensation inflated by: • 1) overblown market valuations • 2) accounting shell games • 3) phantom profits • 4) high tech bubble • 5) lack of transparency

17. Executive Compensation: Adjustments • 1) Alternative options: spin off companies, restricted stock • 2) Improved disclosure (transparency) • 3) Indexed options • 4) Stronger compensation committees • 5) Regulation (e.g. Sarbanes-Oxley Act in US) • 6) Shareholder activism – “say on pay” (2010) • 7) Reversion to bonuses • 8) Performance measures • "Compensation packages paid to chief executive officers have come under intense scrutiny and pressure from shareholders, the media, and the general public. There is no clear relationship between CEO compensation and any measure of corporate performance," Hugh Mackenzie, Canadian Centre for Policy Alternative

18. Class Objectives - Revisited • Executive Compensation as an agency contract • Elements of executive compensation contracts • Executive compensation inflation and adjustments