Chapter 10: Corporate Governance 323in other countries increases the complexity associated with a board of directors’ efforts to
use executive compensation as an effective internal corporate governance mechanism.^9210-3c The Effectiveness of Executive Compensation
As an internal governance mechanism, executive compensation—especially long-term
incentive compensation—is complicated, for several reasons. First, the strategic deci-
sions top-level managers make are complex and nonroutine, meaning that direct super-
vision (even by the firm’s board of directors) is likely to be ineffective as a means of
judging the quality of their decisions. The result is a tendency to link top-level managers’
compensation to outcomes the board can easily evaluate, such as the firm’s financial
performance. This leads to a second issue in that, typically, the effects of top-level man-
agers’ decisions are stronger on the firm’s long-term performance than its short-term
performance. This reality makes it difficult to assess the effects of their decisions on
a regular basis (e.g., annually). Third, a number of other factors affect a firm’s perfor-
mance besides top-level managerial decisions and behavior. Unpredictable changes in
segments (economic, demographic, political/legal, etc.) in the firm’s general environment
(see Chapter 2) make it difficult to separate the effects of top-level managers’ decisions
and the effects (both positive and negative) of changes in the firm’s external environment
on the firm’s performance.
Properly designed and used incentive compensation plans for top-level managers may
increase the value of a firm in line with shareholder expectations, but such plans are sub-
ject to managerial manipulation.^93 Additionally, annual bonuses may provide incentives
to pursue short-run objectives at the expense of the firm’s long-term interests. Although
long-term, performance-based incentives may reduce the temptation to underinvest in
the short run, they increase executive exposure to risks associated with uncontrollable
events, such as market fluctuations and industry decline. The longer term the focus of
incentive compensation, the greater are the long-term risks top-level managers bear. Also,
because long-term incentives tie a manager’s overall wealth to the firm in a way that is
inflexible, such incentives and ownership may not be valued as highly by a manager as
by outside investors who have the opportunity to diversify their wealth in a number of
other financial investments.^94 Thus, firms may have to overcompensate for managers
using long-term incentives.^95 The Strategic Focus provides an examination of some of
the issues that confront boards of directors with regard to how much to pay the CEO.
The media often focuses on the size of the CEO compensation package, especially if it is
exceptionally large and compares it to the pay of the average worker.
Much of the size of CEO pay has been driven by stock options and long-term incen-
tives. Even though some stock option-based compensation plans are well designed with
option strike prices substantially higher than current stock prices, some have been
developed for the primary purpose of giving executives more compensation. Research of
stock option repricing, where the strike price value of the option has been lowered from
its original position, suggests that action is taken more frequently in high-risk situations.^96
However, repricing also happens when firm performance is poor, to restore the incentive
effect for the option. Evidence also suggests that politics are often involved, which has
resulted in “option backdating.”^97 While this evidence shows that no internal governance
mechanism is perfect, some compensation plans accomplish their purpose. For example,
recent research suggests that long-term pay designed to encourage managers to be envi-
ronmentally friendly has been linked to higher success in preventing pollution.^98
As the Strategic Focus suggests, this internal governance mechanism is likely to continue
receiving a great deal of scrutiny in the years to come. When designed properly and used
effectively, each of the three internal governance mechanisms can contribute positively to
the firm operating in ways that best serve stakeholders and especially shareholders’ interests.