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This chapter discusses the traditional approach to agency conflicts and corporate governance in behavioral corporate finance. It explores the goals of compensation contracts and the challenges faced by directors in structuring incentives appropriately. The role of overconfidence among directors and executives is examined, along with the impact on executive compensation policies. The chapter also covers the implications of stock options-based compensation and auditing in the context of agency conflicts and prospect theory.
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Chapter 8 AGENCY CONFLICTS AND CORPORATE GOVERNANCE Behavioral Corporate Finance by Hersh Shefrin
Traditional Approach to Agency Conflicts • Agency theory is used to study the structure of compensation contracts that principals offer to agents engaged to act on their behalf. • In the corporate governance setting, shareholders are the principals, the board of directors is charged with representing the interests of shareholders, and the firm’s managers are the agents.
Cont.. • Rational Principals offer contracts to rational agents that combine positive rewards and penalties, with three goals in mind. • The principal’s first goal is to offer the agent a contract that is at least as attractive as the agent’s next best alternative, inorder to induce the agent to principal. This goal is known as the Participation Constraint.
Cont.. • The second goal is to set the differential between the carrot and stick components so as to induce the agent to represent the interest of principal. This goal, the alignment of manager’s interests and investors’ interests, is known as the incentive compatibility constraint. • The third goal is for the contract not to be unduly generous to the agent. This goal is known as the nonoverpayment constraint.
Paying For Performance In Practice • Executive compensation displays • too little variability in respect to pay for performance • insufficient dismissal • excessive payment • Directors are overconfident in their ability to structure incentives appropriately without overpaying executives. • Directors' tasks are made more difficult by the overconfidence of executives.
Overconfidence among directors and executives • Overconfidence on the part of directors will lead them to underestimate the extent of both traditional agency conflicts and behavioral biases on the part of executives that contribute to those conflicts. • Overconfident directors will be inclined to think that they can do better job of addressing agency conflicts that they do.
Cont.. • In consequence, overconfident directors will be prone to approve compensation policies that exhibit insufficient pay for performance and that overpay executives. • An important facet of overconfidence is self attribution error, the tendency for people to take credit for positive outcomes and to blame others or bad luck for negative outcomes.
Cont.. • Another important facet of overconfidence is the better than average effect. The better than average effect involves more people viewing themselves as above the median in ability than below the median.
Stock Options-Based Compensation • Excessively optimistic employees overvalue stock options. • Managers who behave in accordance with prospect theory might find the risk characteristics of stock options attractive because of the casino effect. • Risk seeking behavior resulting from overweighting low probabilities.
Auditing:Agency Conflicts And Prospect Theory • Auditors are vulnerable to being “bribed” by unscrupulous firms in order to issue clean options. • Audit firms are partnerships, not corporations. • Traditional view holds that auditing firms have reputations for integrity to protect.
Policy 2X • In 1997, the partners at Andersen Consulting voted to split off completely from Arthur Andersen to become Accenture. • In the wake of their departure Arthur Andersen instituted a policy known as “2X.” • Under 2X, for every dollar of auditing work, partners were required to bring in twice the revenue in non-auditing work.
Conflicts of Interest: Arthur Andersen • Consulting division became much more profitable than the auditing division. • In 1989, the consultants managed to alter the profit-sharing rule, in their favor. • The change in sharing rule left the auditors lagging behind those of attorneys, investment bankers, and especially consultants.
Sarbanes-Oxley • In the wake of these financial scandals, Congress passed the Sarbanes-Oxley Act of 2002. • SEC requires that the CEO and CFO of every publicly traded firm certify, under oath, the veracity of their firm’s financial statements.
Example: HealthSouth • First firm charged under Sarbanes-Oxley. • The SEC accused HealthSouth executives of having engaged in insider trading. • Executives sold substantial amounts of HealthSouth stock while they knew that the firm’s financial statements grossly misstated its earnings and assets.
HealthSouth Executives • Five former HealthSouth CFOs pled guilty to charges. • HealthSouth CEO claimed he was victim of deception by his CFOs and was acquitted. • Government attorneys dismayed at failure of first prosecution under Sarbanes-Oxley.
Fraud and stock options: Illustrative Example • In theory, granting stock to executives serves to align their interests with those of shareholders. • In theory, executive stock options serve to counteract executives reluctance to accept risky projects that would benefit shareholders. • An implicit assumption in traditional theory is that market prices are efficient.
Cont.. • In practice, prices might be inefficient, and the use of stocks and stock options can provide managers with perverse incentives. • Indeed, the granting of stock options might serve to induce managers to accept risky projects that feature negative net present value.
